This Document Contains Chapters 24 to 25 Chapter 24 Money and Inflation 24.1 Money and Inflation: Evidence 1) The condition of a continually rising price level is defined as A) stagflation. B) stagnation. C) disinflation. D) inflation. Answer: D 2) The economist who proposed that, "Inflation is always and everywhere a monetary phenomenon" was A) John Maynard Keynes. B) John R. Hicks. C) Milton Friedman. D) Franco Modigliani. Answer: C 3) Complete Milton Friedman's famous proposition: "Inflation is always and everywhere a ________ phenomenon." A) monetary B) political C) policy D) budgetary Answer: A 4) At first cut, the simple solution to fighting inflation is A) reducing the growth rate of the money supply. B) limiting the number of terms that politicians can serve in elective office. C) returning the economy to barter by prohibiting the use of fiat money. D) to impose price controls on businesses that attempt to raise prices. Answer: A 5) "How do we prevent the inflationary fire from igniting again and stop the roller coaster ride in the inflation rate of the last 40 years?" Milton Friedman's famous proposition suggests the simple solution: A) reduce the number of terms that politicians are allowed to serve. B) reduce the growth rate of the money supply. C) reduce the marginal tax rate on low-income wage earners. D) increase the marginal tax rates on businesses that hike prices in excess of 5 percent per year. Answer: B 6) Milton Friedman's proposition concerning the cause of inflation implies a simple solution to the inflation problem: A) reduce government budget deficits. B) limit the ability of fiscal policymakers to bring pressure to bear on the monetary authority. C) limit the number of terms that politicians are allowed to serve. D) reduce the growth rate of the money supply. Answer: D 7) Milton Friedman's proposition that inflation is always and everywhere a monetary phenomenon holds only if A) government budget deficits do not rise continually. B) the unemployment rate does not rise continually. C) the price level rises continually. D) the United States does not experience more than one negative supply shock per decade. Answer: C 8) Inflation occurs whenever A) the price level rises. B) the money supply increases. C) the price level rises continuously over a period of time. D) the price level falls continuously over a period of time. Answer: C 9) Evidence strongly supports the view that countries with high inflation also have A) the lowest nominal interest rates. B) the highest rates of money growth. C) the smallest budget deficits. D) the lowest interest rates. Answer: B 10) Countries with the highest inflation rates are likely to have A) the highest rates of money growth. B) small budget deficits relative to GDP. C) the lowest interest rates. D) non accommodating monetary policy. Answer: A 11) The proposition that inflation is the result of a high rate of money growth is A) not supported by evidence from the German hyperinflation. B) held only by sociologists and is no longer believed by economists. C) supported by evidence from inflationary episodes throughout the world. D) largely a political fabrication designed to make the Fed a scapegoat for poor fiscal policy. Answer: C 12) Which of the following would provide the strongest evidence that rapid money growth is the driving force behind inflation? A) An endogenous increase in the money supply that preceded the onset of inflation. B) An exogenous increase in the money supply that preceded the onset of inflation. C) An endogenous increase in the money supply that lagged the onset of inflation. D) An exogenous increase in the money supply that lagged the onset of inflation. Answer: B 13) The Zimbabwean hyperinflation of 2008 supports the proposition that excessive monetary growth causes inflation and not the other way around since the increase in monetary growth appears to have been A) unintentional. B) intentional. C) endogenous. D) exogenous. Answer: D 14) The German hyperinflation of 1921-1923 provides important support for the view that high money growth results when A) the government sets an employment target that is too high. B) the government expands the money supply to finance its expenditures. C) the government raises taxes to finance its expenditures. D) the government sells bonds to the public. Answer: B 24.2 Meaning of Inflation 1) A one-time increase in the price level A) is rarely reported by the news media as inflation, but is nevertheless considered to be inflation by economists. B) is regularly reported by the news media as inflation, but is not considered to be inflation by economists. C) is rarely reported by the news media as inflation because it is not considered to be inflation by economists. D) is regularly reported by the news media as inflation because it is considered to be inflation by economists. Answer: B 2) When inflation is defined to be a condition of a continually rising price level, ________ economists agree with Milton Friedman's proposition that inflation is a monetary phenomenon. A) no B) very few C) about half of practicing D) almost all Answer: D 24.3 Views of Inflation 1) According to aggregate demand and supply analysis, inflation is caused by A) supply shocks. B) expansionary fiscal policies. C) expansionary monetary policies. D) rising prices. Answer: C 2) According to aggregate demand and supply analysis, a continually increasing money supply causes a ________ in aggregate demand, everything else held constant. A) continual increase B) continual decrease C) one-time increase D) one-time decrease Answer: A 3) According to aggregate demand and supply analysis of inflation and with everything else held constant, a continually increasing money supply causes A) aggregate demand to increase along a stationary aggregate supply curve, leading to continually increasing aggregate output and prices. B) aggregate supply to decrease along a stationary aggregate demand curve, leading to continually contracting aggregate output and prices. C) aggregate demand to increase continually as aggregate supply decreases continually, leading to higher and higher price levels. D) aggregate demand to decrease continually as aggregate supply increases continually, leading to higher and higher price levels. Answer: C 4) Aggregate demand and supply analysis conclude that continuously growing ________ will cause the price level to rise continually, thus