CEA Monetary and Fiscal Policy 4 — Questions and Answers
Question 1: The 'sacrifice ratio' in monetary economics measures:
- The cost in lost output per percentage point reduction in inflation (Correct answer)
- The trade-off between deficit spending and economic growth
- How much reserves banks sacrifice when meeting reserve requirements
- The reduction in government revenue from tax cuts relative to GDP growth
Correct answer: The cost in lost output per percentage point reduction in inflation
The sacrifice ratio is the cumulative percentage loss in real GDP (or rise in unemployment) required to reduce inflation by one percentage point.
Question 2: A steepening yield curve (short rates falling relative to long rates) typically signals:
- Tighter monetary policy and lower expected inflation
- Easier monetary conditions and higher expected future growth or inflation (Correct answer)
- A deflationary spiral driven by fiscal contraction
- Declining confidence in long-term government debt sustainability
Correct answer: Easier monetary conditions and higher expected future growth or inflation
A steepening yield curve usually reflects central bank rate cuts (lowering short rates) combined with market expectations of stronger future growth or higher inflation.
Question 3: The primary goal of the Federal Reserve's dual mandate is to achieve:
- Price stability and balanced federal budgets
- Maximum employment and stable prices (Correct answer)
- Economic growth and a stable dollar exchange rate
- Full employment and positive current account balance
Correct answer: Maximum employment and stable prices
The Federal Reserve is legally mandated to pursue maximum employment and stable prices (approximately 2% inflation), with no direct mandate for fiscal balance or exchange rates.
Question 4: Which situation would most likely cause a fiscal multiplier to be larger?
- An economy operating at full capacity with low unemployment
- An open economy with high propensity to import
- A closed economy in a deep recession with idle resources (Correct answer)
- An economy with a highly responsive monetary policy tightening
Correct answer: A closed economy in a deep recession with idle resources
Fiscal multipliers are larger when there is economic slack (idle resources), limited monetary policy offset, and low import leakage, as in a closed recessionary economy.
Question 5: Central bank 'sterilization' of foreign exchange interventions means:
- Preventing currency appreciation by buying foreign bonds
- Offsetting domestic monetary effects of FX interventions via open market operations (Correct answer)
- Removing old currency notes from circulation after FX purchases
- Restricting banks from trading foreign currency
Correct answer: Offsetting domestic monetary effects of FX interventions via open market operations
Sterilization involves using open market operations to offset the domestic money supply effect of foreign exchange interventions, keeping monetary conditions unchanged.
Question 6: The 'debt monetization' concern arises when:
- Foreign investors buy a majority of government bonds
- The central bank permanently buys government debt, expanding the money supply (Correct answer)
- Government deficits are financed through higher taxes rather than borrowing
- The debt-to-GDP ratio stabilizes at a high level
Correct answer: The central bank permanently buys government debt, expanding the money supply
Debt monetization occurs when the central bank purchases and holds government bonds, effectively financing deficits by printing money and risking inflation.
Question 7: Under contractionary monetary policy, the transmission mechanism to the real economy primarily works through:
- Lower taxes reducing disposable income and consumer spending
- Higher interest rates reducing investment, housing, and consumer credit spending (Correct answer)
- Currency depreciation raising import prices and reducing purchasing power
- Government spending cuts reducing public sector employment directly
Correct answer: Higher interest rates reducing investment, housing, and consumer credit spending
Higher policy rates raise borrowing costs throughout the economy, dampening business investment, housing activity, and consumer credit-financed spending.
CEA Monetary and Fiscal Policy 4
The 'sacrifice ratio' in monetary economics measures: