6) Imagine that the economy is at a point on the DD -AA schedule that is above both AA and DD and where both the output and asset markets are out of equilibrium. Explain what will happen next?
Answer: Since the asset market adjusts very quickly, the exchange rate drops immediately to a point on the AA
schedule. There will be excess demand for the domestic currency because the high expected future appreciation rate of the domestic currency implies that the expected domestic currency return on foreign deposits is below that on domestic deposits. This excess demand leads to an immediate fall in the exchange rate.
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7) A na? ve implication of the DD-AA framework is that either fiscal or monetary policy can lead to full employment. Discuss why this view is na?ve. Answer: (1) Inflation may arise without any gain in output if the government misuses its power to print
money.
(2) In practice, it is sometimes hard to be sure whether a disturbance to the economy originates in the output or assets markets.
(3) Shifts in fiscal policy often can be made only after lengthy legislative deliberations. Governments are likely to respond to disturbances by changing the monetary policy even when a shift in fiscal policy would be more appropriate.
(4) Fiscal policy impacts the government budget and may lead to government budget deficit that must be sooner or later be closed by a fiscal reversal. The state of the electoral cycle may be more important.
(5) Policies operate in reality with lags of varying length.
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8) Use a figure to study the following question: Imagine that the economy is at a point on the DD -AA schedule that is above both AA and DD, where both the output and asset markets are out of equilibrium. Explain what will happen next.
Answer: Since the asset market adjusts very quickly, the exchange rate drops immediately to a point on the AA
schedule. There will be excess demand for the domestic currency because the high expected future appreciation rate of the domestic currency implies that the expected domestic currency return on foreign deposits is below that on domestic deposits. This excess demand leads to an immediate fall in the exchange rate. The figure:
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16.7 Temporary Change in Monetary and Fiscal Policy
1) In the short run, with prices fixed, how would an increase in government spending affect the DD -AA
schedule?
A) It will increase output and appreciate the currency.
B) It will increase output and depreciate the currency.
C) It will decrease output and appreciate the currency.
D) It will decrease output and depreciate the currency.
E) None of the above.
Answer: A
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2) In the short -run, an increase in government purchases causes A) a shift of the DD curve to the left, output increases B) a shift of the DD curve to the right, output decreases
C) a shift of the DD curve to the left, output decreases D) a shift of the DD curve to the right, output increases E) None of the above.
Answer: D
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3) What are two ways the government can use to maintain full employment in an open economy? Also give an
example for each.
Answer: There are two types of government policy, monetary and fiscal policy. Examples of monetary policy
are changes in the money supply. Examples of fiscal policy are changes in government spending or taxes.
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4) Using a figure show that under full employment, a temporary fiscal expansion would increase output
(over-employment) but cannot increase output in the long run.
Answer: A temporarily fiscal expansion will move the economy from DD 1 to DD2, and output increases. A
permanent fiscal expansion will also shift the AA curve to the left and down. The nominal exchange
rate appreciates, i.e. E decreases.
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16.8 Inflation Bias and Other Problems of Policy Formulation
1) What is inflation bias? What measures have governments taken to avoid it?
Answer: Inflation bias is caused when a government is expected to use policy tools to create an economic
expansion (such as before an election). Because it is expected, wages and therefore prices are increased. If the government did not pursue the expansionary policy then, there would be a recession! Inflation is increased without the advantage of an increase in output.
Making the central bank independent of the political government is one answer to avoid inflation bias.
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2) Explain and give some governmental policy problems?
Answer: Steady nominal prices give government the power to raise output when it is low. It can also cause
them to create a tool that can be used for an economic boom. An example is just before an election. The temptation can be a problem when workers and companies expect it in advance. This will cause a rise in wage demand and prices in the expected expansionary policies. An inflation bias causing high inflation but no average gains in output is also a problem. Others are the difficulty in showing the sources or time of economic changes, and time lags in implementing policies. Impact on the
government budget by fiscal policy also causes problems by the way of a tax cut; increase in spending may lead to a government budget deficit that must sooner or later be closed by a fiscal reversal. Policy problem that seem to act quickly have actually a lag time with varying lengths.
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16.9 Permanent Shifts in Monetary and Fiscal Policy
1) If the economy starts in long -run equilibrium, a permanent fiscal expansion will cause A) an increase in exchange rate, E.
B) a decrease in exchange rate, E.
C) an increase in output, Y.
D) a decrease in output, Y.
E) shifting of the AA curve up and to the right.
Answer: B
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2) In the long -run equilibrium, after a permanent money-supply increase there follows: A) an increase in exchange rate, E.
B) a decrease in exchange rate, E.
C) an increase in output, Y.
D) a decrease in output, Y.
E) Both B and D.
Answer: A
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3) Which one of the following statements is the most accurate?
A) Over time, the inflationary pressure that follows a temporary money supply expansion pushes the price
level to its long-run value and returns the economy to full employment.
B) Over time, the inflationary pressure that follows a permanent money supply expansion pushes the
price level to its long-run value and returns the economy to full employment.
C) Over time, the inflationary pressure that follows a temporary money supply expansion pushes the price
level to its long-run value, but leaves the economy in a state of artificially low employment.
D) Over time, the inflationary pressure that follows a permanent money supply expansion pushes the
price level to its long-run value, but leaves the economy in a state of artificially low employment. E) None of the above.
Answer: B
Question Status: New
4) Using the DD -AA framework, which one of the following statements is the most accurate? A) Only monetary policy can bring the economy to full employment.
B) Only fiscal policy can bring the economy to full employment.
C) Only both monetary and fiscal policies can bring the economy to full employment.
D) Neither policy is capable of bringing the economy to full employment.
E) Monetary policy by itself or fiscal policy by itself can bring the economy to full employment.
Answer: E
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5) Which one of the following statements is the most accurate?
A) A permanent increase in the money supply cannot have any short -run effects. B) A permanent increase in taxes cannot have any short -run effects. C) A permanent decrease in the money supply cannot have short -run effects. D) A permanent decrease in taxes cannot have short -run effects. E) None of the above.
Answer: E
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6) A permanent increase in the domestic money supply
A) must ultimately lead to a proportional decrease in E, and, therefore, the expected future exchange rate
must rise proportionally.
B) must ultimately lead to a proportional decrease in E, and, therefore, the expected future exchange rate
must decrease proportionally.
C) must ultimately lead to a proportional rise in E, and, therefore, the expected future exchange rate must
rise proportionally.
D) must ultimately lead to a proportional rise in E, and, therefore, the expected future exchange rate must
rise more than proportionally.
E) must ultimately lead to a proportional rise in E, and, therefore, the expected future exchange rate must
rise less than proportionally. Answer: C
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7) In the short run, a permanent increase in the domestic money supply causes
A) a greater upward shift in the DD curve than that caused by an equal, but transitory, increase.
B) a greater downward shift in the AA curve than that caused by an equal, but transitory, increase.
C) an smaller upward shift in the AA curve than that caused by an equal, but transitory, increase.
D) a smaller downward shift in the AA curve than that caused by an equal, but transitory, increase.
E) a greater upward shift in the AA curve than that caused by an equal, but transitory, increase.
Answer: E
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8) In the short run, a permanent increase in the domestic money supply
A) has stronger effects on the exchange rate and output than an equal temporary increase.
B) has stronger effects only on the exchange rate but not on output than an equal temporary increase.
C) has weaker effects on the exchange rate and output than an equal temporary increase.
D) has stronger effects on output, but lower effect the exchange rate than an equal temporary increase.
E) None of the above.
Answer: A
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9) A permanent fiscal expansion
A) shifts the DD and the AA schedules to the right, increasing output.
B) shifts the DD and the AA schedules to the right, decreasing output.
C) shifts the DD to the right and the AA schedule to the left, increasing output.
D) shifts the DD to the left and the AA schedule to the left, decreasing output.
E) shifts the DD and the AA schedules to the left, leaving output the same.
Answer: E
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10) Explain the following figure:
Answer: The figure depicts the effect of a permanent increase in the money supply starting from full
employment equilibrium. After the initial increase in the money supply and the move of the AA curve to the right from AA1 to AA2, a steadily increasing price level shifts the AA and the DD schedules to
the left until a new long-run equilibrium is reached. Note that point 3 is above point 1, because Ee is permanently higher after a permanent increase in the money supply. The expected exchange rate, Ee, has risen by the same percentage as Ms. Notice that along the adjustment path between the initial short-run equilibrium (point 2) and the long-run equilibrium (point 3) the domestic currency actually appreciates (from E2 to E3) following its initial sharp depreciation (from E1 to E2).
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