CHAPTER 34: THE INFLUENCE OF MONETARY AND

FISCAL POLICY ON AGGREGATE DEMAND

1.The government builds a new water-treatment plant. The owner of the
company that builds the plant pays her workers. The workers increase
their spending. Firms from which the workers buy goods increase their
output. This type of effect on spending illustrates
a. the multiplier effect.
b. the wealth effect.
c. the crowding-out effect.
d. the Fisher effect.

2. The “crowding out” effect from government borrowing is best described

as
a. the lower exports due to an appreciating domestic currency versus other
currencies.
b. the leftward shift in AD in response to the rising interest rates from
expansionary fiscal policy.
c. the rightward shift in AD in response to the decreasing interest rates from
contractionary fiscal policy.
d. the effect of the President increasing the money supply, which decreases real
interest rates, and increases AD.

3. Which of the following correctly explains the crowding-out effect?

a. An increase in government expenditures increases the interest rate and so
reduces investment spending.
b. An increase in government expenditures decreases the interest rate and so
increases investment spending.
c. A decrease in government expenditures decreases the interest rate and so
reduces investment spending.
d. A decrease in government expenditures increases the interest rate and so
increases investment spending.

4. In a certain economy, when income is $200, consumer spending is $145.

The value of the multiplier for this economy is 6.25. It follows that, when
income is $230, consumer spending is
a. $170.20. For this economy, an initial impulse of $10 in consumer spending
translates into a $70.20 increase in aggregate demand.
b. $166.75. For this economy, an initial impulse of $10 in consumer spending
translates into a $66.75 increase in aggregate demand.
c. $166.75. For this economy, an initial impulse of $10 in consumer spending
translates into a $62.50 increase in aggregate demand.
d. $170.20. For this economy, an initial impulse of $10 in consumer spending
translates into a $62.50 increase in aggregate demand.

Solution:

5. The effect of the spending multiplier is lessened if

a. the price level is constant with an increase in the aggregate demand.
b. the price level rises with an increase in the aggregate demand.
c. the price level is constant with an increase in the long-run aggregate supply.
d. the price level falls with an increase in the aggregate supply.

6. If the government wants to contract aggregate demand, it can …………

government purchases or ………… taxes.
a. increase, increase
b. decrease, decrease
c. decrease, increase
d. increase, decrease

7. Assume the MPC is 0.75. Assume there is a multiplier effect and that the
total crowding-out effect is $6 billion. An increase in government purchases
of $10 billion will shift aggregate demand to the
a. left by $36 billion.
b. right by $34 billion.
c. right by $36 billion.
d. left by $24 billion.

Solution:
To calculate the multiplier, we use the formula:
Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.75) = 1 / 0.25 = 4
Increase in aggregate demand = Multiplier * Increase in government purchases
Increase in aggregate demand = 4 * $10 billion = $40 billion

8. When households find themselves holding too much money, they respond
by
a. purchasing interest-earning financial assets and interest rates rise.
b. selling interest-earning financial assets, which eliminates the excess supply of
money.
c. holding the extra money and interest rates rise.
d. purchasing interest-earning financial assets and interest rates fall.

9. Shifts in the aggregate-demand curve can cause fluctuations in

a. neither the level of output nor the level of prices.
b. the level of prices, but not in the level of output.
c. the level of output, but not in the level of prices.
d. the level of output and in the level of prices.

10. According to liquidity preference theory, an increase in the price level

causes the interest rate to
a. decrease, which increases the quantity of goods and services demanded.
b. increase, which decreases the quantity of goods and services demanded.
c. increase, which increases the quantity of goods and services demanded.
d. decrease, which decreases the quantity of goods and services demanded.

11. Which of the following is a predictable advantage of expansionary

monetary policy in a recession?
a. It increases unemployment, but low prices negate this effect.
b. It keeps interest rates high, which attracts foreign investment.
c. It increases aggregate demand, which increases real GDP and employment.
d. It decreases aggregate demand so that the price level falls.

12. If there is excess demand for money, then people will

a. withdraw money from interest-bearing accounts, and the interest rate will fall.
b. deposit more money into interest-bearing accounts, and the interest rate will
fall.
c. deposit more money into interest-bearing accounts, and the interest rate will
rise.
d. withdraw money from interest-bearing accounts, and the interest rate will
rise.

13. If the SBV conducts open-market purchases, the money supply

a. increases and aggregate demand shifts left.
b. decreases and aggregate demand shifts right.
c. increases and aggregate demand shifts right.
d. decreases and aggregate demand shifts left.

14. In which of the following cases would the quantity of money demanded
be largest?
a. r = 0.05, P = 0.9
b. r = 0.04, P = 1.2
c. r = 0.03, P = 1.3
d. r = 0.03, P = 1.2
Solution:

15. Suppose that the SBV is concerned about the effects of falling stock
prices on the economy. What could it do?
a. buy bonds to lower the interest rate
b. buy bonds to raise the interest rate
c. sell bonds to raise the interest rate
d. sell bonds to raise the interest rate

16. Which of the following would NOT be an example of contractionary

fiscal policy?
a. Increasing income taxes
b. Increasing government budget for infrastructure projects
c. Canceling the annual cost of living adjustments to the salaries of government
employees
d. Decreasing government budget on social programs

17. People will want to hold more money if the price level
a. decreases or if the interest rate increases.
b. or the interest rate increases.
c. increases or if the interest rate decreases.
d. or the interest rate decreases.

18. When the interest rate increases, the opportunity cost of holding money
a. decreases, so the quantity of money demanded decreases.
b. increases, so the quantity of money demanded increases.
c. increases, so the quantity of money demanded decreases.
d. decreases, so the quantity of money demanded increases.

19. With the economy in a recession because of inadequate aggregate

demand, the government increases its purchases by $1,200. Suppose the
central bank adjusts the money supply to hold the interest rate constant,
investment spending is fixed, and the marginal propensity to consume is
2/3. How large is the increase in aggregate demand?
a. $800
b. $400
c. $3,600
d. $1,800

Solution:

20. Which of the following statements is correct for the short run?
a. Output responds to the aggregate demand for goods and services; the interest
rate adjusts to balance the supply and demand for loanable funds; the price level
adjusts to balance the supply and demand for money.
b. Output is determined by the amount of capital, labor, and technology; the
interest rate adjusts to balance the supply and demand for loanable funds; the
price level adjusts to balance the supply and demand for money.
c. Output is determined by the amount of capital, labor, and technology; the
interest rate adjusts to balance the supply and demand for money; the price level
adjusts to balance the supply and demand for loanable funds.
d. Output responds to the aggregate demand for goods and services; the interest
rate adjusts to balance the supply and demand for money; the price level is
relatively slow to adjust.

21. The multiplier effect states that there are additional shifts in aggregate
demand from fiscal policy, because it
a. increases the money supply and thereby reduces interest rates.
b. increases income and thereby increases consumer spending.
c. decreases income and thereby increases consumer spending.
d. reduces investment and thereby increases consumer spending.

22. Fiscal policy refers to the idea that aggregate demand is affected by
changes in
a. the money supply.
b. government spending and taxes.
c. trade policy.
d. All of the above are correct.

23. If, at some interest rate, the quantity of money supplied is less than the
quantity of money demanded, people will desire to
a. sell interest-bearing assets, causing the interest rate to decrease.
b. buy interest-bearing assets, causing the interest rate to increase.
c. sell interest-bearing assets, causing the interest rate to increase.
d. buy interest-bearing assets, causing the interest rate to decrease.

24. Which of the following shifts aggregate demand to the right?

a. The price level rises.
b. The price level falls.
c. The money supply falls.
d. None of the above is correct.
25. To reduce the effects of crowding out caused by an increase in
government expenditures, the Central Bank could
a. increase the money supply by buying government bonds.
b. increase the money supply by selling government bonds.
c. increase the money supply by selling government bonds.
d. decrease the money supply by buying government bonds.