CEA Monetary and Fiscal Policy 5 — Questions and Answers
Question 1: The 'time inconsistency' problem in monetary policy refers to:
- Delays between policy implementation and economic effects
- The incentive for central banks to renege on low-inflation commitments to boost output (Correct answer)
- The lag between fiscal stimulus passage and spending disbursement
- Conflicting inflation targets set by different central bank governors over time
Correct answer: The incentive for central banks to renege on low-inflation commitments to boost output
Time inconsistency describes how a central bank that committed to low inflation may later find it optimal to allow higher inflation to reduce unemployment, undermining credibility.
Question 2: Which of the following best defines 'seigniorage'?
- Revenue the government earns from issuing currency at low production cost (Correct answer)
- Profit earned by commercial banks on the spread between lending and deposit rates
- The tax revenue lost due to tax-exempt government bond interest
- Fees charged by the Federal Reserve for clearing interbank payments
Correct answer: Revenue the government earns from issuing currency at low production cost
Seigniorage is the profit the government earns by issuing currency whose face value exceeds its production cost, effectively a revenue source from money creation.
Question 3: In the IS-LM framework, expansionary fiscal policy in a liquidity trap has:
- No effect because the LM curve is perfectly elastic (horizontal)
- Maximum effect because monetary policy cannot crowd out fiscal stimulus (Correct answer)
- Minimal effect because the IS curve is perfectly inelastic
- No effect because the LM curve becomes perfectly inelastic
Correct answer: Maximum effect because monetary policy cannot crowd out fiscal stimulus
In a liquidity trap the LM curve is flat, so IS curve shifts from fiscal expansion raise output without raising interest rates, eliminating crowding out.
Question 4: Which metric best captures whether fiscal policy is expansionary or contractionary independent of automatic stabilizers?
- The nominal budget deficit as a percent of GDP
- The cyclically adjusted (structural) budget deficit (Correct answer)
- The change in total government spending year over year
- The ratio of tax revenue to government expenditures
Correct answer: The cyclically adjusted (structural) budget deficit
The cyclically adjusted deficit removes automatic stabilizer effects, isolating discretionary fiscal policy changes that reflect active government policy choices.
Question 5: The 'portfolio balance channel' of QE suggests that asset purchases stimulate the economy by:
- Forcing banks to lend excess reserves to the private sector
- Pushing investors into riskier assets by reducing returns on safe assets purchased (Correct answer)
- Directly financing consumer spending via central bank transfers
- Lowering the overnight federal funds rate below the zero lower bound
Correct answer: Pushing investors into riskier assets by reducing returns on safe assets purchased
By purchasing safe assets like Treasuries, QE reduces their yields and induces investors to rebalance into riskier assets like corporate bonds and equities, easing financial conditions.
Question 6: A country running persistent twin deficits (budget and current account) is most at risk from:
- Deflation caused by excess domestic saving relative to investment
- Sudden capital flow reversals if foreign investor confidence deteriorates (Correct answer)
- An overvalued currency reducing the cost of debt service
- Excessive domestic investment crowding out government borrowing
Correct answer: Sudden capital flow reversals if foreign investor confidence deteriorates
Twin deficit countries rely heavily on foreign capital inflows; if confidence falters, sudden stops or reversals can trigger currency crises and financial instability.
Question 7: Which of the following policy combinations would most effectively reduce inflation without causing a severe recession?
- Highly contractionary monetary policy paired with expansionary fiscal policy
- Gradual monetary tightening combined with credible central bank inflation targets (Correct answer)
- Immediate large rate hikes with simultaneous large tax increases
- Quantitative easing combined with reduced government spending
Correct answer: Gradual monetary tightening combined with credible central bank inflation targets
Gradual, credible monetary tightening anchors inflation expectations and reduces the sacrifice ratio, lowering inflation at a smaller cost to employment and output.
CEA Monetary and Fiscal Policy 5
The 'time inconsistency' problem in monetary policy refers to: