Intermediate Macro Mankiw Ch13 20 Questions PDF

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Name TestBanks Chapter 13 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate Regime
Description
Instructions
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Multiple Choice 1 points
Question
Compared to a closed economy, an open economy is one that:
Answer allows the exchange rate to float.
fixes the exchange rate.
trades with other countries.
does not trade with other countries.
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Question
The Mundell–Fleming model assumes that:
Answer prices are flexible, whereas the IS–LM model assumes that prices are fixed.
prices are fixed, whereas the IS–LM model assumes that prices are flexible.
as in the IS–LM model, prices are fixed.
as in the IS–LM model, prices are flexible.
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Question
The Mundell–Fleming model is a ______ model for a ______ open economy.
Answer short-run; small
short-run; large
long-run; large
long-run; small
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Question
In the Mundell–Fleming model:
Answer the exchange rate system must have a floating exchange rate.
the exchange rate system must have a fixed exchange rate.
it makes no difference whether the exchange rate system has a floating or a fixed exchange rate.
the behavior of the economy depends on whether the exchange rate system has a floating or fixed
exchange rate.
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Question
In the Mundell–Fleming model, the domestic interest rate is determined by the:
Answer intersection of the LM and IS curves.
domestic rate of inflation.
world rate of inflation.
world interest rate.
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Question
In a small open economy with perfect capital mobility, if the domestic interest rate were to rise above the world interest
rate, then ______ would drive the domestic interest rate back to the level of the world interest rate.
Answer capital inflow
capital outflow
the central bank
a decline in domestic saving
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Question
Assuming there is perfect capital mobility, compared to a large open economy, a small open economy is one in which
the:
Answer exchange rate is fixed.
exchange rate is floating.
domestic interest rate equals the world interest rate.
domestic interest rate is not equal to the world interest rate.
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Question
In a small open economy a decrease in the exchange rate will _____ net exports and shift the _____ curve.
Answer increase; IS
decrease; IS
increase; LM
decrease; LM
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Question
If short-run equilibrium in the Mundell–Fleming model is represented by a graph with Y along the horizontal axis and
*
the exchange rate along the vertical axis, then the IS curve:
Answer slopes downward and to the right because the higher the exchange rate, the lower the level of net exports
and, therefore, of short-run equilibrium income in the goods market.
is vertical because there is only one investment level that is consistent with the world interest rate.
*
is vertical because the exchange rate does not enter into the IS equation.
slopes downward and to the right because the higher the exchange rate, the higher the level of net exports
and, therefore, of short-run equilibrium income in the goods market.
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Question
* *
In the Mundell–Fleming model on a Y – e graph, the curves labeled IS and LM are labeled that way as a reminder
that:
Answer the price level is held constant at the world price level p*.
the interest rate is held constant at the world interest rate r*.
the exchange rate is held constant at the world exchange rate e*.
output is held constant at the full employment level.
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Question
If short-run equilibrium in the Mundell–Fleming model is represented by a graph with Y along the horizontal axis and
*
the exchange rate along the vertical axis, then the LM curve:
Answer slopes upward and to the right because at a higher income a higher interest rate is needed to increase
velocity.
is vertical because monetary velocity is independent of the interest rate.
*
is vertical because the exchange rate does not enter into the LM equation.
slopes upward and to the right because a higher exchange rate leads to a higher income.
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Question
In the Mundell–Fleming model, the exogenous variables are the:
Answer world interest rate, the price level, and the exchange rate.
level of government spending, taxes, and income.
exchange rate and level of income.
price level, world interest rate, monetary policy, and fiscal policy.
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Question
* *
The intersection of the IS and LM curves shows the ______ and the ______ at which both the goods market and the
money market are in equilibrium.
Answer interest rate; price level
price level; exchange rate
level of output; exchange rate
level of output; price level
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Question
Under a floating system, the exchange rate:
Answer fluctuates in response to changing economic conditions.
is maintained at a predetermined level by the central bank.
is changed at regular intervals by the central bank.
fluctuates in response to changes in the price of gold.
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Question
In a small open economy with a floating exchange rate, an effective policy to increase equilibrium output is to:
Answer increase government spending.
increase taxes.
increase the money supply.
decrease the money supply.
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Question
In a small open economy with a floating exchange rate, an effective policy to decrease equilibrium output is to:
Answer decrease government spending.
decrease taxes.
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Question
In a small open economy with a floating exchange rate, the exchange rate will appreciate if:
Answer the money supply is increased.
the money supply is decreased.
government spending is decreased.
taxes are increased.
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Question
In a small open economy with a floating exchange rate, the exchange rate will depreciate if:
Answer the money supply is decreased.
import quotas are imposed.
government spending is increased.
taxes are decreased.
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Question
In a small open economy with a floating exchange rate, if the government adopts an expansionary fiscal policy, in the
new short-run equilibrium:
Answer income and the exchange rate will both rise.
the exchange rate will rise, but income will remain unchanged.
income will rise, but the exchange rate will remain unchanged.
both income and the interest rate will rise.
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Question
In a small open economy with a floating exchange rate, a rise in government spending in the new short-run equilibrium:
Answer chokes off investment, but not by as much as the new government spending.
chokes off an amount of investment just equal to the new government spending.
attracts foreign capital, thus raising the exchange rate and reducing net exports, but not by as much as the
new government spending.
attracts foreign capital, thus raising the exchange rate and reducing net exports by an amount just equal to
the new government spending.
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Question
In a small open economy with a floating exchange rate, the supply of real money balances is fixed and a rise in
government spending:
Answer raises the interest rate, so that income must rise to maintain equilibrium in the money market.
raises the interest rate so that net exports must fall to maintain equilibrium in the goods market.
cannot change the interest rate so that net exports must fall to maintain equilibrium in the goods market.
cannot change the interest rate so income must rise to maintain equilibrium in the money market.
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Question
Exhibit: IS*–LM*
Reference: Ref 13-1
(Exhibit: IS*–LM*) A small open economy with a floating exchange rate is initially at equilibrium A with IS* , LM* ,
1 1
equilibrium exchange rate e , and equilibrium output Y . If there is an increase in government spending to IS* , the
2 1 2
new equilibrium will be at ____, holding everything else constant.
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Answer A
B
C
D
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Question
Exhibit: IS*–LM*
Reference: Ref 13-1
(Exhibit: IS*–LM*) A small open economy with a floating exchange rate is initially at equilibrium A with
equilibrium exchange rate e , and equilibrium output Y . If there is a monetary expansion to the new equilibrium
2 1
will be at ____, holding everything else constant.
Answer A
B
C
D
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Question
In a small open economy with a floating exchange rate, if the government decreases the money supply, then in the new
short-run equilibrium:
Answer income falls and the exchange rate rises.
the exchange rate falls and income rises.
income remains unchanged but the exchange rate rises.
the exchange rate remains unchanged but income falls.
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Question
In a small open economy with a floating exchange rate, if the government increases the money supply, then in the new
short-run equilibrium the:
Answer interest rate falls and the level of investment rises.
exchange rate falls and net exports increase.
interest rate falls but the level of investment does not rise.
exchange rate falls but net exports do not increase.
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Question
According to the Mundell–Fleming model for a small open economy with flexible exchange rates, if the Federal
Reserve cannot alter domestic interest rates, changes in the money supply could still influence aggregate income
through changes in the:
Answer exchange rate.
price level.
level of government spending.
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tax rates.
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Question
In a small open economy with a floating exchange rate, if the government imposes an import quota, then in the new
*
short-run equilibrium the IS curve shifts to the right, raising the exchange rate:
Answer but not raising net exports or income.
and net exports but not income.
and income but not net exports.
net exports and income.
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Question
In a small open economy with a floating exchange rate, if the government imposes a tariff on foreign goods, then in the
Answer imports will decrease while exports remain constant, leading to a rise in net exports.
imports will decrease and exports will increase, leading to a rise in net exports.
imports will decrease and exports will decrease by an equal amount.
both imports and exports will remain unchanged.
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Question
Exhibit: Shifting IS* and LM*
Reference: Ref 13-2
(Exhibit: Shifting IS* and LM*) A small open economy with a floating exchange rate is initially in equilibrium at A with
Holding all else constant, if the government imposes a tariff on imports in order to protect domestic jobs,
then the _____ curve will shift to _____.
Answer
LM*;
LM*;
IS*;
IS*;
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Question
Exhibit: Shifting IS* and LM*
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Reference: Ref 13-2
(Exhibit: Shifting IS* and LM*) A small open economy with a floating exchange rate is initially in equilibrium at A with
Holding all else constant, if domestic consumers develop greater preferences for imported goods, then
the _____ curve will shift to _____.
Answer
LM*;
LM*;
IS*;
IS*;
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Question
Under a fixed system, the exchange rate:
Answer fluctuates in response to changing economic conditions.
is maintained at a predetermined level by the central bank.
is changed at regular intervals by the central bank.
fluctuates in response to changes in the price of gold.
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Question
To maintain a fixed-exchange-rate system, if the exchange rate moves below the fixed-exchange-rate level, then the
central bank must:
Answer buy foreign currency.
sell foreign currency from reserves.
raise taxes.
decrease government spending.
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Question
If the Fed announced it would fix the exchange rate at 100 yen per dollar, but with the current money supply the
equilibrium exchange rate was 150 yen per dollar, then:
Answer arbitrageurs would sell yen in the marketplace.
arbitrageurs would buy yen from the Fed.
the money supply would fall until the market exchange rate was 100 yen per dollar.
the money supply would rise until the market exchange rate was 100 yen per dollar.
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Question
Under a fixed-exchange-rate system, the central bank of a small open economy must:
Answer have a reserve of its own currency, which it must have accumulated in past transactions.
have a reserve of foreign currency, which it can print.
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allow the money supply to adjust to whatever level will ensure that the equilibrium exchange rate equals
the announced exchange rate.
follow a rule specifying a constant growth rate for the money supply.
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Question
If there is a fixed-exchange-rate system, then in the short run described by the Mundell–Fleming model:
Answer the nominal exchange rate is fixed, but the real exchange rate is free to vary.
the real exchange rate is fixed, but the nominal exchange rate is free to vary.
both the nominal and real exchange rates are fixed.
the nominal exchange rate is fixed, but whether the real exchange rate is fixed depends on whether the
central bank follows a rule of constant growth of the money supply.
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Question
If there is a fixed-exchange-rate system, then in the long run:
Answer the nominal exchange rate is fixed, but the real exchange rate is free to vary.
the real exchange rate is fixed, but the nominal exchange rate is free to vary.
both the nominal and real exchange rates are fixed.
the nominal and real exchange rates vary by a fixed amount.
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Question
During the era of the gold standard, the price of gold in England:
Answer was always equal to the price of gold in the United States.
was always a little higher than the price of gold in the United States, but it could not be higher by more
than the cost of transporting gold from the United States to England.
was always a little lower than the price of gold in the United States, but it could not be lower than the cost
of transporting gold from England to the United States.
could be higher or lower than the price of gold in the United States, but not by more than the cost of
transporting gold between the two countries.
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Question
In a small open economy with a fixed exchange rate, if the government increases government purchases, then in the
Answer the exchange rate rises but income does not rise.
income rises but the exchange rate does not rise.
both income and the exchange rate rise.
neither income nor the exchange rate rises, as the money supply contracts.
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Question
In a small open economy with a fixed exchange rate, if the government increases government purchases, then in the
process of adjusting to the new short-run equilibrium the money supply:
Answer increases to keep the exchange rate unchanged, thus augmenting the effect of government spending on
income.
decreases to keep the exchange rate unchanged, thus offsetting the effect of government spending on
income.
remains unchanged, and there is no effect of government spending on income.
remains unchanged to keep the interest rate at the world interest rate, so that government spending
reduces income.
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Question
In a small open economy with a fixed exchange rate, an effective policy to increase equilibrium output is to:
Answer decrease government spending.
decrease taxes.
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Question
Exhibit: IS*–LM*
Reference: Ref 13-3
(Exhibit: IS*–LM*) A small open economy with a fixed exchange rate e is initially at equilibrium A with
2
and equilibrium output Y . If there is an increase in government spending to the new equilibrium will be at ____,
1
holding everything else constant.
Answer A
B
C
D
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Question
Exhibit: IS*–LM*
Reference: Ref 13-3
(Exhibit: IS*–LM*) A small open economy with a fixed exchange rate e is initially at equilibrium A with
2
and equilibrium output Y . If there is a monetary expansion to the new equilibrium will be at ____, holding
1
everything else constant.
Answer A
B
C
D
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Question
In a small open economy with a fixed exchange rate, if the central bank tries to increase the money supply, then in the
Answer income rises.
income falls.
the exchange rate falls.
income remains constant.
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Question
In a small open economy with a fixed exchange rate, if the country devalues its currency, then in the new short-run
equilibrium the exchange rate ______, and the LM* curve shifts to the ______.
Answer decreases; left
increases; left
decreases; right
increases; right
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Question
In the Mundell–Fleming model with fixed exchange rates, attempts by the central bank to increase the money supply
lead the exchange rate to fall, giving arbitrageurs the incentive to ______ the central bank, which causes the money
supply to ______.
Answer sell domestic currency to; increase
sell domestic currency to; decrease
buy domestic currency from; increase
buy domestic currency from; decrease
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Question
In the Mundell–Fleming model with fixed exchange rates, attempts by the central bank to decrease the money supply:
Answer lead to a lower equilibrium level of income.
lead to a higher equilibrium level of income.
must be abandoned in order to maintain the fixed exchange rate.
must be offset by expansionary fiscal policy.
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Question
A revaluation of a currency under a fixed-exchange-rate system occurs when the level at which the currency is fixed is:
Answer increased.
decreased.
allowed to float.
kept fixed within a band.
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Question
A devaluation of a currency under a fixed-exchange-rate system occurs when the level at which the currency is fixed is:
Answer increased.
decreased.
allowed to float.
kept fixed within a band.
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Question
During the Great Depression, countries that devalued their currencies generally ______ whereas countries that
maintained the old exchange rate ______.
Answer suffered longer; experienced no depression
recovered relatively quickly; experienced no depression
suffered longer; recovered relatively quickly
recovered relatively quickly; suffered longer
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Question
In a small open economy with a fixed exchange rate, if the government imposes an import quota, then net exports:
Answer decrease but the money supply falls and income falls.
increase, the money supply increases, and income increases.
are unchanged but the money supply falls and income falls.
are unchanged, the money supply is unchanged, and income is unchanged.
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Question
In the Mundell–Fleming model with fixed exchange rates, the imposition of trade restrictions results in an increase in
net exports because:
Answer investment increases.
investment decreases.
saving increases.
saving decreases.
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Question
According to the Mundell–Fleming model, under:
Answer floating exchange rates, a monetary expansion raises income whereas a fiscal expansion does not, but
under fixed exchange rates, a fiscal expansion raises income whereas a monetary expansion does not.
both floating and fixed exchange rates, a monetary expansion raises income, but a fiscal expansion does
not.
both floating and fixed exchange rates, a fiscal expansion raises income, but a monetary expansion does
not.
floating exchange rates, a fiscal expansion raises income whereas a monetary expansion does not; but
under a fixed exchange rate, a monetary expansion raises income whereas a fiscal expansion does not.
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Question
According to the Mundell–Fleming model, under floating exchange rates a fiscal expansion:
Answer lowers the exchange rate, but a monetary expansion raises it.
raises the exchange rate, but a monetary expansion or an import restriction lowers it.
or an import restriction lowers the exchange rate, but a monetary expansion raises it.
or an import restriction raises the exchange rate, but a monetary expansion lowers it.
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Question
According to the Mundell–Fleming model, under fixed exchange rates expansionary fiscal policy causes income to
______, and under flexible exchange rates expansionary fiscal policy causes income to ______.
Answer increase; increase
increase; remain unchanged
remain unchanged; remain unchanged
remain unchanged; increase
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Question
According to the Mundell–Fleming model, in an economy with flexible exchange rates, expansionary fiscal policy
causes the exchange rate to ______ and expansionary monetary policy causes the exchange rate to ______.
Answer rise; rise
rise; fall
fall; fall
fall; rise
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Question
According to the Mundell–Fleming model, in an economy with flexible exchange rates, expansionary fiscal policy
causes net exports to ______, and expansionary monetary policy causes net exports to ______.
increase; decrease
decrease; decrease
decrease; increase
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Question
According to the Mundell–Fleming model, import restrictions in an economy with flexible exchange rates cause net
exports to ______ and in an economy with fixed exchange rates import restrictions cause net exports to ______.
increase; remain unchanged
remain unchanged; remain unchanged
remain unchanged; increase
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Question
According to the Mundell–Fleming model, under flexible exchange rates expansionary monetary policy ______
increase income, and under fixed exchange rates expansionary monetary policy ______ increase income.
Answer can; can
can; cannot
cannot; can
cannot; cannot
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Question
The risk premium included in the interest rate of small open economies incorporates:
Answer country risk and expectations of future exchange-rate changes.
the law of one price.
inefficient activity by arbitrageurs.
capital mobility.
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Question
Country risk included in the risk premium in interest rates refers to the:
Answer additional costs incurred when loans are made in currencies other than the domestic currency.
possibility that loans in some countries may not be repaid because of political upheaval.
expectation that the exchange rate may change in the future.
potential change in the terms of trade between countries.
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Question
Exhibit: Risk Premium
A small open economy with a floating exchange rate is initially in equilibrium at A with If there is an
increase in the risk premium, then will shift to _____ and will shift to _____.
Answer
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Question
A small open economy with a floating exchange rate is initially in equilibrium at A with If the establishment
of a new government in the country decreases the risk premium, then will shift to _____ and will shift to
_____.
Answer
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Question
In order to compensate for an expected future decline in the Japanese yen relative to the U.S. dollar, the interest rate
in Japan must be ______ the interest rate in the United States.
Answer higher than
lower than
equal to
fixed relative to
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Question
In the Mundell–Fleming model, if political turmoil raises the risk premium in a country's interest rate, then the exchange
rate will ______.
Answer increase
decrease
remain constant
either increase or decrease, depending on whether the IS* or LM* curve shifts more.
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Question
In the Mundell–Fleming model, expectations that a currency will lose value in the future will cause the current
exchange rate to:
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Answer increase in the present.

decrease in the present.
remain constant in the present.
decrease only in the future.
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Question
An increase in income generated by an increase in the country risk premium will not occur if there is a(n) ______
sufficient to offset the decline in the demand for money caused by the higher risk premium.
Answer decrease in the money supply
increase in the money supply
decrease in government spending
fall in the price level
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Question
An increase in income generated by an increase in the country risk premium will not occur if there is a(n) ______
sufficient to offset the decline in the demand for money caused by the higher risk premium.
Answer increase in the money supply
decrease in government spending
increase in the price level caused by more expensive imports
fall in the price level caused by less expensive imports
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Question
According to the Mundell–Fleming model with floating exchange rates, political uncertainty in Mexico in 1994 caused
the risk premium on Mexican interest rates to ______ and the Mexican exchange rate to ______.
increase; decrease
decrease; increase
decrease; decrease
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Question
At the end of 1994 the Mexican government was unable to maintain a fixed exchange rate because it:
Answer ran out of foreign-currency reserves.
was unable to increase the supply of Mexican pesos.
was forced by the IMF to let the peso float.
joined an exchange-rate union.
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Question
“Crony capitalism” refers to situations in which banks make loans to those borrowers with the most:
Answer profitable investment projects.
political clout.
ability to repay the loans.
creditworthy borrowers.
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Question
One argument favoring a floating-exchange-rate system is that it:
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Answer makes international trade less difficult.

minimizes destabilizing speculation by international investors.
allows monetary policy to be used for other purposes.
helps prevent excessive growth in the money supply.
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Question
One argument favoring a fixed-exchange-rate system is that it:
Answer allows monetary policy to be used for stabilizing output and prices.
reduces exchange-rate uncertainty, thereby promoting more international trade.
leads to excessive growth of the money supply.
requires no actions on the part of the central bank to implement.
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Question
A monetary union with a common currency is an example of a:
Answer fixed-exchange-rate system.
flexible-exchange-rate system.
small open economy.
large open economy.
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Question
Some economists argue that monetary union will not work as well in Europe as it does in the United States for all of the
following reasons except:
Answer labor is not as mobile in Europe as it is in the United States.
there is no strong central government that can use fiscal policy in Europe as there is in the United States.
there is no common language in Europe as there is in the United States.
there is no European central bank as there is in the United States.
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Question
If the exchange rate of currency A is fixed to a unit of currency B, then a potential problem for the central bank in
charge of currency A is:
Answer running out of currency A.
running out of currency B.
generating excessive revenue from seigniorage.
ineffective fiscal policy.
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Question
A speculative attack on a currency occurs when:
Answer a central bank switches from a floating to a fixed exchange rate.
investors' perceptions change, making a fixed exchange rate untenable.
a country accepts dollarization.
a central bank adopts a currency board to back the domestic currency with a foreign currency.
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A change in investors' perceptions that make a fixed exchange rate untenable is known as:
Answer a speculative attack.
dollarization.
seigniorage.
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a floating currency board.
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Question
An arrangement by which a central bank holds enough foreign currency to back each unit of the domestic currency is
called a:
Answer floating exchange rate.
dollarization.
monetization.
currency board.
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Question
When a country abandons its national currency and adopts the currency of the United States, this is known as:
Answer a floating exchange rate system.
dollarization.
a speculative attack on the United States.
a currency board.
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Question
The principal economic loss when a country dollarizes is the loss of:
Answer seigniorage revenue.
income tax revenue.
monetary stability.
a fixed exchange rate with the dollar.
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Question
The “impossible trinity” refers to the idea that it is impossible for a country to simultaneously have:
Answer low inflation, low unemployment, and a rapid rate of GDP growth.
free capital flows, a fixed exchange rate, and an independent monetary policy.
high interest rates, a budget deficit, and a trade deficit.
an expansionary fiscal policy, a contractionary monetary policy, and a flexible exchange rate.
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Question
If a country chooses to have free capital flows and to conduct an independent monetary policy, then it must:
Answer live with exchange-rate volatility.
restrict its citizens from participating in world financial markets.
give up the use of monetary policy for purposes of domestic stabilization.
have a fixed exchange rate.
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If a country chooses to have free capital flows and to maintain a fixed exchange rate, then it must:
restrict its citizens from participating in world financial markets.
give up the use of fiscal policy for purposes of domestic stabilization.
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Question
If a country chooses to restrict international capital flows and to maintain a fixed exchange rate, then it must:
control its citizens' access to world financial markets.
give up the use of fiscal policy for purposes of domestic stabilization.
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Question
Between 1995 and 2005, China chose to:
Answer conduct independent monetary policy, allow free international-capital flows, and maintain a fixed exchange
rate.
maintain a fixed exchange rate, allow free international-capital flows, and give up the use of monetary
policy for domestic stabilization.
conduct an independent monetary policy, restrict international-capital flows, and maintain a fixed exchange
rate.
allow a flexible exchange rate, conduct an independent monetary policy, and allow free international-
capital flows.
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Question
Which of the following would be evidence that a country with a fixed exchange rate has an undervalued currency?
Answer The government has a budget surplus.
The government has a budget deficit.
The central bank's foreign-currency reserves are increasing.
The central bank's foreign-currency reserves are decreasing.
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Question
In the Mundell–Fleming model, if the price level falls, then the equilibrium income
Answer rises and the real exchange rate appreciates.
rises and the real exchange rate depreciates.
falls and the real exchange rate appreciates.
falls and the real exchange rate depreciates.
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Question
In the Mundell–Fleming model, if the economy is operating at or below the natural level in the short run, then in the
long run the price level will fall, the exchange rate will ______, and net exports will ______ to restore the economy to
its natural rate.
Answer appreciate; increase
appreciate; decrease
depreciate; increase
depreciate; decrease
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Question
In the Mundell–Fleming model with flexible exchange rates, an increase in the price level results in a(n) ______ in the
real exchange rate and a(n) ______ in net exports.
increase; decrease
decrease; decrease
decrease; increase
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Question
Exhibit: IS*–LM* and AD
Reference: Ref 13-4
(Exhibit: IS*–LM* and AD) A small open economy with a floating exchange rate is initially in equilibrium at A with
Holding all else constant, if the domestic price level increases, then the _____ curve will shift to _____.
Answer
LM*;
LM*;
IS*;
IS*;
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Question
Exhibit: IS*–LM* and AD
Reference: Ref 13-4
(Exhibit: IS*–LM* and AD) A small open economy with a floating exchange rate is initially in equilibrium at A with
Holding all else constant, if the domestic price level decreases, then the _____ curve will shift to _____.
Answer
LM*;
LM*;
IS*;
IS*;
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Question
In a large open economy with a floating exchange rate, such as in the United States, in the short run a monetary
contraction:
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Answer raises the interest rate, lowers investment and income, but does not affect the exchange rate.
raises the exchange rate, lowers net exports and income, but does not affect the interest rate.
initially raises the exchange rate, causing arbitrageurs to sell dollars and return the money supply to its
initial level.
raises the interest rate and lowers investment and income, but also raises the exchange rate and lowers
net exports.
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Question
In a short-run model of a large open economy with a floating exchange rate, net capital outflow ______ as the
domestic interest rate increases and is just equal to ______.
Answer decreases; the increase in net exports.
decreases; the decrease in net exports.
increases; the increase in net exports.
increases; the decrease in net exports.
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Question
In a short-run model of a large open economy, after net capital outflow is substituted for net exports in the IS curve:
Answer the larger the absolute value of the responsiveness of net capital outflow with respect to the interest rate,
the flatter the IS curve.
the larger the absolute value of the responsiveness of net capital outflow with respect to the interest rate,
the steeper the IS curve.
if both domestic investment and net capital outflow are very responsive to the interest rate, they will tend to
cancel each other out.
the slope of the IS curve depends only on the interest responsiveness of investment and the marginal
propensity to consume.
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Question
In a short-run model of a large open economy with a floating exchange rate:
Answer net exports determine the exchange rate, which in turn determines net capital outflow.
net exports determine net capital outflow, which determines the interest rate.
the interest rate is determined in the IS–LM framework, and this value determines net capital outflow; then
the exchange rate adjusts to make net exports equal net capital outflow.
the interest rate determines investment and net capital outflow, which are equal within the IS–LM
framework; the exchange rate then determines net exports.
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Question
In a short-run model of a large open economy with a floating exchange rate, a fiscal expansion causes an increase in:
Answer the exchange rate and a fall in net exports but has no effect on income.
the money supply and an increase in income but has no effect on the exchange rate.
income, the interest rate, and net exports, but a decrease in investment and in the exchange rate.
income, the interest rate, and the exchange rate, but a decrease in investment and net exports.
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Question
In a short-run model of a large open economy with a floating exchange rate, a monetary expansion causes a decrease
in the interest rate and:
Answer the exchange rate but has no effect on income.
the exchange rate, and increases in income, net capital outflow, and net exports.
the exchange rate and net capital outflow, and increases in income and net exports.
net exports and net capital outflow, but increases in investment and income.
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19 of 27 12/8/2012 11:42
Question
A fall in consumer confidence about the future, which induces consumers to spend less and save more, will, according
to the Mundell–Fleming model with floating exchange rates, lead to:
Answer a fall in consumption and income.
no change in consumption or income.
no change in income but a rise in net exports.
no change in income or net exports.
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Question
A fall in consumer confidence about the future, which induces consumers to spend less and save more, will, according
to the Mundell–Fleming model, with fixed exchange rates, lead to:
Answer a fall in consumption and income.
no change in consumption or income.
a fall in income but a rise in net exports.
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Question
The introduction of a stylish new line of Toyotas, which makes some consumers prefer foreign cars over domestic cars,
will, according to the Mundell–Fleming model with floating exchange rates, lead to:
Answer a fall in income and net exports.
a fall in income but no change in net exports.
no change in income but a fall in net exports.
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Question
The introduction of a stylish new line of Toyotas, which makes some consumers prefer foreign cars over domestic cars,
will, according to the Mundell–Fleming model with fixed exchange rates, lead to:
Answer a fall in income and net exports.
a fall in income but no change in net exports.
no change in income but a fall in net exports.
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Question
The introduction of automatic teller machines, which reduces the demand for money, will, according to the Mundell–
Fleming model with floating exchange rates, lead to:
Answer no change in income and net exports.
a rise in income but no change in net exports.
a rise in both income and net exports.
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Question
The introduction of automatic teller machines, which reduces the demand for money, will, according to the Mundell–
Fleming model with fixed exchange rates, lead to:
Answer a rise in income and net exports.
a rise in income but no change in net exports.
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20 of 27 12/8/2012 11:42
Question
In the Mundell–Fleming model with a floating exchange rate, a rise in the world interest rate will lead income:
Answer and net exports both to fall.
to rise and net exports to fall.
to fall and net exports to rise.
and net exports both to rise.
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Question
In the Mundell–Fleming model with a fixed exchange rate, a rise in the world interest rate will lead income:
Answer and net exports both to fall.
to fall while net exports are unchanged.
to be unchanged and net exports to fall.
and net exports to both be unchanged.
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Question
The goods produced in U.S. industries may be made more competitive in world markets by:
Answer appreciating the U.S. currency.
depreciating the U.S. currency.
keeping the exchange rate fixed.
expanding the money supply.
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Question
If investors in a large open economy become more willing to substitute foreign and domestic assets, then this will make
the net capital outflow function:
Answer steeper, and the slope of the IS curve steeper.
steeper, and the slope of the IS curve flatter.
flatter, and the slope of the IS curve steeper.
flatter, and the slope of the IS curve flatter.
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Essay 1 points
Question
Assume that the LM curve for a small open economy with a floating exchange rate is given by Y = 200r – 200 + 2(M/P),
while the IS curve is Y = 400 + 3G – 2T + 3NX – 200r. The function for NX is NX = 200 – 100e, where e is the
*
exchange rate. The price level (P) is fixed at 1.0. The international interest rate is r = 2.5 percent.
a. Using the LM curve, find the equilibrium level of Y in the small open economy, if M = 100.
b. Given this value of Y, if G = 100 and T = 100, what must be the equilibrium value of NX?
c. If this value of NX is to be achieved, what must be the equilibrium exchange rate, e?
Answer a. Equilibrium Y = 500.

