CEA Monetary and Fiscal Policy 3 — Questions and Answers
Question 1: The money multiplier in a fractional reserve banking system is calculated as:
- 1 divided by the reserve ratio (Correct answer)
- The reserve ratio times the monetary base
- The velocity of money divided by real GDP
- Total deposits minus required reserves
Correct answer: 1 divided by the reserve ratio
The simple money multiplier equals 1/reserve ratio, showing how much the money supply can expand for each dollar of base money injected into the banking system.
Question 2: Which fiscal policy tool is considered an automatic stabilizer?
- Discretionary defense spending increases
- Emergency infrastructure appropriations
- Progressive income taxes and unemployment insurance (Correct answer)
- Central bank asset purchase programs
Correct answer: Progressive income taxes and unemployment insurance
Progressive income taxes and unemployment insurance automatically shrink during expansions and expand during recessions without legislative action, stabilizing the economy.
Question 3: Quantitative easing (QE) differs from traditional monetary policy primarily because it:
- Targets the federal funds rate rather than reserves
- Involves purchasing longer-term assets to inject liquidity beyond the zero lower bound (Correct answer)
- Requires congressional approval unlike rate changes
- Only affects the money supply through reserve requirements
Correct answer: Involves purchasing longer-term assets to inject liquidity beyond the zero lower bound
QE involves large-scale purchases of longer-term securities to lower long-term rates and inject liquidity when conventional rate cuts are constrained by the zero lower bound.
Question 4: Under a fixed exchange rate regime, a country's monetary policy is most constrained because:
- The government cannot run budget deficits without devaluing the currency
- The central bank must prioritize exchange rate stability over domestic goals (Correct answer)
- Inflation automatically increases with fiscal expansion
- Capital controls are required to maintain the exchange rate
Correct answer: The central bank must prioritize exchange rate stability over domestic goals
With a fixed exchange rate, the central bank must adjust monetary policy to maintain the peg, sacrificing independence over domestic objectives like inflation or employment.
Question 5: Which scenario best illustrates 'fiscal dominance'?
- The legislature sets interest rates to support government bond sales
- Government borrowing needs force the central bank to monetize deficits (Correct answer)
- The finance ministry directs central bank reserve requirements
- Congress determines the inflation target instead of the Fed
Correct answer: Government borrowing needs force the central bank to monetize deficits
Fiscal dominance occurs when large government deficits pressure the central bank to create money to finance debt, undermining its anti-inflation mandate.
Question 6: The Ricardian Equivalence hypothesis suggests that deficit-financed tax cuts:
- Are more stimulative than spending increases of equal size
- Have no effect on aggregate demand because consumers save the tax cut to pay future taxes (Correct answer)
- Permanently reduce national savings and raise interest rates
- Stimulate consumption only in the short run before crowding out occurs
Correct answer: Have no effect on aggregate demand because consumers save the tax cut to pay future taxes
Ricardian Equivalence holds that rational consumers anticipate future tax increases to repay debt and therefore save rather than spend current tax cuts, neutralizing fiscal stimulus.
Question 7: Which of the following would shift the LM curve to the right?
- An increase in the price level
- A reduction in the money supply
- A decrease in income tax rates
- An increase in the nominal money supply (Correct answer)
Correct answer: An increase in the nominal money supply
An increase in the nominal money supply shifts the LM curve rightward, lowering interest rates at each income level and stimulating economic activity.
CEA Monetary and Fiscal Policy 3
The money multiplier in a fractional reserve banking system is calculated as: