Chapter 21 A+ Test Prep

If the marginal propensity to consume is 0.80, and there is no investment accelerator or crowding out, a $10 billion increase in government expenditures would shift the aggregate demand curve to the right by _______.

$50 billion The multiplier is calculated as 1/(1 - MPC). Because the MPC = 0.80, this means the multiplier is 1/(1 - 0.80) = 1/(0.20) = 5. Therefore, a $10 billion increase in government expenditures translates into a $10 billion x 5 = $50 billion increase in aggregate demand in the absence of the crowding-out effect.

Take the following information as given for small, imaginary economy: When income is $10,000, consumption spending is $6,500. When income is $11,000, consumption spending is $7,100. For this economy, an initial increase of $200 in net exports translates into a _______ increase in aggregate demand in the absence of the crowding-out effect.

$500 The spending multiplier is calculated as 1/(1 - MPC). The marginal propensity to consume is the fraction of extra income that a household consumes rather than saves. In this case, an extra $1,000 of income increases spending by $600, so the MPC = 0.60. This means the multiplier is 1/(1 - 0.60) = 1/(0.40) = 2.5. Therefore, a $200 increase in net exports translates into a $200 x 2.5 = $500 increase in aggregate demand in the absence of the crowding-out effect.

The multiplier for changes in government spending is calculated as _______.

1/(1 - MPC) The impact on aggregate demand of a change in government purchases is the equivalent to the infinite sum 1 + MPC + MPC2 + MPC3 + ... Using the formula for an infinite geometric series, this means that the multiplier is equal to 1/(1 - MPC).

Take the following information as given for small, imaginary economy: When income is $10,000, consumption spending is $6,500. When income is $11,000, consumption spending is $7,100. The spending multiplier for this economy is _______.

2.50 The spending multiplier is calculated as 1/(1 - MPC). The marginal propensity to consume is the fraction of extra income that a household consumes rather than saves. In this case, an extra $1,000 of income increases spending by $600, so the MPC = 0.60. This means the multiplier is 1/(1 - 0.60) = 1/(0.40) = 2.5.

Which of the following is an example of crowding out?

A decrease in taxes increases interest rates, causing investment to fall. The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy, such as an increase in government spending or a decrease in taxes, raises the interest rate and thereby reduces investment spending.

Which of the following shifts aggregate demand to the left?

A decrease in the money supply. The aggregate-demand curve shows the relationship between the price level and the quantity of output. Therefore, a change in the price level results in a movement along the aggregate-demand curve, not a shift. When the Fed sells government bonds, it decreases the money supply causing the equilibrium interest rate to rise. Because the interest rate is the cost of borrowing, this results in a leftward shift of the aggregate-demand curve.

According to liquidity preference theory, which of the following is not true?

A decrease in the price level shifts money demand to the right. According to liquidity preference theory, a decrease in the interest rate increases the quantity of money demanded but does not change the quantity of money supplied since this is fixed by the Fed. This is shown as a movement along the money-demand curve. Also, an increase in the price level shifts money demand to the right because people will choose to hold a larger quantity of money as a result of higher prices.

Which of the following events would cause the Fed to stabilize output through decreasing the money supply?

An increase in net exports A decrease in the money supply by the Fed would cause interest rates to rise. Because the interest rate is the cost of borrowing, the rise in the interest rate lowers the quantity of goods and services demanded, which would decrease the equilibrium level of output in an economy. This means that the event that would cause the Fed to stabilize in this way must cause output to rise. A decrease in government spending, an increase in taxes, and an increase in interest rates all cause aggregate demand to fall, whereas an increase in net exports causes aggregate demand to rise.

Which of the following events would cause the Fed to stabilize output through increasing the money supply?

An increase in taxes An increase in the money supply by the Fed would cause interest rates to decline. Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of goods and services demanded, which would increase the equilibrium level of output in an economy. This means that the event that would cause the Fed to stabilize in this way must cause output to fall. An increase in net exports, an increase in government spending, and a decrease in interest rates all cause aggregate demand to rise, whereas an increase in taxes causes aggregate demand to decline.

