Economics 161

E. McDevitt
Study Questions on Monetary Policy and Fiscal Policy
1. What is Monetary policy? What is the general strategy of monetary policy? Use an
AS/AD graph to explain your answer.
2. What is Keyness Liquidity preference theory? According to this theory,what happens
in the short-run when the supply of money exceeds the demand for money? when
supply of money is less than the demand for money?
3. Suppose there is an increase in the money supply. Using a graph show the impact this
has on the real rate of interest in the SR. What happens to I and AD?
4. When the Fed describes its monetary policy actions, it usually does so in terms of an
interest-rate target. Explain why an interest-rate target effectively amounts to a money
supply target. Use a graph to explain your answer.
5. What is the federal funds rate?
6. What is Fiscal Policy? What is general strategy of fiscal policy?
7. What is the crowding-out effect? Provide a detailed explanation of the crowding-out
effect.
8. What is the primary argument against active fiscal policy and monetary policy?
9. Explain what is meant by the term automatic stabilizers.
10. Multiple choice questions. Select the best answer.
10a. The crowding-out effect implies that an increase in G (holding taxes constant) would
lead to all of the following EXCEPT:
a. a decrease (leftward shift) in money demand.
b. an increase in the real rate of interest.
c. a decrease in investment spending.
d. an offset to the initial increase in aggregate demand.
e. it would lead to all of the above.
10b. The federal funds rate is:
a. is the interest rate that the Fed charges banks for short-term loans.
b. is the interest rate that banks charge each other for short-term loans of reserves.
c. is the interest rate that banks charge their best corporate customers.
d. is the interest rate that banks pay on savings accounts.
e. None of the above.
10c. An example of an automatic stabilizer is:
a. the President and Congress agree to new legislation that will cut taxes during a
recession.
b. the drop in income taxes that occurs during recessions from the general drop in
incomes.
c. the President and Congress agree to new legislation that will increase government
spending during a recession.
d. All of the above.
e. None of the above.

10d. According to the AS/AD framework, if there is an unanticipated drop in

consumer wealth and if policy makers wanted to avoid a drop in real output and
employment, they should:
a.
b.
c.
d.
e.

increase government spending.

cut taxes.
increase the growth rate of the money supply.
any of the above.
none of the above.

10e. See graph below. The initial money supply and money demand are MS1 and MD1,
respectively. Suppose the Fed expects money demand to increase in MD2. If the Fed
desires to maintain the interest rate at r* it would have to
, because if the Fed
kept the money supply constant at MS1 the interest rate would
.
a. increase the money supply to MS2; fall.
b. increase the money supply to MS2; rise.
c. decrease the money supply to MS0; fall..
d. decrease the money supply to MS0; rise.

MS0

MS1

MS2

r*

target
MD2
MD1
Quantity of Money

ANSWERS
1. Monetary Policy refers to changes in the money supply that are designed to reduce
fluctuations in output, employment and the price level.
The general strategy of monetary policy is to increase the growth rate of the money
supply during periods of recessions (high unemployment and low output growth) and
reduce the money supply growth rate during periods of high inflation.
For example, suppose there is unexpected decrease in consumer confidence. This would
ordinarily lead to a drop in AD (see arrow 1)and consequently a decline in Y (a
recession). However, if the Fed expands the money supply this will increase AD (see
arrow 2) and thereby offset the initial decline in AD. There will therefore be no change in
Y, or if Y has already started to fall it will dampen the decline and speed up recovery
from the recession.
P

LRAS
1

SRAS
2
AD1
AD2
YLR
Quantity of
Real Output

2. It claims that the interest rate adjusts to bring about equilibrium between money supply
and money demand. If the supply of money exceeds the demand for money, then the
public will attempt to reduce their excess holdings of money by buying bonds and/or
depositing funds into banks. This will cause the real rate of interest to fall. As the interest
rate falls, the opportunity cost of holding money declines. This in turn results in an
increase in the demand for money (movement down along the MD curve) until money
supply and money demand are again equal.
If the demand for money exceeds the supply of money, then the public will attempt to
increase their holdings of money by selling bonds and/or withdrawing funds from banks.
This will cause the real rate of interest to rise. As the interest rate increases, the
opportunity cost of holding money rises. This in turn results in a decrease in the demand
for money (movement up along the MD curve) until money supply and money demand
are again equal.

