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MACRO: Policies and Theories Flashcards

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  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?

    Answer: AD falls by $200 billion

    The spending multiplier amplifies the initial change, so a $100B cut reduces AD by $100B × 2 = $200 billion.

  2. Which school of thought argues that the economy self-corrects in the long run, making active fiscal policy unnecessary?

    Answer: Classical economics

    Classical economists believe flexible wages and prices restore full employment automatically, so government intervention is unnecessary.

  3. The Taylor Rule is a guideline that suggests central banks should adjust the federal funds rate based on which two variables?

    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.

  4. Supply-side economics primarily advocates which of the following to stimulate long-run economic growth?

    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.

  5. What does the concept of 'crowding out' suggest happens when the government borrows heavily in the loanable funds market?

    Answer: Private investment declines as interest rates rise

    Government borrowing increases the demand for loanable funds, raising interest rates and reducing private sector investment.

  6. In the Mundell-Fleming model for a small open economy with a fixed exchange rate, fiscal policy is:

    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.

  7. The liquidity trap, associated with Keynesian theory, describes a situation where:

    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.