b. Equilibrium NX = 166.67.
c. Equilibrium e = 1/3.
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Question
Assume that the LM curve for a small open economy with a fixed exchange rate is given by Y = 200r – 200 + 2(M/P).
This IS curve is given by Y = 400 + 3G – 2T + 3NX – 200r. The function for the net exports is NX = 200 – 100e, where
*
e is the exchange rate. The price level is fixed at 1.0, the world interest rate is r = 2.0 percent, and the exchange rate
is initially 1.0.
a. If M = 100, G = 100, and T = 100, solve for the equilibrium short-run values of Y and NX. Is the initially
given exchange rate equal to the equilibrium exchange rate?
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b. If the Fed buys bonds in order to raise the money supply, will equilibrium Y increase?
Answer a. Equilibrium values are Y = 400 and NX = 100. The initially given exchange rate is equal to the
equilibrium exchange rate.
b. Equilibrium Y will not increase.
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Question
Assume that a large open economy with a floating exchange rate is described in the short run by the equations:
C = 0.5(Y – T)
T = 1,000
I = 1,500 – 250r
G = 1,500
NX = 1,000 – 250e
C + I + G + NX = Y
M/P = 0.5Y – 500r
M = 1,000
CF = 500 – 250r
NX = CF
The last two equations specify that CF, net capital outflow, decreases with r, the interest rate, and that NX, the net
exports, is equal to net capital outflow. NX is also related to the exchange rate, e, and falls when e appreciates. The
price level (P) is fixed at 1.0.
Calculate short-run equilibrium values of Y, r, C, I, CF, NX, e, private saving, public saving, and foreign saving. Foreign
saving is defined here as minus NX. Check your work by ensuring that C + I + G = Y and private saving plus public
saving plus foreign saving equals domestic investment. (Hint: As in the appendix to textbook Chapter 13, form the IS
curve from C + I + G + NX = Y, and then substitute CF for NX to get C + I + G + CF = Y. Combine with the LM curve
and solve for Y, r, and CF and then use NX = CF to get NX and the equation relating NX to e to get e.)
Answer Y = 4,000; r = 2 percent; C = 1,500; I = 1,000; CF = 0; NX = 0; e = 4; Sp = 1,500; Sg = –50; Sf = 0; 1,500 +
p g
1,000 + 1,500 + 0 = 4,000; 1,500 – 500 + 0 = 1,000. Here S refers to private saving, S refers to
f
government or public saving (T – G), and S refers to foreign saving (–NX).
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Question
Suppose Congress cuts government spending in order to balance the budget. Use the Mundell–Fleming model with
floating exchange rates to illustrate graphically the short-run impact of the cuts in government spending on the dollar
exchange rate and output in the United States. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium
levels; iv. the direction the curves shift; and v. the new short-run equilibrium.
Answer
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Question
Suppose the government of a small open economy with a floating exchange rate imposes 50 percent tariffs on all
imports. Use the Mundell–Fleming model to illustrate graphically the short-run impact of the tariffs of the exchange rate
and output in the country. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium levels; iv. the direction the
curves shift; and v. the new short-run equilibrium.
Answer
22 of 27 12/8/2012 11:42
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Question
In early 1994, Mexico was adhering to a fixed-exchange-rate system. Use the Mundell–Fleming model to illustrate
graphically the short-run impact on the exchange rate and level of output of increased country risk caused by the
Chiapas uprising and the assassination of presidential candidate Colosio. Be sure to label: i. the axes; ii. the curves; iii.
the initial equilibrium levels; iv. the direction the curves shift; and v. the new short-run equilibrium.
Answer
The increase in the risk premium shifts to and to To maintain the fixed exchange
rate must shift to
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Question
a. You are the chief economic adviser in a small open economy with a floating-exchange-rate system. Your
boss, the president of the country, wishes to increase the level of output in the short run in order to win
reelection. Do you recommend using expansionary or contractionary monetary or fiscal policy?
b. Use the Mundell–Fleming model to illustrate graphically your proposed policy. Be sure to label: i. the
axes; ii. the curves; iii. the initial equilibrium levels; iv. the direction the curves shift; and v. the new
short-run equilibrium.
Answer a. expansionary monetary policy

b.
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23 of 27 12/8/2012 11:42
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Question
Economic expansion throughout the rest of the world raises the world interest rate. Use the Mundell–Fleming model to
illustrate graphically the impact of an increase in the world interest rate on the exchange rate and level of output in a
small open economy with a floating-exchange-rate system. Be sure to label: i. the axes; ii. the curves; iii. the initial
equilibrium levels; iv. the direction the curves shift; and v. the new short-run equilibrium.
Answer
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Question
Two small open economies, Fixed and Flex, can be described by the Mundell–Fleming model. The countries are
otherwise identical except that Fixed maintains a fixed exchange rate, while Flex maintains a flexible exchange-rate
regime. The governments of both countries increase spending by the same amount. Compare what happens in the two
countries to:
a. the exchange rate
b. equilibrium output
c. net exports.
Answer a. The central bank in Fixed will keep the exchange rate fixed, while the exchange rate will increase in
Flex.
b. Output will increase in Fixed but will be unchanged in Flex.
c. Net exports will be unchanged in Fixed (because the exchange rate does not change) but will decrease
in Flex (because the exchange rate increased).
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Question
Macroland is a small open economy with perfect capital mobility and a flexible-exchange-rate system. Macroland is
initially in equilibrium at the natural level of output with balanced trade. Compare the impact of a tax cut in the short run
(when prices are fixed) and in the long run (when prices are flexible) on: (a) output, b) consumption, (c) investment, (d)
net exports, and (e) the exchange rate.
Answer a. In both the short run and long run, output is unchanged.
b. Consumption is higher in both the short run and the long run because the tax cut increases disposable
income.
c. Investment is unchanged in the short run and the long run because there is no change in the world
interest rate.
d. In the short run and long run, net exports decrease by the amount that consumption increases because
the exchange rate increases. Starting from balanced trade, the country will have a trade deficit in the
short run and the long run.
e. In the short run and long run, the exchange rate is higher because the tax cut puts upward pressure on
the domestic interest rate, which attracts capital inflows and drives up the exchange rate.
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Question
The government of a small open economy with perfect capital mobility wants to establish a “stronger” currency by
moving its exchange rate higher. Suggest both an appropriate monetary policy adjustment and an appropriate fiscal
policy adjustment that would allow the economy to move to a higher exchange rate. What are the consequences of
these adjustments on domestic output and net exports?
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Answer Contractionary monetary policy would move the economy to a higher exchange rate. Domestic output would
be reduced by the decrease in the money supply, and the higher exchange rate would reduce net exports.
Expansionary fiscal policy would also move the economy to the higher exchange rate. The level of domestic
output would not change, but the composition of output would change. The higher exchange rate resulting
from either more government spending or more consumption spending caused by lower taxes would crowd
out net exports.
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Question
A U.S. Congressman wants to reduce the U.S. trade deficit by imposing tariffs on imports. Use a model of a large open
economy with a flexible exchange rate to predict the impact of tariffs on U.S. imports, exports, net exports, the
exchange rate, and the interest rate.
Answer The tariffs reduce the demand for imports, raise the demand for net exports, and cause the exchange rate to
appreciate. The higher exchange rate reduces exports by an amount equal to the decrease in imports, so
there is no change in net exports or in the trade deficit. Since there is no change in saving or investment, there
is no change in the interest rate.
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Question
Explain how net capital outflows change in a large open economy when there is a:
a. monetary contraction
b. fiscal contraction.
Answer a. A monetary contraction increases the domestic interest rate, which will make domestic investment
opportunities more attractive and reduce net capital outflows.
b. A fiscal contraction decreases the domestic interest rate, which will make domestic investment
opportunities less attractive and increase net capital outflows.
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Question
Holding everything else constant, compare the impact of a monetary expansion in a small open economy with a
floating exchange rate and in a large open economy with a floating exchange rate on:
a. domestic investment
b. domestic output
Answer a. Since the world interest rate does not change, domestic investment will not change in the small open
economy, but the domestic interest rate will decrease in the large open economy, which will increase
domestic investment.
b. The monetary expansion increases domestic output in both economies, but through different pathways.
In the small open economy the monetary expansion will reduce the exchange rate, increasing domestic
output via an increase in net exports (and induced consumption spending through the increase in
income). In the large open, economy, output increases not only because of the increase in net exports,
but the monetary expansion also reduces the domestic interest rate and increases domestic investment.
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Question
During periods of economic downturn, there is frequently pressure to protect domestic production from foreign
competition in the belief that protectionist policies will save domestic jobs. Will protectionist policies increase or
decrease domestic production in a large open economy with a floating exchange rate, holding all else constant?
Illustrate your answer graphically and explain in words.
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Answer The protectionist policies will not change domestic output. There is no change in net capital outflows, so the IS
does not shift in the IS–LM model. The protectionist polices shift the NX schedule and result in a higher
exchange rate. The reduction in imports generated by the protectionist policies is met with an equal reduction
in exports as a result of the higher exchange rate, resulting in no change in net exports or in domestic output.
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Essay 1 points
Question
What type of monetary or fiscal policy will generate both a “stronger” economy (increased Y) and a “stronger” dollar
(increased e) in a large open economy with a floating exchange rate? Explain.
Answer Expansionary fiscal policy raises domestic output and domestic interest rates. The higher domestic interest
rates will reduce net capital outflows and increase the exchange rate, thereby generating both “stronger”
output and a “stronger” exchange rate.
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Question
Graphically illustrate and explain how a steep decline in the value of the stock market and housing prices would affect
the level of domestic output, the interest rate, and the exchange rate in a large open economy with a floating exchange
rate.
Answer The stock market and housing price declines reduce consumption spending and shift the IS curve to the left,
resulting in lower output and a lower domestic interest rate. The lower interest rate makes domestic
investment opportunities less attractive and increases net capital outflows, which reduces the exchange rate
and increases net exports. Thus, output, the interest rate, and the exchange rate all decline as a result of the
stock market and housing price declines.
26 of 27 12/8/2012 11:42
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Question
The “impossible trinity” refers to the idea that a country can simultaneously pursue only two of the three following
policies: free international-capital flows, monetary policy for domestic stabilization, and a fixed exchange rate. For each
of the following combinations indicate what the economy gives up by selecting the combination and why the omitted
policy cannot be achieved:
a. a fixed exchange rate and free international-capital flows
b. a monetary policy for domestic stabilization and a fixed exchange rate
c. a monetary policy for domestic stabilization and free international-capital flows
Answer a. The economy loses the ability to use monetary policy for domestic stabilization because monetary policy
must be used to maintain the fixed exchange rate.
b. The economy must restrict the free flow of international capital to isolate the determinants of the
domestic interest rate from the world interest rate, so monetary policy can be used to influence the
domestic economy and at the same time fix the exchange rate.
c. The economy cannot fix the exchange rate because monetary policy is used for domestic stabilization
rather than to fix the exchange rate. The free flow of capital ensures that the domestic interest rate is
determined by the world interest rate rather than by domestic monetary policy.
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27 of 27 12/8/2012 11:42
Pool Canvas
Name TestBanks Chapter 14 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment
Description
Instructions
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Question
The basic aggregate supply equation implies that output exceeds natural output when the price level is:
Answer low.
high.
less than the expected price level.
greater than the expected price level.
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Question
Some firms do not instantly adjust the prices they charge in response to changes in demand for all of the following
reasons except:
Answer it is costly to alter prices.
they do not want to annoy their frequent customers.
prices do not adjust when there is perfect competition.
some prices are set by long-term contracts between firms and customers.
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Question
According to the sticky-price model:
Answer all firms announce their prices in advance.
all firms set their prices in accord with observed prices and output.
some firms set their prices according to the aggregate supply equation.
some firms announce their prices in advance, and some firms set their prices in accord with observed
prices and output.
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Question
According to the sticky-price model, other things being equal, the greater the proportion, s, of firms that follow the
sticky-price rule, the ______ the ______ in output in response to an unexpected price increase.
Answer greater; increase
smaller; increase
greater; decrease
smaller; decrease
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Question
Each of the two models of short-run aggregate supply is based on some market imperfection. In the sticky-price model,
the imperfection is that:
Answer some firms do not adjust their prices instantly to changes in demand.
expectations are formed adaptively rather than rationally.
firms confuse changes in the overall level of prices with changes in relative prices.
the real wage adjusts to bring labor supply and labor demand into equilibrium.
1 of 23 12/8/2012 11:42
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Question
In the sticky-price model, the relationship between output and the price level depends on:
Answer the proportion of firms with flexible prices.
the target real wage rate.
the target nominal wage rate.
the implicit agreements between workers and firms.
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Question
Based on the sticky-price model, the short-run aggregate supply curve will be steeper, the greater the:
Answer target nominal-wage rate.
target real-wage rate.
proportion of firms with flexible prices.
proportion of firms with sticky prices.
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Question
According to the sticky-price model, output will be at the natural level if:
Answer firms expect a high price level and the demand for goods is high.
the proportion of firms with flexible prices equals the proportion of firms with sticky prices.
the price level equals the expected price level.
expectations are formed adaptively, but not if expectations are formed rationally.
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Question
According to the sticky-price model, deviations of output from the natural level are _____ deviations of the price level
from the expected price level.
Answer positively associated with
negatively associated with
not related to
equal to
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Question
The imperfect-information model bases the difference in the short-run and long-run aggregate supply curve on:
Answer sticky wages.
sticky prices.
temporary misperceptions about prices.
procyclical real wages.
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Question
The imperfect-information model assumes that producers find it difficult to distinguish between changes in:
Answer real wages and nominal wages.
the overall level of prices and relative prices.
the overall level of prices and the expected level of prices.
cost-push inflation and demand-pull inflation.
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2 of 23 12/8/2012 11:42
Question
According to the imperfect-information model, when the price level rises by the amount the producer expected it to rise,
the producer:
Answer increases production.
does not change production.
decreases production.
hires more workers.
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Question
Each of the two models of short-run aggregate supply is based on some market imperfection. In the imperfect-
information model, the imperfection is that:
Answer some firms do not adjust their prices instantly to changes in demand.
contracts and arrangements may prevent nominal wages from adjusting rapidly to changing economic
conditions.
firms confuse changes in the overall level of prices with changes in relative prices.
the real wage adjusts to bring labor supply and labor demand into equilibrium.
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Question
According to the imperfect-information model, when the price level falls but the producer did not expect it to fall, the
producer:
Answer increases production.
does not change production.
decreases production.
hires more workers.
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Question
After examining international data, the economist Robert Lucas found that aggregate demand has the biggest effect on
output in countries where aggregate demand:
Answer and prices are most stable.
and prices are most variable.
is most stable but prices are most variable.
is most variable but prices are most stable.
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Question
According to the imperfect-information model, in countries in which there is a great deal of variability of prices:
Answer the response of output to unexpected changes in prices will be relatively large.
the response of output to unexpected changes in prices will be relatively small.
output will respond negatively to an unexpected rise in prices.
output will not respond to an unexpected change in prices.
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Question
Using the sticky-price model, the higher the average rate of inflation, the more frequently firms must adjust their prices,
which implies that a high rate of inflation:
Answer has no effect on the slope of the short-run aggregate supply curve.
should make the short-run aggregate supply curve flatter.
makes the short-run aggregate supply curve steeper.
causes prices to be sticky.
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3 of 23 12/8/2012 11:42
Question
According to the imperfect-information model, when the price level is greater than the expected price level, output will
_____ the natural level of output
Answer be greater than
be less than
be equal to
shift the
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Question
The short-run aggregate supply curve is drawn for a given:
Answer output level.
price level.
expected price level.
level of aggregate demand.
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Question
Both models of aggregate supply discussed in Chapter 14 imply that if the price level is higher than expected, then
output ______ natural rate of output.
Answer exceeds the
falls below the
equals the
moves to a different
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Question
Both models of aggregate supply discussed in Chapter 14 imply that if the price level is lower than expected, then
output ______ natural rate of output.
Answer exceeds the
falls below the
equals the
moves to a different
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Question
Starting from the natural level of output, an unexpected monetary contraction will cause output and the price level to
______ in the short run; and in the long run the expected price level will ______, causing the level of output to return to
the natural level.
increase; decrease
decrease; decrease
decrease; increase
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Question
The model of aggregate demand and aggregate supply is consistent with short-run monetary ______ and long-run
monetary ______.
Answer neutrality; neutrality
nonneutrality; nonneutrality
neutrality; nonneutrality
nonneutrality; neutrality
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4 of 23 12/8/2012 11:42
Question
Along an aggregate supply curve, if the level of output is less than the natural level of output, then the price level is:
Answer greater than the expected price level.
less than the expected price level.
equal to the natural price level.
stuck at the existing price level.
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Question
Along any aggregate supply curve, there is only one:
Answer unemployment level.
expected price level.
inflation level.
output level.
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Question
Which of the following will shift the aggregate supply curve up to the left?
Answer an increase in the price level
a decrease in the level of output
an increase in the expected price level
a decrease in the price level
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Question
In the short-run, if the price level is greater than the expected price level, then in the long run the aggregate:
Answer demand curve will shift leftward.
demand curve will shift rightward.
supply curve will shift upward.
supply curve will shift downward.
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Question
Exhibit: AD–AS Shifts
Reference: Ref 14-1
(Exhibit: AD–AS Shifts) Starting from long-run equilibrium at A with output equal to and the price level equal to P , if
1
there is an unexpected monetary contraction that shifts aggregate demand from AD to AD , then the short-run
1 3
nonneutrality of money is represented by the movement from:
Answer A to B
A to G
5 of 23 12/8/2012 11:42
A to C
A to D
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Question
Reference: Ref 14-1
(Exhibit: AD–AS Shifts) Starting from long-run equilibrium at A with output equal to and the price level equal to P , if
1
there is an unexpected monetary contraction that shifts aggregate demand from AD to AD , then the long-run
1 3
neutrality of money is represented by the movement from:
Answer A to B
A to G
A to C
A to D
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Question
The Phillips curve shows a ______ relationship between inflation and unemployment, and the short-run aggregate
supply curve shows a ______ relationship between the price level and output.
Answer positive; positive
positive; negative
negative; negative
negative; positive
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Question
The relationship between short-run aggregate supply curves and Phillips curves is that there:
Answer is no relationship between short-run aggregate supply curves and Phillips curves.
are several short-run aggregate supply curves for each Phillips curve.
are several Phillips curves for each short-run aggregate supply curve.
is exactly one Phillips curve corresponding to each short-run aggregate supply curve.
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Question
The Phillips curve depends on all of the following forces except:
Answer the current exchange rate.
expected inflation.
the deviation of unemployment from its natural rate.
supply shocks.
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6 of 23 12/8/2012 11:42
Question
According to the Phillips curve, other things being equal, inflation depends positively on:
Answer expected inflation.
the unemployment rate.
the rate of technological change.
the quantities of capital and labor.
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Question
The Phillips curve expresses a short-run link:
Answer among nominal variables.
among real variables.
among unexpected variables.
between nominal and real variables.
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Question
If the short-run aggregate supply curve is steep, the Phillips curve will be:
Answer flat.
steep.
backward-bending.
unrelated to the slope of the short-run aggregate supply curve.
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Question
Along a short-run aggregate supply curve, output is related to unexpected movements in the ______. Along a Phillips
curve, unemployment is related to unexpected movements in the ______.
Answer price level; inflation rate
inflation rate; price level
unemployment rate; price level
price level; level of output
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Question
All of the following are ways that the modern Phillips curve differs from the relationship observed by A. W. Phillips in
1958 except that the modern Phillips curve:
Answer substitutes the output gap for unemployment.
includes supply shocks.
includes expected inflation.
substitutes price inflation for wage inflation.
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Question
The classical dichotomy breaks down for a Phillips curve, which shows the relationship between a nominal variable,
______, and a real variable, ______.
Answer output; prices
money; output
inflation; unemployment
unemployment; inflation
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7 of 23 12/8/2012 11:42
Question
Based on the Phillips curve, unexpected movements in inflation are related to ______, and based on the short-run
aggregate supply curve, unexpected movements in the price level are related to ______.
Answer sticky wages; sticky prices
sticky prices; sticky wages
output; unemployment
unemployment; output
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Question
The NAIRU is the:
Answer North American institutional rate of unemployment.
natural aggregate investment return on utilization.
nonaccelerating inflation rate of unemployment.
normal American inelastic rate of unemployment.
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Question
When adaptive expectations are used to model inflation expectations in the Phillips curve, then the natural rate of
unemployment is called the ______ rate of unemployment.
Answer structural
cyclical
short-run aggregate supply
nonaccelerating inflation
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Question
If the equation for a country's Phillips curve is = 0.02 – 0.8(u – 0.05), where is the rate of inflation and u is the
unemployment rate, what is the short-run inflation rate when unemployment is 4 percent (0.04)?
Answer above 2 percent (0.02)
below 2 percent (0.02)
2 percent (0.02)
–2 percent (–0.02)
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Question
The assumption of adaptive expectations for inflation means that people will form their expectations of inflation by:
Answer taking all information into account using the best economic model available.
asking the opinions of experts.
basing their opinions on recently observed inflation.
flipping a coin.
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Question
Inflation inertia is represented in the aggregate supply–aggregate demand model by continuing upward shifts in the:
Answer aggregate demand curve.
short-run aggregate supply curve.
long-run aggregate supply curve.
aggregate demand and short-run aggregate supply curves.
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Inflation inertia refers to the idea that inflation:
8 of 23 12/8/2012 11:42
Answer is always present in economies.

keeps on going unless something acts to stop it.
cannot be reduced unless unemployment is increased.
can be generated by either demand-pull or cost-push forces.
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Question
To illustrate inflation inertia in an aggregate demand–aggregate supply model, the short-run aggregate supply curve
shifts upward because of increases in ______, and the aggregate demand curve shifts upward because of increases in
______.
Answer the expected price level; the money supply
the money supply; the expected price level
output; the price level
the price level; output
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Question
Demand-pull inflation is the result of:
Answer high aggregate demand.
low aggregate demand.
favorable supply shocks.
adverse supply shocks.
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Question
In the case of demand-pull inflation, other things being equal:
Answer both the inflation rate and the unemployment rate rise at the same time.
the unemployment rate rises but the inflation rate falls.
the inflation rate rises but the unemployment rate falls.
both the inflation rate and the unemployment rate fall.
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Cost-push inflation is the result of:
Answer high aggregate demand.
low aggregate demand.
favorable supply shocks.
adverse supply shocks.
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In the case of cost-push inflation, other things being equal:
Answer both the inflation rate and the unemployment rate rise at the same time.
the unemployment rate rises but the inflation rate falls.
the inflation rate rises but the unemployment rate falls.
both the inflation rate and the unemployment rate fall.
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9 of 23 12/8/2012 11:42
Reference: Ref 14-2
(Exhibit: AD–AS Shifts) Starting from long-run equilibrium at A with output equal to and the price level equal to P , a
1
cost-push inflation would be represented by a shift from:
Answer AD1 to AD2
AD1 to AD3
AS1 to AS2
AS1 to AS3
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Question
Reference: Ref 14-2
(Exhibit: AD–AS Shifts) Starting from long-run equilibrium at A with output equal to and the price level equal to P , a
1
demand-pull inflation would be represented by a shift from:
Answer AD1 to AD2
AD1 to AD3
AS1 to AS2
AS1 to AS3
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Question
In the 1960s, in the United States:
Answer both the inflation rate and the unemployment rate rose at the same time.
the unemployment rate rose but the inflation rate fell.
the inflation rate rose but the unemployment rate fell.
both the inflation rate and the unemployment rate fell.
10 of 23 12/8/2012 11:42
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Question
The most prominent feature of the U.S. economy in the 1970s was:
Answer cost-push deflation.
cost-push inflation.
demand deflation.
demand inflation.
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Question
The most prominent feature of the U.S. economy in the 1980s was:
Answer cost-push inflation.
cost-push deflation.
demand-pull inflation.
demand-pull deflation.
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Question
The short-run Phillips curve:
Answer shifts upward if expected inflation increases.
shifts upward if expected inflation decreases.
shifts downward if expected inflation increases.
is vertical.
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Question
The Phillips curve analysis described in Chapter 14 implies that there is a negative tradeoff between inflation and
unemployment in:
Answer both the short run and long run.
in the short run only.
in the long run only.
in neither the short run nor the long run.
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Question
The tradeoff between inflation and unemployment does not exist in the long run because people will adjust their
expectations so that expected inflation:
Answer exceeds the inflation rate.
equals the inflation rate.
is below the inflation rate.
equals the inflation rate of the previous year.
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Question
Analysis of the short-run Phillips curve suggests that policymakers who want to reduce unemployment in the short run
should ______ aggregate demand at a cost of generating ______ inflation.
Answer increase; higher
increase; lower
decrease; higher
decrease; lower
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11 of 23 12/8/2012 11:42
Question
Short-run Phillips Curve
Reference: Ref 14-3
(Exhibit: Short-Run Phillips Curve) As the short-run Phillips curve shifts from A to B to C to D, policymakers face:
Answer the same tradeoff between inflation and unemployment.
a lower rate of inflation for any level of unemployment.
a higher rate of inflation for any level of unemployment.
higher than expected inflation rates and lower unemployment rates.
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Question
Short-run Phillips Curve
Reference: Ref 14-3
(Exhibit: Short-Run Phillips Curve) As the short-run Phillips curve shifts from A to B to C to D:
Answer the expected rate of inflation is unchanged at every level of unemployment.
there is a lower-expected rate of inflation at every level of unemployment.
there is a higher-expected rate of inflation for every level of unemployment.
the natural rate of unemployment falls
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Question
Each of the following phenomena hinders the precise estimation of the natural rate of unemployment except:
Answer supply shocks such as oil price increases.
demographic changes such as the aging baby boomers.
policy changes such as minimum wage increases.
introduction of new products such as DVD players.
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Economists are able to estimate the natural rate of unemployment in the United States:
12 of 23 12/8/2012 11:42
Answer very precisely.

in a 95 percent confidence interval of 2 to 3 percentage points.
in a 95 percent confidence interval of 10 to 20 percentage points.
only in years when there are no supply shocks.
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Question
The sacrifice ratio measures the:
Answer number of percentage points of the money supply that must be reduced to reduce inflation by 1
percentage point.
extra taxes that must be paid to balance the budget.
number of months of real gross domestic product (GDP) that must be foregone to reduce the inflation rate
by 1 percentage point.
percentage of a year's real gross domestic product (GDP) that must be foregone to reduce inflation by 1
percentage point.
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Question
The percentage of a year's real GDP that must be foregone to reduce inflation by 1 percentage point is called the:
Answer NAIRU.
short-run Phillips curve.
sacrifice ratio.
Okun's law.
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Question
Assume that the sacrifice ratio for an economy is 4. If the central bank wishes to reduce inflation from 10 percent to 5
percent, this will cost the economy ______ percent of one year's GDP.
Answer 4
5
20
40
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Question
An economy must sacrifice 12 percent of GDP to reduce inflation. Which of the following plans represents the “cold
turkey” solution to inflation?
Answer Reduce output by 1 percent for 12 years.
Reduce output by 2 percent for 6 years.
Reduce output by 4 percent for 3 years.
Reduce output by 12 percent for 1 year.
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Question
The assumption of rational expectations for inflation means that people will form their expectations of inflation by:
Answer optimally using all available information, including information about current policies, to forecast the future.
asking the opinions of the best experts.
subscribing to the forecasting service that uses the best econometric model.
basing their opinions on recently observed inflation.
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The rational-expectations point of view, in the most extreme case, holds that if policymakers are credibly committed to
reducing inflation, and rational people understand that commitment and quickly lower their inflation expectations, then
13 of 23 12/8/2012 11:42
the sacrifice ratio will be approximately:

Answer 5.
2.8.
1.
0.
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Question
All of the following are requirements for reducing inflation without causing a recession except:
Answer workers and firms must form expectations rationally.
the plan must be announced before expectations are formed.
the plan must be believed by workers and firms.
the government's budget must be balanced.
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Question
Advocates of the rational-expectations approach predict that a credible policy to lower inflation will ______ the sacrifice
ratio.
Answer raise
lower
not change
sometimes raise and sometimes lower
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Question
The estimate of the sacrifice ratio from the Volcker disinflation is approximately:
Answer 5–6.
2.5–3.
1–1.5.
0–0.5.
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Question
The hypothesis that hysteresis may play an important role in macroeconomics implies, among other things, that:
Answer the history of economic thought is important to macroeconomics.
workers get hysterical during long depressions.
hysteresis lowers the sacrifice ratio.
the natural rate of unemployment may increase if unemployment is high for a long period of time.
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Question
According to the natural-rate hypothesis, fluctuations in aggregate demand affect output in:
Answer both the short run and the long run.
only in the short run.
only in the long run.
in neither the short run nor the long run.
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Question
According to the natural-rate hypothesis, output will be at the natural rate:
Answer if inflation exceeds expected inflation.
if inflation falls below expected inflation.
14 of 23 12/8/2012 11:42
in the long run.

