AP Macro MACRO: Policies and Theories 2 — Questions and Answers
Question 1: According to the Keynesian model, what happens to aggregate demand when the government cuts spending by $100 billion, assuming a spending multiplier of 2?
- AD falls by $50 billion
- AD falls by $100 billion
- AD falls by $200 billion (Correct answer)
- AD is unchanged because taxes offset the cut
Correct answer: AD falls by $200 billion
The spending multiplier amplifies the initial change, so a $100B cut reduces AD by $100B × 2 = $200 billion.
Question 2: Which school of thought argues that the economy self-corrects in the long run, making active fiscal policy unnecessary?
- Keynesian economics
- Classical economics (Correct answer)
- Behavioral economics
- Post-Keynesian economics
Correct answer: Classical economics
Classical economists believe flexible wages and prices restore full employment automatically, so government intervention is unnecessary.
Question 3: The Taylor Rule is a guideline that suggests central banks should adjust the federal funds rate based on which two variables?
- Unemployment rate and exchange rate
- Inflation and output gap (Correct answer)
- Money supply and government debt
- Trade balance and consumer confidence
Correct answer: Inflation and output gap
The Taylor Rule prescribes adjusting the policy interest rate in response to deviations of inflation from its target and output from potential.
Question 4: Supply-side economics primarily advocates which of the following to stimulate long-run economic growth?
- Increased government spending on infrastructure
- Higher tariffs to protect domestic industries
- Tax cuts and deregulation to boost productive capacity (Correct answer)
- Expansionary monetary policy to lower interest rates
Correct answer: Tax cuts and deregulation to boost productive capacity
Supply-side economists argue that reducing taxes and regulation increases incentives to work, save, and invest, shifting LRAS rightward.
Question 5: What does the concept of 'crowding out' suggest happens when the government borrows heavily in the loanable funds market?
- Private investment rises due to higher confidence
- Interest rates fall, stimulating more borrowing
- Private investment declines as interest rates rise (Correct answer)
- The money supply automatically expands
Correct answer: Private investment declines as interest rates rise
Government borrowing increases the demand for loanable funds, raising interest rates and reducing private sector investment.
Question 6: In the Mundell-Fleming model for a small open economy with a fixed exchange rate, fiscal policy is:
- Highly effective because monetary policy accommodates it (Correct answer)
- Ineffective because capital flows offset the stimulus
- Effective only in the short run but not the long run
- Harmful because it always causes inflation
Correct answer: Highly effective because monetary policy accommodates it
With a fixed exchange rate, the central bank must expand money supply to maintain the peg, so fiscal expansion is fully effective.
Question 7: The liquidity trap, associated with Keynesian theory, describes a situation where:
- Banks refuse to lend despite ample reserves
- Monetary policy becomes ineffective because people hoard money at near-zero interest rates (Correct answer)
- Consumers spend all income, leaving no savings
- The velocity of money rises sharply
Correct answer: Monetary policy becomes ineffective because people hoard money at near-zero interest rates
In a liquidity trap, interest rates are so low that individuals prefer holding cash over bonds, making further monetary easing ineffective.
AP Macro MACRO: Policies and Theories 2
According to the Keynesian model, what happens to aggregate demand when the government cuts spending by $100 billion, assuming a spending multiplier of 2?