Economics/05 Monetary and Fiscal Policy

Monetary and Fiscal Policy Test ID: 7694022
Question #1 of 88 Question ID: 413855
The primary objective of a central bank is to:
A) achieve full employment.
B) stabilize exchange rates.

C) control inflation.
Explanation
Although some central banks have other stated goals including stabilizing exchange rates and achieving full employment,
the primary objective for a central bank is to control inflation and promote price stability.
If a monetary policy is focused on combating inflation, which open market actions by the Federal Reserve will most
effectively accomplish this?
A) Sell Treasury securities, causing aggregate demand to decrease.
B) Purchase Treasury securities, causing aggregate demand to decrease. C)

Sell Treasury securities, causing aggregate demand to increase.
Explanation
If the Federal Reserve wants to slow inflation, it needs to decrease aggregate demand (i.e., business investment,
consumer purchases of durable goods, and exports). To accomplish this, the Federal Reserve could engage in open
market sales of Treasury securities.
Arguments against being concerned about the size of a fiscal deficit include:
A) the crowding-out effect.
B) Ricardian equivalence.
C) higher future taxes.
Explanation
Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase
because the effect on the total level of demand in the economy is the same. Arguments for being concerned about the size of
the fiscal deficit include the crowding-out effect of government borrowing taking the place of private sector borrowing and the
negative effects on work incentives and entrepreneurship from higher future taxes.
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On January 3, Logan Industries deposited $1,000,000 in cash at Federal Savings Bank. No excess reserves were present at
the time Logan made the deposit and the required reserve ratio is 10%. What is the maximum amount by which Federal
Savings Bank can increase its lending?
A) $100,000.
B) $10,000,000.
C) $900,000.
Explanation
Since there are no excess reserves present at the time that Logan deposited the money, the bank would be required to
maintain $100,000 ($1,000,000 × 0.10) on reserve and would b e able to loan out or increase the money supply by $900,000.
If households are holding larger real money balances than they desire, which of the following is least likely?
A) The interest rate is higher than its equilibrium rate in the market for real money balances.
B) The opportunity cost of holding money balances will decrease.
C) The central bank must sell securities to absorb the excess money supply and establish equilibrium.
Explanation
If households' real money balances are larger than they desire, the interest rate (opportunity cost of holding money balances)
is higher than its equilibrium rate. Households will use their undesired excess cash to buy securities, bidding up securities
prices and reducing the interest rate toward equilibrium. This market process does not require any action by the central bank.
Which of the following statements best explains how automatic stabilizers work? Even without a change in fiscal policy,
automatic stabilizers tend to promote:
A) a budget surplus during a recession and a budget deficit during an inflationary expansion.
B) a budget deficit during a recession but do not promote a budget surplus during an
inflationary expansion.
C) a budget deficit during a recession and a budget surplus during an inflationary expansion.
Explanation
Automatic stabilizers such as unemployment compensation, corporate profits tax, and the progressive income tax run a
deficit during a business slowdown but run a surplus during an economic expansion. Therefore, they automatically
implement countercyclical fiscal policy without the delays associated with policy changes that require legislative action.
When additional or excess reserves are injected into the U.S. banking system, the money supply can potentially increase by an
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amount equal to the additional excess reserves multiplied by which of the following?
A) Required reserve ratio.

B) Reciprocal of the required reserve ratio.
C) Reciprocal of one minus the required reserve ratio.
Explanation
The potential deposit expansion multiplier = 1 / (required reserve ratio)
The potential increase in the money supply = potential deposit expansion multiplier × increase in exce ss reserves
Which of the following relationships in regard to the quantity theory of money is least accurate?
A) Money × Velocity = Money Supply × Velocity.
B) Nominal GDP = Price × Money Supply.
C) Nominal GDP = Money Supply × Velocity = Price × Real Ou tput.
Explanation
The quantity theory of money holds that: Money Supply × Velocity = Nominal GDP = Price × Real Output.
Which of the following policy tools is the least likely to be available to the U.S. Federal Reserve Board?
A) Setting the discount rate at which banks can borrow from the Federal Reserve.
B) Requiring the banking system to tighten or loosen its credit

policies. C) Buying and selling Treasury securities in the open market.
Explanation
The U.S. Federal Reserve can encourage or persuade banks as a whole to tighten or loosen their credit policies, but it
cannot compel them to do so.
If a country's economy is growing at an unsustainably rapid rate and the central bank decreases its target overnight interest
rate, the country's:
A) expected rate of inflation is likely to decline.
B) long-term rate of economic growth will increase.

C) inflation rate is likely to increase.
Explanation
The central bank should increase target interest rates when the economy is growing at an unsustainable (above-full-employment)
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level. Decreasing the target overnight rate is likely to further increase aggregate demand and cause inflation to accelerate,
which will be detrimental to the long-term growth rate of the economy.
The amount of money a commercial bank has available to lend is known as:
A) required reserves.
B) excess reserves.
C) fractional reserves.
Explanation
Excess reserves are the amount of money a commercial bank has available with which to make new loans, after depositing
its required reserves with the central bank.
Which of the following statements regarding the monetary policy transmission mechanism is most accurate?
A) Central banks can control long-term interest rates directly because decisions by consumers and
businesses are based on these rates.
B) Central banks can control short-term interest rates by increasing the money supply to
increase interest rates or by decreasing the money supply to decrease interest rates.
C) Central banks can control short-term interest rates directly, but long-term interest rates are
beyond their control.
Explanation
Central banks can control short-term interest rates directly. However, the decisions of consumers and businesses are based
on long-term interest rates, which are beyond the control of central banks. Increasing the money supply will decrease interest
rates and decreasing the money supply will increase interest rates.
The supply of money is primarily determined by:
A) the monetary authorities.
B) interest rates.
C) inflation.
Explanation
The monetary authorities determine the quantity of money available to the economy. Inflation and interest rates affect the demand for
money balances.
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When the Federal Reserve sells government securities on the open market, bank reserves are:
A) decreased, which reduces the amount of money banks are able to lend, causing an increase in
the federal funds rate.
B) increased, which increases the amount of money banks are able to lend, causing a decrease in
C) decreased, which reduces the amount of money banks are able to lend, causing a decrease in
Explanation
When the Federal Reserve wants to increase the federal funds rate through open market operations, it sells
government securities. Open-market sales reduce bank reserves and cause the federal funds rate to increase.
The most likely reason for deflation to persist despite expansionary monetary policy is:
A) inelastic demand for money.

B) a liquidity trap.
C) bond market vigilantes.
Explanation
Deflation is often associated with liquidity trap conditions. A liquidity trap is a situation in which demand for money becomes
highly elastic. Expanding the money supply has little effect on economic activity under these conditions because individuals
and firms choose to hold the additional money in cash. "Bond market vigilantes" is an expression referring to the fact that
expansionary monetary policy may cause long-term interest rates to increase, instead of decreasing as intended, if bond
market participants expect the expansionary policy to increase future inflation rates.
Banks choose to hold a higher percentage of deposits as reserves because they believe general business conditions in
the economy are subject to greater uncertainty. If all else is held constant, what is the most likely impact of this action?
A) There will be no effect on the money supply.

B) The money supply will decrease.
C) The money supply will increase during a period of inflation, but will decrease if the economy
goes into a recession.
Explanation
If banks choose to hold excess reserves, they will decrease their lending. Less bank lending will cause the money supply
to decrease.

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An economy's long-term trend rate of real GDP growth is 3% and the central bank's target inflation rate is 2%. If the policy rate
is 6%, monetary policy is:
A) contractionary.
B) expansionary.
C) neutral.
Explanation
Monetary policy is contractionary when the policy rate is greater than the neutral rate, which is the sum of the real trend rate of
economic growth and the target rate of inflation. Here, the neutral rate is 3% + 2% = 5% and the policy rate of 6% is greater
than the neutral rate. Monetary policy is expansionary when the policy rate is less than the neutral interest rate.
Policies that can be used as tools for redistribution of wealth and income include:
A) both fiscal policy and monetary policy.
B) monetary policy only.

C) fiscal policy only.
Explanation
Fiscal policy can be used as a tool for redistribution of income and wealth, through a variety of taxation and spending policies.
Which one of the following Federal Reserve monetary policies, when pursued in line with the U.S. government's fiscal
policies, would help increase aggregate demand during a period of high unemployment?
A) A decrease in the discount rate.
B) An increase in the reserve requirements for financial

institutions. C) The sale of bonds by the Fed.
Explanation
A decrease in the Fed's lending rate is a monetary tool that the Fed can use to increase the money supply, thereby
increasing aggregate demand during recessionary times when there is high unemployment. An increase in the reserve
requirements and the sale of bonds by the Fed would all be restrictive monetary policies that would reduce the amount of
money in the economy and reduce aggregate demand.
If a central bank implements an exchange rate targeting policy successfully, the country's inflation rate is most likely to be:
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A) less than that of the target currency.
B) the same as that of the target currency.

C) greater than that of the target currency.
Explanation
Successful exchange rate targeting should result in the same inflation rate in the targeting country as in the country of the
target currency.
The three reasons for holding money are most accurately described as:
A) transaction demand, precautionary demand, and speculative demand.
B) broad money demand, narrow money demand, and transaction demand. C)

narrow money demand, precautionary demand, and speculative demand.
Explanation
The three reasons for holding money are: transaction demand, for buying goods and services; precautionary demand, to
meet unforeseen future needs; and speculative demand, to take advantage of investment opportunities. Narrow money and
broad money refer to measures of money in circulation.
The Fisher effect holds that a nominal rate of interest equals a real rate:
A) plus actual inflation.
B) minus expected inflation.

C) plus expected inflation.
Explanation
The Fisher effect states that a nominal rate of interest equals a real rate plus expected inflation.
A government that is implementing a contractionary fiscal policy is most likely to:
A) decrease transfer payments to households.
B) increase spending on public works.

C) decrease income tax rates.
Explanation
Decreasing spending or increasing taxes are contractionary fiscal policy actions. Increasing spending or decreasing taxes
are expansionary.
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Contractionary monetary policy is least likely to decrease consumption spending by decreasing:
A) expectations for economic growth.
B) the foreign exchange value of the currency.