Which of the following is not correct? a. When money demand shifts leftward, the interest rate falls. b. A lower price level shifts money demand leftward. c. As the interest rate falls, the quantity of money demanded falls. d. A lower interest rate increases the quantity of goods and services demanded.

As the interest rate falls, the quantity of money demanded falls. A lower price level means that people will choose to hold a smaller quantity of money, causing the money-demand curve to shift to the left. Recall that the money-demand curve is downward sloping, so a lower interest rate means a higher quantity of money demanded. When money demand shifts leftward, the interest rate falls. Because the interest rate is the cost of borrowing, the lower interest rate increases the quantity of goods and services demanded.

According to liquidity preference theory, the opportunity cost of holding money is the inflation rate.

False According to liquidity preference theory, the opportunity cost of holding money is the interest rate. That is, when you hold wealth as cash in your wallet, instead of as an interest-bearing bond, you lose the interest you could have earned on that money.

When the interest rate increases, the opportunity cost of holding money decreases, so the quantity of money demanded decreases.

False According to liquidity preference theory, the opportunity cost of holding money is the interest rate. That is, when you hold wealth as cash in your wallet, instead of as an interest-bearing bond, you lose the interest you could have earned on that money. Therefore, when the interest rate increases, the opportunity cost of holding money increases, so the quantity of money demanded decreases.

Refer to the figure. You can explain a decrease in Y from Y1 to Y2 in the following way: A decrease in P in P2 to P1 causes the money-demand curve to shift from MD1 to MD2; this shift of MD causes r to increase from r1 to r2 ; and this increase in r causes Y to decrease from Y1 to Y2 .

False An increase in P from P1 to P2, causes people to want to hold more money, which shifts the money-demand curve to the right from MD1 to MD2. This shift in money demand causes the interest rate to rise from r1 to r2. Because the interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods and services demanded from Y1 to Y2.

During periods of expansion, automatic stabilizers cause government expenditures to rise and taxes to fall.

False Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Some examples of automatic stabilizers include the unemployment compensation system, the federal income tax, and the welfare system.

If the Fed conducts open-market purchases, the money supply decreases and aggregate demand shifts right.

False If the Fed buys government bonds in open-market operations, it will increase the money supply. This reduces the equilibrium interest rate which raises the quantity of goods and services demanded at a given price level. Therefore, the aggregate-demand curve also shifts to the right.

A tax increase has a multiplier effect but not a crowding-out effect.

False The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier and crowding-out effects. When the government cuts taxes and stimulates consumer spending, earnings and profits rise which further stimulates consumer spending. At the same time, higher income leads to higher money demand, which tends to raise interest rates. This makes borrowing more costly, which reduces investment spending.

A reduction in personal income taxes increases aggregate demand through an increase in private savings.

False When the government cuts personal income taxes, it increases households' take-home pay. Households will save some of this additional income, but they will also spend some of it on consumer goods. Because a tax cut increases consumer spending, it shifts the aggregate-demand curve to the right.

The Federal Funds Rate is the interest rate the Fed charges depository institutions for short-term loans.

False The Federal Funds rate is the interest rate banks charge each other for short-term loans. The discount rate is the interest rate on the loans that the Fed makes to banks.

Which of the following is not true according to classical macroeconomics theory?

For any given level of output, the interest rate adjusts to balance the supply of, and demand for, money. According to classical macroeconomics theory, output is determined by the supplies of capital and labor and the available production technology. Moreover, for any given level of output, the interest rate adjusts to balance the supply of, and demand for, loanable funds. Then, given output and the interest rate, the price level adjusts to balance the supply of, and demand for, money.

Stabilization Figure 2: Refer to the figure. Suppose the economy is at point A. Which of the following statements is true? a. If policymakers want to restore output to its natural level YN, they should decrease both government purchases and taxes. b. If the economy is left alone, then as it corrects itself and moves to the natural level of output, the price level will remain at P1. c. If the economy is left alone, then as it corrects itself and moves to the natural level of output, the price level will rise above P1. d. If policymakers want to restore output to its natural level YN, they should increase both government purchases and taxes.

