Macro Tut 8: Monetary and Fiscal Policy

Multiple Choice: Identify the choice that best completes the statement or answers the question.

1. Fiscal policy refers to the idea that aggregate demand is affected by changes in
a. the money supply.
b. government spending and taxes.
c. trade policy.
d. All of the above are correct.

2. In a certain economy, when income is $100, consumer spending is $60. The value of the multiplier for this
economy is 3. It follows that, when income is $101, consumer spending is
a. $60.60.
b. $60.67.
c. $61.33.
d. $63.00.

Scenario 34-1. Take the following information as given for a small, imaginary economy:
•When income is $10,000, consumption spending is $6,500.
•When income is $11,000, consumption spending is $7,300.

3. Refer to Scenario 34-1. For this economy, an initial increase of $500 in net exports translates into a
a. $2,000 increase in aggregate demand when the crowding-out effect is taken into account.
b. $2,500 increase in aggregate demand when the crowding-out effect is taken into account.
c. $2,000 increase in aggregate demand in the absence of the crowding-out effect.
d. $2,500 increase in aggregate demand in the absence of the crowding-out effect.

4. A decrease in government spending

a. increases the interest rate and so investment spending increases.
b. increases the interest rate and so decreases investment spending decreases.
c. decreases the interest rate and so investment spending increases.
d. decreases the interest rate and so investment spending decreases.

5. If the marginal propensity to consume is 5/6, and there is no investment accelerator or crowding out, a $20
billion increase in government expenditures would shift the aggregate demand curve right by
a. $60 billion, but the effect would be larger if there were an investment accelerator.
b. $60 billion, but the effect would be smaller if there were an investment accelerator.
c. $120 billion, but the effect would be larger if there were an investment accelerator.
d. $120 billion, but the effect would be smaller if there were an investment accelerator.

6. Assume the MPC is 0.75. The multiplier is

a. 0.75.
b. 1.25.
c. 4.00.
d. 6.25.

7. Assume the MPC is 0.75. Assume there is a multiplier effect and that the total crowding-out effect is $6
billion. An increase in government purchases of $10 billion will shift aggregate demand to the
a. left by $24 billion.
b. left by $36 billion.
c. right by $34 billion.
d. right by $36 billion.

8. If a $1,000 increase in income leads to a $750 increase in consumption expenditures, then the marginal
propensity to consume is
a. 0.75 and the multiplier is 1 1/3.
b. 0.75 and the multiplier is 4.
c. 0.25 and the multiplier is 1 1/3.
d. 0.25 and the multiplier is 4.

9. As income rises
a. money demand rises, so the interest rate rises.
b. money demand rises, so the interest rate falls
c. money demand falls, so the interest rate rises.
d. money demand falls, so the interest rate falls.

10. Initially, the economy is in long-run equilibrium. The aggregate demand curve then shifts $80 billion to the
left. The government wants to change spending to offset this decrease in demand. The MPC is 0.75. Suppose
the effect on aggregate demand of a tax change is 3/4 as strong as the effect of a change in government
expenditure. There is no crowding out and no accelerator effect. What should the government do if it wants to
offset the decrease in real GDP?
a. Raise both taxes and expenditures by $80 billion dollars.
b. Raise both taxes and expenditures by $10 billion dollars.
c. Reduce both taxes and expenditures by $80 billion dollars.
d. Reduce both taxes and expenditures by $10 billion dollars.

11. Suppose the MPC is 0.75. There are no crowding out or investment accelerator effects. If the government
increases its expenditures by $200 billion, then by how much does aggregate demand shift to the right? If the
government decreases taxes by $200 billion, then by how far does aggregate demand shift to the right?
a. $800 billion and $800 billion
b. $800 billion and $600 billion
c. $600 billion and $600 billion
d. $600 billion and $450 billion

12. A tax cut shifts aggregate demand

a. by more than the amount of the tax cut.
b. by the same amount as the tax cut.
c. by less than the tax cut.
d. None of the above is necessarily correct.

13. An increase in government spending on goods to build or repair infrastructure

a. shifts the aggregate demand curve to the right.
b. has a multiplier effect.
c. shifts the aggregate supply curve to the right, but this effect is likely more important in the long run.
d. All of the above are correct.

14. In the early 1960s, the Kennedy administration made considerable use of
a. fiscal policy to stimulate the economy.
b. fiscal policy to slow down the economy.
c. monetary policy to stimulate the economy.
d. monetary policy to slow down the economy.