generating inflation. A) money supply B) government spending C) interest rates D) consumer expenditure Answer: A 5) According to aggregate demand and supply analysis and with everything else held constant, a continuous increase in the money supply causes A) the price level to increase, but has no lasting effect on the inflation rate. B) the price level to fall. C) inflation. D) output to increase, but leaves the price level and inflation unchanged. Answer: C 6) According to aggregate demand and supply analysis, an increase in government spending will cause aggregate demand to ________, causing output to ________ , everything else held constant. A) increase; fall B) increase; rise C) decrease; fall D) decrease; rise Answer: B 7) Aggregate demand and supply analysis indicates that negative supply shocks A) decrease the price level, but cannot decrease the inflation rate. B) increase the price level, but cannot increase the inflation rate. C) increase both the price level and the inflation rate. D) decrease both the price level and the inflation rate. Answer: B 8) Suppose that the economy is at the natural rate of output. In the absence of accommodating policy and everything else held constant, the net result of a negative supply shock is that A) the economy returns to full employment at the initial price level. B) the economy returns to full employment at a higher price level. C) the economy returns to full employment at a lower price level. D) aggregate output increases above the natural rate level, but only temporarily. Answer: A 9) Explain and show graphically why continuous monetary growth is needed to generate inflation. Describe how the inflation process is generated. Answer: See figure below. Only continuous monetary growth can cause continuous increases in aggregate demand of the sort needed to generate inflation. Other factors can increase demand and the price level, but none can increase demand continuously. In the graph, the monetary expansion increases AD. The increase in output above the natural rate increases wages and decreases AS. Monetary expansion increases AD repeatedly, and wages continue to adjust upward. 10) Suppose that the economy is at the natural rate of output. Explain how a positive supply shock, followed by a more restrictive monetary policy, allows policymakers a painless way to reduce inflation. Answer: The positive supply shock increases aggregate supply, exerting downward pressure on prices. Policymakers can now reduce demand to further reduce inflationary pressure without reducing output below the natural rate. 24.4 Origins of Inflationary Monetary Policy 1) To say that inflation is a monetary phenomenon seems to beg the question: A) Why does inflationary monetary policy occur? B) Why do politicians seek reelection? C) Why is the Fed independent? D) Why does the U.S. Treasury print so much money? Answer: A 2) The combination of a successful wage push by workers and the government's commitment to high employment leads to A) demand-pull inflation. B) supply-side inflation. C) supply-shock inflation. D) cost-push inflation. Answer: D 3) If the Fed responds by increasing the money supply in response to a successful wage push by workers, monetary policy is said to be A) accomplishing. B) non accommodating. C) non accomplishing. D) accommodating. Answer: D 4) If workers do not believe that policymakers are serious about fighting inflation, they are most likely to push for higher wages, which will ________ aggregate ________ and lead to unemployment or inflation or both, everything else held constant. A) decrease; demand B) increase; demand C) decrease; supply D) increase; supply Answer: C 5) Workers will have greater incentives to push for higher wages when government policymakers place greater concern on ________ than ________ and are thus ________ likely to adopt accommodative policies. A) inflation; unemployment; less B) inflation; unemployment; more C) unemployment; inflation; less D) unemployment; inflation; more Answer: D 6) In the absence of an accommodating monetary policy, a push by workers to get higher wages will cause A) cost-push inflation. B) demand-pull inflation. C) higher unemployment. D) a lower price level. Answer: C 7) If workers believe that government policymakers will increase aggregate demand to avoid a politically unpopular increase in unemployment when workers demand higher wages, then workers will not fear higher unemployment and their wage demands will result in A) demand-pull inflation. B) hyperinflation. C) deflation. D) cost-push inflation. Answer: D 8) If policymakers set a target for unemployment that is too low because it is less than the natural rate of unemployment, this can set the stage for a higher rate of money growth and A) cost-push inflation. B) demand-pull inflation. C) cost-pull inflation. D) demand-push inflation. Answer: B 9) Theoretically, one can distinguish a demand-pull inflation from a cost-push inflation by comparing A) how fast prices rise relative to wages. B) the unemployment rate with its natural rate level. C) when prices rise relative to wages. D) government debt to real GDP. Answer: B 10) Demand-pull inflation can result when A) policymakers set an unemployment target that is too high. B) a persistent budget deficit is financed by selling bonds to the public. C) a persistent budget deficit is financed by selling bonds to the central bank. D) workers get numerous wage increases. Answer: C 11) Which of the following is least likely to lead to inflationary monetary policy? A) Rising unemployment B) Expanding federal budget deficits C) Declining oil prices D) Conflict in the Middle East Answer: C 12) Which of the following is most likely to lead to inflationary monetary policy? A) Declining oil prices B) Resolution of conflict in the Middle East C) The enactment of a free-trade agreement with Mexico D) Rising unemployment Answer: D 13) Which of the following is most likely to lead to inflationary monetary policy? A) Declining oil prices B) Resolution of conflict in the Middle East C) The enactment of a free-trade agreement with Mexico D) Rising government budget deficits Answer: D 14) Methods of financing government spending are described by an expression called the government budget constraint, which states the following: A) the government budget deficit must equal the sum of the change in the monetary base and the change in government