If the economy is left alone, then as it corrects itself and moves to the natural level of output, the price level will rise above P1. Because the short-run equilibrium level of output is larger than the natural level, this means that the economy is not experiencing full employment and the unemployment rate is lower than its natural level. If the economy is left alone, then as the economy moves from point A to long-run equilibrium, the price level will rise further. However, if the government wants to restore output to its long-run level, it should reduce government purchases to cause a leftward shift of the AD or increase taxes cause a leftward shift of the SRAS.

Sometimes during times of heightened national security, government expenditures are larger than normal. What could the Fed do to reduce the effects this spending creates on interest rates?

Increase the money supply by buying bonds The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy, such as an increase in government spending or a decrease in taxes, raises the interest rate and thereby reduces investment spending. In order to counter this rise in the interest rate, the Fed would want to increase the money supply since this puts downward pressure on the interest rate in the market for money. In order to do this, the Fed could buy bonds through open-market operations

Which of the following is true about liquidity preference theory?

It is most relevant to the short run of interest rates. Liquidity preference refers directly to Keynes' theory concerning the effect of changes in money demand and supply on interest rates. Therefore, it is most relevant to the short run and supposes that the interest rate adjusts to bring money supply and money demand into balance. This theory is most helpful in understanding the interest-rate effect.

Which of the following is true about the interest-rate effect?

It is the most important reason, in the case of the United States, for the downward slope of the aggregate-demand curve. The interest-rate effect depends on the idea that decreases in interest rate increase the quantity of goods and services demanded. Of the three reasons why the aggregate-demand curve slopes downward (the wealth effect, the interest-rate effect, and the exchange-rate effect), the interest-rate effect is the most important reason, in the case of the United States, for the downward slope of the aggregate-demand curve.

Which of the following is not true about the Employment Act of 1946?

It states that the government should not promote full employment and production. The Employment Act of 1946 states that "it is the continuing policy and the responsibility of the federal government to . . . promote full employment and production." This act has two implications. The first is that the government should avoid being a cause of economic fluctuations. The second is that the government should respond to changes in the private economy to stabilize aggregate demand. The act passed not long after the publication of Keynes' The General Theory of Employment, Interest, and Money, so the act does reflect some of the ideas noted in this book.

In the short run, which of the following statements is true about the effects of an increase in the money supply?

It will lower the cost of borrowing. An increase in the money supply reduces the equilibrium interest rate. Because the interest rate is the cost of borrowing, the fall in the interest rate raises the quantity of goods and services demanded at a given price level. This causes the aggregate-demand curve to shift to the right.

Refer to the figure. Which of the following is not correct? a. Only monetary policy could be used to move the economy from point b to point a. b. A wave of optimism could not move the economy from point a to point b. c. If the economy is left alone, then as the economy moves from point b to long-run equilibrium, the price level will fall further. d. Unemployment rises as the economy moves from point a to point b.

Only monetary policy could be used to move the economy from point b to point a. Since the root cause of the shift in aggregate demand is unknown, it is possible that either fiscal or monetary policy might have caused the shift from AD1 to AD2. A wave of optimism would cause an increase in aggregate demand and not a decrease as is shown in this figure. As a result of the decrease in aggregate demand, unemployment rises as the economy moves from point a to point b. If the economy is left alone, then as the economy moves from point b to long-run equilibrium, the price level will fall further.

Which of the following Fed actions would decrease the money supply?

Raising the reserve requirement When the Fed raises the reserve requirement, banks must keep more funds as reserves so the money supply decreases. When the Fed buys government bonds, the reserves of the banking system increase, so the money supply increases. Also, a decrease in the discount rate (the interest rate at which banks can borrow reserved from the Fed) encourages bank borrowing, which increases bank reserves and the money supply.

Which of the following statements about the multiplier effect is not true?

Tax reductions are said to have a multiplier effect on aggregate supply. The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy, such as increasing government purchases, increases income and thereby increases consumer spending. Additionally, the logic of the multiplier effect applies to any change in spending on any component of GDP.

