Chapter 11 - Monetary and Fiscal Policy

Chapter 11
Monetary and Fiscal Policy

Multiple Choice Questions

1. A change in which of the following will NOT shift the IS-curve?

a. Autonomous investment
B. Autonomous money demand
c. Autonomous consumption
d. Autonomous net exports
e. Autonomous saving

Difficulty: Easy

2. If money supply is held constant, a cut in government transfer payments will eventually
cause interest rates to
a. Decline, enhancing the expansionary impact of the policy
B. Decline, decreasing the restrictive impact of the policy
c. Increase, decreasing the expansionary impact of the policy
d. Increase, decreasing the restrictive impact of the policy
e. Increase, enhancing the restrictive impact of the policy

Difficulty: Medium

3. In an IS-LM model, if the government enacts restrictive fiscal policy through a tax increase
or a cut in government purchases,
a. The interest rate will decline, lowering the incentive to save and thus also the level of
investment spending
b. The level of income will decrease but the interest rate will increase
C. Both income and the interest rate will decrease
d. The LM-curve will shift to the left
e. The IS-curve will shift to the left, followed by a shift of the LM-curve to the left since this
policy will change interest rates and therefore money demand

Difficulty: Medium

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4. When the government employs a "tight fiscal policy," we should expect that
a. The level of output will only be affected by a small amount
b. Interest rates will increase
c. Monetary policy will be "easy" at the same time
d. Inflation will be lowered more than unemployment
E. The budget deficit will decrease

Difficulty: Easy

5. One side effect of expansionary fiscal policy is that

A. Higher interest rates cause a change in the composition of GDP
b. Higher interest rates significantly increase private saving
c. Consumption spending is crowded out
d. The Fed has to reinforce the policy through open market sales
e. All of the above

Difficulty: Medium

6. Monetary policy becomes more effective as

a. The marginal propensity to save increases
B. The interest sensitivity of money demand decreases
c. The interest sensitivity of investment decreases
d. The income tax rate increases
e. None of the above

Difficulty: Medium

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7. If we were in a liquidity trap,

a. Investment would be totally interest insensitive
B. Fiscal expansion would be unlikely to drive interest rates up
c. Monetary policy would be more powerful than fiscal policy
d. An increase in government spending would be totally offset by a decrease in private
investment
e. Crowding out would be made worse by the inability of monetary policy to accommodate
fiscal policy

Difficulty: Medium

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8. Monetary policy becomes less effective as

a. The marginal propensity to consume increases
b. The interest sensitivity of money demand decreases
C. The interest sensitivity of investment decreases
d. The LM-curve becomes steeper
e. The IS-curve becomes flatter

Difficulty: Medium

9. The liquidity trap exists when

a. The IS-curve is vertical
b. The LM-curve is vertical
C. The LM-curve is horizontal
d. An increase in government spending is always fully crowded out
e. Money demand is completely insensitive to changes in the interest rate

Difficulty: Easy

10. If we have a normal IS-curve but a horizontal LM-curve,

A. Fiscal policy is the most effective way to reduce unemployment
b. Fiscal policy is at its weakest in reducing unemployment
c. Monetary policy can aid fiscal policy in reducing unemployment
d. Monetary policy is the most effective way to reduce unemployment
e. Neither fiscal nor monetary policy is effective in reducing unemployment

Difficulty: Medium

11. In an IS-LM model, if we assume that money demand is completely insensitive to changes
in the interest rate,
A. Fiscal policy cannot change the level of output but will change the composition of GDP
b. Monetary policy is totally ineffective in changing the level of output
c. Interest rates cannot be lowered by fiscal or monetary policy
d. The economy cannot be stimulated by fiscal or monetary policy
e. Monetary policy can change income but not interest rates

Difficulty: Medium

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12. The view that "only money matters" is accurate when

a. Investment is completely interest insensitive
B. Money demand is completely interest inelastic
c. Money demand is completely interest elastic
d. We are in the liquidity trap
e. Both C and D

Difficulty: Easy

13. When the LM-curve is vertical,

a. The monetary policy multiplier is zero
b. Monetary policy is at its weakest but fiscal policy has a maximum effect on income
C. Monetary policy has a maximum effect, but fiscal policy has no effect on income
d. Fiscal policy's impact on interest rates will not affect investment
e. Monetary policy affects interest rates but no change in investment spending results

Difficulty: Medium

14. The LM-curve is vertical when

a. The interest elasticity of investment is zero
b. The central bank keeps nominal money supply constant
C. We are in the classical case
d. We are in the liquidity trap
e. None of the above

Difficulty: Medium

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15. Which of the following describes a part of the transmission mechanism?