bonds held by the public. B) the government budget deficit must equal the difference between the change in the monetary base and the change in government bonds held by the public. C) the government budget deficit must equal the difference between the change in the monetary base and the change in government bonds held by the Fed. D) the government budget deficit must equal the difference between the change in the monetary base and the change in government bonds held by the Treasury. Answer: A 15) Methods of financing government spending are described by an expression called the government budget constraint, which states the following: A) DEFICIT = (G - T) = ΔMB + ΔBONDS. B) DEFICIT = (G - T) = ΔMB - ΔBONDS. C) DEFICIT = (G - T) = ΔBONDS - ΔMB. D) DEFICIT = (G - T) = ΔMB/ΔBONDS. Answer: A 16) If the government finances its spending by issuing debt to the public, the monetary base will ________ and the money supply will ________. A) increase; increase B) increase; decrease C) decrease; increase D) not change; not change Answer: D 17) If the government finances its spending by selling bonds to the central bank, the monetary base will ________ and the money supply will ________. A) increase; increase B) increase; decrease C) decrease; decrease D) not change; not change Answer: A 18) Financing government spending with taxes A) causes both reserves and the monetary base to rise. B) causes both reserves and the monetary base to decline. C) causes reserves to rise, but the monetary base to decline. D) has no net effect on the monetary base. Answer: D 19) Financing government spending by selling bonds to the public, which pays for the bonds with currency, A) leads to a permanent decline in the monetary base. B) leads to a permanent increase in the monetary base. C) leads to a temporary increase in the monetary base. D) has no net effect on the monetary base. Answer: D 20) The financing of government spending by issuing debt A) causes both reserves and the monetary base to rise. B) causes both reserves and the monetary base to decline. C) causes reserves to rise, but the monetary base to decline. D) has no net effect on the monetary base. Answer: D 21) The finance of government spending through a Treasury sale of bonds which are then purchased by the Fed A) causes both reserves and the monetary base to rise. B) causes both reserves and the monetary base to decline. C) causes reserves to rise, but the monetary base to decline. D) has no net effect on the monetary base. Answer: A 22) This method of financing government spending is frequently called printing money because high-powered money (the monetary base) is created in the process. A) Financing government spending with taxes. B) The finance of government spending through a Treasury sale of bonds that are then purchased by the Fed. C) Financing government spending by selling bonds to the public, which pays for the bonds with currency. D) Financing government spending by selling bonds to the public, which pays for the bonds with checks. Answer: B 23) Only when budget deficits are financed by money creation does the increased government spending lead to ________ in the ________. A) a decrease; monetary base B) an increase; monetary base C) a decrease; money multiplier D) an increase; money multiplier Answer: B 24) If the deficit is financed by selling bonds to the ________, the money supply will ________, increasing aggregate demand, and leading to a rise in the price level. A) public; rise B) public; fall C) central bank; rise D) central bank; fall Answer: C 25) If the deficit is financed by selling bonds to the ________, the money supply will ________, causing aggregate demand to ________. A) public; rise; increase B) public; fall; decrease C) central bank; rise; increase D) central bank; fall; decrease Answer: C 26) Kayla, an economist, is interested in knowing if government deficits have been a factor in explaining rapid money growth in her country in the past twenty years. What ratio should Kayla examine? A) The ratio of money to the monetary base B) The ratio of currency to demand deposits C) The ratio of money to government debt D) The ratio of government debt to GDP Answer: D 27) If an economist were interested in testing whether government budget deficits had been the cause of excessive monetary growth for a country for the period 1950-2000, she would examine the behavior of A) the ratio of government spending to GDP. B) the money supply-to-monetary-base ratio. C) interest rates. D) the government debt-to-GDP ratio. Answer: D 28) Evidence from episodes of hyperinflation indicates that A) wage-push demands have been the ultimate source of inflationary monetary policies. B) supply shocks have been the ultimate source of inflationary monetary policies. C) huge government budget deficits have been the ultimate source of inflationary monetary policies. D) there is no common source of inflationary monetary policies. Answer: C 29) Analysis of episodes of hyperinflation indicate that the rapid money growth leading to the inflation is the result of A) governments financing massive budget deficits by printing money. B) central banks' attempts to peg interest rates. C) central banks' attempts to peg exchange rates. D) increases in taxes. Answer: A 30) Although the U.S. has a well-developed government bond market and has experienced relatively small budget deficits relative to GDP, deficits can be inflationary if A) deficits put upward pressure on interest rates, and the Fed attempts to keep interest rates from rising. B) deficits put upward pressure on interest rates, and fiscal authorities raise taxes in an attempt to keep interest rates from rising. C) the Fed refuses to purchase government bonds. D) the world's supply of gold expands because of new gold discoveries. Answer: A 31) Moderate deficits, such as those experienced by the United States in the last decade, present an inflationary problem if A) they put upward pressure on interest rates, and the Fed has a goal of preventing high interest rates. B) they put upward pressure on interest rates, and the Fed has a goal of preventing interest rates from falling too low. C) the Fed responds by reducing the growth of high-powered money. D) the Fed cuts money growth to offset the expansionary fiscal effects. Answer: A 32) If moderate deficits put ________ pressure on interest rates, the Fed may ________ bonds, leading to an increase