178.200 06-9

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178.200 Intermediate MacroeconomicsTutorial (9)

Policy & Debt

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Short Answer Questions

1. Suppose a economy is initially at point A on the graph.

(a) Compare the effects of the passive and the active policy responses to the fluctuations in real output.

A

P

Y

SRAS

AD

YN

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Short Answer QuestionsAnswer: At point A, the real

output YA is less than the natural rate of output YN. Hence, the actual price level P must be less than the expected price level PE. In the future years, PE will fall.

A

P

Y

SRAS

AD

YA YN

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Short Answer QuestionsAnswer: (continued) If macroeconomic policies

remain unchanged, a decrease in PE leads to shift the aggregate supply curve to the right until eventually actual output equal to YN.

Therefore, if no policy response is taken, real output will eventually rise and the price level will fall.

A

P

Y

SRAS1

AD

YA YN

SRAS2

PA

PN

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Answer: (continued) If policymakers want

to increase output to the natural rate quickly, they could increase M, or G, or decrease T. These policies would shift the AD curve to the right.

A

P

Y

SRAS

AD1

YN

AD2

YA

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Answer: (continued)

Thus, if an active policy response is taken, real output will rise and the price level will also rise.

A

P

Y

SRAS

AD1

YN

AD2

YA

PA

PN

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(b) Briefly explain the limitations when the active policy measures are taken to stabilize output.

Answer: One limitation of active policy concerns is

that fiscal policy has a relatively long inside lag whereas monetary policy has a relatively long outside lag.

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Answer: (continued)

Another limitation is that the track record of economic forecasts has not been especially good. Finally, policymakers occasionally seem to be unwilling or unable to implement the appropriate macroeconomic policies due to political considerations.

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2. Analysis the short run effect of tax cuts according to the traditional view of government debt.

Answer:

In a closed economy in the short run, a tax cut will shift the IS curve to the right. This shift will increase the consumption, the real income, and the real interest rate. As a result, investment will fall and the tax cut partially crowds out investment.

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Answer: (continued)

In a small open economy, the real interest rate is fixed at the world interest rate. If the foreign exchange rate is floating, a tax cut will lead to an appreciation of the domestic currency and national income will be unchanged. Disposable income and consumption, however, will increase and the tax cut will completely crowd out net export.

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Answer: (continued)

If the foreign exchange rate is fixed, the tax cut will increase real income and increase on consumption. To maintain the fixed exchange rate, the central bank will have to increase the money supply.

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Multiple-Choice Questions(2005 Exam Question)

(1) The following statement is TRUE:a. Monetary policy has an especially long outside

lag.b. Fiscal policy has an especially long inside lag.c. Automatic stabilizers eliminate part of the inside

lag in the conduct of fiscal policy.d. All of the above.Answer: d.Hint: P382.

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Multiple-Choice Questions(2005 Exam Question)(2) Arguments against the use of active stabilization

policy include all of the following EXCEPT the:a. existence of long inside and outside lags.b. limited ability of economic forecasters to predict

future economic conditions accurately.c. responsiveness of labor force participation rates to

changes in national output.d. historical view that ill-advised policy choices

were the cause of the Great Depression.Answer: c.Hint: PP382-387

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(3)The system of unemployment insurance can be used to illustrate:

a. the time inconsistency of policy.b. the way that the economy is automatically

stabilized in the event of a shock.c. the Lucas critique.d. long inside lags in policy implementation.Answer: b.Hint: P383.

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Multiple-Choice Questions (2005 Exam Question)

(4) Suppose that the index of leading indicators falls. Economic forecasters will expect all of the following to occur EXCEPT:

a. the unemployment rate will increase.b. real output growth will decrease.c. inflation will increase.d. tax revenue growth will decrease.Answer: c.Hint: P383.

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Multiple-Choice Questions(2005 Exam Question)(5) According to the Lucas critique:a. traditional methods of policy evaluation do not

adequately account for the impact of policy changes on expectations.

b. traditional estimates of the sacrifice ratio are unreliable.

c. economists cannot be completely confident when they make assessments about the effects of alternative economic policies.

d. all of the above.Answer: d.Hint: P386.