Stabilization Figure 2: Refer to the figure. Suppose the economy is currently at point A. Which of the following policies would policymakers not recommend to restore full employment?

The Fed increases the money supply. If the economy is currently at point A, then a policy that decreases aggregate demand would restore the economy to full employment. When the Fed sells government bonds, it reduces the money supply, which causes aggregate demand to fall. Similarly, when the government engages in fiscal policy either by reducing government purchases or increasing taxes, this has a negative effect on aggregate demand.

Jason is a critic of stabilization policy. Which of the following statements would he not agree with?

The Fed should try to fine-tune the economy during times of economic fluctuations. The primary argument against active monetary and fiscal policy is that these policies affect the economy with a long lag. Most economists believe it takes at least six months for changes in monetary policy to have much effect on output and employment. In the case of fiscal policy, the lag is largely attributable to the political process. By the time the change in policy is passed and ready to implement, the condition of the economy may well have changed.

Which of the following statements is true about the Kennedy administration in the early 1960s?

The Kennedy administration made considerable use of fiscal policy to stimulate the economy. In the early 1960s, the Kennedy administration made considerable use of fiscal policy to stimulate the economy. In particular, the Kennedy tax cut of 1964 was designed to shift the aggregate-demand curve and aggregate-supply curve to the right, and it was successful in stimulating the economy.

Equilibrium in the Money Market Figure 1: Refer to the figure. On the graph that depicts the theory of liquidity preference, which of the following is not true?

The demand-for-money curve is vertical. On the graph that depicts the theory of liquidity preference, the horizontal axis represents the quantity of money, and the vertical axis represents the interest rate. Since the quantity of money supplied is fixed by Fed policy, the supply-of-money curve is vertical. However, the demand for money depends on the interest rate and therefore slopes downward.

Which of the following is an example of an increase in government purchases?

The government builds new bridges. Fiscal policy refers to the government's choices regarding the overall level of government purchases and taxes. When the government builds new bridges, this is an example of an increase in government purchases. However, when the Federal Reserve sells government bonds, this is an example of a monetary policy.

Slope of the Aggregate-Demand Curve Figure: Refer to the figure. Which of the following statements is not true?

The nominal interest rate is held constant as we move from one point to another on either graph. The horizontal axis of the left-hand graph is the quantity of money, and on the right-hand graph it is real output. As we move from one point to another on either graph, the expected inflation rate is held constant according to the theory of liquidity preference. In economies such as the U.S., the slope of the AD curve is primarily due to the interest-rate effect as opposed to the wealth effect or the exchange-rate effect.

According to the theory of liquidity preference, which of the following is not true? a. If the interest rate is above the equilibrium level, then the quantity of money people want to hold is less than the quantity of money the Fed has created. b. If the interest rate is below the equilibrium level, then the quantity of money people want to hold is greater than the quantity of money the Fed has created. c. The supply of money depends on the interest rate. d. The demand for money is represented by a downward-sloping line on a supply-and-demand graph.

The supply of money depends on the interest rate. Because the quantity of money supplied is fixed by Fed policy, it does not depend on the interest rate. However, the demand for money is represented by a downward-sloping line. According to the theory of liquidity preference, the interest rate adjusts to bring the quantity of money supplied and the quantity of money demanded into balance. If the interest rate is above the equilibrium level, the quantity of money people want to hold is less than the quantity the Fed has created, and vice versa.

If the Fed decreases the money supply, the interest rate increases.

True A decrease in the money supply increases the equilibrium interest rate since the money-demand curve is downward sloping.

The tax system is the most important automatic stabilizer.

True Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. The most important automatic stabilizer is the tax system. When the economy goes into a recession, the amount of taxes collected by the government falls automatically because almost all taxes are closely tied to economic activity. Other examples of automatic stabilizers include the unemployment compensation system and the welfare system.

Keynes would agree with the statement that irrational waves of pessimism cause aggregate demand to be unstable.

