178.200 06-9

178.
200 Intermediate Macroeconomics

Tutorial (9)
Policy & Debt
1
Short Answer Questions
1. Suppose a economy P
is initially at point A SRAS
on the graph.
(a) Compare the effects
of the passive and the A
active policy
responses to the
AD
fluctuations in real
output.
YN Y
2
Answer:
At point A, the real P
output YA is less than
the natural rate of SRAS
output YN. Hence, the
actual price level P
must be less than the A
expected price level
PE. In the future
years, PE will fall. AD
YA YN Y
3
Answer: (continued)
If macroeconomic
policies remain P
unchanged, a decrease in SRAS1
PE leads to shift the
aggregate supply curve
to the right until SRAS2
eventually actual output A
PA
equal to YN.
Therefore, if no policy PN
response is taken, real AD
output will eventually
rise and the price level
will fall. YA YN Y
4
Answer: (continued) P
If policymakers want SRAS
to increase output to
the natural rate
quickly, they could
increase M, or G, or A
decrease T. These AD2
policies would shift
the AD curve to the
right. AD1
YA YN Y
5
Answer: (continued) P
Thus, if an active SRAS
policy response is
taken, real output
will rise and the price PN
A
level will also rise. PA AD2
AD1
YA YN Y
6
(b) Briefly explain the limitations when the

active policy measures are taken to stabilize
output.
Answer:
One limitation of active policy concerns is
that fiscal policy has a relatively long inside
lag whereas monetary policy has a
relatively long outside lag.
7
Answer: (continued)
Another limitation is that the track record of
economic forecasts has not been especially
good. Finally, policymakers occasionally
seem to be unwilling or unable to
implement the appropriate macroeconomic
policies due to political considerations.
8
2. Analysis the short run effect of tax cuts according

to the traditional view of government debt.
Answer:
In a closed economy in the short run, a tax cut will
shift the IS curve to the right. This shift will
increase the consumption, the real income, and the
real interest rate. As a result, investment will fall
and the tax cut partially crowds out investment.
9
Answer: (continued)
In a small open economy, the real interest rate is
fixed at the world interest rate. If the foreign
exchange rate is floating, a tax cut will lead to an
appreciation of the domestic currency and national
income will be unchanged. Disposable income and
consumption, however, will increase and the tax
cut will completely crowd out net export.
10
Answer: (continued)
If the foreign exchange rate is fixed, the tax
cut will increase real income and increase
on consumption. To maintain the fixed
exchange rate, the central bank will have to
increase the money supply.
11
Multiple-Choice Questions
(2005 Exam Question)
(1) The following statement is TRUE:

b. Monetary policy has an especially long outside
lag.
c. Fiscal policy has an especially long inside lag.
d. Automatic stabilizers eliminate part of the inside
lag in the conduct of fiscal policy.
e. All of the above.
Answer: d.
Hint: P382.
12
(2) Arguments against the use of active stabilization
policy include all of the following EXCEPT the:
b. existence of long inside and outside lags.
c. limited ability of economic forecasters to predict
future economic conditions accurately.
d. responsiveness of labor force participation rates
to changes in national output.
e. historical view that ill-advised policy choices
were the cause of the Great Depression.
Answer: c.
Hint: PP382-387
13
(3)The system of unemployment insurance can be

used to illustrate:
b. the time inconsistency of policy.
c. the way that the economy is automatically
stabilized in the event of a shock.
d. the Lucas critique.
e. long inside lags in policy implementation.
Answer: b.
Hint: P383.
14
(4) Suppose that the index of leading indicators falls.

Economic forecasters will expect all of the
following to occur EXCEPT:
b. the unemployment rate will increase.
c. real output growth will decrease.
d. inflation will increase.
e. tax revenue growth will decrease.
Answer: c.
Hint: P383.
15
(5) According to the Lucas critique:
b. traditional methods of policy evaluation do not
adequately account for the impact of policy
changes on expectations.
c. traditional estimates of the sacrifice ratio are
unreliable.
d. economists cannot be completely confident
when they make assessments about the effects of
alternative economic policies.
e. all of the above.
Answer: d.
Hint: P386. 16
(6) The following statement is FALSE:
b. A policy that is active cannot be conducted by
rule.
c. The problem of time inconsistency is especially
relevant to policy conducted by discretion.
d. The conflicting interests of politicians reduce the
desirability of policy conducted by discretion
compared with policy conducted by rule.
e. Monetary policy currently is conducted by
discretion.
Answer: a.
17
Hint: P394.
(7) If the Reserve Bank conducts monetary policy by setting a
targeted unemployment rate of 5.5%, then the :
b. Unemployment rate will fall above or below 5.5%.
c. Natural rate of unemployment will converge to the
Reserve Bank’s target.
d. Reserve Bank will increase the growth rate of the money
supply whenever unemployment exceeds this targeted
rate.
e. Reserve Bank will adjust its target whenever
unemployment deviates from this rate.
Answer: c.
Hint: P389.
18
(8) The stock of government debt is equal to:

