Economics (McConnell), AP Edition, 20th Edition Chapter (27).docx

Chapter 37: Current Issues in Macro Theory and Policy Multiple-Choice Questions 1. The economic theory that holds that the economy is generally unstable is known as (A) Classical theory (B) Keynesian theory (C) Monetarist theory (D) Rational Expectations theory (E) Neoclassical theory (B) The other theories hold that the economy is stable at full-employment output. According to those theories, if any event destabilizes the economy, the economy will self-adjust. Difficulty: Easy Style: Factual AP Economics Curricular Requirement Macroeconomics: Stabilization Policies Book Section: Mainstream View 2. Keynesians argue that the economy does not self-adjust to demand shocks because (A) increased unemployment only lowers wage rates (B) reductions in demand cause significant deflation in the economy (C) wages and prices tend to be downwardly inflexible (D) expansionary fiscal policy is unpopular, so consumers do not change their spending in response to fiscal stimuli (E) firms do not change output in response to reductions in demand (C) Prices and wages tend to be downwardly inflexible (sticky) due to long-term contracts. When demand decreases, costs of production tend not to decrease or adjust quickly. As a result, the economy will be producing at less than full-employment output for a protracted period of time. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Sticky versus Flexible Wages and Prices Book Section: Mainstream View of Self-Correction 3. The Monetarist equation of exchange states that the money supply times the velocity equals (A) the inflation rate (B) the unemployment rate (C) the federal budget (D) real GDP (E) nominal GDP (E) The Quantity Theory of Money is MV=PQ, where M is the money supply, V is the velocity of money, P is the price level, and Q is real output. Nominal GDP is the P x Q on the right side of the equation, representing the price level and the quantity of output produced. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Quantity Theory of Money Book Section: Monetarist View 4. According to Monetarists, the quantity theory of money holds that if the central bank increases the money supply in response to a recession, the policy will result in I. a reduction in unemployment II. a possible increase in real output III. an increase in interest rates IV. an increase in the price level (A) I only (B) II only (C) III only (D) IV only (E) II and IV only (E) Monetarists hold that velocity is stable (or even constant). An increase in money supply will then increase either the price level or real output or both (nominal GDP). Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Quantity Theory of Money Book Section: Monetarist View 5. Classical economists argue that when the economy experiences supply or demand shocks, it self-corrects through the mechanism of flexible (A) output (B) employment rates (C) wages and prices (D) money supply (E) tax rates (C) When wages and prices are flexible, wages and costs of production can change, allowing the economy to self-adjust to shocks. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Sticky versus Flexible Wages and Prices Book Section: New Classical View of Self-Correction 6. Economists who adhere to the Rational Expectations Theory argue that fiscal and monetary policy are ineffective because (A) people anticipate policy changes and act to protect themselves (B) policymakers take too long to create policy (C) lower wages during recessions only further reduce aggregate demand (D) higher interest rates do not reduce inflationary expectations (E) the policies have contradictory interest rate effects (A) According to the Rational Expectations Theory, people are fully aware of economic conditions and fully anticipate the corrective fiscal and monetary policies policymakers are likely to undertake. Because the market has already reacted, policy intervention will be rendered ineffective. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Stabilization Policies Book Section: New Classical View of Self-Correction 7. Monetarists advocate the monetary rule, saying a nation’s central bank should increase the money supply (A) in response to a decrease in aggregate demand (B) in response to a decrease in aggregate supply (C) only when the government simultaneously increases taxes (D) at a steady rate based on the average rate of growth in the nation’s productive capacity (E) only when fiscal policy has failed to resolve a recession (D) Because Monetarists are convinced that increasing the money supply in an attempt to stabilize the economy only causes inflation, they advocate only increasing the money supply by the average rate of increase in the GDP to avoid further destabilizing the economy. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Stabilization Policies Book Section: In Support of Policy Rules 8. Monetarists oppose the use of expansionary fiscal policy, claiming that it (A) increases unemployment (B) reduces interest rates (C) reduces the money supply (D) causes deflation (E) crowds out private investment (E) Expansionary fiscal policy requires the government to borrow to finance deficit spending. Increased demand for money in the loanable funds market pushes up interest rates, reducing private investment (the crowding-out effect). Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Crowding Out Book Section: In Support of Policy Rules 9. The Taylor rule holds that economic policy must not only consider the relationship between real GDP and potential GDP, but also that the (A) government should also increase spending by ½% for each 1% increase in unemployment (B) government should also increase spending and raise taxes by ½% for each 1% increase in unemployment (C) Federal Reserve should raise the real federal funds rate by ½% for each 1% increase in the inflation rate above the 2% target rate (D) Federal Reserve should raise the required reserve ratio by ½% for each 1% increase in the inflation rate above the 2% target rate (E) Federal Reserve should increase the money supply by ½% for each 1% increase in the inflation rate above the 2% target rate (C) The Taylor rule considers both the gap in output between actual GDP and full-employment GDP and the inflation rate as it sets the federal funds rate. It holds that a 2% target rate of inflation is tolerable and must be considered as the Fed establishes the real federal funds rate. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Stabilization Policies Book Section: The Taylor Rule: Could a Robot Replace Ben Bernanke? 10. Unlike mainstream economic theorists, Monetarist theorists I. oppose expansionary fiscal policy II. believe that the economy is slow to self-correct from recession III. believe fiscal policy has a strong tendency to crowd out private investment IV. believe the economy does not easily self-correct after supply shocks (A) I only (B) I and III only (C) II only (D) II and IV only (E) II, III, and IV only (B) Monetarists hold that expansionary fiscal policy results in deficit spending and increased government borrowing. The increase in demand for loanable funds by the government will shift the demand curve to the right, increase the real interest rates, and reduce business investment (the crowding-out effect). According to Monetarists, the result is that expansionary fiscal policy will be largely ineffective. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Crowding Out Book Section: Monetarist View 11. Mainstream economists, unlike Monetarists, hold that when the economy is in recession I. downward wage inflexibility can keep the economy mired in recession II. expansionary fiscal policy intervention is constructive III. government deficit spending in recession will not crowd out private investment IV. expansionary monetary policy needs to be flexible (A) I only (B) I and III only (C) I, II, and III only (D) II and IV only (E) I, II, III, and IV (E) While these are four key tenets of mainstream economists, they are in direct conflict with Monetarist thought. Monetarists reject the value of discretionary policy intervention and are in support of established policy rules. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Fiscal and Monetary Policies Book Section: Mainstream View of Self-Correction 12. Assume that the economy finds itself in a short-run condition illustrated by the graph above. Classical economic theory policy maintains that without government intervention I. wages and resource prices are perfectly flexible II. the economy will naturally adjust to a new full-employment level of real GDP III. the economy will naturally adjust to a new equilibrium level at point C IV. the economy will naturally adjust to a new equilibrium level at point B (A) I only (B) II only (C) III only (D) I, II, and III only (E) I, II, and IV only (E) In this case, the economy faces an inflationary gap with real actual output at point A greater than real potential output at QFE. Without government intervention, wages and prices will increase, shifting SRAS1 to the left, to a new long-run equilibrium at point B. Price levels will increase, but there will be a decrease in real GDP. Difficulty: Hard Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Short-Run and Long-Run Analyses Book Section: New Classical View of Self-Correction 13. Assume that the economy finds itself in a short-run condition illustrated by the graph above. Classical economic theory policy maintains that without government intervention I. wages and resource prices are perfectly flexible II. the economy will naturally adjust to a new full-employment level of real GDP III. the economy will naturally adjust to a new equilibrium level at point C IV. the economy will naturally adjust to a new equilibrium level at point B (A) I only (B) II only (C) III only (D) I, II, and III only (E) I, II, and IV only (D) In this case, the economy faces a recessionary gap with real actual output at point A less than real potential output at QFE. Without government intervention, wages and prices are flexible and will decrease, shifting SRAS1 to the right, to a new long-run equilibrium at point C. Price levels will decrease and real output will increase. Difficulty: Hard Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Short-Run and Long-Run Analyses Book Section: New Classical View of Self-Correction 14. Mainstream economists contend that crowding out is not a serious problem in the use of fiscal policy because during a period of recession (A) the Fed will increase interest rates (B) Congress will not increase tax rates (C) private sector demand for loanable funds falls, reducing interest rates (D) government demand for loanable funds falls, reducing interest rates (E) firms increase investment in plant and equipment, increasing interest rates (C) During recessions, when aggregate demand is falling and unplanned inventories are building, firms reduce investment in plant and equipment. Decreased demand for loanable funds reduces the interest rate, reducing or even eliminating the impact of increased government demand for loanable funds. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Crowding Out Book Section: In Defense of Discretionary Stabilization Policy 15. Mainstream economists refute Monetarists’ criticisms of the use of monetary policy, arguing that I. the velocity of money is more variable and unpredictable than Monetarists admit II. a steady increase in money supply does not guarantee a steady increase in aggregate demand III. monetary policy can effectively deal with changes in business investment optimism IV. prices are flexible downward, so monetary policy can return the economy to full employment (A) I only (B) I and II only (C) III and IV only (D) I, II, and III only (E) I, II, III, and IV (D) Mainstream economists argue that prices are not flexible downward, so the economy can require a great deal of time to adjust to full-employment output. Difficulty: Medium Style: Conceptual AP Economics Curricular Requirement Macroeconomics: Stabilization Policies Book Section: In Defense of Discretionary Stabilization Policy