True Keynes argued that aggregate demand fluctuates because of largely irrational waves of pessimism and optimism. When pessimism exists, households reduce consumption spending and firms reduce investment spending, which causes a reduction in aggregate demand, lower production, and higher unemployment.

The multiplier effect amplifies the effects of an increase in government expenditures, while the crowding-out effect diminishes the effect.

True The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. Therefore, the multiplier effect amplifies the effects of an increase in government expenditures, while the crowding-out effect diminishes the effect.

The theory of liquidity preference only attempts to explain the nominal interest rate.

false According to liquidity preference theory, the opportunity cost of holding money is the interest rate. That is, when you hold wealth as cash in your wallet, instead of as an interest-bearing bond, you lose the interest you could have earned on that money.

Marta is having a policy debate with their cousin Natombi. Natombi points out that the political process is mostly responsible for the lag in implementing _______.

fiscal policy The primary argument against active monetary and fiscal policy is that these policies affect the economy with a long lag. Monetary policy works by changing interest rates, which in turn influence investment spending, but many firms make investment plans far in advance. Therefore, most economists believe it takes at least six months for changes in monetary policy to have much effect on output and employment. In the case of fiscal policy, the lag is largely attributable to the political process. By the time the change in policy is passed and ready to implement, the condition of the economy may well have changed.

Steve is having a policy debate with his brother Brian. He points the fact that business firms make investment plans far in advance. This is a lag problem associated with _______.

monetary policy The primary argument against active monetary and fiscal policy is that these policies affect the economy with a long lag. Monetary policy works by changing interest rates, which in turn influence investment spending, but many firms make investment plans far in advance. Therefore, most economists believe it takes at least six months for changes in monetary policy to have much effect on output and employment. In the case of fiscal policy, the lag is largely attributable to the political process. By the time the change in policy is passed and ready to implement, the condition of the economy may well have changed.

The government builds a new recycling plant. The manager of the company hires workers and pays them an annual salary. These workers then increase their spending. The firms that sell the goods these workers buy also increase their output. This type of effect on spending illustrates the _______.

multiplier effect The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy, such as increasing government purchases, increases income and thereby increases consumer spending. Therefore, this scenario is an example of the multiplier effect.

Assume the MPC is 0.6. Assume there is a multiplier effect and that the crowding-out effect is $10 billion. An increase in government purchases of $20 billion will shift aggregate demand to the _______.

right by $40 billion The spending multiplier is calculated as 1/(1 - MPC). Because the MPC = 0.6, this means the multiplier is 1/(1 - 0.6) = 1/(0.4) = 2.5. This means that in the absence of crowding out, a $20 billion increase in government purchases will shift the aggregate demand curve to the right by 2.5 x $20 billion = $50 billion. The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. Therefore, accounting for the crowding-out effect, the aggregate demand curve will only shift to the right by $50 billion - $10 billion = $40 billion.

An increase in U.S. net exports would shift U.S. aggregate demand _______.

rightward; in an attempt to stabilize the economy, the government could decrease expenditures An increase in U.S. net exports shifts U.S. aggregate demand to the right. This would cause the level of output in the economy to rise. If the government wants to stabilize output, it could decrease expenditures which would shift aggregate demand leftward and return output to its previous level.

If money demand shifted to the left and the Federal Reserve desired to return the interest rate to its original value, it could _______.

sell bonds to decrease the money supply If the money-demand curve shifted to the left, this lowers the interest rate. In order to return the interest rate to its original value, the Fed would need to conduct an open-market operation that decreases the money supply since that will put upward pressure on the equilibrium interest rate. This occurs when the Fed sells bonds to the public.

To stabilize interest rates, the Federal Reserve will respond to a decrease in money demand by _______.

selling government bonds, which decreases the supply of money A decrease in money demand causes the interest rate to fall. If the Federal Reserve wants to stabilize the interest rate, it needs to decrease the supply of money to put upward pressure on interest rates. When the Fed sells government bonds, this open-market operation causes money supply to fall.