A. A change in real money balances causes a portfolio disequilibrium and asset holders'
reactions influence interest rates
b. An income tax rate cut stimulates private spending but the resulting interest rate increase
dampens the income expansion
c. The central bank undertakes open market purchases and the resulting interest rate increase
encourages people to save more
d. An increase in government spending is partially offset by the crowding out of private
investment
e. Both B and D

Difficulty: Difficult

16. In the classical case,

A. The fiscal policy multiplier is zero
b. Crowding out cannot occur
c. Investment does not respond to interest rate changes
d. An increase in the income tax rate cannot lower the budget deficit
e. Monetary policy is totally ineffective

Difficulty: Medium

17. The transmission mechanism

a. Is the process by which fiscal policy affects aggregate demand
b. Works best if money demand is completely interest elastic
C. Fails if none of the components of aggregate demand responds to changes in interest rates
d. Relates to the effects of tax rate changes on the fiscal multiplier
e. All of the above

Difficulty: Medium

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18. The transmission mechanism between an open market purchase by the central bank and an
increase in aggregate demand can break down if
A. Banks are unwilling to lend to private firms
b. Money demand is totally interest inelastic
c. Investment is very interest sensitive
d. Bond prices increase too much
e. None of the above

Difficulty: Medium

19. If the Fed undertakes open market sales, then

a. The LM-curve will shift to the right
B. The LM-curve will shift to the left
c. Interest rates will decrease and income will increase
d. Bond prices will increase
e. Both A and C

Difficulty: Medium

20. If investment is not very sensitive to interest rate changes,

a. Fiscal policy will be largely ineffective in changing output
b. Monetary policy will be very effective in changing output
c. The economy is in the classical case
d. Monetary policy cannot be used to lower interest rates
E. The size of the crowding out effect following expansionary fiscal policy will be small

Difficulty: Medium

21. Fiscal policy is weakest and monetary policy is strongest when

a. We are in the liquidity trap
b. Money demand is very interest elastic
c. Investment is very interest inelastic
D. We are in the classical case
e. The IS-curve is very steep and the LM-curve is very flat

Difficulty: Medium

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22. Fiscal policy becomes more powerful in changing the level of output as
a. Investment becomes more interest elastic
b. Money demand becomes more interest inelastic
c. Money demand becomes more income elastic
D. The marginal propensity to save gets smaller
e. The marginal propensity to consume gets smaller

Difficulty: Medium

23. Assume we combine restrictive monetary policy with expansionary fiscal policy. Which is
most likely to occur?
a. Unemployment and interest rates will both go down
b. Unemployment will go down but interest rates will stay the same
c. Investment and consumption will both increase
d. Interest rates and the budget deficit will both decrease
E. Investment will decrease and the budget deficit will increase

Difficulty: Difficult

24. Assume the government cuts the level of government purchases and the Fed responds by
increasing money supply. Which of the following is the most likely result?
A. Lower interest rates and a higher budget surplus
b. A large decrease in the interest rate and output
c. A decrease in investment and the budget deficit
d. An increase in consumption and lower tax revenues
e. A decrease in consumption and investment

Difficulty: Medium

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25. Monetary policy is said to be accommodating when

a. The central bank undertakes open market sales to fight inflation
b. The central bank responds to a tax increase by increasing money supply
c. The central bank responds to fiscal expansion by undertaking open market sales
D. In the course of fiscal expansion, the central bank increases money supply to prevent
interest rates from rising
e. The central bank does not interfere in any way when the government undertakes fiscal
policy

Difficulty: Medium

26. A policy mix designed to promote economic growth through an increase in investment
might involve
a. Open market sales combined with income tax cuts
b. A government spending increase financed by a tax increase
C. Cuts in government purchases combined with higher investment tax credits
d. An increase in government purchases combined with monetary restriction
e. Removal of investment subsidies

Difficulty: Medium

27. Assume that policy mix A combines restrictive monetary policy with expansionary fiscal
policy, while policy mix B combines expansionary monetary policy with restrictive fiscal
policy. Compared to policy mix B, policy mix A will cause
A. A lower level of investment
b. A higher level of investment
c. A lower level of consumption
d. A higher level of saving
e. Both C and D

Difficulty: Medium

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28. Expansionary fiscal policy can be successful without a negative impact on the level of
investment if
a. The government spending increase is financed by a tax increase
b. The Fed undertakes open market sales at the same time
C. It is implemented via an investment subsidy rather than a cut in personal income taxes
d. Money demand is completely interest inelastic
e. It is implemented through a cut in personal income taxes rather than an increase in
government purchases

Difficulty: Medium

29. Crowding out occurs when

a. An increase in defense spending causes a decrease in consumption
b. Expansionary monetary policy fails to stimulate economic growth
C. Expansionary fiscal policy causes interest rates to rise, thereby reducing private spending
d. Tax increases result in a drop in consumption
e. A policy designed to increase the budget surplus causes the economy to enter a recession

Difficulty: Easy

30. In a normal IS-LM framework, crowding out may be avoided if

a. Banks ration credit
b. The government matches a tax increase with an increase in government purchases
C. The central bank increases the money supply to accommodate fiscal expansion
d. The central bank sells government bonds on a large scale
e. Both C and D

Difficulty: Medium

31. In an IS-LM framework, fiscal expansion generally leads to income expansion

a. Only if it is combined with monetary expansion
b. Except if we are in the liquidity trap
c. But interest rates will increase, leading to a lower level of saving
D. But the composition of output will change
e. But most consumption spending will be crowded out

Difficulty: Medium

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32. The crowding out effect is zero if

A. The LM-curve is horizontal
b. The LM-curve is vertical
c. The central bank conducts open market sales following fiscal expansion
d. Income is stimulated via a tax cut rather than an increase in government spending
e. None of the above

Difficulty: Medium

33. Crowding out

a. Does not occur in the liquidity trap
b. Is caused by a rise in interest rates resulting from expansionary fiscal policies
c. Cannot happen if the LM-curve is horizontal
d. Cannot happen if the IS-curve is vertical
E. All of the above

Difficulty: Medium

34. Assume the government wants to increase the level of consumption and investment.
Which of the following policies should be implemented?
A. Higher investment tax credits
b. Removal of investment subsidies combined with monetary restriction
c. An income tax cut combined with monetary restriction
d. An increase in government transfer payments to low income households financed by a tax
increase on high income households
e. None of these

Difficulty: Easy

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35. Given a normal IS-LM model, which of the following is FALSE?

a. Expansionary monetary policy will increase the level of investment and consumption
b. Lower income tax rates will raise the level of consumption but lower the level of
investment
c. A cut in government transfer payments will reduce consumption and interest rates
D. An investment subsidy will increase the level of investment but not the level of
consumption
e. Restrictive monetary policy will lower consumption, investment, and the budget surplus

Difficulty: Medium

36. Assume you would like to stimulate investment but leave the level of GDP roughly the
same. What policy mix would you propose?
a. An income tax cut combined with monetary expansion
b. A tax cut combined with monetary restriction
C. A cut in government spending combined with monetary expansion
d. A cut in government spending combined with monetary restriction
e. An investment subsidy combined with monetary expansion

Difficulty: Medium

37. In a normal IS-LM framework, if government purchases and taxes are both increased by
the same amount, the level of output
a. Will increase by exactly that amount
b. Will remain the same but its composition will change
c. Will not change and neither will the composition of output
D. Will increase as will the interest rate
e. Will increase but only if this fiscal policy is accommodated by expansionary monetary
policy

Difficulty: Medium

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38. The longest peacetime expansion in the United States occurred in the
a. 1950s
b. 1960s
c. 1970s
d. 1980s
E. 1990s

Difficulty: Easy

39. When conducting monetary policy, a central bank should

a. Never monetize the budget deficit since this will lower the level of investment
B. Be less concerned with current conditions than with future conditions
c. Always try to keep interest rates low
d. Always respond to expansionary fiscal policy by expanding money supply
e. None of the above