C) securities prices.
Explanation
Contractionary monetary policy is likely to increase the value of the domestic currency in the foreign exchange market, which
decreases foreign demand for the country's exports. Contractionary monetary policy should cause both securities prices and
expectations for economic growth to decrease, each of which is likely to cause consumers to decrease spending.
If the money interest rate is measured on the y-axis and the quantity of money is measured on the x-axis, the money
supply curve is:
A) vertical.
B) downward sloping to the lower right.

C) upward sloping to the upper right.
Explanation
The money supply schedule is vertical because it is not affected by changes in the interest rate but is determined by
the monetary authorities such as the Federal Reserve System (Fed) in the United States.
Unemployment compensation is an example of:
A) an automatic fiscal policy stabilizer.
B) a discretionary fiscal policy stabilizer. C)

an automatic monetary policy stabilizer.
Explanation
Unemployment compensation automatically rises and falls with the business cycle, therefore it is an example of an
automatic fiscal policy stabilizer.
The time it takes for policy makers to enact a fiscal policy action is best described as:
A) legislative lag.
B) action lag.
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C) implementation lag.
Explanation
The time it takes for fiscal policy actions to be proposed, approved, and implemented is referred to as action lag.
Monetary policy refers to actions that influence economic activity by increasing or decreasing:
A) tax rates on income and consumption.

B) the supply of money and credit.
C) government purchases of goods and services.
Explanation
Monetary policy attempts to influence economic growth and inflation by increasing or decreasing the money supply and
the availability of credit in the economy. Taxes and government spending are tools of fiscal policy.
Which of the following statements about the relationship between interest rates and the demand for and supply of money is most accurate?
Interest rates affect:
A) the supply of money only.
B) the demand for money only.
C) both the demand for and supply of money.
Explanation
Interest rates only affect the demand for money. With higher interest rates, the opportunity cost of holding money increases, and people hold
less money and more interest-earning assets. Monetary authorities determine the supply of money. Therefore, the supply of money is
independent of the interest rate.
Central banks pursuing expansionary policies may:
A) decrease the policy rate and make open market sales of securities.
B) increase the policy rate and make open market purchases of securities. C)
decrease the policy rate and make open market purchases of securities.
Explanation
Decreasing the policy rate, decreasing reserve requirements, and purchasing securities in the open market are
expansionary monetary policy actions.
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Arguments for being concerned about the size of a fiscal deficit least likely include:
A) Ricardian equivalence.
B) a reduction in long-term economic growth.

C) the crowding-out effect.
Explanation
If Ricardian equivalence holds, private savings will increase in anticipation of the future taxes required by a fiscal deficit. The
crowding-out effect of government borrowing on private investment and the reduction in long-term economic growth due to
higher future taxes argue in favor of being concerned about the size of a fiscal deficit.
The government is reducing its spending to balance the budget, while the central bank is lowering its official policy rate. What
will most likely be the combined effect on the economy?
A) The public and private sectors as a percentage of GDP will neither decrease nor increase.
B) The private sector as a percentage of GDP will increase. C)

The public sector as a percentage of GDP will increase.
Explanation
The private sector will expand as a percentage of GDP because (1) the public sector will decrease as a percentage of GDP
due to government spending cuts and (2) lower interest rates should cause the private sector to expand.
Central banks that are able to define how inflation is computed and determine its desired level are best described as having:
A) target independence.
B) transparency.
C) operational independence.
Explanation
Target independence means the central bank defines how inflation is computed, sets the target inflation level, and determines
the horizon over which the target is to be achieved. Central banks that have operational independence are allowed to
determine the policy rate. Transparency refers to the degree to which central banks report to the public on the state of the
economic environment and is one of the three essential qualities of an effective central bank.
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Xanadu attempts to decrease its inflation rate by implementing contractionary monetary policy. Which of the following is
most likely to be the long-run effect on Xanadu's trade balance as a result of the monetary policy change?
A) Improve.
B) Worsen.
C) Remain the same.
Explanation
Contractionary monetary policy likely will cause higher domestic interest rates and attract foreign capital. As foreign capital
flows in, the currency will appreciate relative to other currencies. The higher cost of its currency will result in higher cost
exports that become less attractive to other countries. Xanadu's trade balance will most likely worsen.
Discretionary fiscal policy refers to:
A) built-in devices that counteract the business cycle phase.
B) active decisions regarding spending and taxing to affect economic

growth. C) increasing aggregate demand through lower interest rates.
Explanation
Discretionary fiscal policy, in contrast to automatic stabilizers, refers to active decisions by the government to affect
economic growth through changes in government spending and taxation. Increasing aggregate demand through lower
interest rates describes expansionary monetary policy.
What are the three essential qualities an effective central bank should possess?
A) Understandability, relevance, and reliability.
B) Transparency, comprehensiveness, and consistency.