Government Purchases Figure: Refer to the figure. A decrease in government purchases will _______.

shift aggregate demand from AD1 to AD3 Fiscal policy refers to the government's choices regarding the overall level of government purchases and taxes. When the government decreases government purchases, this directly lowers aggregate demand, causing the aggregate-demand curve to shift from AD1 to AD3.

According to liquidity preference theory, an increase in money demand for some reason other than a change in the price level causes _______.

the interest rate to rise, so aggregate demand shifts left An increase in money demand causes the money-demand curve to shift to the right. This causes a rise in the equilibrium interest rate. Because the interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods and services demanded at a given price, so aggregate demand shifts left.

The fraction of extra income that a household consumes rather than saves is called _______.

the marginal propensity to consume The marginal propensity to consume is the fraction of extra income that a household consumes rather than saves. Fiscal policy refers to the government's choices regarding the overall level of government purchases and taxes, whereas the multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

In a certain economy, when income is $200, consumer spending is $160. The value of the multiplier for this economy is 4. It follows that, when income is $300, consumer spending is _______.

$235 The spending multiplier is calculated as 1/(1 - MPC). Rearranging this equation yields MPC = 1 - (1/Multiplier). Therefore, if the multiplier is 4, then the MPC is 1- (1/4) = 0.75. If income increases by $300 - $200 = $100, then consumer spending will rise by 0.75 x $100 = $75, to $160 + $75 = $235.

Crowding Out Figure: Refer to the figure. Suppose the multiplier is 4 and the government increases its purchases by $10 billion. Also, suppose the AD curves would shift from AD1 to AD2 if there were no crowding out; the AD curve actually shifts from AD1 to AD3 with crowding out. Also, suppose the horizontal distance between the curves AD1 and AD3 is $35 billion. The extent of crowding out, for any particular level of the price level, is _______.

$5 billion The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. If the multiplier is 4 and the government increases its purchases by $10 billion, this means that the aggregate demand curve will shift to the right by 4 x $10 billion = $40 billion. The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. Because the distance between AD1 and AD3 is $35 billion, this means the extent of crowding out is $40 billion - $35 billion = $5 billion.

Take the following information as given for small, imaginary economy: When income is $10,000, consumption spending is $6,500. When income is $11,000, consumption spending is $7,100. The marginal propensity to consume for this economy is _______.

0.60 The marginal propensity to consume is the fraction of extra income that a household consumes rather than saves. In this case, an extra $1,000 of income increases spending by $600. This increase represents a $600/$1,000=0.60 fraction of the increase in income.

If the multiplier is 5, then the MPC is _______.

0.8 The multiplier for changes in government spending is calculated as 1/(1 - MPC). Rearranging this equation yields MPC = 1 - (1/Multiplier). Therefore, if the multiplier is 5, then the MPC is 1- (1/5) = 0.8.

If the marginal propensity to consume is 2/3, then the government purchases multiplier is _______.

3 The multiplier for changes in government spending is calculated as 1/(1 - MPC). Since the MPC = 2/3 in this case, the multiplier is 1/(1 - 2/3) = 1/(1/3) = 3.

Which of the following policy actions does not shift the aggregate-demand curve?

A change in the price level Fiscal policy such as a decrease in taxes or an increase in government spending shifts the aggregate-demand curve. Similarly, monetary policy such as the Fed conducting open-market operations also shifts the aggregate-demand curve. Because the aggregate demand curve represents the relationship between the price level and the quantity of output, a change in the price level causes a movement along the aggregate-demand curve.

Which of the following does fiscal policy not primarily affect in the long run?

Aggregate demand In the long run, fiscal policy influences saving, investment, and growth. In the short run, it affects primarily aggregate demand.

Which of the following illustrates how the investment accelerator works?

An increase in government expenditures increases aggregate spending so that Starshine Inc. finds it profitable to update its car-wash equipment. When higher government spending spurs higher demand for investment goods, this positive feedback from demand to investment is called the investment accelerator. In this case, an increase in government expenditures that increases aggregate spending and encourages Starshine Inc. to invest in newer car-wash equipment is an example of the investment accelerator.

Which of the following is not an automatic stabilizer?