For the following questions, use the diagram below:

Figure 34-6.
15. Refer to Figure 34-6. Which of the following is correct?
a. A wave of optimism could move the economy from point a to point b.
b. If aggregate demand moves from AD1 to AD2, the economy will stay at point b in both the short run
and long run.
c. It is possible that either fiscal or monetary policy might have caused the shift from AD1 to AD
d. All of the above are correct.

16. When the Fed lowers the growth rate of the money supply, it must take into account
a. only the short-run effect on production.
b. only the short-run effects on inflation and production.
c. only the long-run effect on inflation.
d. the long-run effect on inflation as well as the short-run effect on production.

27. Which of the following is not an automatic stabilizer?

a. the minimum wage
b. the unemployment compensation system
c. the federal income tax
d. the welfare system

EXERCISES AND PROBLEMS:

Exercise 1: Fill the blank with NO MORE THAN 4 WORDS:

 1. Both monetary policy and fiscal policy affect …………………
2. Stock prices often ……………….. when the Fed raises interest rates
3. If the marginal propensity to consume is 4/5, then a decrease in government spending of $1
billion decreases the demand for goods and services by ………………….
4. Both the multiplier effect and the …………………… tend to make the aggregate-demand curve
shift further than it does due to an initial increase in government expenditures.
5. If the inflation rate is zero, then the ………………………….. and …………………… are equal
6. An increase in the money supply decreases the equilibrium ………………………… and shifts the aggregate-
demand curve to the right

Exercise 2: Find the underlined parts that are incorrect in these statements and correct them:
7. In principle, the government could increase the money supply or increase tax to try to offset the
A B C
effects of a wave of pessimism about the future of the economy.
D
8. Changes in monetary policy aimed at reducing aggregate demand involve decreasing the money
A B
C
supply or increasing the exchange rate.
D
9. In liquidity preference theory, an increase in the interest rate, other things the same, decreases
A
the quantity of money supplied, but does not shift the money demand curve.
B C D
10. When the Fed increases the money demand, the interest rate decreases. This decrease in the
A
interest rate increases consumption and investment demand, so the aggregate-demand curve
B C
shifts to the right.
D
11. During economic boom, unemployment insurance payments tend to rise.
A B C D

Problem 1:
For each of the following scenarios, identify whether it is an example of expansionary
discretionary fiscal policy, contractionary discretionary fiscal policy, or an automatic
stabilizer.
a. During 2006, tax revenue for Macrovia falls as the economy enters a recession.
b. During 2006, in light of projected deficiencies in AD, Macrovia’s legislation
authorizes an expenditure of $200 million to build a new hydroelectric dam.
c. In 2009, fearing a too rapidly expanding economy, Macrovia adopts a budget that calls
for 10% spending cuts in all government departments for the following fiscal year.
d. In 2008, unemployment benefits rise 5% in response to rising unemployment in
Macrovia.

Problem 2:
Suppose you are given the following information about Macroland, a small, closed economy.
Assume that government spending is currently $0, taxes are constant at $50, and the aggregate
price level is originally fixed at $100.
Consumption
Year Real GDP Taxes Spending Planned Investment
Spending
1 $100 $50 $40 $50
2 150 50 80 50
3 300 50 200 50
a. Fill in the following table, using the information given above.
Year Disposable Income
1
2
3
b. What is the MPC for this economy?
c. What is the value of the spending multiplier for this economy?

Problem 3:
Funlandia’s economists estimate its potential output is $100 in year 1 and grows 5% per year. Assume
Funlandia is a closed economy.
a. Fill in the following table for Funlandia, given the above information.
Year Potential output
1 $100
2
3
4

b. Suppose Funlandia’s economists provide you with the following data. (All numbers are in
dollars.)

Actual
Year Potential output Taxes (T) Disposable Consumption Investment Government
spending
output income (YD) spending (C) spending (I) (G)
1 100 10 90 55 30 15
2 104 10 30 17
3 115 10 30 22.5
4 10 108 64 30 24
c. Fill in the missing values for the table, using the information you have been given or that you
computed in parts (a) and (b).
d. Fill in the following table for Funlandia.

Year Recessionary gap Inflationary gap Actual output equals

potential output
1 No No Yes
2
3
4
e. Suppose Funlandia maintains a policy of using discretionary fiscal policy to ensure that
actual output equals potential output. Summarize the recommended discretionary fiscal
policy necessary to achieve this goal in the following table.
Year Discretionary fiscal policy
1
2
3
4