Deck 14: The Basic Tools of Finance

Question 1

According to the Phillips curve, inflation depends on expected inflation because:

A)the real interest rate depends on the expected rate of inflation.
B)the central bank sets its target inflation rate based on the expected rate of inflation.
C)the natural level of output depends on the expected rate of inflation.
D)when some firms set prices in advance, expected inflation influences future prices.

Answer 1

D

Question 2

In the dynamic model, the demand for goods and services will as the natural level of output increases and
As the real interest rate increases.

A)increase; increase
B)increase; decrease
C)decrease; decrease
D)decrease; increase

Answer 2

B

Question 3

To follow a monetary policy rule, the central bank raises the nominal interest rate by:

A)raising the inflation target.
B)decreasing the money supply.
C)increasing the GDP gap.
D)decreasing inflation expectations.

Answer 3

B

Question 4

Which of the following would be represented by a negative value of the random supply shock, υt
$\text { ? }$

A)an irrational wave of pessimism among investors
B)a decrease in government spending
C)oil price decreases resulting from a breakdown in the cartel
D)a decrease in the central bank's inflation target

Question 5

The dynamic model of aggregate demand and aggregate supply assumes that people form expectations of inflation based on:

A)forecasts optimally using all available information.
B)recently observed inflation.
C)the central bank's inflation target.
D)the difference between the nominal and real interest rate.

Question 6

The natural rate of interest is the real interest rate:

A)at which the demand for goods and services equals the natural level of output.
B)that most people anticipate based on their expectations of inflation.
C)at which the natural rate of unemployment equals the natural rate of output.
D)equal to the nominal interest rate minus the natural rate of inflation.

Question 7

A higher real interest rate reduces the demand for goods and services by:

A)shifting the dynamic aggregate supply curve.
B)decreasing the natural level of output.
C)increasing inflation expectations.
D)reducing investment and consumption spending.

Question 8

According to the monetary policy rule, when inflation is at its target level and output is at the natural level, then the real interest rate equals the:

A)nominal rate of interest.
B)target rate of inflation.
C)natural rate of interest.
D)current rate of inflation.

Question 9

According to the monetary policy rule, the central bank sets the nominal interest rate so the real interest rate
When inflation is above its target and the real interest rate when output is below its natural level.

A)rises; falls
B)rises; rises
C)falls; falls
D)falls; rises

Question 10

The real interest rate at which, in the absence of any shock, the demand for goods and services equals the natural level of output is called the rate of interest.

A)ex ante
B)ex post
C)natural
D)nominal

Question 11

Expectations of inflation based on recently observed inflation is called the assumption of expectations.

A)natural
B)rational
C)dynamic
D)adaptive

Question 12

In the dynamic model, the supply shock variable, υ , is a variable appearing in which of the following equations of the
T
Model?

A)Fisher equation
B)Phillips curve
C)monetary-policy rule
D)adaptive expectations

Question 13

According to the Phillips curve, firms prices when output is below the natural level of output, or equivalently, when the unemployment rate is the natural rate of unemployment.

A)raise; above
B)raise; below
C)lower; above
D)lower; below

Question 14

According to the monetary policy rule, the central bank sets the nominal interest rate so the real interest rate increases when inflation its target, or output its natural level.

A)rises above; rises above
B)rises above; falls below
C)falls below; falls below
D)falls below; rises above

Question 15

The monetary policy rule specified in the dynamic model of aggregate demand and aggregate supply indicates that the central bank adjusts interest rates in response to fluctuations in:

A)inflation expectations.
B)money supply and money demand.
C)inflation and output.
D)nominal and real exchange rates.

Question 16

Long-run growth the demand for goods and services.

A)increases
B)decreases
C)does not change
D)may either increase or decrease

Question 17

Which of the following would be represented by a positive value of the random supply shock, υ ?
T

A)an irrational wave of optimism among investors
B)an increase in government spending
C)widespread drought leading to large increases in food prices
D)an increase in the central bank's inflation target

Question 18

According to the Phillips curve, firms raise prices when output is the natural level of output, or equivalently, when the unemployment rate is the natural rate of unemployment.

A)above; above
B)above; below
C)below; below
D)below; above

Question 19

In the dynamic model, the demand for goods and services decreases as the natural level of output or the real rate of interest .

A)increases; increases
B)increases; decreases
C)decreases; decreases
D)decreases; increases

Question 20

In order to achieve the target for the nominal interest rate established by the monetary policy rule, the central banks adjusts:

A)the inflation rate.
B)the natural rate of interest.
C)the money supply.
D)the inflation target.

Question 21

Use the model of dynamic aggregate demand and aggregate supply to graphically illustrate the impact of an exceptional weather pattern that results in a one-period glut of food worldwide that reduces food prices (a one-period
negative supply shock) on output and inflation when the economy is initially at long-run equilibrium. Explain the time path of output and inflation in words.

Question 22

According to the Taylor rule, when real GDP is below its natural level, the nominal federal funds rate should be , and when inflation exceeds 2 percent, the nominal federal funds rate should be .

A)raised; raised
B)raised; lowered
C)lowered; raised
D)lowered; lowered

Question 23

John Taylor's rule for setting the federal funds rate proposes increasing the nominal federal funds rate as inflation
And the GDP gap .

A)increases; increases
B)increases; decreases
C)decreases; increases
D)decreases; decreases

Question 24

The Taylor rule can be written as FF rate = π + 2.0 + 0.5(π - 2.0) + 0.5(GDP gap), where FF rate is the nominal federal funds rate, π is the inflation rate, and the GDP gap is the percentage deviation of real GDP from its natural level. If inflation is 2 percent and GDP is at the natural level, then according to the Taylor rule, the Fed should set the nominal federal funds rate at percent.

A)2
B)3
C)4
D)5

Question 25

Use the model of dynamic aggregate demand and aggregate supply to graphically illustrate the impact of a permanent increase in the central bank's inflation target when the economy is initially at long-run equilibrium. Explain the time path of output and inflation in words.

Question 26

The Taylor rule can be written as FF rate = π + 2.0 + 0.5(π - 2.0) + 0.5(GDP gap), where FF rate is the nominal federal funds rate, π is the inflation rate, and the GDP gap is the percentage deviation of real GDP from its natural level. If inflation is 4 percent and the GDP gap is 2 percent, then according to the Taylor rule, the Fed should set the nominal federal funds rate at percent.

A)4
B)8
C)10
D)12

Question 27

Predetermined variables in a model are treated as if they are essentially:

A)endogenous variables.
B)exogenous variables.
C)parameters.
D)equilibrium conditions.

Question 28

Use the model of dynamic aggregate demand and aggregate supply to graphically illustrate the impact of a temporary four-period increase in taxes (a four-period negative demand shock) on output and inflation when the economy is initially at long-run equilibrium. Explain the time path of output and inflation in words.

Question 29

According to the Taylor rule, when real GDP is above its natural level, the nominal federal funds rate should be
, and when inflation is below 2 percent, the nominal Federal funds rate should be .

A)raised; raised
B)raised; lowered
C)lowered; raised
D)lowered; lowered

Question 30

The Taylor rule can be written as FF rate = π + 2.0 + 0.5(π - 2.0) + 0.5(GDP gap), where FF rate is the nominal federal funds rate, π is the inflation rate, and the GDP gap is the percentage deviation of real GDP from its natural level. If inflation is 2 percent and the GDP gap is -2 percent, then according to the Taylor rule, the Fed should set the nominal federal funds rate at percent.

A)2
B)3
C)4
D)5

Question 31

According to the Taylor Principle, for inflation to be stable, the central bank must respond to an increase in inflation with
Increase in the nominal interest rate.

A)no
B)an equal
C)a greater
D)a smaller

Question 32

Central Bank A conducts monetary policy according to the following monetary policy rule: i = π + 2.0 + 0.90(π - 2.0) +
0.10(Y - 100). Central Bank B conducts monetary policy according to the following monetary policy rule: i = π + 2.0 +
0.10(π - 2.0) + 0.90(Y - 100), where i is the nominal interest rate measured in percent, π is the inflation rate measured in percent, and Y is output measured as a percentage of the natural level of output. The economies of the two
countries are otherwise identical and operate as described by the dynamic model of aggregate demand and aggregate supply.
a. In which country will the dynamic aggregate demand curve be steeper? Explain.
b. If a positive supply shock of the same magnitude hits both countries, which country will experience the greatest variability in output? Explain.

Question 33

The interest rate at which banks make loans to other banks is called the:

A)federal funds rate.
B)prime rate.
C)Federal Reserve discount rate.
D)Treasury bill rate.