At r1, MS>MD*.
The interest rate is bid down to r2.
r

At r1, MS<MD*.
The interest rate is bid up to r2.
r

MS

MS
Excess supply
of money at r1.

r1

Excess demand
for money

r2
r2
r1

MD
MD
MD* MS

Quantity
of Money

MS

MD* Quantity
of Money

3. Suppose there is an increase in the money supply. See graph below.

r
MS1

MS2

r1
r2
MD1
Quantity of Money
The increase in the money supply will initially create an excess supply of money at r1
(that is, MS2 > MD1 at r1). The public reduces excess holdings of money by buying bonds
and/or depositing it in a deposit at the bank. This causes the real rate of interest to decline
to r2. The lower interest rate means that the cost of borrowing is lower and this will cause
investment spending (which if financed by borrowing) to rise. The increase in investment
leads to an increase in aggregate demand (i.e., the AD curve shifts to the right).

4. Suppose the Fed desires to lower the interest rate to r* (so r* is the target interest rate).
To do so would require an increase in the money supply to MS2. In other words, to adopt
a policy that lowers r is to adopt a policy that increases the money supply since the
increase in the money supply is necessary to achieve the lower interest rate.
See graph below.
r
MS1

MS2

r1

r*

target
MD
Quantity of Money

Suppose the Fed desires to raise the interest rate to r* (so r* is the target interest rate).
To do so would require a decrease in the money supply to MS2. In other words, to adopt a
policy that raises r is to adopt a policy that decreases the money supply since the decrease
in the money supply is necessary to achieve the higher interest rate. See graph below.
r

r*

MS2

MS1

target

r1
MD

Quantity of Money

5. The federal funds rate is the interest rate that banks charge each other for short-term
loans of reserves. In recent years, the Fed has conducted monetary policy by targeting
this rate of interest.
6. Fiscal policy refers to the use of government spending (G) and/or taxes (T) by the
government to reduce to fluctuations in such macro variables as real output and
employment. The general strategy behind fiscal policy is to raise government spending
and/or cut taxes during recessions. Either an increase in G or decrease in T will raise
aggregate demand.
7. Crowding-out effect: the offset in aggregate demand that results when expansionary
fiscal policy (increase G and/or cut in T) raises the interest rate and thereby reduces
investment spending.
The (unanticipated) increase in G causes the AD curve to shift to right (to AD2 in the
graph below). The increase in AD leads to an increase in P and Y. The increase in P and
Y lead to higher money demand (MD shifts to MD2 in graph below) and this causes the
interest rate to be bid up to r2. The higher interest rate leads to a drop in investment and a
reduction in AD (the AD shifts back to the left-- AD3 in the graph). This reduction in AD
partially offsets the initial increase in AD. Thus, fiscal policy has a smaller impact on
real output and employment.
Summary: G AD to AD2 P and Y MD to MD2 rI AD to AD3 .
r

LRAS

MS
r2
r1

SRAS
MD2
AD2
MD1
Quantity of Money

AD3
AD1
YLR Y*

Quantity of
real output

8. Monetary and fiscal policy affect the economy with a long lag.
For fiscal policy, before legislation can be passed the legislators must (a) agree or
recognize that the economy is in a recession, (b)then they must agree on what type fiscal
policy (spending increase? tax cut? Both? Which type of spending increase? which type
of tax cut?), and (c) once the legislation is passed there is lag between the time G and/or
T are changed and when these changes have an impact on the economy.
Monetary policy works by cutting interest rates to affect investment. But many firms
make investment plans far in advance. Thus, investment spending is not immediately
affected.

The lags imply that policy makers will generally act too late. In fact, these policies may
make matters worsethat is, they may destabilize the economy since their effects may be
felt when the problem they were designed to solve no longer exists.
9. During recessions income tax revenue falls as there is a general decline in incomes.
Also, government spending programs like welfare and unemployment insurance increase
as employment declines. Thus, without the passage of any new legislation government
spending automatically rises and taxes automatically fall during recessionshence the
name automatic stabilizers.
10a. a.
10b. b.
10c. b.
10d. d.
10e. b.