if aggregate demand affects output in the long run.
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Question
A recession may alter an economy's natural rate of unemployment in all of the following ways except by:
Answer changing an unemployed individual's attitude toward work.
reducing an unemployed worker's job skills.
permanently reducing the money supply.
altering the wage-setting process.
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Question
The idea that the natural rate of unemployment is increased following extended periods of unemployment is called:
Answer Okun's law.
the cold-turkey approach.
the natural-rate hypothesis.
hysteresis.
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Question
If the hypothesis of hysteresis is correct and output is lost even after a period of disinflation, the sacrifice ratio for an
economy will:
Answer increase.
decrease.
remain unchanged.
be zero.
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Question
According to the natural-rate hypothesis, the levels of output and unemployment depend on:
Answer aggregate demand in the short run, but not in the long run.
aggregate demand in the long run, but not in the short run.
the natural rate of unemployment in the short run, but the natural rate of inflation in the long run.
the natural rate of inflation in the short run, but the natural rate of unemployment in the long run.
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Question
Each of the following conditions will tend to reduce the sacrifice ratio except when:
Answer workers and firms set wages and prices based on rational expectations.
policymakers make credible commitments to policy changes.
announcements of policy changes are made before workers and firms have formed expectations.
the concept of hysteresis accurately describes the impact of history on the natural rate of unemployment.
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Question
The endogenous variables of the mother of all models in the Appendix to Chapter 14 include the level of output, the
natural rate of output, the price level, and:
Answer the real and nominal interest rates.
the money supply.
the world price level.
government purchases.
15 of 23 12/8/2012 11:42
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Question
All of the following are exogenous variables in the mother of all models in the Appendix to Chapter 14 except the:
Answer world interest rate.
labor force.
world real interest rate.
price level.
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Question
If price expectations are assumed to be correct, money demand is proportional to income, and there are no
international capital flows, then the mother of all models in the Appendix to Chapter 14 corresponds to which of the
following special cases?
Answer classical closed economy
classical open economy
IS–LM model
Mundell–Fleming model with floating exchange rate
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Question
If price expectations are assumed to be correct, money demand is proportional to income, and net capital flow is
infinitely elastic, then the mother of all models in the Appendix to Chapter 14 corresponds to which of the following
special cases?
classical open economy
IS–LM model
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Question
If the short-run aggregate supply curve is assumed to be horizontal and money demand is proportional to income, then
the mother of all models in the Appendix to Chapter 14 corresponds to which of the following special cases?
aggregate demand and aggregate supply
IS–LM model
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Question
If the short-run aggregate supply curve is assumed to be horizontal and there are no international capital flows, then
the mother of all models in the Appendix to Chapter 14 corresponds to which of the following special cases?
IS–LM model
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Question
If the short-run aggregate supply curve is assumed to be horizontal and international capital flows are infinitely elastic,
then the mother of all models in the Appendix to Chapter 14 corresponds to which of the following special cases?
IS–LM model
16 of 23 12/8/2012 11:42
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Question
If the short-run aggregate supply curve is assumed to be horizontal, international capital flows are infinitely elastic, and
the nominal exchange rate is fixed, then the mother of all models in the Appendix to Chapter 14 corresponds to which
of the following special cases?
Answer classical open economy
IS–LM model
Mundell–Fleming model with fixed exchange rate
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Question
In the sticky-price model, if no firms have flexible prices, the short-run aggregate supply schedule will:
Answer be vertical.
be steeper than it would be if some firms had flexible prices.
slope upward to the right.
be horizontal.
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Question
Assume that an economy has the Phillips curve = ¿ 0.5(u ¿ 0.06). Then the natural rate of unemployment is:
¿1
Answer 0.5.
0.12.
0.06.
0.03.
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Question
Assume that an economy has the Phillips curve = ¿ 0.5(u ¿ 0.06). How many percentage-point-years of cyclical
¿1
unemployment are needed to reduce inflation by 5 percentage points?
Answer 20
10
5
2.5
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Question
The government can lower inflation with a low sacrifice ratio if the:
Answer money supply is reduced slowly.
public has adaptive expectations.
short-run aggregate supply schedule is relatively flat.
public believes that policymakers are committed to reducing inflation.
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Question
If only unanticipated changes in the money supply affect real GDP, the public has rational expectations, and everyone
has the same information about the state of the economy, then:
Answer monetary policy can be used to systematically stabilize output.
monetary policy cannot be used to systematically stabilize output.
a policy of keeping the money supply constant is optimal.
17 of 23 12/8/2012 11:42
a policy of adjusting the money supply in response to the state of the economy is optimal.
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Question
Assume that an economy has the usual type of Phillips curve except that the natural rate of unemployment in an
economy is given by an average of the unemployment rates in the last two years. Then, there is:
Answer a long-run tradeoff between inflation and unemployment.
no long-run tradeoff between inflation and unemployment.
no short-run tradeoff between inflation and unemployment.
a sacrifice ratio that is large but not infinite.
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Essay 1 points
Question
e e e
Assume that an economy is governed by the Phillips curve = ¿ 0.5(u ¿ 0.06), where = (P ¿ P )/P , =( ¿
¿1 ¿1
e
P¿1)/P¿1, and 0.06 is the natural rate of unemployment. Further assume =
¿1
. Suppose that, in period zero, =
e
0.03 and = 0.03¿that is, that the economy is experiencing steady inflation at a 3-percent rate.
a. Now assume that the government decides to impose whatever demand is necessary to cut
unemployment to 0.04. Suppose the government follows this policy for periods 1 through 5. Create a
e
table of and for these five periods.
b. Assume that, for periods 6 through 10, the government decides to hold unemployment at 0.06. Create
another table of and pe for these five periods. Is there any reason to expect the inflation rate to go
back to 0.03?
c. If the government persisted in its behavior under part a, do you think the public would continue for long
e
forming expectations according to = ? Why?
¿1
Answer a. Period
e
1 0.03 0.04
2 0.04 0.05
3 0.05 0.06
4 0.06 0.07
5 0.07 0.08
e
b. Period
6 0.08 0.08
7 0.08 0.08
8 0.08 0.08
9 0.08 0.08
10 0.08 0.08
N
There is no reason to expect inflation to fall as long as U = U .
c. After a while, one would not expect the public to be fooled by steadily accelerating inflation.
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Essay 1 points
Question
Assume that an economy is initially operating at the natural rate of output. Use the model of aggregate demand and
aggregate supply (using the upward-sloping short-run aggregate supply curve) to illustrate graphically the short-run
and long-run effects on price and output of a reduction in government spending that produces a budget surplus.
Answer
18 of 23 12/8/2012 11:42
In the short run output and prices decrease. In the long run output increases to restore full employment, but
at a lower price level.
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Essay 1 points
Question
Assume that an economy is initially at the natural rate of unemployment.
a. Use a Phillips curve diagram to illustrate graphically how the inflation rate and unemployment rate
respond both in the short run and in the long run to an unexpected expansionary monetary policy.
b. Use a Phillips curve diagram to illustrate graphically how the inflation rate and unemployment rate
respond both in the short run and in the long run to the announcement of a credible plan of
expansionary monetary policy when people have rational expectations.
Answer a.
In the short run, the inflation rate increases to and the unemployment rate falls to u . However, in the long
2 2
run, the Phillips curve shifts upward to the right. The unemployment rate returns to the natural rate, but with a
higher rate of inflation than what it was initially. There is a short-run tradeoff between inflation and
unemployment.
b.
Since expectations are formed rationally and the policy is credible, the Phillips curve will immediately shift
upward to the right. In both the short run and the long run, the inflation rate increases to , but the
2
unemployment rate remains at u . There is no short-run tradeoff between inflation and unemployment in the
n
short run or in the long run.
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Question
The firms and workers in Alpha form expectations adaptively. The firms and workers in Omega form expectations
rationally. Their otherwise identical economies are initially in equilibrium at the natural level of output with 10 percent
19 of 23 12/8/2012 11:42
inflation. The central banks of both Alpha and Omega make credible commitments to reduce the growth rates of money
until they achieve 2 percent inflation. Compare and contrast the adjustment process to the new equilibrium at the lower
rate of inflation in both countries.
Answer In Alpha, the reduction in aggregate demand causes a recession. The short-run aggregate supply curve will
not change very much, because expectations are based on the past experience of 10 percent inflation. The
reduction in aggregate demand will cause the actual price level to fall below the expected price level, leading
to lower output. Only as inflation expectations adjust gradually will the short-run aggregate supply curve shift
downward, allowing the economy to return to full employment at the natural rate.
In contrast, if workers and firms of Omega are able to immediately adjust their expectations based on the
credible policy announcement, the short-run aggregate supply curve will adjust immediately. There will be no
difference between the expected price level and the actual price level, and the economy will move to the new
equilibrium at the lower rate of inflation without experiencing a recession.
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Question
For each of the two models of short-run aggregate supply (sticky price and imperfect information) compare the
following characteristics:
a. the nature of the market imperfection that generates the short-run movements in output associated with
unexpected movements in the price level;
b. whether prices are flexible or fixed;
Answer a. In the sticky-price model the market imperfection exists because not all firms adjust prices
instantaneously to changes in demand. In the imperfect-information model the market imperfection
exists because of temporary misperceptions about prices.
b. A proportion of firms in the sticky-price model have fixed (sticky) prices. All prices are flexible in the
imperfect-information model.
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Question
The Phillips curve in Lowland takes the form of = 0.04 – 0.5 (u – 0.05), where is the actual inflation rate and u is
the unemployment rate. The Phillips curve in Highland takes the form of = 0.08 – 0.5 (u – 0.05). The current
unemployment rate in both countries is 9 percent (0.09).
a. Explain the similarities in the Phillips curves in Highland and in Lowland.
b. Explain the difference in the Phillips curves in Highland and in Lowland.
c. In which country will policymakers face a bigger tradeoff if they try to reduce unemployment in the short
run?
Answer a. Both countries have a natural rate of unemployment of 5 percent, and the slope of the Phillips curve is
the same in both countries. The Phillips curves in both countries indicate a short-run tradeoff between
more inflation and less unemployment.
b. The expected rate of inflation is higher in Highland (8 percent) than in Lowland (4 percent). The actual
rate of inflation is also higher in Highland (4 percent) than in Lowland (2 percent).
c. The policymakers in Highland will face twice the increase in the inflation rate as the policymakers in
Lowland when they both attempt to reduce unemployment. For example, to reduce the unemployment
rate to 5 percent, the inflation rate will increase from 2 percent to 4 percent in Lowland, but will increase
from 4 percent to 8 percent in Highland. It will require a much higher rate of inflation in Highland to
achieve the same rate of unemployment as in Lowland.
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Essay 1 points
Question
a. What is the sacrifice ratio?
b. What is one factor that could possibly lower the sacrifice ratio for an economy?
c. What is one factor that could possibly increase the sacrifice ratio for an economy?
Answer a. The sacrifice ratio is the percentage of a year's real GDP that must be given up to reduce inflation by 1
percent.
b. Rational expectations and credible public announcements in advance of policy changes could reduce
the sacrifice ratio.
c. If hysteresis exists in an economy, causing output loss to continue after the disinflation is over, then the
sacrifice ratio will be higher.
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20 of 23 12/8/2012 11:42
Essay 1 points
Question
Use the aggregate demand–aggregate supply model to graphically illustrate the difference between demand-pull and
cost-push inflation. Explain your graphs in words.
Answer
Starting at long-run equilibrium at A, a demand-pull inflation would be represented by an increase in the

aggregate demand curve from AD to AD . The new short-run equilibrium at B represents an increase in the
1 2
price level from P to P , and thus an inflation resulting from an increase in demand. A cost-push inflation
1 2
would be represented by a shift in the aggregate supply curve from AS to AS . The new short-run equilibirum
1 2
at C represents an increase in the price level from P to P , and thus an inflation resulting from an increase in
1 2
supply.
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Question
Illustrate the short-run and long-run impact of an unexpected monetary contraction using both the AD–AS model and
the Phillips curve. Assume the economy starts at full employment.
Answer In the AD–AS model, the unexpected monetary contraction shifts aggregate demand from AD to AD . The
1 2
new short-run equilibrium at B has a lower price level and lower output. In the long run when the lower price
level (and lower inflation) become expected, the aggregate supply curve shifts from AS to AS and the long
1 2
run equilibrium is at the natural level of output at C. Using the Phillips curve, the unexpected monetary
contraction reduces the inflation rate in the short run. The lower inflation rate results in a higher unemployment
rate at a point like B on the same Phillips curve. In the long run when the lower inflation rate becomes
expected the Phillips curve shifts down and the unemployment rate returns to the natural rate at C.
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Question
How would an adverse supply shock change the short-run tradeoff between inflation and unemployment? Illustrate
your answer using a Phillips curve diagram.
Answer
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An adverse supply shock ( ) would shift the Phillips curve up from PC to PC . The inflation rate at the natural
1 2
rate of unemployment increases by the amount of the inflation shock. Now a policymaker would face a higher
inflation rate associated with every unemployment rate. For example at u , the inflation rate now shifts from
1 1
to . Alternatively every inflation rate is now associated with a higher unemployment rate. For example, at
2 1
the unemployment rate now shifts from u1 to 2.
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Essay 1 points
Question
Assume that people form expectations rationally and that the sticky-price model describes the aggregate supply curve
in the economy. For each of the following scenarios explain whether or not monetary policy can have real effects on the
economy.
a. The central bank determines monetary policy using the same information available to all firms and at the
same time firms are setting prices, so that both firms and policymakers have all of the same information.
b. The central bank determines monetary policy after firms have set prices using information not available
at the time prices were set.
Answer a. The aggregate supply curve implies that the central bank can only cause output to deviate from the
natural level and have an impact on real variables if it can change (P–EP). Therefore, only unexpected
changes in monetary policy can change output. If firms have access to all information when they form
expectations, then they have already taken into account the anticipated effect of monetary policy and
the expected monetary policy cannot have real effects on the economy.
b. If the central bank sets monetary policy after all firms have formed expectations, then monetary policy
can have real effects on the economy by changing the price level. As a result the actual price level will
deviate from the expected price level, which was already set, and the level of output will deviate from
the natural level, a real change in the economy.
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Question
An economy is initially in equilibrium at the natural level. The central bank increases the money supply. Graphically
illustrate and explain short-run monetary nonneutrality and long-run monetary neutrality using the AD–AS model.
Answer
Monetary nonneutrality occurs when changes in money affect real variables. Graphically, this is shown in the
short run as the economy moves from A to B. The increase in money increases output, a real variable. This
occurs because firms and workers are expecting price level P , but the price level rises to P . Eventually,
1 2
workers' expectations of the price level increase, shifting the AS curve up.
Monetary neutrality occurs when changes in money affect only nominal variables, not real variables.
Graphically, this is depicted in the long run as the economy eventually moves from A to C. The increase in
money affects only prices.
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22 of 23 12/8/2012 11:42
23 of 23 12/8/2012 11:42
Pool Canvas
Name TestBanks Chapter 15 A Dynamic Model of Aggregate Demand and Aggregate Supply
Description
Instructions
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Question
In the dynamic model, the demand for goods and services will ____ as the natural rate of output increases and _____
as the real interest rate increases.
increase; decrease
decrease; decrease
decrease; increase
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Question
In the dynamic model, the demand for goods and services decreases as the natural rate of output _____ or the real
rate of interest _____.
Answer increases; increases
increases; decreases
decreases; decreases
decreases; increases
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Question
In the dynamic model, changes in fiscal policy are captured in changes in the:
Answer natural rate of interest.
expected rate of inflation.
random demand shock.
natural level of output.
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Question
A higher real interest rate reduces the demand for goods and services by:
Answer shifting the dynamic aggregate supply curve.
decreasing the natural level of output.
increasing inflation expectations.
reducing investment and consumption spending.
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Question
Long-run growth ____ the demand for goods and services.
Answer increases
decreases
does not change
may either increase or decrease
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1 of 19 12/8/2012 11:43
Question
Which of the following would be represented by a positive value of the random demand shock, ε ?
t
Answer an irrational wave of optimism among investors
a decrease in government spending
an aggressive increase in oil prices by a cartel
an increase in the central bank's inflation target
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Question
Which of the following would be represented by a negative value of the random demand shock, ε ?
t
an aggressive increase in oil prices by a cartel
a decrease in the central bank's inflation target
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Question
The real interest rate at which, in the absence of any shock, the demand for goods and services equals the natural rate
of output is called the _____ rate of interest.
Answer ex ante
ex post
natural
nominal
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Question
The natural rate of interest is the real interest rate:
Answer at which the demand for goods and services equals the natural rate of output.
that most people anticipate based on their expectations of inflation.
at which the natural rate of unemployment equals the natural rate of output.
equal to the nominal interest rate minus the natural rate of inflation.
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Question
According to the Fisher equation, the real interest rate equals the nominal interest rate minus the:
Answer natural rate of interest
expected rate of inflation
expected rate of interest
ex ante rate of interest.
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Question
According to the Fisher equation, the real interest, r , equals the nominal interest rate, i , minus the expected inflation
t t
rate, which is written as:
Answer Et t
Et t+1
Et+1 t
Et + 1 t+1
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2 of 19 12/8/2012 11:43
Question
The ex ante real interest rate that prevails at time t equals:
Answer it – Et t
it – Et t+1
it – t
it – t+1
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Question
The ex post real interest rate that prevails at time t equals:
Answer it – Et t
it – Et t+1
it – t
it – t+1
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Question
The current inflation rate, , represents the change in the price level between periods:
t
Answer t – 1 and t
t and t + 1
t – 1 and t + 1
t and t + 2
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Question
The nominal interest rate, i , is the rate of return between periods:
t
Answer t – 1 and t
t and t + 1
t – 1 and t + 1
t and t + 2
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Question
According to the Phillips curve, the inflation rate depends on all of the following except:
Answer previously expected inflation.
an exogenous supply shock.
the real interest rate.
the deviation of output from its natural rate.
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Question
According to the Phillips curve, inflation depends on expected inflation because:
Answer the real interest rate depends on the expected rate of inflation.
the central bank sets its target inflation rate based on the expected rate of inflation.
the natural level of output depends on the expected rate of inflation.
when some firms set prices in advance, expected inflation influences future prices.
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3 of 19 12/8/2012 11:43
Question
According to the Phillips curve, firms raise prices when output is _____ the natural level of output or, equivalently, when
the unemployment rate is _____ the natural rate of unemployment.
Answer above; above
above; below
below; below
below; above
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Question
According to the Phillips curve, firms _____ prices when output is below the natural level of output, or equivalently,
when the unemployment rate is _____ the natural rate of unemployment.
Answer raise; above
raise; below
lower; above
lower; below
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Question
In the dynamic model, the supply shock variable, , is a variable appearing in which of the following equations of the
t
model?
Answer Fisher equation
Phillips curve
monetary-policy rule
adaptive expectations
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Question
Which of the following would be represented by a negative value of the random supply shock, ?
t
Answer an irrational wave of pessimism among investors
oil price decreases resulting from a breakdown in the cartel
a decrease in the central bank's inflation target
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Question
Which of the following would be represented by a positive value of the random supply shock, ?
t
an increase in government spending
widespread drought leading to large increases in food prices.
an increase in the central bank's inflation target
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Question
The dynamic model of aggregate demand and aggregate supply assumes that people form expectations of inflation
based on:
Answer forecasts optimally using all available information.
recently observed inflation.
the central bank's inflation target.
the difference between the nominal and real interest rate.
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4 of 19 12/8/2012 11:43
Question
Expectations of inflation based on recently observed inflation is called the assumption of _____ expectations.
Answer natural
rational
dynamic
adaptive
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Question
In the specification of adaptive expectation used in the dynamic model of aggregate demand and aggregate supply, at
time t the expected inflation rate at time t + 1 is:
Answer
t – 1.
t.
t + 1.
t + 2.
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Question
In the specification of adaptive expectation used in the dynamic model of aggregate demand and aggregate supply,
people at time t – 1 forecast the inflation rate in time period t will be:
Answer
t–2
t–1
t+1
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Question
According to the monetary policy rule, when inflation is at its target level and output is at the natural level, then the real
interest rate equals the:
Answer nominal rate of interest.
target rate of inflation.
natural rate of interest.
current rate of inflation.
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Question
According to the monetary policy rule, the central bank sets the nominal interest rate so that the real interest rate
increases when inflation ____ its target, or output ____ its natural level.
Answer rises above; rises above
rises above; falls below
falls below; falls below
falls below; rises above
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Question
According to the monetary policy rule, the central bank sets the nominal interest rate so that the real interest rate
_____ when inflation is above its target, and the real interest rate _____ when output is below its natural level.
Answer rises; falls
rises; rises
falls; falls
5 of 19 12/8/2012 11:43
falls; rises
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Question
To follow a monetary policy rule, the central bank raises the nominal interest rate by:
Answer raising the inflation target.
decreasing the money supply.
increasing the GDP gap.
decreasing inflation expectations.
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Question
In order to achieve the target for the nominal interest rate established by the monetary policy rule, the central bank
adjusts:
Answer the inflation rate.
the natural rate of interest.
the money supply.
the inflation target.
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Question
The monetary policy rule specified in the dynamic model of aggregate demand and aggregate supply indicates that the
central bank adjusts interest rates in response to fluctuations in:
Answer inflation expectations.
money supply and money demand.
inflation and output.
nominal and real exchange rates.
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Question
The interest rate at which banks make loans to other banks is called the:
Answer federal funds rate.
prime rate.
Federal Reserve discount rate.
Treasury bill rate.
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Question
John Taylor's rule for setting the federal funds rate proposes increasing the nominal federal funds rate as inflation
_____ and the GDP gap _____.
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Question
The Taylor rule can be written as FF rate = + 2.0 + 0.5 ( – 2.0) + 0.5(GDP gap), where FF rate is the nominal
federal funds rate, is the inflation rate, and the GDP gap is the percentage deviation of real GDP from its natural
level. If inflation is 4 percent and the GDP gap is 2 percent, then according to the Taylor rule, the Fed should set the
nominal federal funds rate at _____ percent.
Answer 4
8
6 of 19 12/8/2012 11:43
10
12
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Question
level. If inflation is 2 percent and the GDP gap is –2 percent, then according to the Taylor rule, the Fed should set the
Answer 2
3
4
5
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Question
level. If inflation is 2 percent and GDP is at the natural rate, then according to the Taylor rule, the Fed should set the
Answer 2
3
4
5
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Question
According to the Taylor rule, when real GDP is below its natural level, the nominal federal funds rate should be _____,
and when inflation exceeds 2 percent, the nominal federal funds rate should be _____.
Answer raised; raised
raised; lowered
lowered; raised
lowered; lowered
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Question
According to the Taylor rule, when real GDP is above its natural level, the nominal federal funds rate should be _____,
and when inflation is below 2 percent, the nominal federal funds rate should be _____.
Answer raised; raised
raised; lowered
lowered; raised
lowered; lowered
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Question
Predetermined variables in a model are treated as if they are essentially:
Answer endogenous variables.
exogenous variables.
parameters.
equilibrium conditions.
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7 of 19 12/8/2012 11:43
Question
All of the following are endogenous variables in the dynamic model of aggregate demand and aggregate supply
except:
Answer Yt, output
central bank's inflation target

rt, real interest rate
Et t+1
, expected inflation
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Question
Which of the following is an exogenous variable in the dynamic model of aggregate demand and aggregate supply?
Answer Et , expected inflation
t+1
rt, real interest rate
, inflation
t
, supply shock
t
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Question
Which of the following is an endogenous variable in the dynamic model of aggregate demand and aggregate supply?
Answer , inflation
t
central bank's inflation target
, the natural rate of interest

, previous period's inflation
t–1
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Question
Long-run equilibrium occurs in the dynamic model of aggregate demand and aggregate supply when:
Answer dynamic aggregate demand equals dynamic aggregate supply.
there are no shocks and inflation is stable.
the demand shock equals the supply shock.
the nominal interest rate equals the real interest rate.
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Question
At long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, the nominal interest rate, i ,
t
equals all of the following except:
Answer
rt + t
+E
t t+1
+r
t
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Question
At long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, the demand and supply
shocks, and , equal _____ and current inflation, equals _____.
t t t,
Answer 0; 0
0;
t–1
8 of 19 12/8/2012 11:43
;0
t
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Question
At long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, which variables will be at
their natural levels?
Answer inflation and output
real and nominal interest rates
inflation and the nominal interest rate
output and the real interest rate
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Question
That output, Y , and the real interest rate, r , do not depend on the central bank's inflation target in long-run equilibrium
t t
in the dynamic model of aggregate demand and aggregate supply demonstrates:
Answer monetary neutrality.
an impulse response function.
adaptive expectations.
Taylor's principle.
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Question
Of the five endogenous variables in the dynamic model of aggregate demand and aggregate supply, which are the real
variables that do not depend on the monetary policy in long-run equilibrium?
Answer Yt and t
it and rt
Et t+1
and
t
Yt and rt
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Question
Of the five endogenous variables in the dynamic model of aggregate demand and aggregate supply, which are the
nominal variables that will change in long-run equilibrium if the central bank changes its inflation target?
Answer Y , r and i
t t, t
Y , i , and E
t t t t+1
, i , and E
t t t t+1
rt, t
, and i
t
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Question
At long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, which variables will equal
the central bank's target rate of inflation?
Answer the current inflation rate, but not the expected inflation rate
the expected inflation rate, but not the current inflation rate
both the current and expected rates of inflation
neither the current nor the expected rates of inflation
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9 of 19 12/8/2012 11:43
Question
The dynamic aggregate supply curve shows the short-run relation between:
Answer the natural rate of output and inflation
the natural rate of output and expected rate of inflation
output and inflation
output and the natural rate of interest
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Question
The dynamic aggregate supply curve is derived from which of the five equations of the model of aggregate demand
and aggregate supply?
Answer the Fisher equation and adaptive expectations
the Phillips curve and adaptive expectations
the monetary policy rule and the Fisher equation
the Phillips curve and the monetary policy rule
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Question
The dynamic aggregate supply curve illustrates a short-run _____ tradeoff between output and _____.
Answer positive; inflation
positive; the price level
negative; inflation
negative; the price level
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Question
The upward slope of the dynamic aggregate supply curve indicates that, holding other factors constant, high levels of
economic activity are associated with:
Answer the natural level of output.
the inflation target.
positive supply shocks.
high inflation.
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Question
The dynamic aggregate supply curve will shift if any of the following changes except the:
Answer current inflation rate.
past inflation rate.
supply shock.
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Question
The dynamic aggregate demand curve is derived from each of the following equations of the model of aggregate
demand and aggregate supply except:
Answer the Fisher equation
the Phillips curve
adaptive expectations
the monetary policy rule
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Question
The dynamic aggregate demand curve illustrates the _____ relationship between the quantity of output demanded in
the short run and _____.
10 of 19 12/8/2012 11:43
Answer positive; inflation

positive; the price level
negative; inflation
negative; the price level
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Question
The dynamic aggregate demand curve will shift if any of the following changes except the:
Answer current inflation rate
inflation target.
demand shock.
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Question
Which of the following is not held constant along a dynamic aggregate demand curve?
Answer the inflation target
the natural rate of output
the demand shock
the money supply
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Question
The dynamic aggregate demand curve is drawn for a given:
Answer money supply.
real interest rate
monetary policy rule.
inflation rate.
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Question
The dynamic aggregate demand curve is downward sloping because as inflation falls, the central bank reduces the
nominal interest rate by more than the fall in the inflation rate, which _____the real interest rate and _____ the quantity
of goods and services demanded.
Answer decreases; decreases
increases; increases
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Question
According to the monetary policy rule (assuming > 0) when inflation increases, the central bank increases the
nominal interest rate by _____ the increase in the rate of inflation, which _____ the real interest rate.
Answer more than; increases
less than; decreases
an amount equal to; does not change
less than; increases
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Question
The negative relationship between inflation and the quantity of goods and services demanded comes about because of
the:
11 of 19 12/8/2012 11:43
Answer Phillips curve.

monetary policy rule.
assumption of adaptive expectations.
Fisher effect.
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Question
The dynamic aggregate demand curve will shift to the right if there is a:
Answer tax cut.
cut in government spending.
decrease in the money supply.
cut in oil prices when the cartel falls apart.
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Question
An increase in the central bank's target rate of inflation is represented by:
Answer a movement up the DAD curve.
a movement down the DAD curve.
a rightward shift in the DAD curve
a leftward shift in the DAD curve.
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Question
When the central bank lowers its target inflation rate, it _____ the nominal and real interest rate, which shifts the
dynamic aggregate demand curve to the _____.
Answer lowers; right
lowers; left
raises; right
raises; left
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Question
To reduce the demand for goods and services, the central bank will ___ its target inflation rate and _____ nominal and
real interest rates.
Answer reduce; decrease
reduce; increase
raise; decrease
raise; increase
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Question
The short-run equilibrium in the dynamic model of aggregate demand and aggregate supply is determined by the
intersection of the:
Answer DADt and DASt – 1
DADt and DASt
Yt and DASt
DADt – 1 and Yt
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Question
The short-run equilibrium in the dynamic model of aggregate demand and supply determines the:
12 of 19 12/8/2012 11:43
Answer inflation rate and inflation target.

real interest rate and natural level of output.
level of output and inflation rate.
natural level of output and level of output.
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Question
In the dynamic model of aggregate demand and aggregate supply, one period in time is connected to the next period
through:
Answer the monetary policy rule.
demand shocks.
inflation expectation.
the natural level of output.
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Question
In the dynamic model of aggregate demand and aggregate supply, changes in the natural level of output change:
Answer the DAD curve, but not the DAS curve.
the DAS curve, but not the DAD curve.
both the DAD curve and the DAS curve.
neither the DAD nor the DAS curve.
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Question
In the dynamic model of aggregate demand and aggregate supply, increases in the natural level of output lead to
_____ in output and ______ in inflation.
increases; no change
no change; increases
no change; no change
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Question
Increases in the natural level of output allow the economy to produce _____ goods and services and make people
want to buy _____ goods and services.
Answer fewer; fewer
fewer; more
more; more
more; fewer
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Question
In the dynamic model of aggregate demand and aggregate supply, holding other factors constant, when the natural
level of output increases, then inflation:
Answer increases.
decreases.
remains the same.
is zero.
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Question
Beginning at long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, in the period in
which a positive supply shock occurs, the DAS curve _____ and the DAD curve _____.
13 of 19 12/8/2012 11:43
Answer shifts upward; shifts rightward

shifts upward; does not shift
does not shift; does not shift
shifts downward; shifts leftward
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Question
Beginning at long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, in the period in
which a positive supply shock occurs, output _____ and inflation _____.
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Question
Starting from long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, a one-period
positive supply shock causes output to:
Answer remain above the natural level for only one period.
remain above the natural level for more than one period.
remain below the natural level for only one period.
remain below the natural level for more than one period.
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Question
Starting from long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, output
immediately decreases as a result of a one-period positive supply shock because:
Answer the central bank raises the nominal and real interest rates in response to the increase in inflation.
the higher prices generate a negative demand shock that reduces output.
the natural level of output falls in response to the increase in inflation.
the central bank increases the target rate of inflation in response to the increase in inflation.
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Question
Graphs that illustrate the time paths of endogenous variables when a shock hits the economy are called:
Answer monetary policy paths.
dynamic shock figures.
impulse response functions.
endogenous growth models.
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Question
Beginning at long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, in the first period
of a four-period positive demand shock, the DAS curve _____ and the DAD curve _____.
does not shift; shifts rightward
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Question
Beginning at long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, in the first period
of a four-period positive demand shock, output _____ and inflation _____.
14 of 19 12/8/2012 11:43

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Question
Beginning at long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, in the periods
after a multiperiod positive demand shock occurs, the DAS shifts upward because:
Answer the central bank increases the target rate of inflation in response to higher rates of inflation.
the deviation of output from the natural level of output increases as result of higher rates of inflation.
higher rates of inflation generate positive supply shocks.
expectations of inflation increase as a result of higher inflation in previous periods.
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Question
Starting from long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, a five-period
positive demand shock causes output to _____ until returning to the natural level in the long run.
Answer remain continuously above the natural level of output
move above and then below the natural level of output
remain continuously below the natural level of output
move below and then above the natural level of output
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Question
Starting from long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, a temporary
five-period tax increase causes output to _____ until returning to the natural level in the long run.
Answer remain continuously above the natural level of output
move above and then below the natural level of output
remain continuously below the natural level of output
move below and then above the natural level of output.
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Question
Beginning at long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, if the central bank
permanently reduces its inflation target, then in the initial period the DAS curve _____ and the DAD curve _____.
does not shift; shifts leftward
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Question
Beginning at long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, if the central bank
permanently reduces its inflation target, then in the initial period of the change output _____ and inflation _____.
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Question
Beginning at long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, in the periods
after a permanent reduction in the central bank's inflation target, the DAS shifts downward because:
15 of 19 12/8/2012 11:43
Answer the natural level of output increases in response to the lower rates of inflation.
the deviation of output from the natural level of output increases as a result of lower rates of inflation.
lower rates of inflation generate negative supply shocks.
expectations of inflation decrease as a result of lower inflation in previous periods.
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Question
Starting from long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, a permanent
reduction in the central bank's inflation target causes the nominal interest rate to:
Answer decline continuously until reaching a lower level in the long run.
increase initially and then decline until reaching a lower level in the long run.
decline immediately to a lower level in the long run.
fall below and then rise continuously to long-run level below the initial level.
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Question
In the dynamic model of aggregate demand and aggregate supply, if the central bank chooses a large value of , the
responsiveness of nominal interest rates to inflation, and a small value of , the responsiveness of nominal interest
Y
rates to output, then the DAD curve will be relatively _____, and supply shocks will have relatively ____ impacts on
inflation than output.
Answer flat; larger
flat; smaller
steep; larger
steep; smaller
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Question
In the dynamic model of aggregate demand and aggregate supply, if the central bank chooses a small value of , the
responsiveness of nominal interest rates to inflation, and a large value of , the responsiveness of nominal interest
Y
rates to output, then the DAD curve will be relatively _____, and supply shocks will have relatively ____ impacts on
inflation than output.
Answer flat; larger
flat; smaller
steep; larger
steep; smaller
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Question
A central bank that chooses a small value of , the responsiveness of nominal interest rates to inflation, and a large
value of , the responsiveness of nominal interest rates to output, is choosing to obtain less _____ at the expense of
Y
more _____.
Answer inflation; output
output; inflation
inflation variability; output variability
output variability; inflation variability
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Question
A central bank that chooses a large value of , the responsiveness of nominal interest rates to inflation, and a small
value of , the responsiveness of nominal interest rates to output, is choosing to obtain less _____ at the expense of
Y
more _____.
Answer inflation; output
output; inflation
16 of 19 12/8/2012 11:43
inflation variability; output variability

output variability; inflation variability
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Question
Equation: Monetary Policy Rule
it = t
+ + (
t
– * +
t Y
(Y –
t
)
Reference: Ref 15-1
(Equation: Monetary Policy Rule) Given the monetary policy rule of the dynamic model of aggregate demand and
aggregate supply, if the inflation rate increases by 1 percentage point, by how much does the nominal interest
increase:
Answer 1
1+
1+
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Question
Equation: Monetary Policy Rule
it = t
+ + (
t
– * +
t Y
(Y –
t
)
Reference: Ref 15-1
(Equation: Monetary Policy Rule) Given the monetary policy rule of the dynamic model of aggregate demand and
aggregate supply, which value of , the responsiveness of nominal interest rates to inflation, would lead to inflation
spiraling out of control following a demand shock?
Answer –0.15
0.50
1.00
1.15
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Question
According to the Taylor principle, for inflation to be stable, the central bank must respond to an increase in inflation with
____ increase in the nominal interest rate.
Answer no
an equal
a greater
a smaller
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Essay 1 points
Question
Use the model of dynamic aggregate demand and aggregate supply to graphically illustrate the impact of a temporary
4-period increase in taxes (a four-period negative demand shock) on output and inflation when the economy is initially
at long-run equilibrium. Explain the time path of output and inflation in words.
Answer
17 of 19 12/8/2012 11:43
Beginning at A in period t – 1, output falls below the natural level in period t (to B) and then gradually moves
back toward the natural level in periods t + 1, t + 2, and t + 3 (to C). In period t + 4 when the demand shock
ends and the DAD returns to its original position, output moves above the natural rate (to D), because the
DAS in period t + 4 continues to shift down as inflation expectations decreased as a result of lower inflation in
the previous period. Output then gradually returns to the natural level (at A) as the DAS shifts upward.
Beginning at A in period t – 1, inflation falls in period t and continues to fall through period t + 3. In period t + 4,
when the DAD returns to its original position, inflation increases and gradually returns to its initial level (at A).
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Essay 1 points
Question
Use the model of dynamic aggregate demand and aggregate supply to graphically illustrate the impact on output and
inflation of an exceptional weather pattern that results in a one-period glut of food worldwide that reduces food prices
(a one-period negative supply shock) when the economy is initially at long-run equilibrium. Explain the time path of
output and inflation in words.
Answer
Output increases from the natural level at A to B as the DAS shifts downward as a result of the supply shock.
In period t + 1 the negative shock goes away, so output increases (to C), but not all the way back to the
natural level, because expected inflation is below the initial level, keeping output below the natural rate.
Output decreases slowly as inflation expectations increase and return the DAS to its original position and
output to the natural level.
Inflation falls in the period of the negative supply shock and then gradually returns to the initial rate.
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Essay 1 points
Question
Use the model of dynamic aggregate demand and aggregate supply to graphically illustrate the impact of a permanent
increase in the central bank's inflation target when the economy is initially at long-run equilibrium. Explain the time path
of output and inflation in words.
Answer
18 of 19 12/8/2012 11:43
Output will initially increase above the natural level in the period in which the inflation target is increased, but
will then gradually fall back to the natural rate of output. Inflation will increase continuously until reaching the
new higher target inflation rate.
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Essay 1 points
Question
Central Bank A conducts monetary policy according to the following monetary policy rule:
i = + 2.0 + 0.90 ( – 2.0) + 0.10 (Y – 100),
and Central Bank B conducts monetary according to the following monetary policy rule:
i = + 2.0 + 0.10 ( – 2.0) +0 .90 (Y – 100),
where i is the nominal interest rate measured in percent, is the inflation rate measured in percent, and Y is output
measured as a percentage of the natural level of output. The economies of the two countries are otherwise identical
and operate as described by the dynamic model of aggregate demand and aggregate supply.
Answer a. In which country will the dynamic aggregate demand curve be steeper? Explain.
b. If a positive supply shock of the same magnitude hits both countries, which country will experience the
greatest variability in output? Explain.
a. Country B will have the steeper DAD curve, because Central Bank B responds more strongly to
changes in output than Central Bank A. Consequently, large changes in inflation will only have a small
effect on output and the DAD will be steeper in Country B than in Country A.
b. Country A will experience the greatest variability of output as a result of a supply shock. Central Bank A
responds more strongly to changes in inflation so Country A has a flatter DAD curve than Country B.
When the supply shock triggers inflation, Central Bank A will increase interest rates by more, which will
reduce output more in Country A than in Country B, where the Central Bank will not increase interest
rates as much.
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Essay 1 points
Question
Use the model of dynamic aggregate demand and aggregate supply to compare the time paths of output and inflation
in response to a one-period positive demand shock versus a one-period positive supply shock.
Answer In response to a one-period positive supply shock output falls below the natural level in the period of the shock
and then gradually returns to the natural level. Output is always less than or equal to the natural level. In
response to a one-period positive demand shock, output increases above the natural rate in the first period,
then falls below the natural rate in the next period, and then gradually returns to the natural rate. Output both
exceeds and is less than the natural rate in response to the demand shock, but remains continuously below
the natural rate in response to the supply shock.
In response to a one-period positive supply shock, inflation increases in the period of the shock and then
gradually returns to the initial rate of inflation. In response to a one-period positive demand shock, inflation
increases in the period of the shock and then gradually returns to the initial rate of inflation—in a manner
similar to the supply shock response.
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19 of 19 12/8/2012 11:43
Pool Canvas
Name TestBanks Chapter 16 Consumption

Description
Instructions
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Question
The consumption decisions of individuals are not important for the:
Answer determination of the steady-state capital stock.
determination of fiscal-policy multipliers.
determination of aggregate demand.
determination of sticky prices.
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Question
The marginal propensity to consume is the:
Answer ratio of consumption to income.
amount consumed out of an additional dollar of income.
amount available for consumption after precautionary saving.
ratio of consumption to wealth.
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Question
The average propensity to consume is the:
Answer ratio of consumption to income.
amount consumed out of an additional dollar of income.
amount available for consumption after precautionary saving.
ratio of consumption to wealth.
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Question
John Maynard Keynes believed that the marginal propensity to consume:
Answer was zero.
was between zero and one.
was one.
increased as income increased.
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Question
John Maynard Keynes believed that the average propensity to consume:
Answer was constant.
increased as income increased.
decreased as income increased.
was less than the marginal propensity to consume.
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1 of 22 12/8/2012 11:44
Question
John Maynard Keynes believed that:
Answer consumers would save more if the interest rate was high.
consumers would consume more if the interest rate was high.
if consumers consume less, the interest rate will be high.
the interest rate is relatively unimportant to the consumption decision.
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Question
If the Keynesian consumption function is written as then the average propensity to consume is:
Answer c.
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Question
If an example of a Keynesian consumption function is C = 2,000 + 0.8Y, and Y is 30,000, then the average propensity
to consume is about:
Answer 0.8.
0.82.
0.85.
0.87.
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Question
The Keynesian consumption function exhibits all of the following properties except that:
Answer the marginal propensity to consume is between 0 and 1.
the average propensity to consume decreases as income increases.
only unexpected policy changes influence consumption.
current income is the primary determinant of consumption.
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Question
Examination of data from households shows that households with high current income ______ than do households
with low current income.
Answer consume less
save less
save a smaller fraction of current income
save a larger fraction of current income
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Question
Economists based their prediction that secular stagnation would occur as economies prospered on the conjecture that:
Answer the marginal propensity to consume is greater than zero.
the marginal propensity to consume is less than one.
the average propensity to consume falls as income rises.
income is the primary determinant of consumption.
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Question
During World War II, economists using John Maynard Keynes's theory predicted that the rate of saving after the war
would be very:
Answer high, and that is what happened.
low, and that is what happened.
low, but that did not happen.
high, but that did not happen.
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Question
Simon Kuznets found that, over long periods of time in the United States, as income rose, the average propensity to
consume:
Answer rose.
fell.
remained constant.
rose and then fell.
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Question
Kuznets' data showed a short-run consumption function with a ______ APC, and a long-run consumption function with
a ______ APC.
Answer constant; constant
constant; falling
falling; constant
falling; falling
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Question
Empirical evidence finds that the average propensity to consume is constant:
Answer for only the short-run consumption function.
for only the long-run consumption function.
for both the short-run and the long-run consumption functions.
for neither the short-run nor the long-run consumption functions.
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Question
Which of the following conjectures that underlie the Keynesian consumption function is not consistent with aggregate
U.S. data?
Answer The marginal propensity to consume is between 0 and 1.
The average propensity to consume decreases as income increases.
There is a high correlation between income and consumption.
Current income is a determinant of consumption.
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Question
Empirical evidence finds that the average propensity to consume is falling:
Answer for only the short-run consumption function.
for only the long-run consumption function.
for both the short-run and the long-run consumption functions.
for neither the short-run nor the long-run consumption functions.
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Question
A consumer's budget constraint for two periods with positive interest rate r may be represented by the equation:
Answer C1 + C2 = Y1 + Y2.
C1 + C2/(1 + r) = Y1 + Y2/(1 + r).
C1 + C2(1 + r) = Y1 + Y2(1 + r).
C1/(1 + r) + C2 = Y1/(1 + r) + Y2.
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Question
The consumer's budget constraint reflects the fact that because interest is earned on savings:
Answer future income is worth less than current income.
future income is worth more than current income.
future consumption costs more than current consumption.
future consumption is worth more than future income.
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Question
In Irving Fisher's two-period consumption model, if Y = 20,000, Y = 15,000, and the interest rate r is 0.50 (50
1 2
percent), then the maximum possible consumption in period one is:
Answer 20,000.
25,000.
30,000.
35,000.
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Question
In Irving Fisher's two-period consumption model, if Y = 20,000, Y = 15,000, and the interest rate r is 0.50 (50
1 2
percent), then the maximum possible consumption in period two is:
Answer 15,000.
25,000.
35,000.
45,000.
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Question
Every indifference curve shows combinations of first-period and second-period consumption that:
Answer are tangent to the intertemporal budget constraint.
have equal income and substitution effects.
are available to the consumer.
make the consumer equally happy.
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Question
The marginal rate of substitution between first-period consumption and second-period consumption:
Answer is the inverse of the slope of an indifference curve, in which first-period consumption is graphed along the
horizontal axis.
is generally high when first-period consumption is high.
indicates by how much first-period consumption changes for a one-unit change in first-period income.
reveals the rate at which the consumer is willing to substitute second-period consumption for first-period
consumption.
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4 of 22 12/8/2012 11:44
Question
Exhibit: Budget Constraint
Reference: Ref 16-1
(Exhibit: Budget Constraint) Based on the graph, if Y and Y represent income in period one and period two,
1 2
respectively, at which point along the budget constraint would a consumer be a borrower in period one?
Answer A
B
C
D
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Question
Exhibit: Budget Constraint
Reference: Ref 16-1
(Exhibit: Budget Constraint) Based on the graph, if Y and Y represent income in period one and period two,
1 2
respectively, r is the interest rate, and the consumer chooses to consume combination A on the budget constraint, what
will be the level of consumption in period two, C ?
2
Answer Y1(1 + r) + Y2
Y1 + Y2/(1 + r)
Y1/(1 + r) + Y2
Y1 + Y2(1 + r)
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Question
In the Fisher two-period model, the consumer achieves his or her optimum combination of current and future
consumption by selecting:
Answer any combination on his or her highest indifference curve.
the combination on his or her highest indifference curve that is tangent to his or her budget constraint.
any combination on his or her budget constraint.
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the combination on his or her budget constraint in which period-one consumption equals period-one
income and period-two consumption equals period-two income.
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Question
When the consumer has chosen his or her optimal values of first-period and second-period consumption, the marginal
rate of substitution equals:
Answer 1 plus the interest rate r.
1 minus the interest rate r.
1 divided by the interest rate r.
the interest rate r.
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Question
A normal good is a good that:
Answer provides pleasure.
would generally be owned by an average household.
has a value greater than zero.
is desired in larger quantities by a consumer when his or her income rises.
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Question
An increase in income in period one in Irving Fisher's two-period consumption model increases consumption in:
Answer period one, but decreases consumption in period two.
period one, but does not change consumption in period two.
both periods one and two, as long as consumption in period one and consumption in period two are both
normal goods.
period two, but does not change consumption in period one.
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Question
The behavior of consumers spreading increases in income earned in one period into increases in consumption over
several periods is known as:
Answer random-walk consumption.
transitory consumption.
consumption smoothing.
the income effect.
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Question
In Irving Fisher's two-period model, if consumption in both periods is a normal good, then an increase in income in
period two:
Answer increases consumption in period one only.
increases consumption in period two only.
increases consumption in both periods.
does not increase consumption in either period.
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Question
In John Maynard Keynes's model, the most important determinant of current consumption is current income. In Irving
Fisher's model, the most important determinant of current consumption is:
Answer also current income.
the interest rate.
6 of 22 12/8/2012 11:44
lifetime resources.
future income.
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Question
The Fisher two-period model shows that current consumption depends on:
Answer only current income.
only future income.
current income, future income, and the interest rate.
current income, future income, the interest rate, and the rate of inflation.
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Question
In Irving Fisher's two-period model, the income effect of an increase in the interest rate in the first period for a saver is
the:
Answer decrease in the relative price of second-period consumption.
additional income earned on first-period saving.
decrease in the relative price of first-period consumption.
additional income earned on second-period saving.
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Question
In Irving Fisher's two-period model, the substitution effect of an increase in the interest rate in the first period, for a
saver, is the:
Answer decrease in the relative price of second-period consumption.
additional income earned on first-period saving.
decrease in the relative price of first-period consumption.
additional income earned on second-period saving.
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Question
In Irving Fisher's two-period model, if the consumer is initially saving in period one and the real interest rate rises, then
first-period consumption will:
Answer certainly fall.
certainly rise.
remain constant.
either rise or fall.
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Question
In Irving Fisher's two-period model, if the consumer is initially a saver and the interest rate and first-period consumption
increase, then we can conclude that the income effect:
Answer was greater than the substitution effect.
was less than the substitution effect.
exactly offset the substitution effect.
and the substitution both increased consumption.
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Question
In Irving Fisher's two-period model, if the consumer is initially a saver and the interest rate increases, and first-period
consumption decreases, then we can conclude that the income effect:
Answer was greater than the substitution effect.
was less than the substitution effect.
7 of 22 12/8/2012 11:44
exactly offset the substitution effect.

and the substitution both decreased consumption.
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Question
In Irving Fisher's two-period model, if the consumer is initially borrowing in period one and the real interest rate rises,
first-period consumption will:
Answer certainly rise.
certainly fall.
remain constant.
either rise or fall.
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Question
In Irving Fisher's two-period model, if the consumer is initially saving in period one and the real interest rate rises, then:
Answer both the income and substitution effects will make the consumer want to consume less in period one.
both the income and substitution effects will make the consumer want to consume more in period one.
the substitution effect will make the consumer want to consume less in period one but the income effect
will make him or her want to consume more.
the income effect will make the consumer want to consume less in period one, but the substitution effect
will make him or her want to consume more.
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Question
In the Fisher two-period model, if the consumer is a saver, consumption in periods one and two are normal goods, and
the income effect of an increase in interest rate is greater than the substitution effect, then saving:
Answer will increase.
will decrease.
will not change.
may either increase or decrease.
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Question
In the Fisher two-period model, if the consumer is a saver, consumption in periods one and two are normal goods, and
the income effect of an increase in interest rate is less than the substitution effect, then saving:
Answer will increase.
will decrease.
will not change.
may either increase or decrease.
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Question
In Irving Fisher's two-period model augmented by a borrowing constraint, an example of a consumer for whom the
borrowing constraint might likely be binding would be:
Answer a college student.
a college student's parent.
a college professor.
the president of a bank.
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Question
If a consumer cannot borrow, then consumption in period one must be ______ income in period(s) _____.
8 of 22 12/8/2012 11:44
Answer less than; one

less than or equal to; one
less than; one and two
less than or equal to; one and two
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Question
A borrowing constraint that is not binding occurs when a consumer wants to consume ______ in period one than he or
she earns in period(s) _____.
Answer less; one
more; one
less; one and two
more; one and two
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Question
In Irving Fisher's two-period consumption model, if Y = 15,000, Y = 20,000, the interest rate r is 0.50 (50 percent),
1 2
and there is a constraint on borrowing that is binding, then C equals:
1
Answer 15,000.
20,000.
28,333.
35,000.
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Question
In Irving Fisher's two-period consumption model, if Y = 15,000, Y = 20,000, the interest rate r is 0.50 (50 percent),
1 2
and there is a constraint on borrowing that is binding, then C equals:
2
Answer 20,000.
22,500.
35,000.
42,500.
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Question
If a consumer is in a position in which a borrowing constraint limits his or her current consumption and a one-time tax is
levied on his or her current income, then the tax will:
Answer lower the consumer's future consumption.
not affect the consumer's future consumption.
increase the consumer's future consumption.
have no effect on either current or future consumption.
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Question
In Irving Fisher's two-period model, consumption for a consumer with a binding borrowing constraint equals an amount
that is:
Answer equal to current income.
greater than current income.
equal to future income.
greater than future income.
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Question
A consumption function based on the Fisher two-period model is consistent with the Keynesian consumption function
for consumers who:
Answer would like to borrow, but cannot.
are initially borrowers when future income increases.
are initially savers when future income increases.
are initially borrowers when the interest rate increases.
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Question
Franco Modigliani's life-cycle hypothesis puts great emphasis on saving for:
Answer a house.
a car.
retirement.
medical emergencies.
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Question
The life-cycle model assumes that consumers use saving and borrowing to ______ consumption over their life cycle.
Answer increase
decrease
smooth
vary
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Question
According to Franco Modigliani's life-cycle hypothesis, the principal determinant(s) of consumption is (are):
Answer permanent income.
income and wealth.
transitory income.
wealth.
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Question
According to Modigliani's life-cycle hypothesis, if a consumer wants equal consumption in every year and the interest
rate is zero, then the marginal propensity to consume out of wealth ______ as years ______ decrease.
Answer increases; of life remaining
decreases; of life remaining
increases; until retirement
decreases; until retirement
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Question
According to Modigliani's life-cycle hypothesis, if a consumer wants equal consumption in every year, and the interest
rate is zero, there are 40 years until retirement, and 60 years of life remaining, then the marginal propensity to
consume out of income equals:
Answer 0.016.
0.40.
0.60.
0.67.
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Question
According to Modigliani's life-cycle hypothesis, the consumption function shifts upward as _____ increases.
Answer income
wealth
the marginal propensity to consume out of income
the number of years until retirement
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Question
Franco Modigliani's answer to Simon Kuznets's puzzle regarding long-term constancy of the average propensity to
consume is that:
Answer the average propensity to consume depends on the wealth-to-income ratio, and income and wealth tend to
grow together over time.
both rich and poor individuals have the same average propensity to consume.
demographic shifts have acted to just cancel out movements in the average propensity to consume.
every consumer consumes all of his or her income over a lifetime, so the average propensity to consume
is constant at one.
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Question
According to the life-cycle model, the average propensity to consume does not fall as income increases in the long run
because:
Answer wealth and income grow together.
as income increases wealth decreases.
saving is constant over the life cycle.
wealth is constant over the life cycle.
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Question
According to the life-cycle model, when wealth is constant in the short run, the average propensity to consume ______
as income increases.
Answer increases
decreases
remains constant
can either increase or decrease
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Question
According to the life-cycle model, when wealth and income increase together in the long run, the average propensity to
consume.
Answer increases
decreases
remains constant
can either increase or decrease
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Question
According to the life-cycle model, the short-run consumption function will not continue to hold in the long run because:
Answer increases in wealth shift the short-run function upward.
decreases in the average propensity to consume shift the short-run function downward.
increases in income shift the short-run function upward.
increases in the average life span shift the short-run function upward.
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Question
According to Franco Modigliani's life-cycle hypothesis, the time of life at which an individual has the largest amount of
wealth is at:
Answer birth.
death.
retirement.
his or her parents' death.
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Question
Empirical studies of Franco Modigliani's life-cycle hypothesis show that:
Answer most elderly individuals try to exhaust all their savings by the time they die.
the elderly do not seem to run down their wealth in old age, as a simple version of the theory would
predict.
elderly individuals generally do not want to leave bequests for their children.
precautionary saving is not an important saving motive for the elderly.
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Question
Precautionary saving is saving for:
Answer retirement, when income falls.
unpredictable expenses.
bequests to benefit children.
repayment of debt previously incurred.
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Question
Milton Friedman viewed current income as the sum of permanent income and:
Answer bonus income.
transitory income.
temporary income.
surprise income.
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Question
Permanent and transitory income differ in the way that permanent income is ______ than is transitory income.
Answer larger
more persistent
taxed at a higher rate
more variable
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Question
Transitory income is:
Answer income that persists.
average income.
random deviations from average income.
current income.
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Question
Milton Friedman argued that, on average, consumption is:
12 of 22 12/8/2012 11:44
Answer proportional to income.

a fraction of permanent income that rises as permanent income rises.
a fraction of permanent income that falls as permanent income falls.
proportional to permanent income.
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Question
According to the permanent-income hypothesis, consumption depends primarily on ______ income.
Answer current
nominal
permanent
transitory
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Question
According to the permanent income hypothesis, households will finance a temporary increase in taxes by: reducing
_______ or increasing _____.
Answer consumption; saving
saving; borrowing
permanent income; transitory income
transitory income; permanent income
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Question
According to the permanent-income hypothesis, if consumers receive a one-time income bonus, then they will:
Answer save most of it in the current year.
spend most of it in the current year.
spend one half of it and save one-half of it in the current year.
not alter their consumption or saving in the current year.
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Question
According to the permanent-income hypothesis, if consumers receive a permanent increase in their salary then they
will:
Answer save most of it in the current year.
spend most of it in the current year.
spend one half of it and save one-half of it in the current year.
not alter their consumption or saving in the current year.
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Question
According to Friedman's permanent-income hypothesis, if the marginal propensity to consume out of permanent
income equals 0.9 and current income equals $55,000 (of which $5,000 is transitory income), then consumption should
equal:
Answer $5,000.
$45,000.
$49,500.
$55,000.
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Question
According to Friedman's permanent-income hypothesis, the marginal propensity to consume out of permanent income
is ______ the marginal propensity to consume out of transitory income.
13 of 22 12/8/2012 11:44
Answer greater than

less than
equal to
one minus
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Question
Milton Friedman argued that, although household studies showed that high-income households generally have lower
average propensities to consume, this phenomenon is due to the fact that these households have, on average:
Answer positive transitory income.
negative transitory income.
higher permanent income.
lower permanent income.
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Question
Milton Friedman argued that, over long periods of time, the average propensity to consume is constant because, over
these long periods of time:
Answer the variation in income is dominated by the transitory component
the variation in income is dominated by the permanent component.
it is the behavior of the average consumer that dominates.
income averages out to a constant.
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Question
Suppose that the government is considering two tax cuts, one temporary and one permanent. Each cut will give each
taxpayer the same amount in the first year. The permanent-income hypothesis predicts that:
Answer each tax cut will lead to the same amount of consumption in the first year.
the temporary tax cut will lead to more extra consumption in the first year.
the permanent tax cut will lead to more extra consumption in the first year.
the temporary tax cut will lead to no extra consumption at all in the first year.
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Question
If the permanent-income hypothesis is correct, and if consumers have rational expectations, then changes in
consumption over time should be:
Answer predictable.
unpredictable.
mostly positive.
mostly negative.
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Question
Consumption is said to follow a random walk if:
Answer consumers have rational expectations.
consumption is proportional to permanent income.
changes in consumption are unpredictable.
changes in consumption produce secular stagnation.
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Question
If consumers have rational expectations and follow the permanent-income hypothesis, their current consumption will
increase when:
14 of 22 12/8/2012 11:44
Answer previously announced tax reductions are implemented.

they receive an anticipated raise.
they receive an unexpected inheritance.
they make the last payment on their automobile loan.
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Question
If consumers obey the permanent-income hypothesis and have rational expectations, then ______ policy changes
influence consumption.
Answer only unexpected
only expected
both expected and unexpected
neither expected nor unexpected
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Question
If consumers obey the permanent-income hypothesis and have rational expectations, then policy changes affect
consumption when the policy changes:
Answer are proposed.
go into effect.
change expectations.
do not surprise consumers.
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Question
If consumers correctly anticipate their future incomes:
Answer the saving rate will be high when consumers anticipate a boom.
the saving rate will be low when consumers anticipate a boom.
the saving rate will be low when consumers anticipate a recession.
they will be disappointed because future income can never be correctly forecasted.
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Question
Economic data suggest that when income is expected to fall by $1, consumption falls by:
Answer $1.
$0.50.
the marginal propensity to consume.
the ratio of years until retirement to the years remaining of life
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Question
The pull of instant gratification may lead consumers to save ______ they would like to save.
Answer more than
less than
approximately the amount
precisely the amount
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Question
Recent research by Laibson and other economists recognizes the importance of incorporating ______ effects into the
study of consumer behavior.
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Answer technological
meteorological
environmental
psychological
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Question
Economist David Laibson suggests that people end up saving less than they wish because of:
Answer an increasing marginal propensity to consume over time.
the pull of instant gratification.
rarely receiving transitory income.
unpredictable changes in consumption.
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Question
A consumer spending excessively today, intending to start saving for retirement tomorrow, but deciding to continue
spending when tomorrow arrives is an example of:
Answer an income effect offsetting a substitution effect.
time-inconsistent preferences.
spending out of permanent income, but not out of transitory income.
an intertemporal budget constraint.
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Question
Consumers with time-inconsistent preferences:
Answer base consumption decisions on transitory rather than permanent income.
seek to consume more in retirement than during their working years.
may alter decisions simply because time passes.
face borrowing constraints that prevent rational behavior.
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Question
Whether workers must “opt into” or “opt out of” a retirement savings plan ______ make a difference if workers are
rational optimizers and ______ make a difference if workers' behavior exhibits inertia.
Answer would; would
would not; would not
would; would not
would not; would
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Question
The success of the “Save More Tomorrow” program is based on the assumption that consumers:
Answer smooth consumption over their life cycles.
save a constant fraction of their permanent incomes.
require help controlling their desires for instant gratification.
save only their transitory incomes.
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Question
The determination of consumption as a function of current disposable income is most strongly associated with:
Answer John Maynard Keynes.
Irving Fisher.
Franco Modigliani.
16 of 22 12/8/2012 11:44
Milton Friedman.
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Question
Recent work on the consumption function suggests that consumption depends on:
Answer current income alone.
current income and expected future income.
current income, expected future income, and interest rates.
current income, expected future income, interest rates, and wealth.
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Question
The life-cycle hypothesis and the permanent-income hypothesis both assume that consumers seek to:
Answer increase consumption during expansions.
minimize consumption during recessions.
increase consumption during retirement
smooth consumption over their lifetimes.
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Question
If a consumer is a borrower in period one and the interest rate rises, the:
Answer income and substitution effects both tend to make consumption higher in the first period.
income and substitution effects both tend to make consumption lower in the first period.
income effect tends to make consumption higher in the first period and the substitution effect tends to
make it lower.
substitution effect tends to make consumption higher in the first period and the income effect tends to
make it lower.
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Question
A binding borrowing constraint will ______ the potency of an announced future tax cut to influence aggregate demand
but will ______ the potency of a temporary tax cut.
Answer not affect; increase
increase; not affect
decrease; increase
increase; decrease
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Question
If consumers want consumption to be as constant as possible over their life cycles and income rises gradually over
their periods of employment, then if borrowing constraints prevent their wealth from falling below zero:
Answer they can achieve constant consumption by borrowing.
their consumption in retirement will be higher than it was in earlier parts of the life cycle.
their consumption during their younger years will be lower than it will be in later parts of the life cycle.
their consumption during their later working years will be higher than it was or will be in other parts of
the life cycle.
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Question
The life-cycle model predicts that if the proportion of the population that is elderly increases over the next 20 years,
then the national saving rate ______ over the next 20 years.
Answer will increase
will remain unchanged
17 of 22 12/8/2012 11:44
will decrease
may first increase and then decrease
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Essay 1 points
Question
Assume that Jeannie Drago is trying to allocate her consumption over two periods of life: work and retirement. Each
period is to last 20 years. To simplify, assume that all income comes at time t in the middle of 20 years of work, and all
1
expenditures come at either t or t , 20 years later. Jeannie's budget constraint is C + C /(1 + r/100) = Y + Y /(1 +
1 2 1 2 1 2
r/100), where the real interest rate r is 100 percent (approximately 3.5 percent per year over 20 years). Jeannie's
preferences are to have equal consumption each period.
a. What are C and C if Y = 1 million and Y = 0?
1 2 1 2
b. What are C and C if Y = 0 and Y = 1 million (reflecting, for example, an individual who plans to come
1 2 1 2
into a large inheritance late in life)? Do these answers depend on Jeannie's being able to borrow against
the inheritance?
Answer a. C = C = $666,666.67
1 2
b. C = C = $333,333.33. Yes, she will have to borrow.
1 2
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Essay 1 points
Question
Assume that Andrew Marcus is 25 years old and expects to live to age 75.
a. If he wins $20 million in cash (after taxes) in the lottery and retires, how much will he consume each
year if he wants to have constant consumption and use up all his wealth by the time he dies? Assume
the real interest rate is zero.
b. If his total income in the year he wins the lottery is his lottery winnings, what will his average propensity
to consume (APC) be for that year?
c. If he has no other earnings in later years but continues his constant consumption, what will his average
propensity to consume be for those later years?
d. What is Andrew's “permanent income” in the year he wins the lottery? What is his “transitory income”?
Answer a. Andrew Marcus's consumption rate will be $400,000 per year.

b. His average propensity to consume will be 0.02.
c. His average propensity to consume will not be defined. “Infinity” should be considered a correct answer.
d. “Permanent income” is not really defined in the text, but $400,000 would seem a correct answer.
“Transitory income” then would be $19,600,000.
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Essay 1 points
Question
Exhibit: Consumption, Income, and Wealth Over the Life Cycle
Consider the stylized pattern of lifetime income, consumption, saving, dissaving, and wealth shown in the above graph.
Assume that consumption is constant over the entire lifetime, income is constant over the working lifetime, the real
interest rate is zero, and there is no uncertainty about life span so that wealth equals zero at the end of life.
a. If there is no population growth, the ratio of wealth to income will be constant for the nation. If all
individuals live T years and work R years, the amount of wealth accumulated at the time of retirement
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must be enough for T – R years of consumption (C per year). What is the formula for the ratio of
average wealth over the whole life cycle W to consumption per year, as a function of T and R? That is,
what is W/C expressed in terms of T and R?
b. If T = 50 and R = 40, what is the numerical value of W/C?
Answer a. W/C = 0.5(T – R).

b. W/C = 5.
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Essay 1 points
Question
Ken Downing behaves according to Irving Fisher's two-period model. Consumption in both periods is a normal good for
Ken. Ken is initially a saver in period one. Ken loses his job in period one. His first-period income becomes his
unemployment benefits, which are much lower than his period-one income had been. His expected income in period
two is unchanged. Illustrate graphically how this job loss affects Ken's consumption in periods one and two.
Answer
Consumption in both periods one and two decreases.

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Essay 1 points
Question
Assume that the typical household behaves according to Irving Fisher's two-period model, that consumption in both
periods is a normal good and that households are initially savers. Illustrate graphically how a tax cut in period one
affects consumption in both periods. Assume that the average consumer does not believe that he or she or anyone in
the family will ever have to pay higher taxes in the future to offset the current cuts.
Answer
Consumption in both periods, one and two, increases.

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Question
Suppose that the Federal Reserve raises the interest rate at which the average household can borrow and lend.
Assume that the typical household behaves according to Irving Fisher's two-period model, that consumption in both
periods is a normal good, and that households are initially borrowers. Illustrate graphically how the increase in the
interest rate in period one affects consumption in both periods.
Answer
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In this drawing both C and C decrease. C must decrease because both the substitution and income effects
1 2 1
work to reduce C However, C may either increase (if the substitution effect is greater than the income
1. 2
effect) or decrease (if the income effect is greater than the substitution effect).
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Question
What variables, in addition to current income, are hypothesized to influence consumption in the:
a. Fisher two-period model?
b. life-cycle model?
c. permanent-income hypothesis?
d. random-walk hypothesis?
Answer a. Fisher's two-period model: future income, the interest rate

b. Life-cycle model: lifetime income, wealth, age structure of the population
c. Permanent-income hypothesis: permanent and transitory income
d. Random-walk hypothesis: unexpected policy changes
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Question
How do binding borrowing constraints change the determination of current consumption in the Fisher two-period model
and in the random-walk hypothesis (permanent-income hypothesis with rational expectations)?
Answer In the Fisher two-period model, binding borrowing constraints make current consumption depend on current
income rather than on both current and future income. Consumers with rational expectations who are
borrowing constrained may not be able to fully adjust their consumption to their expected lifetime income,
making their consumption more closely tied to their current income than the random-walk hypothesis predicts.
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Question
What is the impact on current consumption of a temporary tax cut according to:
a. the Keynesian consumption function?
b. the permanent-income hypothesis?
Answer a. In the Keynesian consumption function, the temporary tax cut increases disposable income and
consumption increases by the MPC times the change in disposable income.
b. According to the permanent-income hypothesis, the additional income available as a result of the
temporary tax cut would be spread over the remaining lifetime, so the increase in current consumption
would be only a tiny fraction of the increase in income.
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Essay 1 points
Question
Suppose that Congress passes a law to permanently cut taxes starting the next year. Assuming that consumers do not
follow Ricardian equivalence, when would consumers adjust their consumption spending according to:
a. the Keynesian consumption function?
b. the Fisher two-period model with binding borrowing constraints?
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c. the random-walk hypothesis (the permanent-income hypothesis with rational expectations) with no
binding borrowing constraint?
Answer a. Consumption would increase in one year when the tax law goes into effect.
b. Consumption would increase in one year when the tax law goes into effect.
c. Consumption would increase as soon as consumers' expectations of higher-lifetime income adjust.
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Question
What is meant by the phrase “consumption smoothing” and why is it a key element of the life-cycle hypothesis and the
permanent-income hypothesis?
Answer Consumption smoothing refers to consumers' desire to avoid large swings in consumption, i.e., to avoid a
“feast or famine” lifestyle. This concept is key in both the life-cycle hypothesis and the permanent-income
hypothesis because these theories assume that consumers are forward-looking and attempt to make optimal
decisions over their lifetimes. Both of these theories consider the consumption decision as occurring over
multiple periods. The consumption-smoothing assumption describes the desired pattern of consumption over
these multiple periods.
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Question
The adequacy of retirement savings is an important public policy issue. Many tax-favored retirement plans impose tax
penalties on any withdrawals from retirement savings plans before a worker reaches a particular age, such as .
However, in some cases workers at an earlier age get access to their savings with no withdrawal penalties when they
change employers. Many workers in this situation spend their accumulated retirement savings on current consumption.
Assuming that the worker is merely changing jobs with no change in expected future income, is this behavior
consistent with the life-cycle/permanent-income hypothesis? Explain why or why not and offer an alternative
explanation based on behavioral economics.
Answer No, this behavior is not consistent with the life-cycle/permanent-income hypothesis, because there has not
been a change in expected income, so there should not be a change in consumption. Behavioral economists
would explain this behavior as an example of a consumer's desire for instant gratification from current
consumption items and a lack of self-discipline. The consumer still wants to save for retirement, but the lure
of more current consumption is too great to resist.
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Question
Assume you are a 25-year old who expects to work for 40 years and then enjoy 30 years of retirement. (Assume a
discount rate of 3 percent.) If you behave according to the life-cycle/permanent income hypothesis, how would your
current consumption change if:
a. You win $1,000,000 in the lottery this year.
b. You expect to get a $1,000,000 “signing bonus” when you get a job next year.
Answer Under the first scenario the present value of your expected income increases by $1,000,000, and under the
second scenario the present value of your expected income increases by slightly less than $1,000,000,
depending on the discount rate ($970,874 with a 3 percent discount rate). Acting according to the
life-cycle/permanent income approach, you would spread additional consumption out of this new income over
your remaining 75-year life span. You would increase current consumption by $13,333 this year
($1,000,000/75) if you won the lottery this year or slightly less ($12,945, for example is $970,874/75) if you
expected the signing bonus and did not face borrowing constraints.
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Question
Some taxpayers voluntarily have more taxes withheld from their paychecks during the year in order to receive a large
tax refund once a year. These taxpayers give the government an interest-free loan and lose the interest they could
have earned by saving a portion of the larger paychecks they would have received during the year. Why might a
person make this choice? What does this choice say about the theory of the consumption function?
Answer Taxpayers who face the “pull of instant gratification” may prefer to over-withhold their taxes. In this way, they
commit themselves to not using the extra money in their paychecks to satisfy a desire for instant gratification.
This pre-commitment offers a way to overcome the time-inconsistency problem. That is, they would like to
save more, but at any particular moment, they face a strong desire for instant gratification that they always
choose to consume rather than to save. This is the type of consumer in David Laibson's theory.
21 of 22 12/8/2012 11:44
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Question
The distinction between current income and expected future income is a critical distinction among the six theories of
consumption. Which theories place greater emphasis on current income and which theories place greater emphasis on
future expected income? Why does this distinction matter for economic policymakers?
Answer The Keynesian consumption function and Laibson's behavioral economics “pull of instant gratification”
emphasize current income. The Fisher two-period model, the life-cycle hypothesis, the permanent-income
hypothesis, and Hall's random-walk model put more emphasis on future expected income. This distinction is
important for policymakers because current changes in tax policy, for example, will have a smaller impact on
aggregate demand if consumers are making decisions on the basis of changes in their expected future
income, rather than changes in their current income, since the tax changes will represent a smaller proportion
of their expected lifetime income than of their current income.
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22 of 22 12/8/2012 11:44
Pool Canvas
Name TestBanks Chapter 17 Investments

Description
Instructions
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Question
The most volatile component of real GDP is:
Answer consumption spending.
government spending.
investment spending.
net exports.
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Question
Investment spending is:
Answer generally countercyclical.
generally procyclical.
unrelated to the business cycle.
generally procyclical for some components and generally countercyclical for others.
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Question
The investment spending component of GDP includes all of the following except:
Answer business fixed investment.
net foreign investment.
residential investment.
inventory investment.
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Question
Business fixed investment includes:
Answer rental housing that landlords buy to rent out.
goods that businesses put aside in fixed storage facilities, including materials and supplies.
the fixed cost of borrowing that businesses pay for new equipment.
equipment and structures that businesses buy to use in production.
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Question
The construction of a new shopping center is an example of:
financial investment.
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Question
The standard model of business fixed investment is called the ______ of investment.
Answer new classical model
neoclassical model
classical model
Keynesian model
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Question
According to the neoclassical model of investment, business fixed investment does not depend on:
Answer the realized profits of firms.
the marginal product of capital.
the interest rate.
tax rules affecting firms.
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Question
If the capital stock is fixed and something happens to raise the marginal product of capital (MPK) for any given quantity
of capital, then the real rental price of capital will:
Answer remain the same.
rise.
fall.
fall and then rise.
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Question
In equilibrium, other things being equal, all of the following changes will increase the real rental price of capital except:
Answer a lower quantity of labor employed.
a lower stock of capital.
better technology.
a higher labor–capital ratio.
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Question
Exhibit: Rental Price of Capital
Reference: Ref 17-1
(Exhibit: Rental Price of Capital) Based on the graph, if the capital market is initially in equilibrium at A with real rental
price R /P and capital stock K , then holding other factors constant, an increase in the capital stock to K will change
3 2 3
the real rental price of capital to:
Answer R1/P.
R2/P.
R4/P.
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R5/P.
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Question
Reference: Ref 17-1
price R /P and capital stock K , then holding other factors constant, an increase in the quantity of labor employed will
3 2
move the real rental price of capital to:
Answer R1/P.
R2/P.
R4/P.
R5/P.
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Question
Reference: Ref 17-1
price R /P and capital stock K , then holding other factors constant, an improvement in technology that increases the
3 2
marginal productivity of capital will move:
Answer the demand curve from D to D .
2 1
the demand curve from D to D .
2 3
the supply of capital from K to K .
2 1
the supply of capital from K to K .
2 3
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Question
If a great wave of immigration increased employment in the United States, this wave would:
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Answer increase the marginal productivity of capital in the United States.

decrease the marginal productivity of capital in the United States.
leave the marginal productivity of capital in the United States unchanged.
increase the marginal productivity of capital in the country from which the immigrants came.
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Question
A firm renting out capital does not bear as cost the:
Answer lost interest it could have earned by depositing the purchase price of the capital in a bank.
wear and tear on the capital.
wages of the labor that works with the capital.
capital loss or gain in the asset's value.
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Question
The rate of depreciation is the:
Answer nominal interest rate times the purchase price of capital.
capital losses resulting from decreases in the price of capital.
fraction of the value of capital lost per period because of wear and tear.
change in the q value of the firm.
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Question
The cost of capital for investment, if the price of capital goods rises with the price of other goods and in the absence of
taxes, may be summarized as the:
Answer nominal interest rate plus the depreciation rate.
real interest rate plus the depreciation rate.
purchase price of a capital good multiplied by the sum of the nominal interest rate plus the depreciation
rate.
purchase price of a capital good multiplied by the sum of the real interest rate plus the depreciation rate.
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Question
The real cost of capital is the:
Answer purchase price of a unit of capital divided by the price level.
purchase price of a unit of capital minus the rate of inflation.
cost of a unit of capital less the marginal product of capital.
cost of buying and renting out a unit of capital measured in units of the economy's output.
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Question
If the price index for capital goods is the same as the price index for other goods, an index of the real cost of capital for
investment, in the absence of taxes, may be summarized as the:
Answer nominal interest rate plus the depreciation rate.
real interest rate plus the depreciation rate.
purchase price of a capital good multiplied by the sum of the nominal interest rate plus the depreciation
rate.
purchase price of a capital good multiplied by the sum of the real interest rate plus the depreciation rate.
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Question
If the real rental price of capital is $10,000 per unit and the real cost of capital is $9,000 per unit, to maximize profits a
firm should:
4 of 20 12/8/2012 11:44
Answer add to its capital stock.

let its capital stock shrink.
keep its capital stock unchanged.
reduce the real rental price of capital.
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Question
The profit rate of a firm that rents capital is equal to:
Answer the marginal product of capital minus the cost of capital.
the cost of capital minus the marginal product of capital.
zero.
a negative number, if it is adding to its capital stock.
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Question
Net investment is the:
Answer business fixed investment minus inventory investment.
change in the stock of capital.
gross investment minus the rate of inflation.
gross investment plus the replacement of depreciated capital.
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Question
A capital rental firm makes a profit if the ______ is ______ the cost of capital.
Answer real rental price of capital; less than
equilibrium marginal product of capital; less than
equilibrium marginal product of capital; equal to
equilibrium marginal product of capital; greater than
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Question
Other things being equal, the neoclassical model of investment predicts that net investment will increase when the:
Answer marginal product of capital falls.
price of new capital goods rises.
real interest rate falls.
depreciation rate rises.
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Question
The neoclassical model of investment says investment depends negatively on the real interest rate because an
increase in the real interest rate:
Answer raises the cost of capital.
lowers the marginal product of capital.
lowers the real rental price of capital.
slows down the speed at which net investment responds to the incentive to invest.
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Question
According to the neoclassical model of investment, when the real interest rate increases, business fixed investment
______ because the ______ of capital increases.
Answer increases; marginal product
increases; cost
decreases; marginal product
5 of 20 12/8/2012 11:44
decreases; cost
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Question
The function showing total spending on investment would be shifted inward and to the left by:
Answer a technological innovation that increases the production function parameter A.
any event that raises the marginal product of capital.
any event that raises the purchase price of capital.
an accident that destroyed one-quarter of the U.S. capital stock while leaving the labor supply intact.
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Question
When the capital stock reaches a steady state, the:
Answer marginal product of capital must exceed the real cost of capital.
marginal product of capital must equal the real cost of capital.
real cost of capital must exceed the marginal product of capital.
real cost of capital must exceed the real rental price of capital.
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Question
The corporate income tax is a tax on the:
Answer earnings of employees of a corporation.
dividends paid to the shareholders of a corporation.
earnings of the managers of a corporation.
profits of a corporation.
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Question
If corporate profit were defined as the real price of capital minus the properly defined cost of capital, then:
Answer having a tax on corporate profits would be more favorable to investment than having no tax at all.
having a tax on corporate profits would be less favorable to investment than having no tax at all.
having a tax on corporate profits would leave investment incentives the same as having no tax at all.
whether a corporate profits tax was more or less favorable for investment than no tax at all would depend
on the rate of tax.
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Question
Because of the way that U.S. tax law defines depreciation, depreciation for tax purposes is:
Answer always less than true economic depreciation.
always greater than true economic depreciation.
always equal to true economic depreciation.
sometimes greater than true economic depreciation and sometimes less.
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Question
The investment tax credit:
Answer enables a firm to deduct a certain proportion of each dollar spent on capital goods from its profits.
enables a firm to deduct a certain proportion of each dollar spent on capital goods from its tax bill.
reduces the corporate tax rate in proportion to each dollar spent on capital goods.
allows a firm to count a certain proportion of each dollar spent on capital goods as depreciation expense.
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6 of 20 12/8/2012 11:44
Question
Because corporate income tax laws do not define profit to be the same as economic profit, many economists believe
that the corporate income tax ______ investment.
Answer encourages
discourages
does not affect
promotes excessive
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Question
______ is a share of ownership in a corporation, and the ______ market is the market where these shares are traded.
Answer Capital; capital
A dividend; stock
A bond; capital
Stock; stock
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Question
Tobin's q equals the:
Answer cost of buying and renting out one unit of capital measured in units of the economy's output.
marginal product of capital minus the cost of capital.
ratio of the replacement value of installed capital to the market value of installed capital.
ratio of the market value of installed capital to the replacement cost of installed capital.
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Question
If Tobin's q is greater than 1, then managers should:
Answer increase the capital stock of the firm.
maintain the existing capital stock of the firm.
allow inventories to run down.
decrease the capital stock of the firm.
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Question
If the replacement cost of installed capital equals $20 trillion and the market value of installed capital equals $25 trillion,
then according to q theory, businesses should:
Answer add to capital stock.
let capital stock shrink.
keep capital stock unchanged.
reduce product prices to increase profits.
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Question
If firms are earning a profit, then this raises the ______ value of installed capital and implies a ______ value of Tobin's
q.
Answer market; low
market; high
replacement; low
replacement; high
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7 of 20 12/8/2012 11:44
Question
Other things being equal, the ratio of Tobin's q will rise if:
Answer stock prices fall.
the replacement cost of capital rises.
more capital is installed.
stock prices rise.
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Question
James Tobin reasoned that:
Answer the stock market is a “random walk.”
if the stock market values capital at less than its replacement cost, the stock market will go up.
if the stock market values capital at less than its replacement cost, the stock market will go down.
if the stock market values capital at less than its replacement cost, the firm's managers will not replace
capital as it wears out.
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Question
The theory behind Tobin's q indicates that:
Answer the stock market may be expected to predict every turning point in real GDP.
the stock market may be expected to be closely tied to fluctuations in output and employment.
every time investment goes up we would expect the stock market to go down.
the stock market and the economy are basically independent of each other.
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Question
According to the efficient markets hypothesis, changes in stock prices are:
Answer driven by irrational waves of optimism.
driven by irrational waves of pessimism.
rational reflections of underlying economic fundamentals.
possible to predict from available information.
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Question
According to the efficient markets hypothesis, changes in stock prices:
Answer follow a random walk.
can be predicted from available information.
are driven by irrational waves of optimism and pessimism.
are based on what investors expect other investors to pay.
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Question
If stock prices follow a random walk, then:
Answer changes in stock prices cannot be predicted from available information.
managed mutual funds should outperform index funds.
it would be easy to beat the market by buying undervalued stocks and selling overvalued stocks.
stock prices fluctuate for no good reason.
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Question
According to Keynes, movements in stock prices:
8 of 20 12/8/2012 11:44
Answer follow a random walk.

reflect rational valuations of underlying economic fundamentals.
result when new information becomes available.
are often driven by irrational waves of optimism and pessimism.
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Question
According to the efficient markets hypothesis, stock price changes reflect ______, but according to Keynes, stock price
changes often reflect ______.
Answer the inventory accelerator; changes in Tobin's q
changes in the real cost of capital; financing constraints
changes in the underlying economic fundamentals; irrational waves of optimism or pessimism
reductions in investment tax credits; the use of historical cost rather than replacement cost in computing
depreciation costs
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Question
For a firm facing financing constraints on its investment spending, the most important determinant of how much it
invests is the:
Answer firm's expected future profitability.
firm's current profitability.
interest rate.
firm's cost of capital.
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Question
The existence of financing constraints makes investment:
Answer more sensitive to current conditions.
less sensitive to current conditions.
spending follow a random walk.
spending increase during recessions.
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Question
During a financial crisis, such as the Great Depression or the recession of 2008–09, financing constraints become
______ prevalent and investment spending ______.
Answer more; increases
more; decreases
less; increases
less; decreases
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Question
The construction of a new apartment building is an example of:
financial investment.
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Question
Residential investment spending includes spending on:
9 of 20 12/8/2012 11:44
Answer new housing that people buy to live in and that landlords buy to rent out.
new and existing housing.
all houses purchased less the value of mortgages used to finance the houses.
only those houses that landlords buy to rent out.
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Question
Residential investment equals the:
Answer stock of existing housing.
flow of new housing.
demand for housing.
imputed rent from housing.
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Question
The demand for housing is brought into equilibrium with the existing stock of housing by changes in the:
Answer real interest rate.
nominal interest rate.
relative price of housing.
overall price level.
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Question
The link between the flow of new housing and the stock of existing housing is the:
Answer relative price of housing.
demand for housing.
demand for residential investment.
real interest rate.
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Question
Analogous to the role of expected profits from owning installed capital in the q theory of business fixed investment is
the role played by the _____ in the model of the housing market.
Answer real interest rate
nominal interest rate
expected imputed rent from owning housing
stock of existing housing
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Question
The price of housing relative to the price of other goods is determined in the short run by the:
Answer cost of construction.
demand for the services of homes.
supply of existing homes.
supply and demand for the existing stock of homes.
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Question
Holding other factors constant, an increase in population due to a large increase in immigrants will ______ the price of
housing and ______ the flow of residential housing investment.
increase; decrease
decrease; increase
10 of 20 12/8/2012 11:44
decrease; decrease
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Question
Holding other factors constant, the decline in aggregate income during a recession will ______ the price of housing
and ______ the flow of residential housing investment.
increase; decrease
decrease; increase
decrease; decrease
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Question
Holding other factors constant, a decline in the real interest rate will ______ the price of housing and ______ the flow
of residential housing investment.
increase; decrease
decrease; increase
decrease; decrease
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Question
In the mortgage market, a rise in the real interest rate:
Answer lowers housing demand, housing prices, and residential investment.
raises housing demand, housing prices, and residential investment.
lowers housing demand and residential investment but raises housing prices.
raises housing demand but lowers housing prices and residential investment.
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Question
Exhibit: Residential Investment
Reference: Ref 17-2
(Exhibit: Residential Investment) Based on the graph, if the capital market is initially in equilibrium at A with the relative
price of housing equal to P /P and the stock of housing capital equal to K , then holding other factors constant, an
H3 H2
economic recession that reduces national income will cause the relative price of housing to move to ______ and the
flow of residential housing to move to ______.
Answer PH1/P; IH4
PH2/P; IH3
PH3/P; IH2
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PH4/P; IH1
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Question
Exhibit: Residential Investment
Reference: Ref 17-2
(Exhibit: Residential Investment) Based on the graph, if the capital market is initially in equilibrium at A with the relative
price of housing equal to P /P and the stock of housing capital equal to K , then holding other factors constant, if a
H3 H2
massive earthquake destroys a significant portion of the stock of housing capital, house prices will move to ______ and
the flow of residential housing will move to______.
Answer PH1/P; IH4
PH2/P; IH3
PH3/P; IH2
PH4/P; IH1
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Question
Loans made to subprime borrowers in the early 2000s had the immediate impact of ______ housing demand and
______ housing prices.
Answer increasing; increasing
increasing; decreasing
decreasing; decreasing
decreasing; increasing
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Question
Inventory investment includes spending on:
Answer equipment and structures that businesses buy to use in production.
goods that businesses put aside in storage, including materials and supplies, work in progress, and
finished goods.
goods that businesses produce to sell to other businesses.
capital equipment less depreciation expense.
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Question
Inventory investment is the ______ component of aggregate spending and is very ______.
Answer largest; volatile
largest; stable
smallest; volatile
12 of 20 12/8/2012 11:44
smallest; stable
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Question
In a typical recession, more than half the fall in spending comes from a decline in:
Answer consumption spending.
net foreign investment.
government spending.
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Question
The production-smoothing motive for holding inventories suggests that:
Answer firms hold inventories in order to produce more output.
when sales are low, firms produce more than they sell and put the extra goods in inventories.
firms hold inventories to avoid losing sales.
when a product is only partly completed, its components are counted as part of the firm's inventory.
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Question
The inventories of a company that manufactures snow blowers increase in the summer and decline in the winter. This
example is most consistent with which of the following explanations for holding inventories?
Answer production smoothing
inventories as factors of production
stock-out avoidance
work in process
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Question
The inventories as a factor of production motive for holding inventories suggests that:
firms hold inventories to avoid paying wages to labor.
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Question
The stock-out avoidance motive for holding inventories suggests that:
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Question
A toy manufacturer accumulates inventories because of the uncertainty of the demand for their product at Christmas
and the desire not to lose any potential sales. This is an example of the ______ motive for holding inventories.
Answer production smoothing
inventories as a factor of production
stock-out avoidance
work in process
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Question
The work in procress motive for holding inventories suggests that:
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Question
Adding to the stock of spare parts that a manufacturer keeps on hand to replace worn out or broken parts is an
example of:
Answer the efficient markets hypothesis.
precautionary saving.
reserve requirements.
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Question
Inventory investment will decrease when interest rates _____ and credit conditions are _____.
Answer decrease; tight
decrease; easy
increase; easy
increase; tight
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Question
Inventory investment, at least in theory, should:
Answer rise when the real interest rate rises, other things being equal.
not depend on the real interest rate, other things being equal.
fall when the real interest rate rises, other things being equal.
depend only on the change in real GDP.
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Question
The opportunity cost of holding inventories is the:
Answer real interest rate.
nominal interest rate.
raw materials used up in the production of inventories.
labor used in the production of inventories.
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Question
Holding other factors constant, a fall in the interest rate will ______ inventory investment.
Answer increase
decrease
have no impact on
sometimes increase and sometimes decrease
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14 of 20 12/8/2012 11:44
Question
The real interest rate should be inversely related to investment in:
Answer plant and equipment, home building, and inventories.
plant and equipment and home building, but not inventories.
plant and equipment and inventories, but not home building.
inventories and home building, but not plant and equipment.
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Question
The investment demand function would shift for all of the following reasons except:
Answer an improvement in technology raises the marginal product of capital.
an increase in population raises the demand for housing.
an increase in government spending raises the real interest rate.
the investment tax credit is reinstated.
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Question
Economic booms should stimulate investment spending because during booms:
Answer the real interest rate increases.
corporate tax rates usually increase.
the purchase price of capital increases.
higher levels of employment increase the marginal product of capital.
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Question
During recessions, investment spending usually decreases because:
Answer the real interest rate falls.
lower profits mean more firms face financing constraints.
the purchase price of capital decreases.
corporate tax rates usually decrease.
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Question
As firms' profits increase during a boom, business fixed investment will increase because:
Answer the marginal product of capital falls.
stock-out avoidance diminishes.
corporate tax payments decrease.
the high profit levels relax financing constraints.
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Question
Business fixed investment, residential investment, and inventory investment ______ as the real interest rate increases
and ______ as output increases.
increase; decrease
decrease; increase
decrease; decrease
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Question
According to the neoclassical model of investment, the immediate impact of a rise in the real interest rate will be to:
15 of 20 12/8/2012 11:44
Answer increase the cost of capital, the rental price of capital, and the rate of investment.
increase the cost of capital and the rental price of capital, but to lower the rate of investment.
increase the rental price of capital and the rate of investment, but to leave the cost of capital unchanged.
increase the cost of capital and lower the rate of investment, but to leave the rental price of capital
unchanged.
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Question
According to the neoclassical model of investment, the immediate impact of an earthquake that destroys part of the
capital stock will be to:
Answer increase the cost of capital, the rental price of capital, and the rate of investment.
increase the rental price of capital and the rate of investment, but to leave the cost of capital unchanged.
increase the rental price of capital and the cost of capital, but to leave the rate of investment unchanged.
increase the rental price of capital and the rate of investment, but to decrease the cost of capital.
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Question
Assume that the government levies a one-time-only tax on oil companies equal to a proportion of the value of the
company's oil reserves. According to the neoclassical model, if firms face no financing constraints and also believe the
tax will not be repeated, the effect of this tax on investment by these firms will be to:
Answer decrease investment.
not affect investment.
increase investment.
decrease the rental price of capital but not change the cost of capital.
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Question
Suppose it is an election year and the economy is in a recession. The opposition candidate proposes an investment
tax credit to take effect next year after he takes office. If the public believes the opposition candidate has a good
chance of winning, the effect of this promise will likely be to:
Answer increase investment both this year and next year.
decrease investment both this year and next year.
increase investment this year and decrease it next year.
decrease investment this year and increase it next year.
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Essay 1 points
Question
Assume that a car-rental company buys cars for $20,000 each and rents them out to other businesses. The company
faces a nominal interest rate of 10 percent per year, and car prices are rising at 6 percent per year. If cars depreciate at
30 percent per year, what will be the company's cost of capital per car?
Answer The cost of capital per car is $6,800.
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Question
a b 1– a – b
Assume that the production function for an economy is given by Y = AK H L , where H is the stock of inventories.
a 1–a–b b–1
Then the marginal product of inventories (MPH) is given by MPH = bAK L H . If the stock of inventories does
not depreciate, the price of inventories is the same as the price of output, and taxes are ignored, then the real “cost of
capital” for inventories is just the interest rate r.
a. Derive an expression for the “desired equilibrium stock of inventories” (H*) as a function of r and output
Y by equating the cost of capital to MPH. (Hint: First substitute the production function into the
expression for MPH to get MPH = bY/H.) If r = 0.1, b = 0.05, and Y = 5,000, what is the desired stock of
inventories?
b. If r rose to 0.12, how would the desired stock of inventories change?
Answer a. H* = bY/r. Using these numbers, H* = 2,500.