C) Independence, credibility, and transparency.
Explanation
A central bank that is independent from political interference, possesses credibility, and exhibits transparency is more likely to
achieve its monetary policy objectives than a central bank that lacks these qualities. The characteristics listed in the other
answer choices relate to financial statements and financial reporting standards.
The term "automatic stabilizers" refers to the fact that:
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A) with given tax rates and expenditure policies, a rise in national income tends to produce a surplus, while a
decline tends to result in a deficit.
B) government expenditures and tax receipts automatically balance over the course of the business cycle,
although they may be out of balance in any single year.
C) legislators automatically change the tax structure and expenditure programs to correct upswings and
downswings in business activity.
Explanation
Automatic stabilizers are built-in fiscal devices that ensure deficits in a recession and surpluses during booms. Automatic stabilizers
minimize the problem of proper timing.
The country of Zurkistan is experiencing both high interest rates and high inflation. The government passes laws that
reduce government spending and increase taxes. It takes many months before interest rates fall and inflation is reduced.
This is an example of:
A) action lag and automatic stabilizers.
B) recognition lag in discretionary fiscal policy.

C) impact lag in discretionary fiscal policy.
Explanation
This is an example of discretionary fiscal policy involving impact lag because it takes time for the impact of the change in
taxing and spending to be felt throughout the economy.
An analyst has determined the projected trend rate of real GDP growth is 2.5% and the central bank's inflation target is 2.5%.
If the central bank policy rate is 5.0%, monetary policy is most likely:
A) expansionary.
B) neutral.
C) contractionary.
Explanation
The neutral rate of interest is real trend rate of economic growth plus the inflation target. In this example, the neutral rate =
2.5% +2.5% = 5.0%. Because the policy rate is the same as the neutral rate of interest, monetary policy is neither
contractionary nor expansionary.
Central banks are most likely to pursue a target inflation rate:
A) equal to 0%.
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B) above 3%.
C) between 0 and 3%.
Explanation
Central banks typically define price stability as a stable inflation rate of about 2% to 3%. A target of zero is not typically
used because it would risk deflation.
A central bank follows an inflation targeting monetary policy. If the permissible band is plus-or-minus 2% around the
target inflation rate, the central bank is most likely to choose a target inflation rate of:
A) 3%.
B) 0%.
C) 1%.
Explanation
Because they consider deflation to be disruptive to an economy, central banks typically choose inflation targets and bands
that do not include a negative rate of inflation.
The demand for money curve represents the relationship between the quantity of money demanded and:
A) the price level.
B) the quantity of money supplied.

C) short-term interest rates.
Explanation
The demand for money curve represents the relationship between short-term interest rates and the quantity of real money
that households and firms demand to hold.
The crowding-out model implies that a:
A) budget deficit will stimulate aggregate demand and trigger a multiplier effect which will lead to
inflation.
B) budget surplus will retard aggregate demand and trigger an economic downturn.
C) budget deficit will increase the real interest rate and thereby retard private investment.
Explanation
Increased budget deficits will increase the demand for loanable funds and lead to higher interest rates and thus lower private
investment. Crowding-out implies that an increase in government spending will choke off private investment and reduce the
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intended impact of fiscal policy changes on aggregate demand.
Robert Necco and Nelson Packard are economists at Economic Research Associates. ERA asks Necco and Packard for their
opinions about the effects of fiscal policy on real GDP for an economy currently experiencing a recession. Necco states that
real GDP is likely to increase if both government spending and taxes are increased by the same amount. Packard states that
if both government spending and taxes are increased by the same amount, there is no expected net effect on real GDP.
Are the statements made by Necco and Packard CORRECT?
Necco Packard
A) Correct Incorrect
B) Incorrect Correct
C) Incorrect Incorrect
Explanation
Necco is correct because the multiplier effect is stronger for government expenditures versus government taxes. All of the
increase in government spending enters the economy as increased expenditure, whereas only a portion of the tax increase
results in lessened expenditure (determined by the marginal propensity to consume), because part of the tax increase will
come from the savings of the taxpayer (determined by the marginal propensity to save). Packard is incorrect; the effect on real
GDP of an increase in government spending combined with equal increase in taxes will be positive because the multiplier
effect is stronger for government spending versus the tax increase.
Assuming the federal government maintains a balanced budget, the most likely effects of a tax increase on
government expenditures and real GDP are:
Government Expenditures Real GDP
A) Increase Decrease
B) Decrease Decrease
C) Increase Increase
Explanation
The amount of the spending program exactly offsets the amount of the tax increase, leaving the budget unaffected (balanced
budget). The multiplier effect is stronger for government spending versus the tax increase. Therefore, the balanced budget
multiplier will be positive. All of the government spending enters the economy as increased expenditure, whereas only a
portion of the tax increase results in lessened expenditure (determined by the marginal propensity to consume), because part
of the tax increase will come from the savings of the taxpayer (determined by the marginal propensity to save).

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A country is experiencing a core inflation rate of 7% during a recessionary period of real GDP growth. If the central bank has
a single mandate to achieve price stability and uses inflation targeting with an acceptable range of zero to 4%, its monetary
policy response is most likely to decrease:
A) GDP growth in the short run.