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Multiple-Choice Questions(2005 Exam Question)(6) The following statement is FALSE:a. A policy that is active cannot be conducted by rule.b. The problem of time inconsistency is especially

relevant to policy conducted by discretion.c. The conflicting interests of politicians reduce the

desirability of policy conducted by discretion compared with policy conducted by rule.

d. Monetary policy currently is conducted by discretion.

Answer: a.Hint: P394.

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Multiple-Choice Questions(2005 Exam Question)(7) If the Reserve Bank conducts monetary policy by setting a

targeted unemployment rate of 5.5%, then the :a. Unemployment rate will fall above or below 5.5%.b. Natural rate of unemployment will converge to the

Reserve Bank’s target.c. Reserve Bank will increase the growth rate of the money

supply whenever unemployment exceeds this targeted rate.

d. Reserve Bank will adjust its target whenever unemployment deviates from this rate.

Answer: c.Hint: P389.

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(8) The stock of government debt is equal to:a. the current government budget deficit.b. the total debt of all individuals in the

nation.c. the outstanding debt of the government.d. government expenditures minus the tax

revenues.Answer: c.

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(9) Most economists believe that the budget deficit should measure the change in the government’s:

a. nominal debt.

b. real debt.

c. tax revenues.

d. fiscal policy.

Answer: b.

Hint: P410.

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Multiple-Choice Questions(2005 Exam Question)(10) During periods of inflation, the official measure of

the budget deficit:a. overstates the change in the government’s real

indebtedness.b. understates the change in the government’s real

indebtedness.c. equals the change in the government’s real

indebtedness.d. should equal the expected rate of inflation.Answer: a.Hint: P410.

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Multiple-Choice Questions(2005 Exam Question)(11) During recessions the:a. actual budget deficit will be smaller than the

cyclically adjusted budget deficit.b. actual budget deficit will be greater than the

cyclically adjusted budget deficit.c. actual budget deficit will be equal to the cyclically

adjusted budget deficit.d. cyclically adjusted budget deficit will always be

positive.Answer: b.Hint: P412.

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(12) According to the traditional view of government debt, a tax cut will lead to all of the following in the short run EXCEPT a(n):

a. increase in consumption.b. increase in private saving.c. increase in investment.d. decrease in public saving.Answer: c.Hint: P414.

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(13) According to the traditional view of government debt, a tax cut will lead to all of the following in the long run EXCEPT a:

a. decreasing in public saving.b. decreasing in national saving.c. decreasing net exports.d. depreciation of the foreign exchange rate.Answer: d.Hint: P414.

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Multiple-Choice Questions(2005 Exam Question)(14) According to the Ricardian view of government

debt, consumers will treat a current tax cut as an increase in:

a. their wealth.b. the sum of their current and expected future

income.c. their current disposable income accompanied by a

future tax increase.d. public saving.Answer: c.Hint: P416.

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(15) According to the Ricardian view of government debt, a current tax cut will:

a. decrease public saving.

b. increasing private saving.

c. have no effect on national saving.

d. all of the above.

Answer: d.

Hint: P416.

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(16) According to the Ricardian view of government debt, the relevant decision-making unit is the:

a. infinitely lived family.

b. finitely lived family.

c. finitely lived individual.

d. infinitely lived world community.

Answer: a.

Hint: P419.

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(17) High budget deficits may:a. encourage excessively expansionary monetary

policy.b. increase the risk of government default on its debt.c. reduce a nation’s political influence throughout the

world.d. all of the above.Answer: d.Hint: PP424-425.

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(18) If higher deficits raise fears of default on a country’s national debt:

a. domestic interest rates will rise.

b. the foreign exchange rate will depreciate.

c. capital flight may occur.

d. all of the above.

Answer: d.

Hint: PP424-425.

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(19) Indexed government bonds:a. have higher interest rates than nonindexed

bonds.b. reduce the government’s incentive to produce

surprise inflation.c. were introduced in US in 1948.d. all of the above.Answer: b.Hint: P426.

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(20) Adherence to a balanced-budget rule by the federal government results in:

a. an inability to use monetary policy to stimulate the economy when it slips into a recession.

b. persistent inflation.c. an inability to lower tax rates to stimulate the

economy when it slips into a recession.d. all of the above.Answer: c.Hint: P422.

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