Deck 16: Alternative Perspectives on Stabilization Policy

Question 1

Macroeconometric models of the economy:

A)usually consist of only a few equations.
B)require no assumptions about monetary and fiscal policy.
C)require assumptions about monetary and fiscal policy.
D)give excellent predictions, regardless of assumptions about monetary and fiscal policy.

Answer 1

require assumptions about monetary and fiscal policy.

Question 2

The time between a policy action and its influence on the economy is called the:

A)automatic stabilizer.
B)time inconsistency of policy.
C)inside lag.
D)outside lag.

Answer 2

outside lag.

Question 3

Which of the following is an example of a fiscal policy that has no inside lag?

A)a decrease in income tax rates
B)an ongoing employment-insurance program
C)an increase in government spending for job training
D)a reduction in the age at which people become eligible for retirement benefits

Answer 3

an ongoing employment-insurance program

Question 4

Arguments in favour of active economic policy include all of the following except:

A)failing to use monetary and fiscal policy leads to inefficient fluctuations in output and employment.
B)policymakers can make precise forecasts about the economy and the effects of their policies.
C)fluctuations in real GDP have been less severe following World War II than prior to World War I.
D)failure of policymakers to respond to large contractionary shocks to private spending caused the Great Depression.

Question 5

Arguments in favour of passive economic policy include all of the following except:

A)monetary and fiscal policies work with long and variable lags, which can produce destabilizing results.
B)economic forecasts have too large a margin of error to be useful in formulating stabilization policy.
C)recessions do not reduce economic well-being, so using monetary and fiscal policy for stabilization is unnecessary.
D)it is difficult to assess the effects of different policies on the economy.

Question 6

Active economic policy seeks to do all of the following except:

A)offset fluctuations in real GDP.
B)use monetary and fiscal policy to shift aggregate demand.
C)respond to changing economic conditions.
D)take a hands-off approach to macroeconomic policy.

Question 7

The lags involved in implementing monetary and fiscal policy are:

A)short and predictable.
B)long and predictable.
C)short and variable.
D)long and variable.

Question 8

The lag between the time that economic stimulus is needed and the time that a tax cut is passed by Parliament is an example of a:

A)fiscal inside lag.
B)fiscal outside lag.
C)monetary inside lag.
D)monetary outside lag.

Question 9

Policies that stimulate or depress the economy without any deliberate policy change are called:

A)leading indicators.
B)time-inconsistent policies.
C)rational expectations policies.
D)automatic stabilizers.

Question 10

The time between when a recession begins and when the central bank lowers interest rates to stimulate aggregate demand is an example of an:

A)inside lag of monetary policy.
B)outside lag of monetary policy.
C)inside lag of fiscal policy.
D)outside lag of fiscal policy.

Question 11

Advocates of passive policy argue that because monetary and fiscal policy lags are:

A)short and fixed, these policies should not be used to offset shocks.
B)long and variable, these policies should not be used to offset shocks.
C)short and fixed these, policies should be used to offset shocks.
D)long and variable these, policies should be used to offset shocks.

Question 12

The lag between the time that the money supply is increased and the time that investment expenditures increase is an example of a:

A)fiscal inside lag.
B)fiscal outside lag.
C)monetary inside lag.
D)monetary outside lag.

Question 13

Fiscal policy has a relatively long _____ lag, and monetary policy has a relatively long _____ lag.

A)inside; outside
B)outside; inside
C)inside; inside
D)outside; outside

Question 14

The time between when government spending increases and when aggregate demand starts to increase is an example of an:

A)inside lag of monetary policy.
B)outside lag of monetary policy.
C)inside lag of fiscal policy.
D)outside lag of fiscal policy.

Question 15

All of the following could be considered automatic stabilizers except:

A)transfer payments that increase during recessions.
B)discretionary changes in taxes.
C)a system of employment insurance.
D)the federal income tax.

Question 16

Automatic stabilizers:

A)require a vote from Parliament before each time they are put into effect.
B)have no outside lag.
C)have no inside lag.
D)have long and variable inside lags.

