Fiscal and Monetary Policy

TOMAS L. OLFATO
ANSWERS TO GROUP 4 EXAM
ECON 204
(NOTE: ANSWERS ARE HIGHLIGHTED IN YELLOW)

PART I. (5 points each)

A. An increase in government spending will shift the IS curve to left increasing output with higher interest rate.

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Expansionary monetary policy or Contractionary monetary policy.

a) To maintain the same level of output, what monetary policy should BSP implement?

ANSWER: EXPANSIONARY MONETARY POLICY (Increasing money supply lowers interest rate)

b) To maintain the same level of interest rate, what monetary policy should BSP implement?

ANSWER: CONTRACTIONARY MONETARY POLICY (Reducing money supply results to an increase in interest rate)

B. An inflationary gap occurs when aggregate demand exceeds aggregate supply at full employment level of output. When there is increased spending and availability of money are high, prices start to rise resulting to an inflationary gap. What fiscal policy (Expansionary or Restrictive) should the government implement to dampen growth and lower inflationary pressures(5 points).

ANSWER: RESTRICTIVE FISCAL POLICY (Racing taxes or cutting government spending to dampen GDP(Aggregate Demand) growth and lower inflationary pressures)

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C. A Deflationary gap occurs when aggregate supply exceeds aggregate demands at full employment level of output. The opposite of Inflation, deflation has the side effect of increased unemployment which can lead to economic depression. What fiscal policy (Expansionary or Restrictive) can government implement to stop severe deflation(5 points).

ANSWER: EXPANSIONARY FISCAL POLICY ( Increasing government purchases, decrease in taxes and/or increase in transfer payments closes a recessionary gap, stimulate the economy and decreases the unemployment rate)

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PART II. (2 points each)

True or False:

FALSE 1. The Keynesian school of thought is based on the premise that free markets can regulate themselves alone, free of any human intervention. There is an invisible hand that moves market towards a natural equilibrium, without the requirement of an intervention.

TRUE 2. Keynesian economic models stress the fact that government intervention is absolutely necessary to ensure growth and economic stability. The government has the very important job of smoothing out the business cycle bumps.

TRUE 3. In the Goods market, an increase in interest rate will result to a decrease in Money Demand while a decrease interest rate will result to an increase in Money Demand.

TRUE 4. In the financial market, an increase in interest rate will increase Money Supply while a decrease in interest rate will decrease Money Supply

TRUE 5. In liquidity trap, people are indifferent as to how much money or how many bonds they hold, so they are willing to hold fewer bonds and more money (more liquid) at the same nominal interest rate. The money supply will increase but the effect on the nominal interest rate remains zero. All the additional money is held as idle balances and equilibrium is unchanged.

FALSE 6. Disposable Income excludes both the negative impact of taxes and positive impact of transfer payments.

FALSE 7. Transfer payments decreases disposable income

TRUE 8. Fiscal neutrality creates a condition where demand is neither stimulated nor diminished by taxation and government spending.

TRUE 9. Crowding out effect happens when expansionary fiscal policy causes interest rates to rise, thereby reducing the investment or spending. If an increase in government spending and/or a decrease in tax leads to a budget deficit and this deficit is financed by increased borrowing, this creates demand for money and loanable funds. This will increase interest rates leading to a reduction in private consumption or investment.

FALSE 10. Expansionary fiscal policy increases national saving thereby reducing the supply of loanable funds and raising the equilibrium of the interest rate.

PART III. (5 points each)

1. A monetary policy wherein the government steps on the break. RESTRICTIVE MONETARY POLICY

2. A policy that focuses on controlling price and interest rates. MONETARY POLICY

3. The most popular policy instrument. OPEN MARKET OPERATIONS

4. A monetary policy instrument in which BSP have no total control. DISCOUNT RATE

5. When the government wants to reduce the money supply in open market, it has to. SELL BONDS TO THE PUBLIC

PART IV. (10 points)

If the government wants to solve the issue on economic growth by increasing the money supply, what should be the effect on interest rate, investment, and consumption?

↑MONEY SUPPLY, ↓ INTEREST RATE, ↑INVESTMENT, ↑ CONSUMPTION

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THANKS