b. the current government budget deficit.
c. the total debt of all individuals in the
nation.
d. the outstanding debt of the government.
e. government expenditures minus the tax
revenues.
Answer: c.
19
(9) Most economists believe that the budget deficit

should measure the change in the government’s:
b. nominal debt.
c. real debt.
d. tax revenues.
e. fiscal policy.
Answer: b.
Hint: P410.
20
(10) During periods of inflation, the official measure
of the budget deficit:
b. overstates the change in the government’s real
indebtedness.
c. understates the change in the government’s real
indebtedness.
d. equals the change in the government’s real
indebtedness.
e. should equal the expected rate of inflation.
Answer: a.
Hint: P410. 21
(11) During recessions the:
b. actual budget deficit will be smaller than the
cyclically adjusted budget deficit.
c. actual budget deficit will be greater than the
d. actual budget deficit will be equal to the
e. cyclically adjusted budget deficit will always be
positive.
Answer: b.
Hint: P412.
22
(12) According to the traditional view of government

debt, a tax cut will lead to all of the following in
the short run EXCEPT a(n):
b. increase in consumption.
c. increase in private saving.
d. increase in investment.
e. decrease in public saving.
Answer: c.
Hint: P414.
23
(13) According to the traditional view of government

debt, a tax cut will lead to all of the following in
the long run EXCEPT a:
b. decreasing in public saving.
c. decreasing in national saving.
d. decreasing net exports.
e. depreciation of the foreign exchange rate.
Answer: d.
Hint: P414.
24
(14) According to the Ricardian view of government
debt, consumers will treat a current tax cut as an
increase in:
b. their wealth.
c. the sum of their current and expected future
income.
d. their current disposable income accompanied by
a future tax increase.
e. public saving.
Answer: c.
Hint: P416. 25

debt, a current tax cut will:
b. decrease public saving.
c. increasing private saving.
d. have no effect on national saving.
Answer: d.
Hint: P416.
26

debt, the relevant decision-making unit is the:
b. infinitely lived family.
c. finitely lived family.
d. finitely lived individual.
e. infinitely lived world community.
Answer: a.
Hint: P419.
27
(17) High budget deficits may:

b. encourage excessively expansionary monetary
policy.
c. increase the risk of government default on its
debt.
d. reduce a nation’s political influence throughout
the world.
Answer: d.
Hint: PP424-425. 28
(18) If higher deficits raise fears of default on a

country’s national debt:
b. domestic interest rates will rise.
c. the foreign exchange rate will depreciate.
d. capital flight may occur.
Answer: d.
Hint: PP424-425.
29
(19) Indexed government bonds:

b. have higher interest rates than nonindexed
bonds.
c. reduce the government’s incentive to produce
surprise inflation.
d. were introduced in US in 1948.
Answer: b.
Hint: P426.
30
(20) Adherence to a balanced-budget rule by the

federal government results in:
b. an inability to use monetary policy to stimulate
the economy when it slips into a recession.
c. persistent inflation.
d. an inability to lower tax rates to stimulate the
economy when it slips into a recession.
Answer: c.
Hint: P422. 31

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178.

200 Intermediate Macroeconomics

(b) Briefly explain the limitations when the

2. Analysis the short run effect of tax cuts according

(1) The following statement is TRUE:

(3)The system of unemployment insurance can be

(4) Suppose that the index of leading indicators falls.

(8) The stock of government debt is equal to:

(9) Most economists believe that the budget deficit

(12) According to the traditional view of government

(13) According to the traditional view of government

(15) According to the Ricardian view of government

(16) According to the Ricardian view of government

(17) High budget deficits may:

(18) If higher deficits raise fears of default on a

(19) Indexed government bonds:

(20) Adherence to a balanced-budget rule by the

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