Question 17

Economists who view the economy as inherently unstable generally argue that:

A)stabilization policy is too dangerous to be used.
B)the economy should be stimulated when it is depressed and slowed when it is overheated.
C)the economy should be slowed when it is depressed and stimulated when it is overheated.
D)monetary and fiscal policies should follow rigid rules of constant growth.

Question 18

The time between a shock to the economy and the policy action responding to that shock is called the:

A)automatic stabilizer.
B)time inconsistency of policy.
C)inside lag.
D)outside lag.

Question 19

Economists who view the economy as naturally stable often argue that:

A)monetary and fiscal policies should not be used to fine-tune the economy.
B)the economy should be stimulated when it is depressed and slowed when it is overheated.
C)the economy should be slowed when it is depressed and stimulated when it is overheated.
D)economists should act to stimulate or slow the economy on the basis of forecasts in order to assure that the policy actions are timely.

Question 20

Increasing government spending when the economy is in a recession is an example of:

A)active monetary policy.
B)active fiscal policy.
C)passive monetary policy.
D)passive fiscal policy.

Question 21

Policymakers may be better able to achieve their goals using a fixed policy rule rather than using discretion if they face the problem of:

A)short and predictable inside lags.
B)time-inconsistent policy.
C)short and predictable outside lags.
D)weak automatic stabilizers.

Question 22

The Lucas critique argues that because the way people form expectations is based _____ on government policies, economists _____ predict the effect of a change in policy without taking changing expectations into account.

A)partly; cannot
B)only partly; can
C)in no way; can
D)in no way; cannot

Question 23

A time-inconsistency problem in macroeconomic policy can occur when the policymaker:

A)is made to follow a strict and an inflexible rule.
B)has discretion in the short run but follows a rule in the long run.
C)changes stated policy because it benefits their current circumstance at the expense of public trust.
D)has no discretion.

Question 24

The political business cycle refers to the:

A)pattern of holding general elections every four years.
B)cycle of municipal, provincial, and federal elections at various times.
C)manipulation of the economy to win elections.
D)pattern of recession and expansion that follows every election.

Question 25

Conducting monetary policy so that the overnight rate = 0.05, where the overnight rate is the nominal overnight interest rate, is an example of:

A)an active policy rule.
B)a passive policy rule.
C)discretionary policy.
D)an automatic stabilizer.

Question 26

The differing interpretations of the historical record of the Great Depression provide support for using:

A)active macroeconomic policy only.
B)passive macroeconomic policy only.
C)either active or passive macroeconomic policy.
D)neither active nor passive macroeconomic policy.

Question 27

An argument in favour of allowing discretionary macroeconomic policy is that:

A)policymakers may make erratic shifts in policy in response to changing political situations.
B)uninformed policymakers may choose incorrect policies.
C)the objectives of policymakers may be in conflict with the well-being of the public.
D)giving policymakers flexibility will allow them to respond to changing conditions.

Question 28

Conducting fiscal policy so that G = T, where G is government expenditures and T is tax revenue, is an example of a(n):

A)active rule.
B)passive rule.
C)discretionary policy.
D)automatic stabilizer.

Question 29

Conducting monetary policy so that the overnight rate = π + 0.5(π - 2) + 0.5 (GDP gap), where the overnight rate is the nominal overnight interest rate, π is the annual inflation rate, and GDP gap is the percentage shortfall of real GDP from its natural level, is an example of:

A)an active policy rule.
B)a passive policy rule.
C)discretionary policy.
D)an automatic stabilizer.

Question 30

According to the Lucas critique, when economists evaluate alternative policies they must take into consideration:

A)how the policies will affect expectations and behaviour.
B)whether the policy will offset the impact of automatic stabilizers.
C)the stage of the political business cycle in which the policy is to be implemented.
D)the length of the inside lags associated with the policies.

Question 31

What are two types of tools that economists use to forecast future economic developments?

A)leading indicators and macroeconometric models
B)direct imputations and indirect attributions
C)visual assessment and global positioning
D)monetary instruments and fiscal instruments

Question 32

Policy is conducted by rule if policymakers:

A)announce in advance how policy will respond to various situations and commit themselves to following through on this announcement.
B)are free to size up the situation case by case and choose whatever policy seems appropriate at the time.
C)set policy according to election results, i.e., set policy by rule of the ballot box.
D)manipulate policy to ensure both low inflation and unemployment on election day.