in high-powered money. A) upward; sell B) upward; buy C) downward; sell D) downward; buy Answer: B 33) If moderate deficits put upward pressure on interest rates, the Fed may ________ bonds, leading to a ________ in high-powered money. A) sell; fall B) buy; fall C) sell; rise D) buy; rise Answer: D 34) If the Fed pursues a policy goal of A) preventing high interest rates, and deficits cause interest rates to rise, then deficits will lead to money creation. B) preventing high inflation, and deficits cause inflation to rise, then deficits will lead to money creation. C) preventing high bond prices, and deficits cause bond prices to rise, then deficits will lead to money creation. D) preventing high stock prices, and deficits cause stock prices to rise, then deficits will lead to money creation. Answer: A 35) Proponents of Ricardian Equivalence reject the view that deficits A) cause the monetary base to decrease. B) cause the monetary base to increase. C) have no effect on the monetary base. D) cannot be inflationary, even when financed by tax hikes. Answer: B 36) According to economists who believe in Ricardian Equivalence, when the government runs a deficit and issues bonds, A) the public recognizes that it will be subject to higher taxes in the future in order to pay off these bonds. B) the public works less to avoid these future taxes, causing the demand for bonds to decrease. C) the Fed must purchase bonds to keep the interest rate from rising. D) the Fed must sell bonds to keep the interest rate from rising. Answer: A 37) Evidence from the time period 1960-1980 indicates that inflation in the United States resulted from A) an employment target that was set too high. B) the government's inability to sell bonds to the Fed. C) an expansion in the money supply to finance federal government expenditures. D) the excessive sale of government bonds to the public. Answer: A 38) Because policies in the United States were too expansionary from 1965 through 1973, the U.S. suffered A) demand-pull inflation. B) cost-push inflation, as workers sought higher wages in order to keep up with inflation. C) both demand-pull and cost-push inflation. D) neither demand-pull nor cost-push inflation. Answer: A 39) In the period 1965 through the 1970s, policymakers pursued ________ policies in order to achieve ________. A) expansionary; high employment B) expansionary; low inflation C) contractionary; high employment D) contractionary; low inflation Answer: A 24.5 The Discretionary/Nondiscretionary Policy Debate 1) If aggregate output is below the natural rate level, advocates of discretionary policy would recommend that the government A) do nothing. B) try to eliminate the high unemployment by attempting to shift the aggregate supply curve to the right. C) try to eliminate the high unemployment by attempting to shift the aggregate demand curve to the right. D) try to eliminate the high unemployment by attempting to shift the aggregate demand curve to the left. Answer: C 2) If aggregate output is below the natural rate level, advocates of nondiscretionary policy would recommend that the government A) do nothing. B) try to eliminate the high unemployment by attempting to shift the aggregate supply curve to the right. C) try to eliminate the high unemployment by attempting to shift the aggregate demand curve to the right. D) try to eliminate the high unemployment by attempting to shift the aggregate demand curve to the left. Answer: A 3) The time that it takes for an discretionary policy to actually influence economic activity is called the A) implementation lag. B) effectiveness lag. C) recognition lag. D) legislative lag. Answer: B 4) The time it takes for policymakers to change policy instruments once they have decided on a new policy is called the A) implementation lag. B) effectiveness lag. C) legislative lag. D) recognition lag. Answer: A 5) The time it takes for a policy to have an impact on the economy, once it has been implemented, is called the A) implementation lag. B) effectiveness lag. C) legislative lag. D) data lag. E) inside lag. Answer: B 6) The ________ lag is the time it takes for policymakers to obtain the data that tell them what is happening to the economy, while the ________ lag is the time it takes for policymakers to be sure of what the data are signaling about the future course of the economy. A) data; recognition B) recognition; data C) data; implementation D) implementation; recognition Answer: A 7) The ________ lag is the time it takes for policymakers to be sure of what the data are signaling about the future course of the economy, while the ________ lag represents the time it takes to pass legislation to implement a particular (fiscal) policy. A) data; recognition B) recognition; legislative C) data; legislative D) implementation; legislative Answer: B 8) The ________ lag represents the time it takes to pass legislation to implement a particular (fiscal) policy, while the ________ lag is the time it takes for policymakers to change policy instruments once they have decided on the new policy. A) legislative; effectiveness B) legislative; recognition C) legislative; implementation D) implementation; legislative Answer: C 9) The ________ lag is the time it takes for policymakers to change policy instruments once they have decided on the new policy, while the ________ lag is the time it takes for the policy to actually have an impact on the economy. A) recognition; implementation B) legislative; effectiveness C) implementation; recognition D) implementation; effectiveness Answer: D 10) The ________ lag is the time it takes for policymakers to obtain the information that tells them what is happening to the economy, while the ________ lag represents the time it takes to implement a particular fiscal policy. A) data; legislative B) recognition; data C) data; implementation D) recognition; legislative Answer: A 11) The ________ lag is the time it takes for policymakers to be sure of what the information is signaling about the future course of the economy, while the ________ lag is the time it takes for policymakers to change policy instruments once they have decided on the new policy. A) recognition; implementation B) recognition; legislative C) data; legislative D) data; implementation Answer: A 12) Of the five time lags that prevent a discretionary policy from returning aggregate output to full employment instantaneously, two