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Wiley CPA Exam Review

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Q: ECON-0072
An economy is at the peak of the business cycle. Which of the following policy packages is the most effective way to dampen the economy and prevent inflation? A: Increase government spending, reduce taxes, increase money supply, and reduce interest rates. B: Reduce government spending, increase taxes, increase money supply, and increase interest rates. C: Reduce government spending, increase taxes, reduce money supply and increase interest rates. D: Reduce government spending, reduce taxes, reduce money supply, and reduce interest rates. Answer A is incorrect because all of these items have the effect of expanding the economy and causing inflation. Answer B is incorrect because increasing the money supply has the effect of expanding the economy and causing inflation. The requirement is to identify the policy package that would be most effective at dampening the economy and preventing inflation. Answer C is correct because reducing government spending, increasing taxes, reducing the money supply, and increasing interest rates all have the effect of dampening the economy and preventing inflation. Answer D is incorrect because increasing taxes and interest rates have the effect of expanding the economy and causing inflation.

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A. Monetary Policy Depository institutions (banks, savings and loans, and credit unions, etc.) borrow savers’ money and lend the money to consumers, businesses, and governments. The Federal Reserve (the US central bank), through its open market controls the actions of depository institutions and can affect the supply of money in the following ways: 1. Reserve requirements. When a bank lends money, it gives the borrower a check drawn on the bank itself. The Federal Reserve controls a bank’s ability to issue check-writing deposits by imposing a reserve requirement on checking deposits. The institution must hold in reserve (much of which is on deposit at a Federal Reserve Bank) a certain percentage of their total checking deposits. The Federal Reserve can influence interest rates by changing the reserve requirements and therefore increasing or decreasing the supply of money. However, making changes in reserve requirements is rarely done. 2. Open-market operations. A more common instrument of monetary policy is open-market operations (by the Federal Open-Market Committee), which involves the purchase or sale of government securities using the Federal Reserve Bank deposits. If the Federal Reserve purchases government securities, they are able to increase the monetary supply and, therefore, put downward pressure on interest rates. When a central bank is purchasing government securities and expanding the money supply, it is called an expansionary openmarket operation. If a central bank is selling government securities it is said to be pursuing a contractionary open-market operation, because this reduces the money supply. 3. The discount rate. When a bank has a reserve deficiency it may borrow funds from a Federal Reserve Bank. By setting the discount rate for such borrowing, the Federal Reserve can influence interest rates in the economy.



Sales taxes are levied based on the amount of income spent. The following are the major types of taxes: a. Sales tax. Fiscal Policy Fiscal policy is government actions. e. This tax is borne both directly (the employee’s share) and indirectly (the employer’s share) by employees because without the tax. As an example. On the other hand. As an example. interest rates and output. such as taxes. In the US the rate structure is generally progressive. A tax commonly used in other industrial nations is the value-added tax (VAT). is called a fiscal expansion. Taxes. Sales taxes are viewed as regressive because low-income individuals pay the same percentage rate as high-income individuals. either due to an increase in government spending or to a decrease in taxes. Wage taxes. gasoline taxes used to pay for roads).g. Value-added tax. which will serve to stimulate economic activity. However. there are a number of social and economic incentives built into the system that dilute its progressive structure.. 5. firms and consumers adjust their expectations based on new information. The effects of monetary policy depend on their effects on the expectations of investors. businesses. and consumers develop expectations about inflation. if expectations remain unchanged. The most significant wage tax in the US is the social security tax. c. On the other hand. and consumers. increases in taxes to reduce a deficit is called fiscal contraction. wages would be higher. d. Economic analysis. Lower interest rates tend to encourage consumer and business spending because finance charges are lower. Property taxes are levied based on wealth. Income taxes are levied on taxable income. 7. and government spending. and an increase in interest rates will slow the economy. Property tax. Higher interest rates tend to discourage spending because finance charges are higher. the Federal Open-Market Committee does extensive economic analysis.. a reduction of taxes increases personal disposable income. and output based on a consideration of all available information.g. the effect on output will be dramatic. Taxes are levied by a government based on two general principles: (1) the ability to pay (e. the effects will be minimal. they adjust their expectation upward. firms. In speeches by the members and when providing the basis for its decisions insights are provided into the state of the economy. An increase in deficit. and the stock prices. b. The economy may also be stimulated through increased government spending. designed to achieve economic goals. In making its monetary decisions. subsidies. The Federal Reserve uses monetary policy to attempt to sustain economic growth while keeping inflation under control. It also encourages saving because the return on savings is higher. interest rates. progressive income taxes). if they find that inflation is higher than expected. business spending.Wiley CPA Exam Review Page 2 of 3 4. Monetary policy works on the principle that a decrease in interest rates will stimulate the economy. They generally are progressive based on the value of the property. and (2) derived benefit (e. 1. This is contrasted to adaptive expectations in which investors. Value-added taxes are levied on the increase in value of each product as it about:blank 13/10/2010 . This information also may have an effect on economic factors such as interest rates. If monetary expansion leads the financial markets to revise their expectations about inflation. 6. B. Income tax. Rational expectations assume that investors.

The VAT is thought to encourage savings because it taxes consumption instead of earnings. Consumers take time to adjust their consumption based on changes in personal disposal income b. In the long and medium run. about:blank 13/10/2010 . In the short run. the tax is paid by the final consumer. Ultimately. Lower budget deficits usually mean more savings and investment. more output. Firms take time to adjust spending based on changes in interest rates d. including a. 2. a reduction in budget deficit leads to reductions in spending and therefore less output. a budget deficit reduction is likely to be beneficial to the economy. Firms take time to adjust production based on changes in sales 3. Fiscal polices can have a large effect on the size of budget deficits. Firms take time to adjust investment based on changes in sales c. Both monetary and fiscal policy take time to have the desired effects for a number of reasons.Wiley CPA Exam Review Page 3 of 3 proceeds through production and distribution processes. and therefore.