Question 33

If people's expectations of inflation are formed rationally rather than based on adaptive expectations and if policymakers make a credible policy move to reduce inflation, then the costs of reducing inflation will be _____ traditional estimates of the sacrifice ratio.

A)much higher than
B)much lower than
C)exactly equal to
D)approximately two percent greater than

Question 34

If the Bank of Canada has discretion to choose its own policy and announces a policy of low inflation, then:

A)the policymaker is required to make the money supply grow at a low rate.
B)private economic agents are sure to believe the announcement because it is credible.
C)private economic actors are likely to discount the policy because the Bank of Canada has an incentive to renege on its policy once expectations are formed.
D)the Bank of Canada is certain to renege on its policy once expectations are formed because then it can lower unemployment with minimum inflation.

Question 35

According to Christina Romer, the reduction in real economic volatility in the period since World War II compared to the period before World War I is the result of improved economic:

A)policy.
B)performance.
C)data.
D)forecasting.

Question 36

If all past economic fluctuations resulted from inept economic policies, then the historical evidence would support using:

A)active macroeconomic policy only.
B)passive macroeconomic policy only.
C)either active or passive macroeconomic policy.
D)neither active nor passive macroeconomic policy.

Question 37

A policy rule:

A)must specify money growth at a constant rate.
B)must specify an active policy.
C)must specify a passive policy.
D)may specify either an active or a passive policy.

Question 38

Conducting fiscal policy so that G = T + β (u - u_n), where G is government expenditures, T is tax revenue, u is the unemployment rate, u_n is the natural rate of unemployment, and β is a positive number, is an example of a(n):

A)active rule.
B)passive rule.
C)discretionary policy.
D)automatic stabilizer.

Question 39

Policy is conducted by discretion if policymakers:

A)announce in advance how policy will respond to various situations and commit themselves to following through on this announcement.
B)are free to size up the situation case by case and choose whatever policy seems appropriate at the time.
C)announce and maintain a constant growth rate of the money supply.
D)announce and achieve a balanced government budget.

Question 40

According to advocates of rational expectations, traditional estimates of the sacrifice ratio are unreliable because they:

A)ignore inside lags.
B)overestimate outside lags.
C)are based on adaptive expectations.
D)are time inconsistent.

Question 41

Central-bank independence refers to:

A)whether central banks pursue monetary policy by rules or discretion.
B)the situation that occurs when the inside lag of monetary policy is not related to the outside lag.
C)the extent to which automatic stabilizers are relied on to cushion economic volatility.
D)the degree of separation between central-bank decision making and political influence.

Question 42

Monetarists believe all of the following except:

A)fluctuations in the money supply are responsible for most fluctuations in the economy.
B)the Bank of Canada should keep the money supply growing at a steady rate.
C)slow and steady growth of the money supply would yield stable output, employment, and prices.
D)the Bank of Canada should adjust the money supply to adjust to various shocks to the economy.

Question 43

As U.S. Secretary of the Treasury, Alexander Hamilton opposed the time-inconsistent policy of:

A)repaying debt.
B)raising taxes.
C)repudiating debt.
D)reducing taxes.

Question 44

In practice, inflation targeting is better considered as operating with constrained discretion rather than according to a policy rule because central banks with inflation targets typically:

A)are not allowed to adjust the target in the event of shocks.
B)set the inflation target as a range rather than as a particular number.
C)are not held accountable for achieving their target.
D)must achieve their target regardless of economic conditions.

Question 45

The Phillips curve describing an economy takes the form u = uⁿ - α(π - Eπ). The central bank directly sets the inflation rate to minimize the following loss function, L (u, π) = u + γπ². The symbol u denotes the unemployment rates, uⁿ is the natural rate of unemployment, π is the inflation rate, Eπ is the expected inflation rate, and α and γ are behavioural response parameters of the economy. Private agents form their expectations rationally before the central bank sets the inflation rate. In an economy in which the central bank dislikes inflation much more than unemployment:

A)α will be very large.
B)a will be very small.
C)γ will be very large.
D)γ will be very small.

Question 46

Economic science has provided convincing evidence in favour of the:

A)rule favouring a constant rate of growth of the money supply.
B)rule favouring use of the money supply to hit a nominal GDP target.
C)rule requiring a constantly balanced budget for the federal government.
D)fact that there is no simple and compelling case for any particular view of macroeconomic policy.

Question 47

When a government honours its debt obligations, this is an example of:

A)discretionary fiscal policy.
B)discretionary monetary policy.
C)a fiscal policy rule.
D)a monetary policy rule.

Question 48

The Phillips curve describing an economy takes the form u = uⁿ - α(π - Eπ). The central bank directly sets the inflation rate to minimize the following loss function, L (u, π) = u + γπ². The symbol u denotes the unemployment rates, uⁿ is the natural rate of unemployment, π is the inflation rate, Eπ is the expected inflation rate, and α and γ are behavioural response parameters of the economy. Private agents form their expectations rationally before the central bank sets the inflation rate. The optimal inflation rate when the central bank operates using a fixed rule will be _____. The optimal inflation rate when the central bank operates with discretion will be _____.

A)uⁿ; 0
B)0; uⁿ
C)0; α/(2γ)
D)α/(2γ); 0

Question 49

If the velocity of money varies a great deal, steady growth of the money supply is a(n):

A)ineffective way to stabilize aggregate demand.
B)example of discretionary monetary policy.
C)automatic stabilizer.
D)active policy rule.

Question 50

A situation where policymakers have the incentive to deviate from their initial course of action once other agents in the economy have acted is called a(n):

A)rational expectation.
B)outside lag.
C)time-inconsistent policy.
D)active policy rule.

Question 51

Unlike a monetarist policy rule, an inflation target has the advantage of:

A)eliminating the need to announce the policy target.
B)providing a real target rather than a nominal one.
C)allowing the central bank unlimited discretion.
D)insulating the economy from changes in money velocity.

Question 52

If a city passes laws limiting rents on apartments but promises to exempt buildings not yet built:

A)construction of new buildings will not be discouraged.
B)construction of new buildings may be discouraged.
C)builders will not expect the city to renege on its promise.
D)the city will have no incentive to renege on its promise.

Question 53

Monetary policy rules that target nominal variables would target any of the following except the:

A)price level.
B)money supply.
C)unemployment rate.
D)level of nominal GDP.

Question 54

Although real variables such as unemployment and real GDP are the best measures of economic performance, most economists do not advocate manipulating money supply directly to hit a real target because:

A)they believe a constant growth rate of the money supply is the best way to stabilize real GDP or unemployment.
B)if the Bank of Canada chose a target that was not natural output or the natural unemployment rate, the result would be accelerating inflation or deflation.
C)if the Bank of Canada chose a target for the unemployment rate above the natural rate, the result would be accelerating inflation.
D)if the Bank of Canada chose a target for the unemployment rate below the natural rate, the result would be accelerating deflation.

Question 55

Economic research finds that greater central-bank independence is _____ correlated with lower and more stable inflation as well as _____ correlated with the average growth and variability of real GDP.

A)strongly; strongly
B)strongly; not
C)not; strongly
D)not; not

Question 56

The Phillips curve describing an economy takes the form u = uⁿ - α(π - Eπ). The central bank directly sets the inflation rate to minimize the following loss function, L (u, π) = u + γπ². The symbol u denotes the unemployment rates, uⁿ is the natural rate of unemployment, π is the inflation rate, Eπ is the expected inflation rate, and α and γ are behavioural response parameters of the economy. Private agents form their expectations rationally before the central bank sets the inflation rate. Compared to making monetary policy with discretion, the optimal inflation rate will be _____ under a fixed rule and the unemployment rate will be _____.

A)higher; lower
B)higher; the same
C)lower; lower
D)lower; the same

Question 57

A monetary policy rule that targets nominal GDP would _____ money growth when nominal GDP rises above the target and _____ money growth when nominal GDP falls below the target.