B) short-term interest rates.
C) the foreign exchange value of the country's currency.
Explanation
If the central bank has a price stability mandate, it will most likely respond to the above-target inflation rate by decreasing the
money supply, even though GDP growth is in a recessionary phase. Decreasing the money supply will result in higher short-
term interest rates and appreciation of the currency, but will likely cause GDP growth to decrease further in the short run.
The time it takes for a fiscal policy action to affect the economy is best described as:
A) fiscal lag.
B) economic lag.
C) impact lag.
Explanation
The time it takes for a fiscal policy action, once implemented, to have its effect on the economy is referred to as impact lag.
According to the Fisher effect, which of the following interest rates includes a premium for the expected rate of inflation?
A) Yields on long-term corporate debt, but not yields on short-term government debt.
B) Both yields on short-term government debt and yields on long-term corporate debt. C)
Neither yields on short-term government debt nor yields on long-term corporate debt.
Explanation
The Fisher effect holds that all nominal interest rates include a premium for expected inflation.
When comparing a barter economy with an economy that uses money as a medium of exchange we would expect
increased efficiencies due to a reduction in which of the following?
A) Nominal interest rates.

B) Transaction costs.
C) The need to specialize.
Explanation
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Money functions as a medium of exchange because it is accepted as payment for goods and services. Compare this to a
barter economy, where if I have goat and want an ox, I have to find someone willing to trade. Finding someone takes time
and time is costly. With money, I can sell the goat and buy the ox. Thus, transaction costs are reduced. Having money as a
medium of exchange would not reduce the inflation rate, interest rates, or the need to specialize in the production of those
goods in which we have a comparative advantage (low opportunity cost producer).
On January 5, the U.S. Federal Reserve (the Fed) bought $10,000,000 of U.S. Treasury securities in the open market. At
the time, the reserve requirement was 25%, and all banks had zero excess reserves. What is the potential impact of the
Fed's purchase on the U.S. money supply?
A) $25,000,000 decrease.
B) $10,000,000 increase.
C) $40,000,000 increase.
Explanation
Buying securities by the Fed increases the money supply because they are injecting money into the banking system. The
money supply can potentially increase by 1 / 0.25 × $10,0 00,000 = $40,000,000.
Which of the following is the most likely result of a central bank's shift to an expansionary monetary policy?
A) Interest rates increase.
B) Domestic currency appreciates.

C) Exports increase.
Explanation
Expansionary monetary policy decreases interest rates. This should cause the domestic currency to depreciate, which
should increase foreign demand for the country's exports.
Which of the following fiscal and monetary policy scenarios is most likely to increase the size of the public sector relative to
the private sector?
A) Contractionary fiscal and monetary policy.
B) Expansionary fiscal policy and contractionary monetary policy. C)

Expansionary monetary policy and contractionary fiscal policy.
Explanation
Expansionary fiscal policy tends to expand the public sector. Contractionary monetary policy tends to contract the private sector.
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Which of the following is the most accurate definition of the velocity of money? The velocity of money is the:
A) GDP of a country divided by its price level.

B) GDP of a country divided by its money supply.
C) money supply of a country divided by its price level.
Explanation
Velocity is the average number of times per year each dollar is used to buy goods and services (velocity = nominal GDP /
money). Therefore, the money supply multiplied by velocity must equal nominal GDP. The equation of exchange must hold
with velocity defined in this way. Letting money supply = M, velocity = V, price = P, and real output = Y, the equation of
exchange may be symbolically expressed as: MV = PY.
The Fisher effect describes a nominal interest rate as the:
A) expected inflation rate plus the real interest rate.

B) actual inflation rate less the real interest rate.
C) expected inflation rate less the real interest rate.
Explanation
The Fisher effect states that a nominal interest rate is equal to the real interest rate plus the expected inflation rate.
Promoting economic growth and price stability are the goals of:
A) monetary policy, but not fiscal policy.
B) fiscal policy, but not monetary policy.

C) both fiscal and monetary policy.
Explanation
Both monetary and fiscal policies are used by policymakers with the goals of maintaining stable prices and producing
positive economic growth.
The time it takes for policy makers to determine that the economy requires a fiscal policy action is best described as:
A) recognition lag.
B) impact lag.
C) action lag.
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Explanation
Recognition lag refers to the time it takes for fiscal policy makers to determine the need for a policy action.
Silvano Jimenez, an analyst at Banco del Rey, is reviewing recent actions taken by the U.S. Federal Reserve (the Fed) in setting
monetary policy. Recently, the Fed decided to increase the money supply, which has resulted in a decrease in real interest rates. At a
staff meeting, Jimenez brings this matter to the attention of his colleagues and makes the following statements:
Statement 1: Although the money supply increase has led to a decrease in real interest rates, we should begin to see U.S.
investors decrease their investments abroad and the U.S. dollar will appreciate in the foreign exchange market.
Statement 2: The Fed's increase in the money supply will increase the amount of imports into the U.S.
Are Statement 1 and Statement 2 as made by Jimenez CORRECT?
Statement 1 Statement 2
A) Incorrect Correct
B) Correct Incorrect
C) Incorrect Incorrect
Explanation
If the Fed increases the money supply and real interest rates decline, U.S. investors will seek higher real rates of return
abroad and the U.S. dollar will depreciate as the dollar will be exchanged for foreign currencies in order to buy the foreign
investments. Likewise, the decrease in real interest rates will reduce the inflow of funds from abroad as foreign investors
seek higher rates of return outside the U.S. With a dollar that has depreciated, U.S. exports should increase, as U.S.
products will become cheaper for foreign buyers. As such, both statements are incorrect.
Compared to the costs of inflation that is unexpected, costs of inflation that iscorrectly anticipated are most likely to be:
A) less severe.
B) equally severe.
C) more severe.
Explanation
Costs of inflation are less severe when inflation is correctly anticipated than when inflation is unexpected. Unexpected
inflation results in wealth being transferred from lenders to borrowers. In addition, producers might misallocate resources if
they cannot determine whether an increase in the price of their output reflects inflation or a genuine increase in demand.
Assuming the economy currently is experiencing high inflation, an example of appropriate discretionary fiscal policy is:
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A) increase the federal funds target rate.
B) reduce the money supply.
C) reduce government expenditures on major government construction projects.
Explanation
Discretionary fiscal policy refers to the federal government's decisions regarding government spending and taxing. A reduction
in government spending on major government construction projects is likely to lead to a reduction in aggregate demand and
less pressure on prices, reducing inflation.
When an economy dips into a recession, automatic stabilizers will tend to alter government spending and taxation so as to:
A) reduce interest rates, thus stimulating aggregate demand.
B) reduce the budget deficit (or increase the surplus).