b. H* would fall to 2,083.33.
16 of 20 12/8/2012 11:44
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Essay 1 points
Question
Assume that the following model of the economy applies:
C = a + b(Y – T)
I = c + dY
fixed
Iinventories = g + hY
Y = C + Ifixed + Iinventories + G
Write an expression for equilibrium Y in this model. If b = 0.5, d = 0.2, and h = 0.2, what are the multipliers for G and T?
Answer The expression is:
Y = (a + c + g)/(1 – b – d – h) + (1/(1 – b – d – h))G – (b/(1 – b – d – h))T.
The multiplier for G is 10; the multiplier for T is –5.
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Essay 1 points
Question
Use the neoclassical model of business fixed investment to illustrate graphically how a plague that kills a large
proportion of the labor force would change the rental price of capital. If other factors remained unchanged, how would
this change the quantity of investment in the economy?
Answer
The quantity of investment would decrease because the real rental price of capital falls (as illustrated above)
while the real cost of capital is unchanged.
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Question
Some economists have predicted that as members of the baby-boom generation (a large segment of the population)
age, they will have a smaller demand for housing. Use the model of residential investment to illustrate graphically the
impact of this prediction on housing prices and residential investment.
Answer
The relative price of housing decreases and the quantity of housing investment decreases.
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Essay 1 points
Question
The housing industry frequently complains that restrictive monetary policy adversely affects their industry more than
other industries. Use the model of residential investment to illustrate graphically the impact of restrictive monetary
policy on housing prices and the quantity of residential investment. Also explain your answer in words.
Answer
17 of 20 12/8/2012 11:44
Restrictive monetary policy generates higher interest rates. Higher interest rates reduce the demand for
housing. Consequently, the relative price of housing falls and the quantity of residential investment
decreases.
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Essay 1 points
Question
According to Hall, consumption spending follows a random walk and, according to the efficient-markets model, stock
prices follow a random walk.
a. What determines changes in consumption and stock prices in this case?
b. What is the implication of following a random walk for predicting changes in consumption and stock
prices?
Answer a. Changes in consumption are the result of new information about permanent income. Changes in stock
prices are the result of new information about the underlying fundamental value of firms.
b. If the changes in consumption and stock prices follow random walks, then these changes are
unpredictable, given available information.
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Question
If real interest rates increase, what will happen to:
a. business fixed investment?
b. residential investment?
c. inventory investment?
Answer a. Increases in the real interest rate increase the cost of capital, which, in the neoclassical model of
investment, reduce business fixed investment.
b. Higher real interest rates reduce the demand for houses, reduce the relative price of housing, and
reduce residential investment.
c. The real interest rate is the opportunity cost of holding inventories. An increase in the real interest rate
increases the cost of holding inventories, which reduces inventory investment.
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Question
How will a decrease in output during a recession affect:
a. business fixed investment?
b. residential investment?
c. inventory investment?
Answer a. Lower output reduces employment and the marginal product of capital, which, according to the
neoclassical model of investment, will reduce business fixed investment.
b. The reduction in employment and income during a recession reduces the demand for housing, the
relative price of houses, and residential investment spending.
c. According to the accelerator model, lower output reduces the stock of inventories that businesses wish
to hold and will reduce inventory investment.
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18 of 20 12/8/2012 11:44
Question
Use the neoclassical model of business fixed investment to illustrate graphically how a hurricane that destroys a large
amount of capital (holding other factors constant) would change the rental price of capital. If other factors remained
unchanged, how would this change the quantity of investment spending in the economy?
Answer
The quantity of business fixed investment would increase because the real rental price of capital increases,
assuming the real cost of capital is unchanged.
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Essay 1 points
Question
Use the model of residential investment to illustrate graphically the impact of a hurricane that destroyed a substantial
quantity of the existing housing stock (holding other factors constant) on housing prices and the quantity of residential
housing investment. Explain your answer in words.
Answer
The destruction of the housing stock raises the relative price of housing, which stimulates residential
investment spending.
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Question
Explain how tight credit markets (credit crunches) affect:
a. business fixed investment,
b. residential investment, and
c. inventory investment.
Answer a. Firms that face financing constraints will be unable to obtain loans to undertake profitable investment,
which can slow growth and lead to a misallocation of saving to other investment projects that are not
credit constrained.
b. When credit conditions are tight, fewer people buy homes and fewer people trade up to bigger homes,
which reduces the demand for housing, puts downward pressure on house prices, and reduces
residential investment at unchanged interest rates.
c. Since many firms rely on bank loans to finance inventories, when credit conditions are tight, businesses
cut back on inventory investment.
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Question
Give at least two reasons why a decline in stock prices might lead to a slowdown in economic activity. Be sure to
connect your reasons to economic models.
Answer Possible explanations include: (1) the decline in stock prices via Tobin's q reflects an expected decline in the
present and future profitability of capital resulting in a decline in investment spending at every interest rate,
which would reduce aggregate demand and reduce the equilibrium level of output; and (2) the decline in stock
prices reduces household wealth, which is a determinant of consumption according to the life-cycle model.
The decline in consumption spending reduces aggregate demand and leads to lower output. Other answers
19 of 20 12/8/2012 11:44
are possible.
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Essay 1 points
Question
Graphically illustrate: (1) what happens to the rental price of capital and the marginal product of capital as the stock of
capital increases, and (2) how the change in the marginal product of capital changes the investment demand function.
Explain in words how this process will continue in the long run until the steady state is reached.
Answer
Panel A illustrates that the increase in the capital stock reduces the equilibrium rental price of capital and the
marginal product of capital since the equilibrium is a movement down the demand curve (MPK). In panel B,
this reduction in the MPK shifts the investment demand curve in, so that at every interest rate there will be
less investment spending. Investment spending increases the capital stock, which leads to lower investment
spending and a smaller increase in the capital stock, until the MPK equals the real cost of capital (P /P)(r + )
k
in the steady state.
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Essay 1 points
Question
Compare and contrast the explanation for declining stock market prices according to:
a. the efficient markets hypothesis, and
b. the Keynesian “beauty contest” hypothesis.
Answer According to the efficient markets hypothesis, the declining stock prices reflect changes in the underlying
fundamentals of the firms. In the case of falling stock prices, this means that current and future profits of firms
are expected to fall. The “beauty contest” approach suggests that market participants may sell stocks because
they are caught up in a wave of irrational pessimism unrelated to any fundamental change in the profits of
firms.
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Essay 1 points
Question
Graphically illustrate how house prices and residential investment were affected by lowered lending standards that
allowed many people with less than perfect credit (subprime borrowers), who had previously been unable to obtain
mortgages, to purchase houses.
Answer
The relative price of housing increases and the flow of residential investment increases as a result of the
increase in demand from the subprime borrowers.
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20 of 20 12/8/2012 11:44
Pool Canvas
Name TestBanks Chapter 18 Alternative Pespectives on Stabilization Policy

Description
Instructions
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Question
Economists who view the economy as inherently unstable generally argue that:
Answer stabilization policy is too dangerous to be used.
the economy should be stimulated when it is depressed and slowed when it is overheated.
the economy should be slowed when it is depressed and stimulated when it is overheated.
monetary and fiscal policies should follow rigid rules of constant growth.
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Question
Economists who view the economy as naturally stable often argue that:
Answer monetary and fiscal policies should not be used to “fine-tune” the economy.
the economy should be stimulated when it is depressed and slowed when it is overheated.
the economy should be slowed when it is depressed and stimulated when it is overheated.
economists should act to stimulate or slow the economy on the basis of forecasts in order to assure that
the policy actions are timely.
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Question
All of the following U.S. federal agencies are directly concerned with macroeconomic policy except the:
Answer Council of Economic Advisers.
Congressional Budget Office.
Federal Reserve.
Department of Health and Human Services.
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Question
The lawmakers who wrote the Employment Act of 1946 believed that:
Answer the economy was naturally stable.
the Great Depression could not happen again.
without active government policy the Great Depression could occur again.
monetary policy should be conducted according to rules.
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Question
Active economic policy seeks to do all of the following except:
Answer offset fluctuations in real GDP.
use monetary and fiscal policy to shift aggregate demand.
respond to changing economic conditions.
take a hands-off approach to macroeconomic policy.
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1 of 17 12/8/2012 11:45
Question
Passive economic policy seeks to:
Answer offset fluctuations in real GDP.
use monetary and fiscal policy to shift aggregate demand.
respond to changing economic conditions.
take a hands-off approach to macroeconomic policy.
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Question
Arguments in favor of passive economic policy include all of the following except:
Answer monetary and fiscal policies work with long and variable lags, which can produce destabilizing results.
economic forecasts have too large a margin of error to be useful in formulating stabilization policy.
recessions do not reduce economic well-being, so using monetary and fiscal policy for stabilization is
unnecessary.
the Great Depression could have been avoided if the Federal Reserve had pursued a policy of steady
money growth.
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Question
Arguments in favor of active economic policy include all of the following except:
Answer failing to use monetary and fiscal policy leads to inefficient fluctuations in output and employment.
the Great Depression could have been avoided if the Federal Reserve had pursued a policy of steady
money growth.
fluctuations in real GDP have been less severe following World War II than prior to World War I.
failure of policymakers to respond to large contractionary shocks to private spending caused the Great
Depression.
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Question
Increasing government spending when the economy is in a recession is an example of:
Answer active monetary policy.
active fiscal policy.
passive monetary policy.
passive fiscal policy.
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Question
Keeping the money supply constant over the business cycle is an example of:
Answer active monetary policy.
active fiscal policy.
passive monetary policy.
passive fiscal policy.
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Question
The concerns of economists who favor passive over active policy are most closely associated with their:
Answer preference for using monetary policy rather than fiscal policy for stabilization.
view that policy made by rules is superior to policy made by discretion.
belief that shocks to modern economies are not large enough to require any policy response.
doubt that the correct policy will be implemented at the correct time.
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2 of 17 12/8/2012 11:45
Question
The lags involved in implementing monetary and fiscal policy are:
Answer short and predictable.
long and predictable.
short and variable.
long and variable.
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Question
The time between a shock to the economy and the policy action responding to that shock is called the:
Answer automatic stabilizer.
time inconsistency of policy.
inside lag.
outside lag.
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Question
The time between a policy action and its influence on the economy is called the:
Answer automatic stabilizer.
time inconsistency of policy.
inside lag.
outside lag.
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Question
The inside lag is the time:
Answer before automatic stabilizers respond to economic activity.
after automatic stabilizers respond to economic activity.
between a shock to the economy and the policy action responding to the shock.
between a policy action and its influence on the economy.
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The outside lag is the time:
Answer before automatic stabilizers respond to economic activity.
when automatic stabilizers are not effective.
between a shock to the economy and the policy action responding to the shock.
between a policy action and its influence on the economy.
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Question
Fiscal policy has a relatively long ______ lag, and monetary policy has a relatively long ______ lag.
Answer inside; outside
outside; inside
inside; inside
outside; outside
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Question
The lag between the time that economic stimulus is needed and the time that a tax cut is passed by Congress is an
example of a:
3 of 17 12/8/2012 11:45
Answer fiscal inside lag.

fiscal outside lag.
monetary inside lag.
monetary outside lag.
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Question
The lag between the time that the money supply is increased and the time that investment expenditures increase is an
example of a:
Answer fiscal inside lag.
fiscal outside lag.
monetary inside lag.
monetary outside lag.
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Question
The time between when a recession begins and when the central bank lowers interest rates to stimulate aggregate
demand is an example of an:
Answer inside lag of monetary policy.
outside lag of monetary policy.
inside lag of fiscal policy.
outside lag of fiscal policy.
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Question
The time between when government spending increases and when aggregate demand starts to increase is an
example of an:
Answer inside lag of monetary policy.
outside lag of monetary policy.
inside lag of fiscal policy.
outside lag of fiscal policy.
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Question
Advocates of passive policy argue that because monetary and fiscal policy lags are:
Answer short and fixed these policies should not be used to offset shocks.
long and variable these policies should not be used to offset shocks.
short and fixed these policies should be used to offset shocks.
long and variable these policies should be used to offset shocks.
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Question
Because monetary and fiscal lags are long and variable:
Answer stronger policies must be used.
successful stabilization policy is completely impossible.
attempts to stabilize the economy are often destabilizing.
policy must be completely passive.
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Question
All of the following could be considered automatic stabilizers except:
4 of 17 12/8/2012 11:45
Answer transfer payments that increase during recessions.

discretionary changes in taxes.
a system of unemployment insurance.
the federal income tax.
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Question
Automatic stabilizers:
Answer require congressional action before each time that they are put into effect.
have no outside lag.
have no inside lag.
have long and variable inside lags.
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Question
Policies that stimulate or depress the economy without any deliberate policy change are called:
Answer leading indicators.
time-inconsistent policies.
rational expectations policies.
automatic stabilizers.
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Question
Which of the following is an example of a fiscal policy that has no inside lag?
Answer a decrease in income tax rates
an ongoing unemployment insurance program
an increase in government spending for job training
a reduction in the age at which people become eligible for retirement benefits
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Question
The long and variable lag before a policy influences the economy makes the job of economic forecasters:
Answer impossible.
easier.
less important.
more important.
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Question
Computer models of the economy:
Answer usually consist of only a few equations.
require no assumptions about monetary and fiscal policy.
require assumptions about monetary and fiscal policy.
give excellent predictions regardless of assumptions about monetary and fiscal policy.
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Question
What are two types of tools that economists use to forecast future economic developments?
Answer leading indicators and computer models
direct imputations and indirect attributions
visual assessment and global positioning
monetary instruments and fiscal instruments
5 of 17 12/8/2012 11:45
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Question
Economic forecasters did:
Answer well in forecasting the Great Depression but did poorly in forecasting the recession of 1982.
poorly in forecasting both the Great Depression and the recession of 1982.
well in forecasting both the Great Depression and the recession of 1982.
poorly in forecasting the Great Depression but did well in forecasting the recession of 1982.
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Question
The Lucas critique argues that because the way people form expectations is based ______ on government policies,
economists ______ predict the effect of a change in policy without taking changing expectations into account.
Answer partly; cannot
only partly; can
in no way; can
in no way; cannot
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Question
The fact that traditional methods of policy evaluation do not take into account the impact of policy on expectations is
known as:
Answer stabilization policy.
the political business cycle.
the Lucas critique.
Okun's law.
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Question
If people's expectations of inflation are formed rationally rather than based on adaptive expectations and if
policymakers make a credible policy move to reduce inflation, then the costs of reducing inflation will be ______
traditional estimates of the sacrifice ratio.
Answer much higher than
much lower than
exactly equal to
approximately two percent greater than
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Question
According to advocates of rational expectations, traditional estimates of the sacrifice ratio are unreliable because they:
Answer ignore inside lags.
overestimate outside lags.
are based on adaptive expectations.
are time inconsistent.
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Question
According to the Lucas critique, when economists evaluate alternative policies they must take into consideration:
Answer how the policies will affect expectations and behavior.
whether the policy will offset the impact of automatic stabilizers.
the stage of the political business cycle in which the policy is to be implemented.
the length of the inside lags associated with the policies.
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6 of 17 12/8/2012 11:45
Question
If past policies kept the economy insulated from shocks to aggregate demand and supply, the historical evidence would
support using:
Answer active macroeconomic policy only.
passive macroeconomic policy only.
either active or passive macroeconomic policy.
neither active nor passive macroeconomic policy.
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Question
If past economic fluctuations resulted from inept economic policies, then the historical evidence would support using:
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Question
The differing interpretations of the historical record of the Great Depression provide support for using:
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Question
According to Christina Romer, the reduction in real economic volatility in the period since World War II compared to the
period before World War I is the result of improved economic:
Answer policy.
performance.
data.
forecasting.
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Question
Policy is conducted by rule if policymakers:
Answer announce in advance how policy will respond to various situations and commit themselves to following
through on this announcement.
are free to size up the situation case by case and choose whatever policy seems appropriate at the time.
set policy according to election results, i.e., set policy by rule of the ballot box.
manipulate policy to ensure both low inflation and unemployment on election day.
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Question
Policy is conducted by discretion if policymakers:
Answer announce in advance how policy will respond to various situations and commit themselves to following
through on this announcement.
are free to size up the situation case by case and choose whatever policy seems appropriate at the time.
announce and maintain a constant growth rate of the money supply.
announce and achieve a balanced government budget.
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7 of 17 12/8/2012 11:45
Question
If policymakers announce in advance how policy will respond to various situations and commit themselves to following
through on this announcement, this is:
Answer policy by rule.
policy by discretion.
time inconsistent policy.
monetary policy.
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Question
If policymakers are free to analyze events as they occur and choose whatever policy seems appropriate at the time,
then this is:
Answer policy by rule.
policy by discretion.
monetary policy.
fiscal policy.
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Question
A policy rule:
Answer must specify money growth at a constant rate.
must specify an active policy.
must specify a passive policy.
may specify either an active or a passive policy.
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Question
Conducting fiscal policy so that G = T, where G is government expenditures and T is tax revenue, is an example of
a(n):
Answer active rule.
passive rule.
discretionary policy.
automatic stabilizer.
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Question
Conducting fiscal policy so that G = T + (u – u ), where G is government expenditures, T is tax revenue, u is the
n
unemployment rate, u is the natural rate of unemployment, and is a positive number, is an example of a(n):
n
Answer active rule.
passive rule.
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Question
Conducting monetary policy so that the FF rate = + 0.5( – 2) + 0.5 (GDP gap), where the FF rate is the nominal
federal funds interest rate, is the annual inflation rate, and GDP gap is the percentage shortfall of real GDP from its
natural level, is an example of :
Answer an active policy rule.
a passive policy rule.
an automatic stabilizer.
8 of 17 12/8/2012 11:45
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Question
Conducting monetary policy so that the FF rate = 0.05, where the FF rate is the nominal federal funds interest rate, is
an example of :
Answer an active policy rule.
a passive policy rule.
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Question
An argument in favor of allowing discretionary macroeconomic policy is that:
Answer policymakers may make erratic shifts in policy in response to changing political situations.
uninformed policymakers may choose incorrect policies.
the objectives of policymakers may be in conflict with the well-being of the public.
giving policymakers flexibility will allow them to respond to changing conditions.
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Question
If citizens vote on the basis of both low inflation and low unemployment at the time of the election, then presidents
might, in order to ensure their reelection:
Answer spur inflation soon after their elections, and then cause a recession.
stimulate the economy throughout their terms.
cause a recession soon after their election, and then stimulate the economy.
run a tight monetary and fiscal policy throughout their terms.
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Question
The political business cycle refers to the:
Answer pattern of holding primaries, conventions, and general elections every four years.
cycle of electing U.S. representatives every two years, the U.S. president every four years, and U.S.
senators every six years.
manipulation of the economy to win elections.
pattern of recession and expansion that follows every election.
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Question
The manipulation of the economy to win elections is called:
Answer discretionary monetary policy.
discretionary fiscal policy.
the political business cycle.
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Question
A time-inconsistency problem in macroeconomic policy can occur when the policymaker:
Answer is made to follow a strict and an inflexible rule.
has discretion in the short run but follows a rule in the long run.
has discretion to act as it seems best in each situation, based on his or her own knowledge and
experience.
has no discretion.
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9 of 17 12/8/2012 11:45
Question
If the Fed has discretion to choose its own policy and announces a policy of low inflation, then:
Answer the policymaker is required to make the money supply grow at a low rate.
private economic agents are sure to believe the announcement because it is credible.
private economic actors are likely to discount the policy because the Fed has an incentive to renege on its
policy once expectations are formed.
the Fed is certain to renege on its policy once expectations are formed because then it can lower
unemployment with minimum inflation.
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Question
Policymakers may be better able to achieve their goals using a fixed policy rule rather than using discretion if they face
the problem of:
Answer short and predictable inside lags.
time-inconsistent policy.
short and predictable outside lags.
weak automatic stabilizers.
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Question
Assume that there is a short-run tradeoff between inflation and unemployment, that the central bank desires both low
inflation and low unemployment, and that the central bank uses discretion in conducting monetary policy. Initially,
households and firms expect high inflation. Following an announcement by the central bank of a low-inflation policy,
households and firms will ______ the central bank's announcement and ______ their expectations of inflation.
Answer believe; lower
not believe; not change
believe; not change
not believe; lower
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Question
Assume that there is a short-run tradeoff between inflation and unemployment, that the central bank desires both low
inflation and low unemployment, and that the central bank follows a fixed rule in conducting monetary policy. Initially,
households and firms expect high inflation. Following a credible announcement by the central bank of a low-inflation
policy, households and firms will ______ the central bank's announcement and ______ their expectations of inflation.
Answer believe; lower
not believe; not change
believe; not change
not believe; lower
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Question
When a government honors its debt obligations, this is an example of:
Answer discretionary fiscal policy.
discretionary monetary policy.
a fiscal policy rule.
a monetary policy rule.
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Question
A situation where policymakers have the incentive to deviate from their initial course of action once other agents in the
economy have acted is called a(n):
10 of 17 12/8/2012 11:45
Answer rational expectation.

outside lag.
time-inconsistent policy.
active policy rule.
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Question
As Secretary of the Treasury, Alexander Hamilton opposed the time-inconsistent policy of:
Answer repaying the debt.
raising taxes.
repudiating the debt.
reducing taxes.
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Question
Monetarists believe all of the following except:
Answer fluctuations in the money supply are responsible for most large fluctuations in the economy.
the Fed should keep the money supply growing at a steady rate.
slow and steady growth of the money supply would yield stable output, employment, and prices.
the Fed should adjust the money supply to adjust to various shocks to the economy.
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Question
Monetary policy rules that target nominal variables would target any of the following except the:
Answer price level.
money supply
unemployment rate.
level of nominal GDP.
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Question
If the velocity of money varies a great deal, steady growth of the money supply is a(n):
Answer ineffective way to stabilize aggregate demand.
example of discretionary monetary policy.
active policy rule.
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Question
A monetary policy rule that targets nominal GDP would ______ money growth when nominal GDP rises above the
target and ______ money growth when nominal GDP falls below the target.
Answer reduce; raise
raise; reduce
reduce; reduce
raise; raise
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Question
Unlike a monetarist policy rule, an inflation target has the advantage of:
Answer eliminating the need to announce the policy target.
providing a real target rather than a nominal one.
allowing the central bank unlimited discretion.
11 of 17 12/8/2012 11:45
insulating the economy from changes in money velocity.
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Question
Inflation targeting is a monetary policy rule that requires the central bank to adjust _____ in order to attain the desired
inflation rate.
Answer a price index
the velocity of money
nominal GDP
the money supply
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Question
Although real variables such as unemployment and real GDP are the best measures of economic performance, most
economists do not advocate manipulating money supply directly to hit a real target because:
Answer they believe a constant growth rate of the money supply is the best way to stabilize real GDP or
unemployment.
if the Fed chose a target that was not natural output or the natural unemployment rate, the result would
be accelerating inflation or deflation.
if the Fed chose a target for the unemployment rate above the natural rate, the result would be
accelerating inflation.
if the Fed chose a target for the unemployment rate below the natural rate, the result would be
accelerating deflation.
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Question
In practice, inflation targeting is better considered as operating with constrained discretion rather than according to a
policy rule because central banks with inflation targets typically:
Answer are not allowed to adjust the target in the event of shocks.
set the inflation target as a range rather than as a particular number.
are not held accountable for achieving their target.
must achieve their target regardless of economic conditions.
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Question
Economic research finds that greater central-bank independence is ______ correlated with lower and more stable
inflation as well as ______ correlated with the average growth and variability of real GDP.
Answer strongly; strongly
strongly; not
not; strongly
not; not
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Question
Central-bank independence refers to:
Answer whether central banks pursue monetary policy by rules or discretion.
the situation that occurs when the inside lag of monetary policy is not related to the outside lag.
the extent to which automatic stabilizers are relied on to cushion economic volatility.
the degree of separation between central-bank decision making and political influence.
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Question
Countries with greater central-bank independence can achieve lower rates of inflation:
12 of 17 12/8/2012 11:45
Answer at the cost of higher levels of unemployment.

at the cost of slower growth rates of real GDP.
at the cost of greater volatility of real GDP.
with no apparent real economic costs.
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Question
Research indicates that greater central-bank independence is correlated with:
Answer higher average growth rates of real GDP.
lower rates of unemployment.
lower and more stable rates of inflation.
less volatility of real GDP.
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Question
Economic science has provided convincing evidence in favor of the:
Answer rule favoring a constant rate of growth of the money supply.
rule favoring use of the money supply to hit a nominal GDP target.
rule requiring a constantly balanced budget for the federal government.
fact that there is no simple and compelling case for any particular view of macroeconomic policy.
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Question
n
The Phillips curve describing an economy takes the form u = u – ( – E ). The central bank directly sets the
2
inflation rate to minimize the following loss function, L(u, )= u– . The symbol u denotes the unemployment rates,
n
u is the natural rate of unemployment, is the inflation rate, E is the expected inflation rate, and and are
behavioral response parameters of the economy. Private agents form their expectations rationally before the central
bank sets the inflation rate. The optimal inflation rate when the central bank operates using a fixed rule will be ______.
The optimal inflation rate when the central bank operates with discretion will be ______.
Answer
un; 0
n
0; u
0; /(2 )
/(2 ); 0
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Question
n
2
un is the natural rate of unemployment, is the inflation rate, E is the expected inflation rate, and and are
bank sets the inflation rate. In an economy in which the central bank dislikes inflation much more than unemployment:
Answer will be very large.
will be very small.
will be very large.
will be very small.
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Question
n
2
un is the natural rate of unemployment, is the inflation rate, E is the expected inflation rate, and and are
bank sets the inflation rate. Compared to making monetary policy with discretion, the optimal inflation rate will be
13 of 17 12/8/2012 11:45
______ under a fixed rule and the unemployment rate will be ______.
Answer higher; lower
higher; the same
lower; lower
lower; the same
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Question
The time-inconsistency problem in discretionary policymaking about unemployment and inflation can be effectively
avoided when the:
Answer policymaker has and is known to have an extremely strong preference for very low inflation.
policymaker does not care about the rate of inflation and simply sets policy to avoid unemployment.
private agents in the economy are not “rational.”
policymaker has more information than do the private agents in the economy.
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Question
A central bank operating with discretion can achieve the same outcome as the central bank committed to a fixed rule of
zero inflation if:
Answer there are no inside lags.
there are no outside lags.
the central bank dislikes unemployment much more than inflation.
the central bank dislikes inflation much more than unemployment.
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Question
Assume that the Democrats always had a policy of high money growth while the Republicans followed a policy of low
money growth, and the economy had a standard Phillips curve. Then, if the two parties took regular terms in office:
Answer there would be no political business cycle, but inflation would be higher under the Democrats.
there would be no political business cycle, but inflation would be higher under the Republicans.
unemployment would be lower under the Democrats but inflation would be higher.
both unemployment and inflation would be higher under the Democrats.
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Question
If a city passes laws limiting rents on apartments but promises to exempt buildings not yet built:
Answer construction of new buildings will not be discouraged.
construction of new buildings may be discouraged.
builders will not expect the city to renege on its promise.
the city will have no incentive to renege on its promise.
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Essay 1 points
Question
Assume that in a certain economy the LM curve is given by Y = 2,000r – 2,000 + 2(M/P), and the IS curve is given by Y
= 8,000 – 2,000r + u, where u is a shock that is equal to +200 half the time and –200 half the time. The price level (P)
is fixed at 1.0. The natural rate of output is 4,000. The government wants to keep output as close as possible to 4,000
and does not care about anything else. Consider the following two policy rules: i. Set the money supply M equal to
1,000 and keep it there. ii. Manipulate M from day to day to keep the interest rate constant at 2 percent.
a. Under rule i, what will Y be when u = +200? What will Y be under rule i when u = –200?
b. Under rule ii, what will Y be when u = +200? What will Y be under rule ii, when u = –200?
c. Which rule will keep output closer to 4,000?
Answer a. Y = 4,100 when u = +200.

Y = 3,900 when u = –200.
b. Y = 4,200 when u = +200.
14 of 17 12/8/2012 11:45
Y = 3,800 when u = –200.

c. Rule i will keep Y closer to 4,000.
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Essay 1 points
Question
Assume that in a certain economy the LM curve is given by Y = 2,000r – 2,000 + 2(M/P) + u, where u is a shock that is
equal to +200 half the time and –200 half the time, and the IS curve is given by Y = 8,000 – 2,000r. The price level (P)
is fixed at 1.0. The natural rate of output is 4,000. The government wants to keep output as close as possible to 4,000
and does not care about anything else. Consider the following two policy rules: i. Set the money supply M equal to
1,000 and keep it there. ii. Manipulate M from day to day to keep the interest rate constant at 2 percent.
a. Under rule i, what will Y be when u = +200? Under rule i, what will Y be when u = –200?
b. Under rule ii, what will Y be when u = +200? Under rule ii, what will Y be when u = –200?
c. Which rule will keep output closer to 4,000?
Answer a. Y = 4,100 when u = +200.