A)reduce; raise
B)raise; reduce
C)reduce; reduce
D)raise; raise

Question 58

Assume that the Liberal party always had a policy of high money growth while the Conservative party followed a policy of low money growth, and the economy had a standard Phillips curve. Then, if the two parties took regular terms in office:

A)there would be no political business cycle, but inflation would be higher under the Liberal party.
B)there would be no political business cycle, but inflation would be higher under the Conservative party.
C)unemployment would be lower under the Liberal party, but inflation would be higher.
D)both unemployment and inflation would be higher under the Liberal party.

Question 59

Inflation targeting is a monetary policy rule that requires the central bank to adjust _____ in order to attain the desired inflation rate.

A)a price index
B)the velocity of money
C)nominal GDP
D)the money supply

Question 60

Countries with greater central-bank independence can achieve lower rates of inflation:

A)at the cost of higher levels of unemployment.
B)at the cost of slower growth rates of real GDP.
C)at the cost of greater volatility of real GDP.
D)with no apparent real economic costs.

Question 61

The following notice appeared on a full page of the Wall Street Journal on February 9, 2009:
​
"There is no disagreement that we need action by our government, a recovery plan that will help to jumpstart the economy."-U.S. President-Elect Barack Obama, January 9, 2009
With all due respect, Mr. President, that is not true. Notwithstanding reports that all economists are now Keynesians and that we all support a big increase in the burden of government, we the undersigned do not believe that more government spending is a way to improve economic performance. More U.S. government spending by Presidents Hoover and Roosevelt did not pull the United States out of the Great Depression in the 1930s. More government spending did not solve Japan's "lost decade" in the 1990s. As such, it is a triumph of hope over experience to believe that more government spending will help the United States today. To improve the economy, policymakers should focus on reforms that remove impediments to work, saving, investment and production. Lower tax rates and a reduction in the burden of government are the best ways of using fiscal policy to boost growth.
​
The statement was signed by more than 200 economists, including 3 Nobel Laureates.
a.Comment on the extent to which the disagreement between the U.S. president and the economists involves a disagreement about whether policy should be passive or active.
b.Identify the rationale(s) used to support the economists' position.​​

Question 62

Assume that in a certain economy, the LM curve is given by Y = 2,000r - 2,000 + 2 (M / P), and the IS curve is given by Y = 8,000 - 2,000r + u, where u is a shock that is equal to +200 half the time and -200 half the time. The price level (P) is fixed at 1.0. The natural rate of output is 4,000. The government wants to keep output as close as possible to 4,000 and does not care about anything else. Consider the following two policy rules: i. Set the money supply M equal to 1,000 and keep it there, and ii. Manipulate M from day to day to keep the interest rate constant at 2 percent.
a.Under rule i, what will Y be when u = +200? What will Y be under rule i when u = -200?
b.Under rule ii, what will Y be when u = +200? What will Y be under rule ii when u = -200?
c.Which rule will keep output closer to 4,000?

Question 63

Many times a monetary policy does not have the effect on the economy that is desired by the regulator. Why does this happen?

Question 64

The time-inconsistency problem in discretionary policymaking about unemployment and inflation can be effectively avoided when the:

A)policymaker has and is known to have an extremely strong preference for very low inflation.
B)policymaker does not care about the rate of inflation and simply sets policy to avoid unemployment.
C)private agents in the economy are not "rational."
D)policymaker has more information than do the private agents in the economy.

Question 65

Compare two procedures for conducting monetary policy:
Method 1: Maintain a steady money growth of 6 percent per year
Method 2: Maintain a steady inflation rate of 3 percent per year
Be sure to consider whether the methods involve (1) active or passive monetary policy and (2) rules or discretion. Discuss why one method might be preferred over the other.

Question 66

Automatic stabilizers start stabilizing the economy as soon as it deviates from its normal course. Explain with an example how this works in a recession.

Question 67

Give an example of an economic policy that the government, after announcing the economic policy, will be tempted to renege.

Question 68

The people of Country A believe that their regulators are committed to a zero-inflation policy, while the people of Country B do not believe that their regulators are committed to a zero-inflation policy. What difference does this make if regulators of both the countries announce a policy that will lower inflation?

Question 69

You are hired as a consultant to set up the central bank of a new country. Suggest at least two possible ways to structure the central bank to keep inflation levels low.