do not slow the effectiveness of monetary policy—the A) implementation and effectiveness lags. B) legislative and effectiveness lags. C) legislative and implementation lags. D) recognition and effectiveness lags. Answer: C 13) Advocates of discretionary policy usually view ________ policy as having a shorter effectiveness lag than ________ policy, but there is substantial uncertainty about how long this lag is. A) fiscal; incomes B) fiscal; monetary C) monetary; incomes D) monetary; fiscal Answer: B 14) Advocates of discretionary policy usually view ________ policy as having a longer effectiveness lag than ________ policy, but there is substantial uncertainty about how long this lag is. A) fiscal; incomes B) fiscal; monetary C) monetary; incomes D) monetary; fiscal Answer: D 15) Economists usually view ________ policy as having a shorter implementation lag than ________ policy, but there is substantial uncertainty about how long this lag is. A) fiscal; incomes B) fiscal; monetary C) monetary; incomes D) monetary; fiscal Answer: D 16) Economists usually view ________ policy as having a longer implementation lag than ________ policy, but there is substantial uncertainty about how long this lag is. A) fiscal; incomes B) fiscal; monetary C) monetary; incomes D) monetary; fiscal Answer: B 17) If output adjusts ________ to the natural rate level, and if time lags between policy actions and changes in aggregate output are relatively ________, then the case for discretionary policy is strengthened. A) slowly; short B) slowly; long C) quickly; short D) quickly; long Answer: A 18) If output adjusts ________ to the natural rate level, and if time lags between policy actions and changes in aggregate output are relatively ________, then the case for discretionary policy is weakened. A) slowly; short B) slowly; long C) quickly; short D) quickly; long Answer: D 19) Advocates of nondiscretionary policy contend that a discretionary policy of shifting the aggregate ________ curve will be costly because it produces ________ volatility in both the price level and output. A) supply; less B) supply; more C) demand; less D) demand; more Answer: D 20) Some economists contend that a policy of shifting the aggregate demand curve will be costly because it produces more volatility in both the price level and output. These economists likely are advocates of ________ policy. A) supply-side B) discretionary C) demand-management D) nondiscretionary Answer: D 21) The existence of lags prevents the instantaneous adjustment of the economy to policies changing aggregate demand, thereby strengthening the case for ________ policy. A) supply-side B) nondiscretionary C) discretionary D) demand-management Answer: B 22) Which of the following views are consistent with the case for nondiscretionary macroeconomic policy? A) Even with time lags, discretionary policy moves the economy to full employment before the economy's self-correcting mechanism would. B) The wage and price adjustment process being extremely slow, a nondiscretionary policy results in a large loss of output. C) Workers will come to expect expansionary policies whenever the economy moves below full employment. D) A discretionary, accommodating policy of shifting the aggregate demand curve will produce less volatility in both the price level and output due to the short time it takes to shift aggregate demand. Answer: C 23) If expectations about policy affect how wages are set, then the case for a(n) ________ policy is much stronger. A) discretionary B) nondiscretionary C) interventionist D) stabilization Answer: B 24) Advocates of nondiscretionary policy emphasize the importance of a constant money growth rate rule more than the balanced-budget amendment or restrictions on union power because A) they regard excessive money growth as the cause of inflation. B) they believe that excessive government spending, not excessive monetary growth, is the cause of inflation. C) they believe that while unions cause inflation, they are too politically powerful to deal with. D) they regard high tax rates as the cause of inflation. Answer: A 25) Advocates of nondiscretionary policy contend that a policy of shifting the aggregate demand curve will be costly because it produces more volatility in both the price level and output. Thus they favor A) a policy of variable money supply growth. B) supply-side policy. C) demand-management policy. D) a constant-money-growth-rate rule. Answer: D 26) A credible, non accommodating policy rule has the ________ that it makes a cost-push by workers ________ likely and thus helps to reduce the output loss from controlling inflation. A) advantage; less B) advantage; more C) disadvantage; less D) disadvantage; more Answer: A 27) Suppose the economy is at the natural rate of output. Explain how a tax increase reduces demand and increases unemployment. Why is the speed of the adjustment of wages and/or the role of expectations important in this situation? Answer: The tax increase decreases aggregate demand. Output falls below the natural rate, increasing unemployment. If wages are slow to adjust, the economy remains below the natural rate for a long time, but adjustment back to the natural rate is rapid if wages adjust quickly or if expectations lead to rapid adjustment of wages. Chapter 25 Rational Expectations: Implications for Policy 25.1 The Lucas Critique of Policy Evaluation 1) Whether one views the discretionary policies of the 1960s and 1970s as destabilizing or believes the economy would have been less stable without these policies, most economists agree that A) stabilization policies proved more difficult in practice than many economists had expected. B) stabilization policies proved not to be inflationary. C) the nondiscretionary policymakers were right in believing that the private economy is inherently stable. D) the discrectionary policymakers were right in believing that the private economy is inherently stable. Answer: A 2) The argument that econometric policy evaluation is likely to be misleading if policymakers assume stable economic relationships is known as A) the monetarist revolution. B) the Lucas critique. C) public choice theory. D) new Keynesian theory. Answer: B 3) Lucas argues that when policies change, expectations will change thereby A) changing the relationships in econometric models. B) causing the government to abandon its discretionary stance. C) forcing the Fed to keep its deliberations secret. D) making it easier to predict the effects of policy changes. Answer: A 4) The rational expectations hypothesis implies that when macroeconomic policy changes, A) the economy will become highly unstable. B) the way expectations are formed will change. C) people will be slow to catch on to the change. D) people will make systematic mistakes. Answer: B 5) The Lucas critique indicates that A) advocates of discretionary policies' criticisms of rational expectations models are well-founded. B) advocates of discretionary policies' criticisms of rational expectations models are not well-founded. C) expectations are important in determining the outcome of a discretionary policy. D) expectations are not important in determining the outcome of a discretionary policy. Answer: C 6) The Lucas critique is an attack on the usefulness of A) conventional econometric models as forecasting tools. B) conventional econometric models as indicators of the potential impacts on the economy of particular policies. C) rational expectations models of macroeconomic activity. D) the relationship between the quantity theory of money and aggregate demand. Answer: B 7) The Lucas critique argues that an econometric model constructed using past data A) may be appropriate for short-run forecasting, but is inappropriate for policy analysis. B) may be appropriate for policy analysis, but is inappropriate for short-run forecasting. C) is appropriate for short-run forecasting and policy analysis. D) is inappropriate for policy analysis and short-run forecasting. Answer: A 8) The interest rate thought to have the most important impact on aggregate demand is the A) short-term interest rate. B) T-bill rate. C) rate on 90-day CDs. D) long-term interest rate. Answer: D 9) A rise in short-term interest rates that is believed to be only temporary A) is likely to have a significant effect on long-term interest rates. B) will have a bigger impact on long-term interest rates than if the rise in short-term rates had been permanent. C) is likely to have only a small impact on long-term interest rates. D) cannot possibly affect long-term interest rates. Answer: C 10) According to the Lucas critique, if past increases in the short-term interest rate have always been temporary, then A) the term-structure relationship using past data will then show only a weak effect of changes in the short-term interest rate on the long-term rate. B) the term-structure relationship using past data will show no effect of changes in the short-term interest rate on the long-term rate. C) one cannot predict the term-structure relationship as it depends on expectations. D) the term-structure relationship using past data will nevertheless show a strong effect of changes in the short-term interest rate on the long-term rate because of a change in the way expectations are formed. Answer: A 25.2 New Classical Macroeconomy Model 1) The new classical macroeconomic model assumes that expectations are ________ formed and that wages and prices are ________ with respect to the expected price level. A) adaptively; completely flexible B) adaptively; sticky C) rationally; completely flexible D) rationally; sticky Answer: C 2) In the new classical macroeconomic model developed by Lucas and Sargent, an anticipated monetary expansion will A) increase aggregate output. B) reduce aggregate output. C) have no effect on aggregate output. D) increase aggregate output and the aggregate price level. Answer: C 3) In the new classical macroeconomic model developed by Lucas and Sargent, expansionary macro policies affect aggregate output A) only when the macro policy change is anticipated. B) only when the macro policy change is unanticipated. C) only after a long and variable lag, provided the policy is anticipated. D) relatively quickly, provided the policy is anticipated. Answer: B 4) An expansionary monetary policy will cause aggregate output to expand in the new classical macroeconomic model A) if the policy is unanticipated. B) if the policy is anticipated. C) only after a long and variable lag, provided the policy is anticipated. D) never; output will never expand in the new classical model when monetary policy is changed. Answer: A 5) According to the new classical model, A) unanticipated policy has no effect on the business cycle. B) only anticipated policy can influence the business cycle. C) anticipated policy has no effect on the business cycle. D) unanticipated policy may or may not have an effect on the business cycle. Answer: C 6) Steve the economist tells his students that one anticipated policy is just like any other—none has any effect on aggregate output. You can probably infer that he is a A) Keynesian economist. B) monetarist. C) proponent of activist policies. D) new classical economist. Answer: D 7) In the view of the new classical economists, an increase in the money supply will affect aggregate output and employment only if the increase in money supply is A) anticipated. B) expected. C) unanticipated. D) the result of an announced open market operation. Answer: C 8) In the new classical model, an anticipated increase in the money stock will cause A) the price level and aggregate output to increase. B) aggregate output to increase. C) the price level to increase. D) no effect on either the price level or aggregate output. Answer: C 9) In the new classical model, A) wages and prices are sticky with respect to expected changes in the price level. B) a rise in the expected price level results in an immediate and equal rise in wages and prices. C) an anticipated increase in the money supply will increase aggregate output temporarily. D) unanticipated policy has no effect on aggregate output and unemployment. Answer: B 10) Suppose that the Federal Reserve announces a 50 basis point decrease in the target for the federal funds rate that was completely anticipated. According to the new classical model and with everything else held constant, this action by the Federal Reserve will cause real GDP to ________. A) increase B) decrease C) remain constant D) either increase, decrease or remain constant Answer: C 11) In the new classical model, an anticipated policy of a continually increasing money supply causes A) aggregate demand increases along a stationary aggregate supply curve, leading to continually increasing aggregate output and prices. B) aggregate supply decreases along a stationary aggregate demand curve, leading to continually contracting aggregate output and prices. C) aggregate demand continually increases while simultaneously aggregate supply continually decreases, leading to higher and higher price levels. D) aggregate demand continually decreases while simultaneously aggregate supply continually increases, leading to higher and higher price levels. Answer: C 12) The short-run response to an anticipated expansionary policy in the new classical model includes ________ in the price level and ________ in aggregate output. A) an increase; an increase B) an increase; no change C) no change; an increase D) no change; no change Answer: B 13) In the new classical model, an unanticipated increase in the money supply causes A) aggregate demand increases along a stationary aggregate supply curve. B) both aggregate demand and supply increase. C) aggregate demand increases as aggregate supply decreases. D) both aggregate demand and supply decrease. Answer: A 14) ________ policies do not change aggregate real output or the unemployment rate in the ________ model. A) Anticipated; new Keynesian B) Unanticipated; new Keynesian C) Anticipated; new classical D) Unanticipated; new classical Answer: C 15) The new classical model has the word classical associated with it because, when an increase in the money supply is anticipated, aggregate output A) drops below the natural rate level. B) rises above the natural rate level. C) remains at the natural rate level. D) increases in the short run, but not in the long run. Answer: C 16) The policy ineffectiveness proposition A) asserts that anticipated changes in monetary policy cannot affect real aggregate output. B) rules out output effects from policy surprises. C) implies that an anticipated contractionary monetary policy cannot reduce the rate of inflation. D) implies that an anticipated expansionary monetary policy will not cause the price level to rise. Answer: A 17) The notion that anticipated monetary policy has no effect on the real aggregate output is commonly called the A) Lucas critique. B) policy ineffectiveness proposition. C) natural rate hypothesis. D) new Keynesian proposition. Answer: B 18) An important feature of the new classical model is that an expansionary policy, such as an increase in the rate of money growth, can lead to a decline in aggregate output if the A) public expects an even more expansionary policy than the one that is actually implemented. B) policy comes as a surprise. C) public expects a less expansionary policy than the one that is actually implemented. D) policy is anticipated. Answer: A 19) In the new classical model, an expansionary monetary policy will lead to a decline in aggregate output if the increase in money supply is ________ anticipated. A) less than B) greater than C) not D) as Answer: A 20) The similarity between advocates of nondiscretionary policies and the new classical economists is that both believe that A) only unanticipated policies can affect aggregate output and employment. B) only anticipated policies can affect aggregate output and employment. C) discretionary policies may be destabilizing. D) discretionary policies will be ineffective in changing aggregate output and employment. Answer: C 21) Demonstrate graphically and explain the short-run and long-run effects of an unanticipated monetary expansion in the new classical model. Answer: See figure below. In the new classical model, unexpected monetary expansion increases aggregate demand. Since this is unexpected, aggregate supply is not affected, and output increases in the short run. As expectations adjust, aggregate supply decreases and output returns to the natural rate, with only prices rising. 22) In the new classical model, show graphically and explain how an expected monetary expansion that is less than expected reduces real output in the short run. What is the long-run result? Answer: See figure below. Demand does not increase as much as expected, so aggregate supply decreases more than the increase in aggregate demand. The result in the short run is a lower aggregate output. In the long-run, AS adjusts to the actual increase in demand with higher prices and no increase in output. 25.3 New Keynesian Model 1) The model that assumes that expectations are formed rationally but does not assume complete wage and price flexibility is known as the A) new classical model. B) Keynesian model. C) monetarist model. D) new Keynesian model. Answer: D 2) Wage and price rigidities created by long-term contracts suggest that an anticipated monetary expansion will have A) no effect on the aggregate price level. B) no effect on aggregate output. C) an effect on aggregate output only. D) an effect on both aggregate output and the price level. Answer: D 3) New Keynesians object to which of the following assumptions? A) Rational expectations B) Wage and price stickiness C) Complete wage and price flexibility D) Long-term contracts as a source of wage and price rigidities Answer: C 4) Rigidities that diminish wage and price flexibility such as long-term contracts suggest that an increase in the expected price level A) might not translate into complete adjustment of wages and prices. B) might cause aggregate demand to decrease. C) might cause aggregate supply to increase. D) will have no effect on the short-run aggregate supply curve. Answer: A 5) It is the existence of rigidities such as sticky wages, not adaptive expectations, that explains why ________ policies can affect real output in the ________ model. A) unanticipated; new classical B) anticipated; new classical C) unanticipated; new Keynesian D) anticipated; new Keynesian Answer: D 6) In the new Keynesian model A) wages and prices are assumed to be sticky with respect to expected changes in the price level. B) only unanticipated policy can affect aggregate output and unemployment. C) only anticipated policy can affect aggregate output and unemployment. D) unanticipated policy has no effect on aggregate output and unemployment. Answer: A 7) Like the new classical model, the new Keynesian model A) concludes that anticipated policies do not affect aggregate output and unemployment. B) distinguishes between the effects of anticipated versus unanticipated policy, with anticipated policy having a greater effect. C) distinguishes between the effects of anticipated versus unanticipated policy, with unanticipated policy having a greater effect. D) assumes that wages and prices are perfectly flexible with respect to changes in the expected price level. Answer: C 8) In the new Keynesian model, an unanticipated increase in the money supply causes A) aggregate demand to increase along a stationary aggregate supply curve. B) both aggregate demand and supply to increase. C) aggregate demand to increase as aggregate supply decreases. D) both aggregate demand and supply to decrease. Answer: A 9) In the new Keynesian model, an expansionary monetary policy will A) not cause aggregate output to increase, even if the policy is unanticipated. B) have a greater effect on aggregate output if the policy is unanticipated. C) have a greater effect on aggregate output if the policy is anticipated. D) have no effect on the price level. Answer: B 10) Mariann the economist argues that expectations are formed rationally, yet a pre-announced monetary expansion will lower unemployment. Mariann is probably a A) Keynesian economist. B) monetarist. C) new classical economist. D) new Keynesian economist. Answer: D 11) Kristin the economist argues that an anticipated monetary expansion will cause aggregate output to increase but believes that aggregate output would increase by an even greater amount if the monetary expansion came as a surprise to everyone. Kristin is probably a A) new Keynesian. B) new classical economist. C) monetarist. D) Keynesian economist. Answer: A 12) In the new Keynesian model, explain and depict graphically why an expected increase in the money supply increases real output in the short run. What is the long-run result? Answer: See figure below. Although the increase in demand is expected, rigidities prevent aggregate supply from decreasing as much as aggregate demand increases. Thus, short-run real output increases. In the long run, with complete adjustment, there will be higher prices and unchanged real output. 25.4 Comparison of the Two New Models with the Traditional Model 1) An anticipated increase in the money supply has no effect on aggregate output in the ________ model. A) new Keynesian B) Keynesian C) new classical D) traditional Answer: C 2) An anticipated increase in the money supply increases short-run real output by the largest amount in A) the traditional model. B) the new Keynesian model. C) the new classical model. D) all three models. Answer: A 3) An anticipated increase in the money supply causes the largest long-run increase in real output in A) the traditional model. B) the new Keynesian model. C) the new classical model. D) no model, as monetary policy does not affect real output in the long run. Answer: D 4) An anticipated increase in the money supply causes the largest short-run increase in the price level in A) the traditional model. B) the new Keynesian model. C) the new classical model. D) all three models. Answer: C 5) In the traditional model, the cost of lost output for each one percentage point reduction in the inflation rate is A) 4 percent of a year's real GDP. B) 0.25 percent of a year's real GDP. C) 0.04 percent of a year's real GDP. D) 25 percent of a year's real GDP. Answer: A 6) Rational expectations theory suggests that the success of an anti-inflationary policy depends on the A) adoption of a gold standard. B) passage of a tax cut. C) credibility of the policy in the eyes of the public. D) imposition of wage and price controls. Answer: C 7) In a new classical view of the world, the best anti-inflation policy, when viewed as being credible, is A) a gradualist policy. B) a cold turkey policy. C) a complete monetary and fiscal reform measure. D) an activist policy. Answer: B 8) When expectations of inflation are formed rationally, an anti-inflationary policy will be more successful if it is A) credible. B) a surprise. C) unanticipated. D) announced. Answer: A 9) It may be necessary to cut the deficit as part of a credible anti-inflationary policy because the public knows that large deficits A) are inflationary by themselves in the long run. B) create inefficiencies. C) put pressure on the Fed to expand the money supply to keep interest rates from rising. D) put pressure on the Fed to contract the money supply to prevent employment from rising. Answer: C 10) By ________ its deficit, the government's credibility of anti-inflationary policy ________. A) not changing; remains the same B) reducing; increases C) reducing; decreases D) not changing; increases Answer: B 11) Explain why anticipated policy has different short-run effects on real output and the price level in the new classical, new Keynesian, and traditional models. What are the long-run effects of anticipated policy in each model? Answer: In the new classical model, wages and prices are fully flexible, and expectations are formed rationally. In the new classical model, an anticipated policy change results in a matching adjustment of wages and prices. Thus, AD and AS shift by matching amounts in the opposite direction. This results in no change in real output, and the largest change in the price level is in the short run. In the new Keynesian model, expectations are rational, but rigidities keep wages and prices from adjusting fully even when policy is anticipated. Thus, AD shifts by more than AS. As a result, real output and prices both change, with prices changing by less than in the new classical model. In the traditional model, expectations are formed adaptively, so policy changes do not affect expectations and AS in the short run. Thus, demand changes cause the largest changes in real output, and smallest initial price level changes of any of the three models. In all three models, the long-run result is that real output does not change, and prices adjust fully to changes in demand. 25.5 Impact of the Rational Expectations Revolution 1) Today, most economists A) accept that expectations formation will change when the behavior of forecasted variables changes. B) believe that the Lucas critique has been discredited. C) accept the notion that there is no role for activist stabilization policy. D) believe that having policy credibility is not an important factor to a successful anti-inflation policy. Answer: A Test Bank for The Economics of Money, Banking and Financial Markets Frederic S. Mishkin 9780321599797, 9780134734200, 9780133836790, 9780134734606, 9780134733821
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