Y = 3,900 when u = –200.
b. Y = 4,000 when u = +200.
Y = 4,000 when u = –200.
c. Rule ii will keep Y closer to 4,000.
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Essay 1 points
Question
Let the symbol stand for the rate of inflation, with E the expected inflation rate, both measured in percent. The
n
letter u is the unemployment rate and u is the natural rate of unemployment. Suppose the short-run Phillips curve is u
n 2
=u – ( – E ) applies in a certain economy. The Fed's loss function is L(u, )=u+ . The analysis in the
appendix to textbook Chapter 18 shows that if the Fed minimizes its loss function under the assumption that E is
fixed and “rational” private agents know this, the expected inflation rate will be E = /2 , and this will also be the
inflation rate the government chooses.
a. Suppose that = 0.5 and = 0.05. What are the expected and actual inflation rates?
b. Suppose = 0.5 and = 0.50. In this case, does the Fed have greater or lesser relative distaste for
inflation than in part a? What are the expected and actual inflation rates with = 0.50? Why do they
differ from the inflation rates in part a?
Answer a. E = 5 percent, = 5 percent

b. The Fed has a greater relative distaste for inflation.
E = 0.5 percent, = 0.5 percent
The public knows that the Fed has a greater relative distaste for inflation and, thus, sets its expectations lower.
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Essay 1 points
Question
You are hired as a consultant to set up the central bank of a new country. Suggest at least two possible ways to
structure the central bank to keep inflation levels low.
Answer Possibilities include: (1) setting up an independent central bank, (2) requiring the central bank to operate by
rules rather than with discretion, and (3) choosing central bankers who dislike inflation more than
unemployment in a central bank that operates with discretion.
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Essay 1 points
Question
For each of the following policies indicate whether the policy is i. a monetary or a fiscal policy, ii an active or a passive
policy, and iii a policy by rules or with discretion:
a. the central bank follows a policy of allowing the money supply to grow at a constant 4 percent per year;
b. a government follows a policy of keeping government spending over a calendar year equal to
government revenue over the calendar year;
c. the central bank uses judgment to adjust the growth of the money supply based on expectations of what
will happen to output and inflation over the next five years.
d. the government keeps tax laws unchanging and allows government spending to change, depending on
which spending bills are passed by the legislature.
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e. the central bank follows a policy of adjusting the money supply according to a formula based on
deviations of unemployment from the natural rate of unemployment.
Answer a. monetary policy; passive; rule

b. fiscal policy; passive; rule
c. monetary policy; active; discretion
d. fiscal policy; passive; discretion
e. monetary policy; active; rule
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Essay 1 points
Question
The central banks of two nearly identical countries, Fixland and Flexland, desire low inflation and low unemployment.
There is a similar short-run tradeoff between unemployment and unexpected inflation in both countries. Private agents
in both Fixland and Flexland form expectations rationally and understand the incentives that central banks may have to
renege on low-inflation policies. Initially, the rates of inflation and unemployment are the same in both countries. The
central bank of Fixland makes a credible announcement that it will operate according to a low-inflation rule. The central
bank of Flexland announces that it plans to follow a low-inflation policy, but retains the right to deviate from this policy
at its discretion.
a. In which country would you expect the rate of inflation to be lower?
b. In which country would you expect the unemployment rate to be lower?
Answer a. Inflation should be lower in Fixland because the central bank follows a credible low inflation policy.
Agents in Flexland understand the incentive for the central bank of Flexland to renege on the
low-inflation policy and adjust their expectations accordingly, leading to higher levels of inflation in
Flexland.
b. The unemployment rates would tend to be the same in the two countries, because there is no
unexpected inflation in either country.
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Essay 1 points
Question
The following notice appeared on a full page of the Wall Street Journal on February 9, 2009:
There is no disagreement that we need action by our government, a recovery plan that will help to jumpstart the
economy. ¿President-Elect Barack Obama, January 9, 2009
With all due respect Mr. President, that is not true. Notwithstanding reports that all economists are now Keynesians
and that we all support a big increase in the burden of government, we the undersigned do not believe that more
government spending is a way to improve economic performance. More government spending by Hoover and
Roosevelt did not pull the United States out of the Great Depression in the 1930s. More government spending did not
solve Japan's ¿lost decade¿ in the 1990s. As such, it is a triumph of hope over experience to believe that more
government spending will help the United States today. To improve the economy, policymakers should focus on
reforms that remove impediments to work, saving, investment and production. Lower tax rates and a reduction in the
burden of government are the best ways of using fiscal policy to boost growth.
The statement was signed by over 200 economists, including 3 Nobel Laureates.
a. Comment on the extent to which the disagreement between the President and the economists involves
a disagreement about whether policy should be passive or active.
b. Identify the rationale(s) used to support the economists' position.
Answer a. The President's statement calls for active policy, i.e., more spending in response to a recessionary gap.
The economists' statement also calls for fiscal policy, but tax cuts and perhaps spending reductions ( to
reduce the burden of government). One could make the case that this fiscal policy is not active policy,
i.e., not specifically required to counteract the output gap, but a more general policy of less government
in the economy regardless of the stage of the business cycle. Some students might suggest that the
President is calling for policies to adjust aggregate demand, while the economists are calling for policies
to adjust aggregate supply.
b. The economists' use their interpretation of the historical record to argue that increases in government
spending will not close a recessionary gap. They refer to the experience of the United States during the
Great Depression and Japan in the 1990s.
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Essay 1 points
Question
Compare two procedures for conducting monetary policy:
Method 1: Maintain a steady money growth of 6 percent per annum, and
Method 2: Maintain a steady inflation rate of 3 percent per annum.
16 of 17 12/8/2012 11:45
Be sure to consider whether the methods involve: (1) active or passive monetary policy and (2) rules or discretion.
Discuss why one method might be preferred over the other.
Answer Both methods 1 and 2 are monetary policy by rule rather than discretion. Method 1 is a passive rule because it
does not depend on the state of the economy. Method 2 is an active rule to the extent that this rule calls for
counteracting any forces in the economy other than monetary policy that may alter the inflation rate. Method 2
may be preferred because it insulates the economy from shifts in velocity that could have an impact on the
outcomes obtained using Method 1. In addition, the public is likely to have a better understanding of the
concept of inflation than the economic concept of money, which the public frequently confuses with the
concepts of income and wealth.
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Essay 1 points
Question
Explain why each of the following statements is a rationale for conducting active or passive policy:
a. Economic circumstances can change dramatically between the time that an economic downturn begins
and the time when policy actions have an effect on the economy.
b. Economists are not very accurate forecasters.
c. Increases in government spending generate increases in economic output.
d. Fluctuations in economic output have been less severe since World War II.
Answer a. This statement supports passive policy. The statement refers to the long and variable lags that
accompany economic policy and might alter the intended impact of policy, making active policy
destabilizing rather than stabilizing.
b. This statement supports passive policy. The statement asserts that economists do not have sufficient
information to diagnose a problem or to gauge what active policy would be appropriate.
c. This statement supports active policy. The statement asserts that economists have powerful tools for
active policy available to offset economic downturns and to stabilize the economy.
d. This statement supports active policy. The implication of this statement is that knowledge of how the
economy works has improved since World War II, allowing the government to engage in active policy
that reduces fluctuations in output.
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Essay 1 points
Question
Assume that an economy starts at a long-run equilibrium with a natural rate of unemployment equal to 6 percent and
an inflation rate of 10 percent. Assume that there is a short-run tradeoff between inflation and unemployment as
described by a Phillips curve. Use the Phillips curve to graphically illustrate why a central bank that desires both low
inflation and low unemployment has the incentive to renege on an announced policy to reduce inflation to 3 percent, if
people set wages and prices on the expectation of 3 percent inflation and the central bank has the discretion to change
its monetary policy after these expectations are set.
Answer Starting from equilibrium at A, if people adjust their expectations from 10 percent to 3 percent inflation, then
the Phillips curve shifts down. If the central bank follows through on its announcement and achieves a 3
percent inflation rate, the economy is at point B on the new Phillips curve with lower inflation, but the same
unemployment rate. However, if the central bank reneges on its announcement, conducts monetary policy to
reduce inflation to 5 percent, rather than the announced 3 percent, for example, then the economy would be at
C and have both lower inflation and lower unemployment. However, people would recognize that the central
bank has the incentive to renege and not expect 3 percent inflation. The Phillips curve would not shift down
and the opportunity for central bankers to gain would go away.
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17 of 17 12/8/2012 11:45
Pool Canvas
Name TestBanks Chapter 19 Government Debt

Description
Instructions
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Question
When a government spends more than it collects in taxes, it runs a:
Answer trade deficit.
trade surplus.
budget surplus.
budget deficit.
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Question
Government debt equals the:
Answer difference between current government purchases and taxes.
difference between saving and investment.
sum of past budget deficits and surpluses.
M1 money supply.
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Question
The amount by which government spending exceeds government revenues is called the ______, and the accumulation
of past government borrowing is called the ______.
Answer deficit; debt
debt; deficit
devaluation; deflation
deflation; devaluation
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Question
The government budget deficit is the ______, and government debt is the ______.
Answer amount by which imports exceed exports; amount by which government spending exceeds government
revenue
amount by which government spending exceeds government revenue; amount by which imports exceed
exports
amount by which government spending exceeds government revenue; accumulation of past government
borrowing
accumulation of past government borrowing; amount by which government spending exceeds government
revenue
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Question
If the debt of the U.S. federal government in 2008 was divided equally among the people in the United States, then the
debt per person would equal approximately:
Answer $3,500.
$35,000.
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$53,000.
$153,000.
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Question
Compared to the size of government debt as a percentage of GDP in other major industrial countries, the federal
government of the United States:
Answer is one of the most heavily indebted governments.
has accumulated a relatively small debt.
has accumulated somewhat greater than average debt.
is one of the least indebted governments.
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Question
Historically, the primary cause of increases in government debt is:
Answer printing too much money.
cutting taxes.
increasing interest rates.
financing wars.
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Question
The large increase in U.S. government debt between 1980 and 1995 was unusual because it occurred:
Answer during peacetime.
during an extended recessionary period.
without increased government spending.
without tax cuts.
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Question
Relative to the size of GDP, the U.S. federal government debt was at its maximum:
Answer at the end of the Revolutionary War.
at the end of the Civil War.
at the end of World War II.
following the 9/11 terrorist attacks in 2001.
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Question
Holding other factors constant, the ratio of government debt to GDP can decrease as a result of any of the following
changes except:
Answer decreases in government spending.
increases in GDP.
decreases in tax revenues.
decreases in transfer payments.
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Question
If government debt is not changing, then:
Answer the economy is at long-run equilibrium.
the government's budget must be balanced.
GDP must equal the natural rate of output.
capital per worker is constant.
2 of 17 12/8/2012 11:46
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Question
The factors most responsible for forecasts of the U.S. government debt spiraling out of control in the next half century
are the projected:
Answer slowdowns in the rates of technological change and human capital growth.
decrease in high-skilled domestic workers and the increase in immigration of low-skilled workers into the
United States.
aging of the U.S. population and rising health care costs.
increase in international competition and the outsourcing of U.S. jobs.
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Question
An increase in the elderly population of a country affects fiscal policy most directly because:
Answer the elderly generally are not required to pay taxes.
governments provide pensions and health care for the elderly.
the elderly favor high interest rates on their savings.
governments spend more on education as the proportion of the elderly increases.
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Question
Which of the following is the most likely explanation of the August 2011 decision by Standard and Poor's to reduce its
credit rating on U.S. government bonds?
Answer A U.S. government debt default was very likely to occur in the short term.
The U.S. government budget deficit was too large.
Strategies to reduce predicted U.S. government future budget deficits did not appear likely, making
default a possibility.
Foreign governments were no longer willing to lend to the U.S. government.
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Question
In a time of inflation when the government budget is balanced in the conventional sense, the real (i.e., deflated) value
of the government debt is:
Answer growing at the rate of inflation.
growing, but at a rate less than the rate of inflation.
constant.
decreasing at the rate of inflation.
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Question
In a time of inflation when the real (i.e., deflated) value of the government debt is constant, then the conventionally:
Answer reported government budget will show a deficit equal to the inflation rate times the outstanding debt.
reported government budget will show a deficit equal to less than the inflation rate times the outstanding
debt.
reported government budget will be balanced.
measured government budget will show a surplus equal to the inflation rate times the outstanding debt.
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Question
Assume that the nominal interest rate is 11 percent, the inflation rate is 8 percent, and government debt at the
beginning of the year equals $4 trillion. By how much is the government budget deficit overstated as a result of
inflation?
Answer $0.12 trillion
$0.32 trillion
3 of 17 12/8/2012 11:46
$0.44 trillion
$0.80 trillion
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Question
A deficit adjusted for inflation should include only government spending used to make _____ interest payments.
Answer real
nominal
foreign
domestic
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Question
If the government debt, D, equals $5 trillion, the nominal interest rate is 7 percent, and the real interest rate is 3
percent, then nominal budget deficit overstates the real deficit by $ ___ trillion.
Answer 0.35
0.20
0.15
0.07
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Question
Current measures of the U.S. federal government's budget deficit account for all of the following except:
Answer government expenditures.
government revenues.
changes in government indebtedness.
changes in government capital assets.
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Question
If capital budgeting procedures were employed, then a budget deficit would be measured as:
Answer the sum of government debt.
the change in government debt.
the change in government debt minus the change in government capital assets.
the change in government capital assets.
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Question
When the federal government incurs additional debt to acquire an asset, under current budgeting procedures the deficit
______, while under capital budgeting procedures the deficit ______.
Answer does not change; increases
increases; does not change
does not change; decreases
decreases; does not change
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Question
Capital budgeting is a procedure that:
Answer adjusts the deficit for inflation.
estimates what the deficit would be if the economy were operating at the natural rate of output.
accounts for assets as well as liabilities.
measures the impact of fiscal policy on the lifetime incomes of individuals of different ages.
4 of 17 12/8/2012 11:46
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Question
Under capital budgeting, all of the following transactions would affect the federal budget deficit except the federal
government's:
Answer sending a check to a welfare recipient.
sending a check to the state of Massachusetts.
selling a highway to the state of New York and using the proceeds to retire federal debt.
selling an office building.
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Question
The amount the government would owe if a borrower were to default on a government-guaranteed loan is an example
of:
Answer capital budgeting.
a contingent liability.
a cyclically adjusted liability.
Ricardian equivalence.
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Question
One item that is considered part of the federal debt is:
Answer Treasury bills.
future Social Security benefits.
student loans, which may go into default.
potential liabilities of savings and loan associations.
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Question
The debt of the United States government is underreported in the view of many economists because all of the following
liabilities are excluded except:
Answer future pensions of government employees.
debt owed to foreigners.
future Social Security benefits.
government guarantees of student loans.
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Question
The cyclically adjusted budget deficit:
Answer adjusts the deficit for inflation.
estimates what the deficit would be if the economy were operating at the natural rate of output.
accounts for assets as well as liabilities.
measures the impact of fiscal policy on the lifetime incomes of individuals of different ages.
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Question
An estimate of what government spending and tax revenue would be if the economy were operating at its natural rate
of output and employment is called the ______ budget.
Answer cyclically adjusted
inflation-adjusted
capital-asset
generational accounting
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5 of 17 12/8/2012 11:46
Question
Cyclically adjusted budgets are useful because they:
Answer systematically account for changes in government assets and liabilities.
reflect policy changes, but not current economic conditions.
account for tax burdens on different generations of taxpayers.
correctly account for the impact of inflation on government indebtedness.
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Question
Assume that a government has a balanced budget when the economy is at full employment. If the economy then
enters a recession, with no change in tax or spending laws, then the budget of the government is most likely to:
Answer remain balanced.
be in deficit.
be in surplus.
be in either deficit or surplus, depending on the severity of the recession.
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Question
Each of the following changes would allow the measured budget deficit to provide a truer picture of fiscal policy except:
Answer correcting for the effects of inflation.
offsetting changes in government liabilities with changes in government assets.
excluding some liabilities altogether.
correcting for the effects of the business cycle.
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Question
Measuring the size of government debt is complicated by all of the following factors except:
Answer inflation.
uncounted liabilities.
capital assets of the government.
failure of the Office of Management and Budget to disclose figures on capital expenditures and credit
programs.
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Question
According to the traditional view of government debt, if taxes are cut without cutting government spending, then the
long-run effects will be ______ steady-state capital and ______ consumption.
Answer higher; higher
lower; lower
higher; lower
lower; higher
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Question
short-run effects will be:
Answer higher output and lower unemployment.
higher output and higher unemployment.
no change in output or unemployment.
no change in output and higher unemployment.
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6 of 17 12/8/2012 11:46
Question
international effect initially will be a capital ______ and a trade ______.
Answer inflow; deficit
inflow; surplus
outflow; deficit
outflow; surplus
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Question
According to the traditional view of government debt, if taxes are cut without a cut in government spending, then in the
United States this situation will lead to ______ net indebtedness on the part of the United States to foreign countries
and ______ net exports.
Answer more; more
more; fewer
less; fewer
less; more
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Question
The international impacts of a debt-financed tax cut, according to the traditional view of government debt, are a(n)
______ in net exports and a domestic currency _____.
Answer increase; appreciation
increase; depreciation
decrease; depreciation
decrease; appreciation
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Question
According to the traditional viewpoint of government debt, a tax cut without a cut in government spending:
Answer stimulates consumer spending in the short run and reduces national saving.
stimulates consumer spending in the short run and reduces private saving.
has no effect on consumer spending but reduces national saving.
has no effect on consumer spending but reduces private saving.
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Question
According to the traditional viewpoint of government debt, a tax cut without a cut in government spending:
Answer raises consumption in both the short run and the long run.
lowers consumption in both the short run and the long run.
raises consumption in the short run but lowers it in the long run.
lowers consumption in the short run but raises it in the long run.
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Question
According to the traditional view of government debt (as in the Mundell–Fleming model), if taxes are cut without cutting
government spending, then the short-run effects are a(n) ______ of the dollar and a(n) ______ in net exports.
Answer appreciation; increase
appreciation; decrease
depreciation; increase
depreciation; decrease
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7 of 17 12/8/2012 11:46
Question
According to the traditional view of government debt (as in the IS–LM model), if taxes are cut without cutting
government spending, then in the short run interest rates will ______ and investment will ______.
increase; decrease
decrease; decrease
decrease; increase
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Question
According to supply siders, tax cuts can raise total tax revenue if the tax cuts generate large enough:
Answer decreases in aggregate supply.
increases in aggregate supply.
decreases in the money supply.
increases in the money supply.
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Question
Government tax policy can affect aggregate supply as well as aggregate demand, because changes in taxes change
the:
Answer supply of money in the economy.
length of the inside lag of fiscal policy.
incentives to work and invest.
tradeoff between inflation and unemployment.
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Question
Ricardian equivalence refers to the same impact of financing government:
Answer whether by printing money or raising taxes.
in the long run as in the short run.
whether by debt or taxes.
in an open economy as in a closed economy.
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Question
The logic of Ricardian equivalence implies that:
Answer tax cuts do not influence consumer spending but changes in government spending do.
neither tax cuts nor changes in government spending affect consumer spending.
tax cuts combined with future decreases in government spending will decrease consumer spending.
if the government cuts taxes and increases current government spending, consumer spending will
increase.
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Question
According to the theory of Ricardian equivalence, if consumers are forward-looking, they will view a tax cut combined
with no plans to reduce government spending as ______, so their consumption will ______.
Answer additional disposable income; increase.
additional disposable income; remain unchanged.
a rescheduling of taxes into the future; increase.
a rescheduling of taxes into the future; remain unchanged.
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8 of 17 12/8/2012 11:46
Question
According to the theory of Ricardian equivalence, tax cuts combined with no plans to reduce government spending
______ public saving and ______ private saving.
Answer reduce; reduce
reduce; increase
increase; increase
increase; reduce
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Question
A debt-financed tax cut will ______ saving in the traditional view and ______ saving in the view of Ricardian
equivalence.
decrease; decrease
decrease; increase
decrease; not change
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Question
A debt-financed tax cut will ______ current consumption in the traditional view and ______ current consumption in the
view of Ricardian equivalence.
increase; decrease
increase; not change
decrease; decrease
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Question
All of the following are arguments against Ricardian equivalence except:
Answer consumers make consumption decisions myopically.
consumers are rational and forward-looking in consumption decision-making.
consumers are borrowing-constrained.
consumers do not expect future taxes to fall on them.
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Question
Suppose a household considers only current income in making consumption decisions. This is an example of:
Answer Ricardian equivalence.
the permanent-income hypothesis.
myopia.
the life-cycle model.
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Question
The Ricardian view on fiscal policy makes less sense if people are:
Answer rational and practice foresight.
shortsighted and not fully rational.
able to plan for the future.
able to borrow without constraint.
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Question
In response to a tax cut, the consumption of a consumer who is borrowing-constrained ______, whereas the
consumption of a forward-looking, unconstrained consumer acting in accord with Ricardian equivalence ______.
increases; remains unchanged
remains unchanged; remains unchanged
remains unchanged; increases
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Question
When President George H. W. Bush lowered tax withholding in 1992 without lowering the amount of taxes owed,
surveys showed that:
Answer almost everyone spent the higher take-home pay.
almost everyone saved the higher take-home pay.
a majority of respondents said they would spend the higher take-home pay, but a significant minority said
they would save it.
a majority of respondents said they would save the higher take-home pay, but a significant minority said
they would spend it.
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Question
Given a reduction in income tax withheld, but no change in income tax owed, households that act according to
Ricardian equivalence would ______ the extra take-home pay, while those facing binding borrowing constraints would
______ the extra-take home pay.
Answer spend; spend
spend; save
save; save
save; spend
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Question
Proponents of Ricardian equivalence argue that the relevant decision-making unit is the:
Answer individual.
household.
infinitely lived family.
community.
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Question
Proponents of Ricardian equivalence argue that if taxes are cut without cutting government spending and taxes are not
expected to increase in the future until after an individual expects to be dead, then the individual will:
Answer spend all of the increase in income.
spend some of the increase in income and save the rest.
use the increase in income to buy government bonds to help finance the deficit.
save all of the increase in income and leave it as a bequest to his or her children.
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Question
From the Ricardian point of view, a consumer should not raise his or her consumption when taxes are cut but
government spending is not cut because:
Answer the government is going to raise taxes by exactly as much as the cut in the next year.
the government is going to raise taxes by exactly as much as the cut plus interest in the next year.
the government is sure to raise taxes by an amount equal in present value to the debt incurred this year,
sometime in the taxpayer's lifetime.
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even if the government does not raise enough extra taxes during the taxpayer's lifetime to pay off, in
present value, the debt incurred this year, the taxpayer should make provision for the taxes that will be
levied on his or her heirs.
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Question
Assume that nobody cares about the economic well-being of future generations. Then the Ricardian equivalence view
of the effect of debt-financed tax cuts is:
Answer totally invalid.
still fully valid because the government has the option to levy taxes to pay off the full debt in just a few
years.
still fully valid as long as the government cuts spending also.
still partially valid because most of the taxpayers will live and pay taxes for a substantial number of years
after the tax cut.
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Question
The strategic bequest motive hypothesizes that parents:
Answer leave bequests to children because they care about their children's well-being.
leave bequests to children who are borrowing-constrained.
make larger bequests the larger the quantity of taxes that will be shifted to their children.
use the threat of disinheritance to control their children's behavior.
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The experience of the 1980s:
Answer clearly contradicted the Ricardian equivalence view because national saving was very low.
clearly supported the Ricardian equivalence view, for people saved little only because they were optimistic,
as confirmed by the stock market.
will provide a clear answer on the validity of Ricardian equivalence as soon as economists are able to
analyze it with their computers.
may be used to argue both in favor of and against the Ricardian equivalence view of the tax cuts.
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Question
In the United States, having a balanced budget is currently enforced for:
Answer the federal government.
no state governments.
all state governments.
many state governments.
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Question
One reason for not requiring a balanced federal budget at all times is that with a balanced-budget rule:
Answer expenditures are not limited because, if the government wants to raise expenditures, it just raises taxes.
in a recession even the automatic stabilizing powers of our system of taxes and transfers could not work.
the distorting features of the tax system are minimized.
it is possible to shift the burden of a war from current to future generations.
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Tax smoothing is a desirable policy because it:
11 of 17 12/8/2012 11:46
Answer reduces the distortions of incentives caused by taxes.

reduces budget deficits in periods of recession.
eliminates the impact of automatic stabilizers.
is consistent with a balanced budget.
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Question
One way to shift the tax burden from the current generation to future generations is to finance a war:
Answer by raising taxes.
by printing money.
by running a budget surplus.
by running a budget deficit.
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Question
To minimize the disincentives of very high taxes, a policy of tax smoothing requires a budget ______ in years of
unusually low government revenue and a budget ______ in years of unusually high government expenditures.
Answer surplus; deficit
deficit; surplus
surplus; surplus
deficit; deficit
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Question
Using fiscal policy, including automatic stabilizers, to stabilize output over a business cycle is not consistent with:
Answer rational expectations.
inflation targeting.
the natural-rate hypothesis.
a strict balanced-budget rule.
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Question
A strict balanced-budget rule would:
Answer permit the use of fiscal policy for stabilization.
allow the use of tax smoothing to reduce tax distortions.
redistribute tax burdens across generations.
restrain political incompetence and opportunism.
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Question
Monetary policy is linked to fiscal policy when government spending is financed by:
Answer taxes.
borrowing from banks.
borrowing from foreigners.
printing money.
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The real value of government debt is reduced by:
Answer expected inflation.
expected deflation.
unexpected inflation.
12 of 17 12/8/2012 11:46
unexpected deflation.
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Question
Financing a budget deficit by ______ leads to inflation, and inflation ______ the real value of government debt.
Answer issuing debt; increases
issuing debt; decreases
printing money; increases
printing money; decreases
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Question
Hyperinflations typically occur when governments:
Answer attempt to keep the unemployment rate below the natural rate.
finance spending with the inflation tax.
set inflation targets too high.
use discretionary monetary policy to stabilize output.
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Question
To force politicians to judge whether government spending is worth the costs, some economists have argued for:
Answer a balanced-budget rule for fiscal policy.
a constant money-growth rule for monetary policy.
avoiding the assumption of any contingent liabilities.
the application of Ricardian equivalence.
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Question
The possibility of capital flight is likely to be greater at higher levels of government debt because there is a greater:
Answer temptation to default on the debt.
likelihood that the government will begin issuing indexed bonds.
probability that a balanced budget will be adopted by the government.
potential for tax smoothing policies to be eliminated.
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Question
High levels of government debt that raise investors' fear of a government default on debt will result in capital ______
and a(n) ______ of the country's exchange rate.
Answer outflows; depreciation
outflows; appreciation
inflows; depreciation
inflows; appreciation
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Question
Indexed bonds produce all of the following benefits except:
Answer less inflation risk.
more financial innovation.
better government incentives.
lower rates of inflation.
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13 of 17 12/8/2012 11:46
Question
A measure of the expected rate of inflation can be found by the:
Answer yield on nominal bonds plus the yield on index bonds.
yield on nominal bonds minus the yield on index bonds.
observed rate of inflation minus the yield on real bonds.
observed rate of inflation minus the yield on nominal bonds.
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Question
Inflation-indexed government bonds have all of the following benefits except:
Answer eliminating inflation.
reducing the government's incentive to produce surprise inflation.
encouraging financial innovation.
eliminating inflation risk.
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Question
If the government levies a one-time temporary tax on the young and gives the proceeds to the elderly, and both
generations follow the life-cycle consumption pattern but are not altruistically linked:
Answer both the young and the old will consume more.
there will be a net increase in overall consumption.
there will be a net decrease in overall consumption.
there will be no change in overall consumption.
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Question
If the government levies a one-time temporary tax on the young and gives the proceeds to the elderly, and both
generations follow the life-cycle consumption pattern and are altruistically linked:
Answer both the young and the old will consume more.
there will be a net increase in overall consumption.
there will be a net decrease in overall consumption.
there will be no change in overall consumption.
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Essay 1 points
Question
If an individual should subtract the present value of future tax obligations due to the government deficit from his or her
disposable income, this situation suggests that, in aggregate analysis, the government deficit should be subtracted
from disposable income. That is, instead of C = a + b(Y – T), we should use: C = a + b((Y – T – (G – T)), or = a + b(Y –
G).
a. Using this consumption function and the further relations:
I=I
G=G
T=T
Y=C+I+G
write the equilibrium equation determining Y as a function of a, I, G, and T.
b. If b equals 0.5, what are the numerical values of the multipliers for I, G, and T, respectively?
Answer a. Y = a/(1 – b) + I/(1 – b) + G.

b. The multiplier for I is 2.
The multiplier for G is 1.
The multiplier for T is zero.
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Essay 1 points
14 of 17 12/8/2012 11:46
Question
Compare the traditional view versus the view of Ricardian equivalence of the effects of a debt-financed tax cut on:
a. national saving,
b. current consumption, and
c. the real interest rate.
Answer a. Traditional view: national saving decreases; Ricardian view: national saving is unchanged
b. Traditional view: current consumption increases; Ricardian view: current consumption is unchanged
c. Traditional view: real interest rate increases; Ricardian view: real interest rate is unchanged
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Essay 1 points
Question
Many people are concerned about the budget deficit of the U.S. federal government. Suggest at least three possible
negative economic effects of a budget deficit and three possible economic benefits of a budget deficit.
Answer Possible negative effects of a deficit include less investment, slower long-term real growth rates, greater
indebtedness to foreigners, and loss of international competitiveness as a result of an appreciated currency.
There are other possibilities.
Possible benefits of a deficit include stabilizing economic activity, distributing the cost of wars across
generations, reducing the distortions of incentives caused by the tax system, and more current consumption.
There are other possibilities.
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Essay 1 points
Question
The U.S. Treasury reports the budget deficit or surplus of the federal government. Give at least one reason why the
measured budget deficit might overstate the “true” deficit and at least one reason the measured figure might understate
the “true” deficit.
Answer The figure may be overstated because no adjustment was made for the reduction in the real value of the debt
due to inflation or because no adjustment was made for the impact of the business cycle on the deficit. The
figure may understate the deficit because some liabilities, such as the pensions of government workers, are
excluded. There are other possibilities.
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Essay 1 points
Question
Explain how tax cuts can affect both aggregate demand and aggregate supply.
Answer Tax cuts increase disposable income, which increases consumption spending and aggregate demand. Tax
cuts increase the incentive to work and save, which increases aggregate supply.
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Essay 1 points
Question
What is Ricardian equivalence? Give at least three reasons why Ricardian equivalence might not correctly describe an
economy.
Answer Ricardian equivalence is the proposition that government debt is the equivalent of future taxes, so financing
government spending by debt is the equivalent of financing it by taxes. Ricardian equivalence assumes
consumers are forward-looking, but if consumers are myopic, then Ricardian equivalence will not hold.
Ricardian equivalence assumes that spending is based on current and future income, but if some consumers
are unable to borrow to achieve their desired level of consumption, then the tax cut will allow consumers to
spend more, and Ricardian equivalence will not hold. Finally, if consumers believe the future taxes will be paid
by the next generation and not themselves, then the equivalence between current debt financing and future
taxes may break down.
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Essay 1 points
Question
Countries seeking to adopt the euro as their currency must meet certain criteria, including the requirements to keep
their government budget deficit equal to 3 percent or less of GDP, and to hold government debt levels below 60 percent
of GDP. Discuss why there are fiscal policy criteria for joining a monetary union.
Answer One way to finance a government budget deficit is to print money, which generates inflation. Large
government deficits also increase government debt. As debt levels increase, governments face greater
incentives to reduce debt burdens through inflationary finance. Generating inflation increases the price level
and reduces the real value of debt. The European Union seeks to keep inflation low and, therefore,
discourages inflationary financing of government deficits and debt.
15 of 17 12/8/2012 11:46
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Essay 1 points
Question
Graphically illustrate the traditional view of the short-run impacts of a debt-financed tax cut on:
a. interest rates and output in a closed economy in the short run, using the IS–LM model.
b. exchange rates and output in a small open economy with a flexible exchange rate in the short run, using
the Mundell–Fleming model.
Answer
Panel A shows that in a closed economy in the short run the debt-financed tax cut shifts the IS curve to the
right and leads to higher output and higher interest rates. Panel B shows that in a small open economy with a
flexible exchange rate, the debt-financed tax cut results in no change in output but a higher exchange rate.
The higher exchange rate reduces net exports, which offsets the expansionary impact on output of the tax cut.
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Essay 1 points
Question
Graphically illustrate the traditional view of the long-run impacts of a debt-financed tax cut on :
a. saving, investment, and real interest rate using the classical model (Chapter 3).
b. steady state capital per worker and output per worker using the Solow growth model.
Answer
Panel A shows that in the long run the debt-financed tax cut reduces national saving, which results in a higher
interest rate and crowds out investment spending. In Panel B the lower saving rate results in a lower
steady-state level of capital per worker and a lower steady-state level of output per worker.
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Essay 1 points
Question
Using the model of aggregate demand–aggregate supply to illustrate the traditional view, graphically compare the
short-run and long-run impact of debt-financed tax cuts on:
a. output,
b. prices.
Answer
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In the short run, the debt-financed tax cut increases aggregate demand and results in more output and a
higher price level, moving the economy from long-run equilibrium at A to short-run equilibrium at B. In the long
run, the expected price level increases since output exceeds the natural level. The short-run aggregate supply
curve shifts up, moving the economy from B to C. In the long run the economy has a higher price level, but
output returns to the natural level.
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17 of 17 12/8/2012 11:46
Pool Canvas
Name TestBanks Chapter 20 The Financial System: Opportunities and Dangers