Difficulty: Easy

40. In an IS-LM model, which is most likely to occur?

a. Expansionary fiscal policy will not be crowded out if the Fed undertakes open market sales
at the same time
B. Expansionary monetary policy will increase the level of spending on investment and
consumption
c. Increased government spending will not affect the level or the composition of GDP unless
it is financed by an increase in money supply
d. An income tax rate cut will increase the slope of the IS-curve increasing the levels of
income and investment
e. Investment subsidies will increase the level of investment at the expense of lowering the
level of consumption

Difficulty: Medium

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41. In an IS-LM model, if net exports is no longer assumed to be exogenous (that is, NX =
NXo), but instead is assumed to decrease as the level of income increases (that is, NX = NXo -
mY, with m > 0), then
A. The IS-curve will become steeper and shift to the left
b. The IS-curve will become flatter and shift to the right
c. The LM-curve will become steeper and shift to the left
d. The LM-curve will become flatter and shift to the right
e. The fiscal policy multiplier will become larger

Difficulty: Difficult

42. Assume the government wants to keep national income stable but change the composition
of GDP away from consumption towards investment. What policy option would you suggest?
A. A decrease in transfer payments to households combined with open market purchases by
the central bank
b. Expansionary fiscal policy combined with restrictive monetary policy
c. Open market sales by the central bank
d. A reduction in investment tax credits
e. A reduction in the income tax rate

Difficulty: Difficult

43. If income taxes and money supply both increase, what is most likely to occur?
a. Income and the interest rate will both increase
b. Consumption and investment will both decrease
c. Income will decrease but the interest rate will increase
D. Investment will increase but consumption will decrease
e. Consumption will decrease but saving will increase

Difficulty: Medium

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44. Which of the following was true for the recession of 1981/82?
A. Nominal interest rates declined from 14.0% in 1981 to 10.7% in 1982, while real interest
rates increased from 4.0% to 4.5%
b. The unemployment rate went above 11%, a higher level than in the Great Depression
c. The T-bill rate was lower than it ever was in the 1970s
d. Real interest rates decreased steadily after 1981
e. All of the above

Difficulty: Easy

45. The recession of 2001 was very short lived since

a. Real GDP already had decreased in the last quarter of 2000, but started to increase again in
the third quarter of 2001
b. The Fed aggressively cut interest rates as soon as the economy started to slow down
c. G.W. Bush's tax cuts helped to increase GDP growth
d. All of the above
E. Only B and C

Difficulty: Easy

46. Between 1981 and 1984,

a. The yield on T-bills declined
b. The real interest rate increased
c. Nominal interest rates and the inflation rate both decreased
d. The full-employment deficit increased rapidly
E. All of the above

Difficulty: Medium

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47. An interesting aspect of the recession of 1990/91 was that

a. Because of rising oil prices, the inflation rate did not fall
b. Unemployment and inflation both increased sharply all through 1991
c. Fiscal policy was highly restrictive and the Fed was very inactive
D. Fiscal policy was immobilized due to a large budget deficit, while monetary policy did not
work well due to credit rationing by banks
e. While the war against Iraq stimulated the economy, the Fed restricted money supply

Difficulty: Medium

48. Through much of the 1990s, the U.S. economy expanded and the stock market boomed,
but inflation and unemployment remained fairly low. This can be attributed to
a. Rapid technological growth
b. Expansionary fiscal policy
c. Prudent aggregate demand management by the Fed
D. All of the above
e. Only A and C

Difficulty: Easy

49. Which of the following is TRUE?

a. The German policy mix in the early 1990s was the exact opposite of that in the U.S. in the
early 1980s
B. The inflation rate in Germany in 1991 was 5.1% and was a matter of great concern
c. Nominal interest rates in Germany decreased from 1990-92, while real interest rates
increased
d. Real GDP growth remained remarkably strong in Germany from 1990-92
e. None of the above

Difficulty: Medium

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50. The re-unification of Germany required a rapid increase in government spending, but the
Bundesbank refused to accommodate the expansionary fiscal policy due to concerns about
rising inflation. What was the outcome?
a. Rising real interest rates
b. A deficit in the current account of the balance of payments
c. An increase in the budget deficit
d. A change in the composition of Germany's GDP
E. All of the above

Difficulty: Medium

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