An increase in money supply Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Some examples of automatic stabilizers include the unemployment compensation system, the federal income tax, and the welfare system.

Which of the following Fed actions would increase the money supply?

Buying bonds When the Fed buys government bonds, the reserves of the banking system increase, so the money supply increases. When the Fed raises the reserve requirement, banks must keep more funds as reserves so the money supply decreases. Also, an increase in the discount rate (the interest rate at which banks can borrow reserved from the Fed) discourages bank borrowing, which decreases bank reserves and the money supply.

Which of the following policies would Keynes's followers support when a decrease in business optimism shifts the aggregate-demand curve away from long-run equilibrium?

Decrease taxes If business optimism dampens, this would cause the aggregate-demand curve to shift to the left. Followers of Keynes would argue that aggregate demand needs to be stimulated. A decrease in government expenditures, the selling of bonds to the public, and a decrease of the money supply, cause aggregate demand to shift further to the left. However, a decrease in taxes causes aggregate demand to increase, which would counteract the effect of a decline in business optimism.

Which among the following assets is the most liquid?

Deposits that can be withdrawn using ATMs An asset's liquidity refers to the ease at with which that asset can be converted into the economy's medium of exchange. Because money is the economy's medium of exchange, it is by definition the most liquid asset available. Therefore, of the assets listed, deposits that can be withdrawn using ATMs are the most liquid.

The interest-rate effect stems from the idea that a higher price level decreases the real value of households' money holdings.

False The wealth effect, not the interest-rate effect, stems from the idea that a higher price level decreases the real value of households' money holdings. Instead, the interest-rate effect depends on the idea that decreases in interest rates increase the quantity of goods and services demanded.

Equilibrium in the Money Market Figure 2: Refer to the figure. Which of the following is true?

If the current interest rate is 2 percent, people will sell more bonds, which drives interest rates up. If the current interest rate is 2 percent, there is an excess demand for money. Therefore, people will sell more bonds, which drives interest rates up to the equilibrium rate of 3 percent.

Which of the following is an example of an automatic stabilizer? a. An increase in money demand b. An increase in tax rates in response to an expansion c. The minimum wage d. The unemployment compensation system

The unemployment compensation system Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Some examples of automatic stabilizers include unemployment benefits, the federal income tax, and the welfare system.

If the interest rate is below the Fed's target, the Fed should sell bonds to decrease the money supply.

True If the interest rate is below the Fed's target, then the Fed should conduct open-market operations that would raise the interest rate. Because a decrease in the money supply would raise the equilibrium interest rate to rise, the Fed should sell bonds to lower the money supply.

If the stock market booms, then _______.

aggregate demand increases, which the Fed could offset by selling government bonds If the stock market booms, then aggregate demand increases. If the Fed wants to offset this, it needs to conduct open-market operations that decrease aggregate demand. This can be achieved through selling government bonds which decreases the money supply, raises the interest rate, and lowers aggregate demand.

Changes in taxes or government spending that increase aggregate demand without requiring policy makers to act when the economy goes into a recession are called _______.

automatic stabilizers Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Stabilization policies are enacted by the government or Fed and may result in time lags.

If the Federal Reserve decided to lower interest rates, it could _______.

buy bonds to raise the money supply If the Fed buys government bonds in open-market operations, it will increase the money supply. This reduces the equilibrium interest rate which raises the quantity of goods and services demanded at a given price level.

If expected inflation is constant and the nominal interest increases by 3 percentage points, then the real interest rate _______.

increases by 3 percentage points The nominal interest rate is the real interest rate plus the expected rate of inflation. If expected inflation is constant and the nominal interest rate increases by 3 percentage points, then the real interest rate must also increase by 3 percentage points.

Temporary tax cuts shift the aggregate-demand curve _______.

not as far to the right as do permanent tax cuts If consumers believe a tax cut to be permanent, they will view the increased take-home pay as adding substantially to their financial resources and increase their spending by a large amount. By contrast, if households expect the tax change to be temporary, they will view it as adding only slightly to their financial resources and will increase their spending by only a small amount.