Description
Instructions
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Question
The financial system refers to the:
Answer mechanism that transfers wealth from consumers to corporations.
institutions that facilitate the flow of funds between savers and investors.
arrangements that allow money to circulate in the economy.
government regulations that govern the terms of borrowing and lending.
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Question
The set of institutions in the economy that facilitates the flow of funds between savers and investors is called the:
Answer financial system.
Federal Reserve system.
World Bank.
fiscal system.
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Question
The allocation of resources between those who want to save and those who want to borrow is accomplished through:
Answer the velocity of money.
fiscal policy.
the financial system.
foreign trade.
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Question
Financial markets allow savers to:
Answer eliminate risk.
indirectly provide resources for investment.
directly provide resources for investment.
avoid adverse selection.
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Question
Funds flow directly between savers and investors in financial _____ and flow indirectly between savers and investors
through financial _____.
Answer stocks; bonds
intermediaries; markets
bonds; stocks
markets; intermediaries
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Question
Financial markets allow households to _____ provide resources for investment, while financial intermediaries allow
households to _____ provide resources for investment.
Answer directly; indirectly
indirectly; directly
productively; unproductively
unproductively; productively
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Question
A document representing an interest-bearing debt of the issuer, usually a corporation or government, is called:
Answer equity.
stock.
a bond.
capital.
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Question
A bond (or debt instrument) is a(n):
Answer ownership claim by the shareholder of a firm.
loan to a firm.
ongoing relationship between customers and a firm.
legal restriction on products a firm may produce.
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Question
Ownership claims by shareholders in a firm are called:
Answer stocks.
bonds.
leverage.
debt.
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Question
Stocks are:
Answer loans to a firm.
assets minus liabilities of a firm.
leverage in a firm.
shares of ownership in a firm.
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Question
Purchasers of bonds issued by companies are _____ of the company, while purchasers of shares of stock issued by a
company are _____ of the company.
Answer creditors; debtors
debtors; creditors
creditors; partial owners
partial owners; debtors
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Question
Issuing bonds is called _____ financing, while issuing stocks is called _____ financing.
2 of 19 12/8/2012 11:46
Answer debt; equity

equity; debt
capital; investment
private; public
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Question
Obtaining funds for a business by borrowing, such as through the bond market, is called _____ finance.
Answer money
liability
debt
equity
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Question
Obtaining funds for a business by issuing ownership shares, such as through the stock market, is called _____ finance.
Answer money
liability
debt
equity
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Question
Debt financing is obtaining funds for a business by:
Answer borrowing.
issuing ownership shares.
seigniorage.
government subsidy
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Question
Equity financing is obtaining funds for a business by:
Answer borrowing.
issuing ownership shares.
seigniorage.
government subsidy
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Question
Institutions that stand between savers and investors, helping to direct financial resources to their best use are called:
Answer financial markets.
financial intermediaries.
financial regulators.
financial capitalists.
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Question
All of the following are examples of financial intermediaries except:
Answer commercial banks.
stock exchanges.
pension funds.
insurance companies.
3 of 19 12/8/2012 11:46
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Question
Risk aversion is a dislike of:
Answer paying interest.
lending.
borrowing.
randomness in economic circumstances.
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Question
A dislike of randomness in economic circumstances is called:
Answer rational expectations.
risk aversion.
adverse selection.
moral hazard.
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Question
Reducing risk by holding many imperfectly correlated assets is called:
Answer diversification.
moral hazard.
risk aversion.
leveraging.
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Question
Risk that affects many businesses at the same time is called _____ risk, while risk associated with individual
businesses is called _____ risk.
Answer asymmetric; symmetric
symmetric; asymmetric
systematic; idiosyncratic
idiosyncratic; systematic
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Question
Diversification allows savers to largely eliminate:
Answer risk aversion.
idiosyncratic risk.
systematic risk.
risk premiums.
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Question
Financial intermediaries that sell shares to savers and use their funds to buy diversified pools of assets are called:
Answer pension funds.
insurance companies.
mutual funds.
commercial banks.
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4 of 19 12/8/2012 11:46
Question
Mutual funds that buy a diversified pool of assets can:
Answer eliminate all risk.
eliminate systematic risk.
reduce idiosyncratic risk.
reduce systematic risk.
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Question
Two types of problems that arise due to asymmetric information are:
Answer systematic and idiosyncratic risk.
risk aversion and diversification
illiquidity and insolvency.
moral hazard and adverse selection.
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Question
A situation in which one party to an economic transaction has more knowledge about the transaction than the other is
called:
Answer risk aversion.
asymmetric information.
systematic risk
learning by doing.
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Question
Adverse selection concerns hidden knowledge about _____, while moral hazard concerns hidden knowledge about
_____.
Answer systematic risk; idiosyncratic risk
attributes; actions
equity finance; debt finance
financial markets; financial intermediaries
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Question
When the borrower has more knowledge about the attributes of an investment project than the lender, then the lender
has a problem of:
Answer adverse selection.
moral hazard.
risk aversion.
systematic risk.
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Question
Adverse selection may cause lenders to be offered opportunities to finance only:
Answer the most desirable business ventures.
less desirable business ventures.
risk-free business ventures.
diversified business ventures.
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Question
The risk that imperfectly monitored agents will act in dishonest or otherwise inappropriate ways is called:
5 of 19 12/8/2012 11:46

moral hazard.
systematic risk.
risk aversion.
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Question
When a borrower uses borrowed funds to engage in activities that are detrimental to the profitability of the business
venture that was financed, there is a problem of:
moral hazard.
systematic risk.
risk aversion.
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Question
Which of the following is an example of moral hazard?
Answer The healthiest people buy life insurance.
The sickest people buy health insurance.
The person with health insurance rides a motorcycle without wearing a helmet.
The person with life insurance exercises daily and eats healthy foods.
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Question
Which of the following is an example of adverse selection?
Answer The careful driver buys extra insurance protection when renting a car.
The sickest people buy health insurance.
The person with health insurance rides a motorcycle without wearing a helmet.
The person with life insurance exercises daily and eats healthy foods.
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Question
Banks help mitigate the problem of moral hazard in lending by:
Answer requiring lengthy applications for loans.
making loans to many different types of borrowers.
adjusting the amount of the loan to fit the requirements of the borrower.
monitoring the business after a loan is made to the business.
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Question
Banks help mitigate the problem of adverse selection in lending by:
Answer developing expertise in evaluating the business prospects of loan applicants.
making loans to many different types of borrowers.
adjusting the amount of the loan to fit the requirements of the borrower.
monitoring the business after a loan is made to the business.
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Question
A well-functioning financial system does all of the following except:
Answer foster economic growth by directing savings to its most productive use.
allocate risk among market participants.
eliminate risk through diversification.
6 of 19 12/8/2012 11:46
direct resources from savers to borrowers.
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Question
Governments can reduce the problem of moral hazard by:
Answer requiring licenses be obtained before starting a business.
prosecuting fraud and malfeasance.
keeping interest rates low.
reducing corporate income tax rates.
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Question
Governments can reduce the problem of adverse selection by:
Answer requiring disclosure about investment projects and a firm's finances.
providing loans from public funds.
keeping interest rates low.
reducing corporate income tax rates.
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Question
The Grameen Bank is:
Answer the central bank of Bangladesh.
a lender of last resort.
a lending microfinance institution.
a subsidiary of the World Bank.
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Question
The Grameen Bank makes loans primarily to:
Answer poor women.
first-time home buyers.
large corporations.
foreign governments.
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Question
A major disruption in the financial system that impedes the economy's ability to intermediate between those who want
to save and those who want to borrow and invest is called a:
Answer moral hazard.
speculative bubble.
financial crisis.
stagflation.
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Question
Common elements of financial crises include:
Answer insolvencies and government corruption
decline in asset prices and insolvencies of financial institutions.
declining liquidity and low interest rates.
high inflation and high interest rates.
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7 of 19 12/8/2012 11:46
Question
A rise in the price of an asset above its fundamental value is called a(n):
Answer financial panic.
insolvency.
liquidity crisis
speculative bubble.
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Question
An asset-price bubble bursts if there is:
Answer a panic cycle of asset sales and falling asset prices.
a statement from the central bank stating that the bubble is over.
an excess demand for an asset that raises asset prices.
a sharp decrease in interest rates that pricks the asset-price bubble.
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Question
The asset price that experienced a boom prior to the 2008–2009 recession was the price of:
Answer oil.
residential real estate.
technology stocks.
food.
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Question
The housing price boom prior to the 2008–2009 recession was fueled by all of the following except:
Answer unusually large increases in building material costs.
lax lending standards.
government policies promoting homeownership.
homebuyers' expectations of never-declining home prices.
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Question
Subprime borrowers are borrowers:
Answer who obtain loans at interest rates below the prime rate.
most likely to make their loan payments on time.
with risky credit profiles.
who borrow to purchase smaller homes.
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Question
Falling house prices generate widespread insolvency of financial institutions by:
Answer reducing the value of collateral assets.
reducing the value of liabilities.
increasing the value of assets.
increasing capital.
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Question
The precipitous fall in the price of assets that takes place when financial institutions must sell their assets quickly in the
midst of a crisis is called a(n):
8 of 19 12/8/2012 11:46
Answer insolvency.
subprime sale
speculative bubble.
fire sale.
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Question
The mortgage defaults during the 2008–2009 financial crisis severely reduced the capital positions of:
Answer major investment banks.
government-sponsored enterprises involved in the mortgage market.
a large insurance company (AIG).
all of the above.
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Question
One avenue by which a loss of confidence in one financial institution spreads to another financial institution is through:
Answer a steep decline in asset prices driven by fire sales to restore liquidity.
a sharp decline in interest rates to compensate for added risk.
an increase in government deposit-insurance coverage.
a rapid slowdown in the withdrawal of deposits.
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Question
The TED spread is an indicator of :
Answer expected defaults in the mortgage market.
expected inflation.
worries about the solvency of the banking system.
the ease or tightness of monetary policy.
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Question
An indicator of the increased lack of confidence in the banking system during the financial crisis of 2008–2009 was the:
Answer increase in the federal government budget deficit.
decrease in interest rates.
increase in the TED spread.
decrease in the TED spread.
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Question
The TED spread is the difference between the interest rate paid on _____ and the interest rate paid on _____.
Answer three-month U.S. certificates of deposit; three-month eurodollar loans
overnight interbank loans in London; overnight interbank loans in the United States
four-week Treasury bills; overnight federal funds
three-month eurodollar interbank loans; three-month Treasury bills
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Question
If banks fear failure and become more conservative in making loans, then the sharp decline in bank lending is called a
credit:
Answer crunch.
hazard.
bubble.
9 of 19 12/8/2012 11:46
swap.
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Question
In the credit crunch during the 2008–2009 recession, banks tightened lending standards:
Answer only for mortgages.
only for small business loans.
only for consumer loans.
for mortgages, small business loans, and consumer loans.
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Question
A credit crunch reduces aggregate demand by:
Answer increasing the exchange rate.
increasing interest rates.
reducing consumption and investment spending.
reducing the money supply.
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Question
The effect of the financial crisis of 2008–2009 on the real economy in the United States was a(n) _____ in aggregate
demand, a(n) _____ in output, and a(n) _________ in the unemployment rate.
Answer increase; increase; increase
decrease; decrease; decrease
decrease; increase; increase
decrease; decrease; increase
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Question
The recession produced by a financial crisis:
Answer mitigates the effects of the financial crisis.
puts an end to the financial crisis.
puts further pressure on asset prices and financial institutions.
re-inflates the asset-price bubble.
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Question
To the extent that low interest rates contributed to the financial crisis of 2008–2009, the blame for this policy lies with:
Answer the Federal Reserve.
investment banks.
rating agencies.
mortgage brokers.
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Question
To the extent that mortgage defaults contributed to the financial crisis of 2008–2009, blame for these actions lies with:
Answer homebuyers who borrowed more than they could afford to repay.
mortgage brokers who encouraged households to borrow excessively.
government policymakers who pursued policies to encourage homeownership
all of the above
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10 of 19 12/8/2012 11:46
Question
To the extent that risky mortgage-backed securities that were sold to buyers who were not fully aware of the risks
contributed to the financial crisis of 2008–2009, blame for this action lies with:
Answer homebuyers.
mortgage brokers.
investment banks.
the Federal Reserve
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Question
To the extent that the undervaluation of the riskiness of mortgage-backed securities contributed to the financial crisis of
2008–2009, blame for this mistake lies with:
Answer mortgage brokers.
investment banks.
rating agencies.
government policymakers.
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Question
To the extent that failure to appreciate the implications of the decline in house prices on the financial system
contributed to the financial crisis of 2008–2009, blame for this mistake lies with:
Answer mortgage brokers.
investment banks.
homebuyers.
regulators.
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Question
Conventional monetary and fiscal policies used in a recession are aimed at:
Answer increasing aggregate supply.
increasing aggregate demand.
decreasing aggregate supply.
decreasing aggregate demand
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Question
During the 2008–2009 period, the conventional monetary policy response was to _____ the target federal funds rate,
while the conventional fiscal policy response was to _____ taxes and to _____ government spending.
Answer increase; increase; increase
decrease; decrease; decrease
increase; increase; decrease
decrease; decrease; increase
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Question
Conventional monetary policy was limited during the 2008–2009 financial crisis because the central bank could not:
Answer purchase enough bonds through open market operations.
print a sufficient quantity of money.
reduce the target interest rate below zero.
adjust the discount rate quickly enough.
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Question
Conventional fiscal policy was limited during the 2008–2009 financial crisis because of:
Answer concerns about increasing the government's budget deficit and debt.
difficulties paying out tax rebates.
the inability of the government to reduce spending below zero.
the inability of the government to raise taxes above 100 percent of income.
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Question
Conventional monetary and fiscal policies during a financial crisis are aimed at _____, while acting as a lender of last
resort or injecting government funds into the financial system during a financial crisis is aimed at _____.
Answer increasing output; reducing inflation
expanding aggregate demand; fixing the financial system
increasing corporate wealth; increasing household wealth
expanding aggregate supply; reducing the national debt
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Question
A bank with assets worth less than liabilities is said to be _____, while a bank without adequate funds immediately
available to make promised payments is said to be _____.
Answer inflated; inverted
inverted; inflated
insolvent; illiquid
illiquid; insolvent
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Question
Illiquid financial institutions:
Answer have assets that are worth less than their liabilities.
do not have immediately available funds to make promised payments
have negative net worth.
do not accept deposits or make loans to households.
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Question
An illiquid bank can become insolvent when it:
Answer refuses to make promised payments.
sells additional stock to obtain funds.
sells assets at fire-sale prices to meet liquidity demands.
can extend the due dates of its liabilities.
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Question
When the central bank acts as a lender of last resort, it:
Answer requires the borrower to put up collateral.
is able to confiscate some of the borrower's assets.
requires voting rights on the borrower's board of directors.
takes over ownership of the borrower.
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Question
A situation in which a solvent bank does not have sufficient cash on hand to satisfy the withdrawal demands of
depositors is called a(n) _____ crisis.
12 of 19 12/8/2012 11:46
Answer lending
shadow
insolvency
liquidity
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Question
The principal purpose of a central bank acting as a lender of last resort is to:
Answer prevent the failure of insolvent financial institutions.
maintain the liquidity of the financial system.
provide adequate funds to finance the government's spending.
keep interest rates as low as possible.
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Question
When the central bank lends to financial institutions in the midst of a liquidity crisis, the central bank is acting as a:
Answer lender of last resort.
shadow bank.
investment bank.
mutual fund.
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Question
During the 2008–2009 financial crisis, the Federal Reserve served as a lender of last resort by providing liquidity to:
Answer both banks and shadow banks with reliable collateral.
any insolvent domestic borrower in the economy.
state and local governments.
households that were underwater on their mortgages.
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Question
Ideally, the purpose of providing funds to insolvent banks beyond required insurance payouts is to:
Answer transfer funds from taxpayers to financial institutions.
give taxpayers ownership in a commercial bank.
reward political loyalty.
prevent bank failures from multiplying.
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Question
The phrase _____ describes a firm so central to that financial system that policymakers will not allow it to enter
bankruptcy.
Answer “no bank left behind”
“too big to fail”
“don't fail, don't bail”
“laissez-faire bank”
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Question
When the phrase _____ was coined, it referred to _____.
Answer “too big to fail”; JPMorgan and Bank One
“one bank, one country”; Bank of America
“laissez-faire”; the Federal Reserve
13 of 19 12/8/2012 11:46
“too big to fail”; Continental Illinois Bank
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Question
The Treasury used most of the funds allocated by the Troubled Asset Relief Program (TARP) to:
Answer purchase mortgage-backed securities.
make equity injections into troubled financial institutions.
create a new regulatory agency to oversee risky assets.
make emergency loans to the FDIC.
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Question
Deposit insurance is an example of ______ used to prop up the financial system.
Answer a giveaway of public funds
risky lending
a capital injection
conventional monetary policy
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Question
The government making loans that are secured by collateral of dubious value to prop up the financial system is an
example of:
Answer a giveaway of public funds.
risky lending.
a capital injection.
conventional monetary policy.
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Question
The government purchasing ownership stakes in a faltering financial institution in order to prop up the financial system
is an example of:
Answer a giveaway of public funds.
risky lending.
a capital injection.
conventional monetary policy.
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Question
One justification for greater regulation of traditional commercial banks than of shadow banks is the:
Answer lower amounts of capital and higher amounts of risky assets held at banks.
absence of economy-wide repercussions when shadow banks fail.
more limited opportunities for excessive risk-taking by shadow banks.
existence of government insurance of bank deposits.
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Question
The benefit of stricter capital requirements for shadow banks is _____, while the cost is _____.
Answer the end of risk-taking behavior; the development of more profitable opportunities
increased monitoring of risk-taking behavior; higher executive compensation
enhancing financial stability; impeding financial intermediation
lower inflation; higher unemployment
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14 of 19 12/8/2012 11:46
Question
All of the following are examples of shadow banks except:
Answer Bear Sterns
AIG
Bank of America
Lehman Brothers
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Question
The resolution authority over shadow banks given to the FDIC as part of the Dodd-Frank Act, gives the FDIC authority
to:
Answer provide deposit insurance to shadow banks.
take over and close shadow banks that could create systemic risk for the economy.
require shadow banks to hold more capital.
serve as a lender of last resort to shadow banks.
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Question
In the event that a bank converted previously issued CoCo bonds (contingent convertible debt), then holders of the
bonds would change from _____ of the bank.
Answer creditors to part owners
creditors to debtors
debtors to creditors
part owners to creditors
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Question
One advantage of CoCo bonds (contingent convertible debt), over alternative methods for recapitalizing banks, is that:
Answer the interest rate paid on CoCo bonds would be lower than on bonds without the conversion feature.
CoCo bonds provide banks with capital from private rather than taxpayer funds.
banks would only have to seek purchasers of CoCo bonds in times of financial stress.
obtaining increased bank capital by converting CoCo bonds would increase bank liabilities.
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Question
Proponents of restricting the size of financial institutions believe this policy will _____, while opponents believe this
policy will _____.
Answer allow firms to take advantage of economies of scale; increase the volatility of the financial system.
reduce the number of financial institutions; give institutions the incentive to take excessive risks.
eliminate the need for deposit insurance; encourage imprudent risk taking
make the financial system more stable; lead to higher costs
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Question
Two policies that are intended to make the financial system more stable by restricting the size of financial institutions
are:
Answer to offer cheaper loans to large financial institutions and to make larger capital injections available for larger
banks.
to lower the cost of deposit insurance for large banks and to provide incentives for large banks to make
speculative investments.
to restrict mergers among large banks and to require higher capital requirements for large banks.
to allow large banks to be more highly leveraged and to increase deposit insurance coverage for
depositors at large banks.
15 of 19 12/8/2012 11:46
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Question
The Volcker rule restricts excessive risk taking by commercial banks by:
Answer prohibiting banks from making certain kinds of speculative investments.
increasing the amount of capital banks must hold.
decreasing the deposit insurance coverage of depositors in commercial banks.
limiting the compensation that bank executives can be paid.
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Question
A key obstacle facing regulators who want to prevent financial institutions from taking excessive risks is the difficulty in:
Answer finding diversified pools of assets to reduce risk.
drawing the line between excessive and appropriate risk taking.
eliminating idiosyncratic risk through diversification.
distinguishing between equity and debt financing.
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Question
Prior to the financial crisis of 2008–2009, financial regulation in the United States consisted of a _____ system of
regulators, which the Dodd-Frank Act sought to improve upon by _____ the number of regulatory bodies.
Answer coordinated; increasing
coordinated; decreasing
fragmented; increasing
fragmented; decreasing
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Question
Which of the following policies are intended to reduce the likelihood of future financial crises?
Answer restricting the size of financial firms
limiting excessive risk taking
reforming regulatory agencies
all of the above
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Question
The purpose of the Financial Services Oversight Council, which was created by the Dodd-Frank Act, is to:
Answer replace the existing regulatory agencies with one agency to enforce all financial regulations.
oversee private credit rating agencies.
determine appropriate levels of executive compensation for firms in the financial system.
coordinate activities of the various regulatory agencies.
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Question
Sovereign debt refers to debt issued:
Answer without collateral.
with no rating by a credit-rating agency.
by governments.
with a promise to repay in a foreign currency.
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16 of 19 12/8/2012 11:46
Question
The potential problem faced by the rest of Europe in the event of a Greek debt default is:
Answer the inability of the European Central Bank to conduct open market operations.
the risk of banks holding Greek debt becoming insolvent.
an increase in the number of U.S. dollars traded per euro in the foreign exchange market.
the strain on the European banking system, while banks in the rest of the world would be unaffected.
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Essay 1 points
Question
a. What is the difference between an illiquid bank and an insolvent bank?
b. Would the Federal Reserve's lender of last resort function be the most appropriate remedy for an illiquid
or an insolvent bank? Explain.
c. Would the FDIC's resolution authority be the most appropriate remedy for an illiquid or an insolvent
bank? Explain.
Answer a. An illiquid bank is a solvent bank that does not have enough cash on hand to meet customer
withdrawals. The illiquid bank has assets worth more than its liabilities, but it is unable to quickly convert
enough of the assets into cash. An insolvent bank is one for which assets are worth less than liabilities.
b. An illiquid bank could benefit by borrowing from the Federal Reserve in its capacity as a lender of last
resort. The illiquid bank can pledge its illiquid assets as collateral for the loan. The borrowed funds
would allow the illiquid bank to meet customer withdrawals until confidence is restored in the financial
system.
c. The FDIC's resolution authority, the ability to take over and close or sell off any remaining assets, would
be the most appropriate remedy for an insolvent bank. The insolvent bank does not possess sufficient
assets to satisfy all obligations. The FDIC can step in to close the bank in an orderly fashion and
attempt to prevent the bank failure from spreading.
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Essay 1 points
Question
In each case identify whether the situation is a case of adverse selection or moral hazard. Explain.
a. Jasper knows, but the car rental company does not know when he is trying to rent a car during a
blizzard in Wisconsin, that Jasper grew up in a tropical climate and has no idea how to drive in cold
weather and snowy conditions.
b. Joan has received a loan from the bank to finance the purchase of more inventory for her quilt shop, but
she intends to use the money (without telling the bank) to take a safari in Africa.
c. Some companies sell annuities, which are policies that make periodic payments as long as the
purchaser lives. Jane is trying to buy an annuity. Jane knows, but the annuity issuers do not know, that
people in Jane's family routinely live to age 100.
Answer a. Adverse selection. There is hidden information about an attribute of the renter—his lack of winter driving
skills.
b. Moral hazard. The imperfectly monitored borrower plans to act in an inappropriate way.
c. Adverse selection. There is hidden information about an attribute of the annuity purchase—her family's
longevity.
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Essay 1 points
Question
How do deposit insurance and the “too big to fail” policy increase moral hazard?
Answer Knowing that the government will cover any losses generated by their mistakes, using public funds to bail
them out, banks have the incentive to take excessive risks. If the excessive risks pay off, the profits go to the
bank. However, if the excessive risks result in losses, the bankers do not lose because the government bails
them out.
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Essay 1 points
Question
Provide one example from the 2008–2009 financial crisis of how the following types of policies were used to respond to
the crisis:
a. conventional monetary and fiscal policy,
b. lender of last resort,
17 of 19 12/8/2012 11:46
c. injections of government funds.
Answer Many responses are possible.

a. An example of conventional monetary policy was the Fed's lowering of the target federal funds rate.
Examples of conventional fiscal policy include authorizing tax rebates and increases in government
spending.
b. The Fed made loans available through the discount window to commercial banks and through other
vehicles to many types of shadow banks, including money market mutual funds.
c. The TARP funds were used to buy equity in troubled banks. Deposit insurance coverage was increased.
The Fed made loans backed by collateral of dubious value.
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Essay 1 points
Question
Provide one argument in favor of and one argument against each of the following proposals to prevent future financial
crises.
a. require shadow banks to hold more capital,
b. give the FDIC resolution authority over shadow banks,
c. impose higher capital requirements on larger banks,
d. prohibit banks from making speculative investments.

a. Proponents contend that higher capital requirements would limit the ability of shadow banks to use
leverage and, therefore, improve financial stability. Critics contend this requirement would limit the
shadow banks' ability to provide financial intermediation.
b. Proponents believe this will allow a more orderly process and limit systemic risk when shadow banks
fail. Critics contend that this will make bailouts of shadow banks with public funds more common and
increase moral hazard.
c. Proponents believe this will provide incentive for banks to be smaller and that the banking system is
more stable with smaller institutions. Critics argue that this would limit the ability of financial institutions
to take advantage of economies of scale and result in higher costs that would be passed on to
consumers.
d. Proponents contend that this would make banks safer. Critics contend that this would make the market
for speculative investments less liquid.
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Essay 1 points
Question
Provide specific examples from the 2008–2009 financial crisis of each of the five stages of a financial crisis:
a. asset-price booms and busts,
b. insolvencies of financial institutions,
c. falling confidence in the financial system,
d. credit crunch,
e. recession.

a. Residential housing prices were the asset prices that boomed and then “busted” to precipitate the
2008–2009 financial crisis.
b. In the 2008–2009 financial crisis, holders of mortgage-backed securities saw large declines in these
asset values, which led to the insolvency of investment banks such Lehman Brothers and Bear Sterns,
and the insurance company AIG.
c. In the 2008–2009 financial crisis, the TED spread, which measures the difference between lending to
banks and lending to the U.S. government, rose dramatically, indicating the increased uncertainty about
the health of banks and the increased interest rates that had to be paid when banks borrowed to
compensate for the perception of increased risk when lending to banks.
d. In the 2008–2009 financial crisis lenders began to require increased down payments for mortgages, and
both businesses and consumers had more difficulty in obtaining credit.
e. The 2008–2009 recession was the most severe since the Great Depression, and the unemployment
rate topped 10 percent.
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Essay 1 points
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Question
What is the difference between systematic and idiosyncratic risk? Which type of risk can be almost eliminated through
diversification?
Answer Risk that affects all businesses at the same time is called systematic risk. Risk associated with a specific
business alone is called idiosyncratic risk. Holding a group of assets with imperfectly correlated returns can
substantially reduce idiosyncratic risk.
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Essay 1 points
Question
Suppose Bank A has a leverage ratio of 20 and Bank B has a leverage ratio of 10. Explain the meaning of these ratios
and what would happen to each of these banks if the value of their assets fell by 6 percent.
Answer The leverage ratio gives the value of assets per $1 of capital. For Bank A this means that $19 of assets were
obtained with borrowed funds per $1 of capital. If the value of assets falls by 6 percent, the bank's capital falls
by 120 percent, wiping out the bank's capital and making the bank insolvent, with liabilities greater than
assets. For Bank B, a 6 percent fall in the value of assets would reduce capital by 60 percent, but Bank B
would still be solvent, with more assets than liabilities.
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Essay 1 points
Question
Use the aggregate demand–aggregate supply model to graphically illustrate the impact of a financial crisis on output
and prices in an economy in the short run. Explain the factors that cause changes from the initial equilibrium to the new
short-run equilibrium.
Answer
The credit crunch brought about by the financial crisis decreases the ability of consumers to borrow to finance
consumption expenditures, as well as reduces the ability of business to borrow to finance investment
spending. Households subject to more rigorous lending standards also find it more difficult to finance spending
on new residential housing, a component of investment spending. The decrease in the value of houses
decreases household wealth, which has a further dampening effect on consumption spending. These factors
reduce both the consumption and investment components of aggregate demand. This can be represented by
a leftward shift in the AD curve in the graph. In the short run, there is a decrease in output to Y and a
2
decrease in the price level to P
2.
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Essay 1 points
Question
What are the benefits of a well-functioning financial system? What are the costs of a financial crisis?
Answer A well-functioning financial system fosters economic growth by transferring resources from savers to
borrowers who have the most productive and profitable investment opportunities. The investment leads to
more capital, more production, and higher levels of output per person. A well-functioning financial system
allows savers to share risk. A financial crisis leads to a reduction in the transfer of resources from savers to
borrowers because of insolvencies of financial institutions and loss of confidence in the financial system. The
amount of consumption and investment in the economy falls, leading to lower output and more unemployment
in the short run and less capital and slower growth in the long run.
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Reference: Ref 13-1

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Reference: Ref 13-2