C) enlarge the budget deficit (or reduce the surplus).
Explanation
During a recession unemployment is high, so the government will pay out more in unemployment compensation at the exact time that tax
receipts from corporations and individuals are low. This will increase the size of the deficit and also maintain aggregate demand during
recessionary periods.
Which of the following statements best explains the importance of the timing of changes in discretionary fiscal policy? Changes
in discretionary fiscal policy must be timed properly if they are going to:
A) enable the government to control the money supply.

B) exert a stabilizing influence on an economy.
C) help the government achieve a balanced budget.
Explanation
Proper timing of discretional policy is needed to reduce economic instability. If timed incorrectly, the fiscal policy change
could increase rather than reduce economic instability.
Which of the following statements about the demand for and supply of money is least accurate?
A) As inflation rises, the demand for money by households and businesses also rises.
B) As gross domestic product rises, the demand for money balances also
rises. C) As the interest rate rises, the supply of money also rises.
Explanation
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The supply of money is determined by the monetary authorities and is not affected by changes in interest rates. Thus, the
supply of money curve is vertical.
Frequent changes in advertised prices are one of the costs of:
A) unexpected inflation only.

B) expected inflation only.
C) both expected and unexpected inflation.
Explanation
Inflation imposes "menu costs" on an economy as businesses must frequently change their advertised prices, regardless
of whether inflation is expected or unexpected.
Which of the following statements regarding money demand and supply is least accurate?
A) As the Fed reduces the money supply, short-term interest rates decrease.
B) The supply curve for money is vertical.
C) The supply of money is determined by the monetary authority and is not affected by changes in interest
rates.
Explanation
As the Fed reduces the money supply, short-term interest rates increase. The other statements concerning the demand and supply for
money are true.
The open market sale of Treasury securities by the Federal Reserve is least likely to result in:
A) increased longer-term interest rates.

B) a decreased rate of inflation.
C) increased exports of U.S. goods.
Explanation
When the Fed sells Treasuries, it causes both short- and long-term interest rates to increase. This rate increase causes the
dollar to appreciate, which reduces foreign demand for domestic goods, causing exports to decline. The interest rate increase
also puts downward pressure on price levels, which causes inflation to slow.
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If a bank needs to borrow funds from the Federal Reserve to fund a temporary shortage in reserves, it would borrow funds at the:
A) discount rate.
B) federal funds rate.

C) prime rate.
Explanation
Banks are able to borrow from the Fed at the discount rate. The federal funds rate is the interest rate banks charge other
banks to borrow reserves from other banks. The prime rate is the rate that commercial banks charge their best customers.
Attempting to influence economic growth and inflation by changing tax rates and government spending is best described as:
A) fiscal policy.
B) monetary policy.
C) government policy.
Explanation
Fiscal policy refers to actions by a government to influence economic activity through changes in taxes and
government spending.
Which of the following is least likely to be a function of the central bank?
A) Tax collection.
B) Control money supply.

C) Issue currency.
Explanation
The three functions of a central bank are to issue a country's currency, regulate its banking system, and to manage the
money supply. Tax collection is typically conducted by a government agency created specifically to carry out that function.
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.
Explanation
Money has three primary functions: it serves as a unit of account because prices of goods and services are expressed in units of
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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.
The government budget deficit of Country M is increasing. At the same time, the government budget surplus of Country N
is decreasing. Are the fiscal policies of these countries expansionary or contractionary?
A) Both are expansionary.
B) One is expansionary and one is

contractionary. C) Both are contractionary.
Explanation
Expansionary fiscal policy increases a budget deficit or decreases a budget surplus. Contractionary fiscal policy decreases
a budget deficit or increases a budget surplus.
Which of the following is determined by the equilibrium between the demand for money and the supply of money?
A) Money supply.
B) Inflation rate.
C) Interest rate.
Explanation
Interest rates are determined by the equilibrium between money supply and money demand.
An example of a contractionary fiscal policy change is a(n):
A) decrease in a fiscal surplus.
B) increase in a fiscal surplus.