Question 70

A central bank operating with discretion can achieve the same outcome as the central bank committed to a fixed rule of zero inflation if:

A)there are no inside lags.
B)there are no outside lags.
C)the central bank dislikes unemployment much more than inflation.
D)the central bank dislikes inflation much more than unemployment.

Question 71

Let the symbol π stand for the rate of inflation, with Eπ the expected inflation rate, both measured in percentage. The letter u is the unemployment rate and uⁿ is the natural rate of unemployment. Suppose the short-run Phillips curve is u = uⁿ - α (π - Eπ) applies in a certain economy. The Bank of Canada's loss function is L (u, π) = u + γπ². The analysis in the appendix to textbook Chapter 16 shows that if the Bank of Canada minimizes its loss function under the assumption that Eπ is fixed and "rational" private agents know this, the expected inflation rate will be Eπ = α/2γ, and this will also be the inflation rate the government chooses.
a.Suppose that α = 0.5 and γ = 0.05. What are the expected and actual inflation rates?
b.Suppose α = 0.5 and γ = 0.50. In this case, does the Bank of Canada have greater or lesser relative distaste for inflation than in part a? What are the expected and actual inflation rates with γ = 0.50? Why do they differ from the inflation rates in part a?

Question 72

Fiscal policy is a tool the government uses to steer the economy of a country. What are the advantages of active fiscal policy over passive fiscal policy?

Question 73

Given that the Philips curve defines an economy as u = 6 - 0.4(π - Eπ) where u is the unemployment rate and π is the inflation rate, and the loss function which tells the social cost of unemployment and inflation is L = u + 0.05π², calculate the optimal level of inflation for the economy taking expected inflation as given.

Question 74

Does the public's expectation of a policy influence its effectiveness?

Question 75

The central banks of two nearly identical countries, Fixland and Flexland, desire low inflation and low unemployment. There is a similar short-run tradeoff between unemployment and unexpected inflation in both countries. Private agents in both Fixland and Flexland form expectations rationally and understand the incentives that central banks may have to renege on low-inflation policies. Initially, the rates of inflation and unemployment are the same in both countries. The central bank of Fixland makes a credible announcement that it will operate according to a low-inflation rule. The central bank of Flexland announces that it plans to follow a low-inflation policy, but retains the right to deviate from this policy at its discretion.
a.In which country would you expect the rate of inflation to be lower?
b.In which country would you expect the unemployment rate to be lower?

Question 76

Assume that in a certain economy, the LM curve is given by Y = 2,000r - 2,000 + 2 (M / P) + u, where u is a shock that is equal to +200 half the time and -200 half the time, and the IS curve is given by Y = 8,000 - 2,000r. The price level (P) is fixed at 1.0. The natural rate of output is 4,000. The government wants to keep output as close as possible to 4,000 and does not care about anything else. Consider the following two policy rules: i. Set the money supply M equal to 1,000 and keep it there, and ii. Manipulate M from day to day to keep the interest rate constant at 2 percent.
a.Under rule i, what will Y be when u = +200? Under rule i, what will Y be when u = -200?
b.Under rule ii, what will Y be when u = +200? Under rule ii, what will Y be when u = -200?
c.Which rule will keep output closer to 4,000?

Question 77

Explain why each of the following statements is a rationale for conducting active or passive policy:
a.Economic circumstances can change dramatically between the time that an economic downturn begins and the time when policy actions have an effect on the economy.
b.Economists are not very accurate forecasters.
c.Increases in government spending generate increases in economic output.
d.Fluctuations in economic output have been less severe since World War II.

Question 78

For each of the following policies, indicate whether the policy is (1) a monetary or a fiscal policy, (2) an active or a passive policy, and (3) a policy by rules or with discretion:
a.The central bank follows a policy of allowing the money supply to grow at a constant 4 percent per year.
b.A government follows a policy of keeping government spending over a calendar year equal to government revenue over the calendar year.
c.The central bank uses judgment to adjust the growth of the money supply based on expectations of what will happen to output and inflation over the next five years.
d.The government keeps tax laws unchanging and allows government spending to change, depending on which spending bills are passed by the legislature.
e.The central bank follows a policy of adjusting the money supply according to a formula based on deviations of unemployment from the natural rate of unemployment.