C) increase in a fiscal deficit.
Explanation
An increase in a fiscal surplus or a decrease in a fiscal deficit is contractionary. An increase in a fiscal deficit or a decrease
in a fiscal surplus is expansionary.
A central bank has operational independence if it can independently determine:

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A) the policy rate.
B) how inflation is calculated.
C) the horizon over which to achieve its inflation target.
Explanation
A central bank is said to have operational independence if it has the authority to determine the policy rate independently.
Determining how inflation is calculated and the time horizon for achieving its target rate of inflation refer to a central bank that
has target independence.
An argument against being concerned with the size of a fiscal deficit is that a deficit can:
A) cause government borrowing to crowd out private borrowing.
B) aid in increasing GDP and employment if the economy is operating at less than potential
GDP. C) lead to higher future taxes that will increase government revenues.
Explanation
One potential argument against being concerned about the size of fiscal deficits is that a deficit can help increase GDP and
employment if output is below potential GDP and the spending does not divert capital from productive uses. Higher deficits
that lead to crowding out or higher future taxes that result in lower long-term economic growth are arguments for concern
about the size of fiscal deficits.
Money functions as a store of value because:
A) money received for work or goods can be saved to purchase goods or services in the future.
B) prices of goods and services are expressed in units of

money. C) money is accepted as the form of payment for goods.
Explanation
Money has three primary functions: it provides a store of value because money received for work or goods can be saved for
future consumption; it serves as a unit of account because prices of all goods and services are expressed in units of money;
and it serves as a medium of exchange because money is accepted as a form a payment.
Policies used with the goal of maintaining stable prices and producing economic growth include:
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A) both fiscal policy and monetary policy.
B) fiscal policy only.
C) monetary policy only.
Explanation
Both fiscal and monetary policies are used to maintain stable prices and produce economic growth. Fiscal policy does so by
mechanisms that involve spending and taxation, and monetary policy uses central bank tools to modify the availability of
money and credit.
If the Federal Reserve wishes to lower market interest rates without changing the discount rate, it can:
A) raise the yield on Treasury securities.

B) buy Treasury securities.
C) increase bank reserve requirements.
Explanation
Buying Treasury securities pumps money into the economy, lowering interest rates. Higher reserve requirements will restrict the
money supply, causing rates to rise. The Federal Reserve has no direct control over the yield on existing Treasury securities.
Assume the U.S. economy is undergoing a recession. In its efforts to stimulate the economy by trying to influence short-
term interest rates the Fed is most likely to take which two actions?
A) Sell Treasury securities and decrease bank reserve requirements.
B) Sell Treasury securities and increase bank reserve requirements. C)

Buy Treasury securities and decrease bank reserve requirements.
Explanation
If the economy is in a recession, the Fed is likely to attempt to decrease short-term interest rates. Thus, the Fed will buy
Treasury securities and decrease bank reserve requirements.
If the U.S. Federal Reserve decides to decrease the money supply, which of the following is most likely to occur in the short run?
A) A decrease in the unemployment rate.

B) An increase in the real rate of interest.
C) An increase in the velocity of money similar to decrease in the money supply.
Explanation
If the U.S. Federal Reserve decreases the money supply, an increase in nominal and real interest rates will occur. Higher real
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rates will cause businesses to invest less, which will cause the unemployment rate to increase. Furthermore, households will
decrease purchases of durable goods, automobiles, and other items that are typically financed at short-term rates. This will
decrease aggregate demand. The decrease in aggregate demand and expenditures will cause incomes to go down, which
further decreases consumption and investment. Moreover, this decrease in aggregate demand will decrease real GDP and
the price level in the short run and the long run.
Which of the following conditions is difficult for monetary policy to address because a central bank cannot reduce its
nominal policy rate below zero?
A) Deflation.
B) Inflation. C)
Stagflation.
Explanation
Deflation is difficult for central banks to address when policy rates cannot be lowered any further. Inflation can be addressed by
contractionary monetary policy. Stagflation is difficult to address because monetary policy cannot pursue higher growth and
lower inflation at the same time.
A distinction between fiscal policy and monetary policy is that fiscal policy:
A) is aimed at promoting economic growth, while monetary policy is aimed at promoting price
stability.
B) is typically expansionary, while monetary policy is typically contractionary.

C) concerns taxes and government spending, while monetary policy concerns the money supply.
Explanation
The distinction between fiscal and monetary policy is that a country's government determines fiscal policy through taxes and
spending, but its central bank determines monetary policy by controlling the money supply. Both fiscal and monetary policy
can be used to promote economic growth and price stability. Either fiscal policy or monetary policy can be expansionary or
contractionary.
Which of the following statements about the demand and supply of money is most accurate? People who are:
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A) holding money when interest rates are lower will try to increase their money balances and, as a result, the
supply of money increases.
B) holding money when interest rates are higher will try to reduce their money balances and, as a result, the
demand for money decreases.
C) buying bonds to reduce their money balances will increase the demand for bonds with an associated
increase in interest rates.
Explanation
Buying bonds would drive bond prices up and interest rates down. Selling bonds would have the opposite effect; driving bond prices down
and interest rates up. When interest rates are lower, there is an excess demand for money. The supply of money is determined by the
monetary authorities.
Fiscal policy includes a government's:
A) tax policies only.

B) spending and tax policies only.
C) spending, tax, and monetary policies.
Explanation
Fiscal policy refers to a government's use of spending and taxation to meet macroeconomic goals. Monetary policy refers
to central bank actions and is not considered part of fiscal policy.
Which of the following statements regarding U.S. Federal Reserve open market operations is least accurate?
A) If the Fed wants to stimulate the economy, it will sell Treasury securities to banks.
B) When the Fed buys Treasury securities, short-term interest rates will generally decrease.
C) When the Fed sells Treasury securities, excess reserves decrease.
Explanation
If the Fed intends to stimulate the economy, they will buy, not sell, Treasury securities. Buying Treasury securities injects reserves into the
banking system.
If a central bank's targeted inflation rate is above the current rate, the central bank is most likely to:
A) buy government securities.
B) increase the overnight lending rate.

C) increase the reserve requirement.
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Explanation
Buying government securities is an expansionary policy that would increase the money supply and allow the inflation rate to
increase to the targeted range. Increasing reserve requirements and overnight lending rates are contractionary and would
have the opposite effects.
To determine whether monetary policy is expansionary or contractionary, an analyst should compare the central bank's
policy rate to the:
A) trend rate of real growth.
B) neutral interest rate.

C) target inflation rate.
Explanation
The neutral interest rate is the sum of the trend rate of real economic growth and the target inflation rate. Monetary policy is
expansionary if the policy rate is less than the neutral interest rate and contractionary if the policy rate is greater than the
neutral interest rate.
Which of the following statements about achieving proper timing in fiscal policy is least accurate?
A) Policy errors are inevitable due to unpredictable events.
B) Improvements in quantitative methods have made the occurrence of recessions or expansions

quite predictable.
C) There is usually a time lag between when a change in policy is needed and when the need
is recognized by policy makers.
Explanation
One problem in achieving proper timing in fiscal policy is the inability to accurately predict a recession or expansion.
When the central bank reduces the quantity of money and credit in an economy, its monetary policy is best described as:
A) accommodative.
B) expansionary.
C) contractionary.
Explanation
When the central bank is reducing the quantity of money and credit in an economy, the monetary policy is said to
be contractionary, restrictive, or tight.
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Economics/05 Monetary and Fiscal Policy

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Monetary and Fiscal Policy Test ID: 7694022

Question #1 of 88 Question ID: 413855

The primary objective of a central bank is to:

A) achieve full employment.

B) stabilize exchange rates.

Question #2 of 88 Question ID: 413862

A) Sell Treasury securities, causing aggregate demand to decrease.

B) Purchase Treasury securities, causing aggregate demand to decrease. C)

Question #3 of 88 Question ID: 434245

A) the crowding-out effect.

Question #5 of 88 Question ID: 413844

Question #6 of 88 Question ID: 413883

Question #7 of 88 Question ID: 413840

A) Required reserve ratio.

The potential deposit expansion multiplier = 1 / (required reserve ratio)

Question #8 of 88 Question ID: 413843

A) Money × Velocity = Money Supply × Velocity.

B) Nominal GDP = Price × Money Supply.

C) Nominal GDP = Money Supply × Velocity = Price × Real Ou tput.

Question #9 of 88 Question ID: 413867

B) Requiring the banking system to tighten or loosen its credit

Question #10 of 88 Question ID: 413870

A) expected rate of inflation is likely to decline.

B) long-term rate of economic growth will increase.

Question #11 of 88 Question ID: 413838

Question #12 of 88 Question ID: 413880

Question #13 of 88 Question ID: 413846

The supply of money is primarily determined by:

A) the monetary authorities.

Question #15 of 88 Question ID: 413879

A) inelastic demand for money.

Question #16 of 88 Question ID: 413842

A) There will be no effect on the money supply.

Question #17 of 88 Question ID: 413878

Question #18 of 88 Question ID: 413829

A) both fiscal policy and monetary policy.

B) monetary policy only.

Question #19 of 88 Question ID: 413902

A) A decrease in the discount rate.

B) An increase in the reserve requirements for financial

Question #20 of 88 Question ID: 413874

B) the same as that of the target currency.

Question #21 of 88 Question ID: 434238

A) transaction demand, precautionary demand, and speculative demand.

B) broad money demand, narrow money demand, and transaction demand. C)

Question #22 of 88 Question ID: 413854

A) plus actual inflation.

B) minus expected inflation.

Question #23 of 88 Question ID: 413899

A government that is implementing a contractionary fiscal policy is most likely to:

A) decrease transfer payments to households.

B) increase spending on public works.

Contractionary monetary policy is least likely to decrease consumption spending by decreasing:

A) expectations for economic growth.

B) the foreign exchange value of the currency.

Question #25 of 88 Question ID: 413850

B) downward sloping to the lower right.

Question #26 of 88 Question ID: 413882