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CHAPTER THIRTEEN
Rules versus Discretion —
Can Policymakers Stick to Their Promises?
True/False
1. Unanticipated inflation benefits creditors.
Ans: False
Dif: M
2. Deflation increases the real cost of borrowing.
Ans: True
Dif: M
3. A central bank’s external goals should always be subordinated to its internal goals.
Ans: False
Dif: D
4. A central bank normally needs to consider the volume of exports and imports when setting
monetary policy because the level of these variables affects real income.
Ans: True
Dif: M
5. Most central banks believe that external goals are separable objectives that can be achieved
separately from its internal goals.
Ans: True
Dif: M
6. An import dependent country is likely to pressure its central bank to maintain a strong currency
value.
Ans: True
Dif: M
7. If a country attempts to use monetary policy to generate persistent trade surpluses it is applying
what is called mercantilism.
Ans: True
Dif: E
8. A nation with a trade surplus that produces mostly exports with elastic demand that their trade
surplus is reduced when their currency depreciates.
Ans: True
Dif: D
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Chapter 13 — Test Bank
9. There are four common types of monetary policy time lags that policymakers have to deal with.
Ans: False
Dif: E
10. Nominal and real GDP estimates are available on a weekly basis, but the estimates often contain
substantial measurement error.
Ans: False
Dif: M
11. Near term uncertainties in data measurement probably extend the transmission lag.
Ans: False
Dif: E
12. The response lag is probably the shortest of the monetary policy lags.
Ans: True
Dif: M
13. The time between the perceived need for a policy change and its ultimate affect on the economy
is called the transmission lag.
Ans: False
Dif: M
14. The transmission lag can last well over a year.
Ans: True
Dif: E
15. It is likely that the practice of discretionary monetary policy pushes up a nation’s average
inflation rate.
Ans: True
Dif: E
16. A nation could produce 15% more than its current output level in real terms. The nation must
then be operating at 85% of output capacity.
Ans: True
Dif: E
17. The inflation bias need not exist if the short run aggregate supply curve is flat which may be the
case when many of the nation’s workers are unemployed.
Ans: True
Dif: D
18. A conservative investment banker is relatively less concerned about unemployment than inflation.
Ans: True
Dif: M
19. One of the reasons that economic independence is important to a central bank is that it is probably
necessary in order for the bank to have political independence.
Ans: True
Dif: M
Rules versus Discretion — Can Policymakers Stick to Their Promises?
20. Nations with central banks that have political and economic independence tend to have higher
inflation rates than other nations, ceteris paribus.
Ans: False
Dif: E
21. Japan, Mexico, France and Pakistan have recently reduced their central bank’s independence due
to these countries’ recent economic woes.
Ans: False
Dif: M
22. Because inflation is influenced by expectations, the credibility of the central bank’s stated desire
to fight inflation is a critical variable in the central bank’s ability to fight inflation.
Ans: True
Dif: E
23. A country seeking to increase domestic aggregate demand increases its money supply which also
results in a lower currency value. The lower currency value induces a trade deficit in a
neighboring country. The effect on the neighboring country would be considered an international
externality and is called a locomotive effect.
Ans: False
Dif: M
24. The formation of the BIS is an example of international policy cooperation.
Ans: True
Dif: E
25. The joint determination of monetary and regulatory policies by a group of central banks is called
international policy cooperation.
Ans: False
Dif: M
26. The ability of a nation’s citizens to control its own resources in its own perceived best interests is
termed national sovereignty.
Ans: True
Dif: E
27. The time inconsistency problem arises because of the long transmission lag of monetary policy.
Ans: False
Dif: E
28. The inflation bias exists because as the central bank increases aggregate demand, prices rise and
real wages fall, inducing workers to demand higher wages, thereby shifting the short run
aggregate supply curve up and reducing real output back to its original level. Eventually, workers
anticipate the price rise and the main effect of an increase in the money supply is inflation.
Ans: True
Dif: M
29. A set of countries that choose to use a common currency is called an optimal currency area.
Ans: False
Dif: M
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Chapter 13 — Test Bank
30. If the EU expands as planned it is highly questionable whether the EU will represent an optimal
currency area.
Ans: True
Dif: E
31. The advantage of maintaining separate currencies between countries is the speedier adjustment of
relative prices when competitive conditions change, but the speedier adjustment prolongs
unemployment.
Ans: False
Dif: D
32. The U.S. fits the definition of an optimal currency area better than the EU.
Ans: True
Dif: M
33. Since the adoption of the Euro, the EU can expect regions of the EU to experience more
prolonged periods of relatively poorer performance than before (ceteris paribus) and more
pressures to allow unfettered immigration between countries.
Ans: True
Dif: D
Multiple Choice
1. Costs of inflation include all but which one of the following?
A) costs of changing price lists, menus, etc.
B) higher nominal interest rates
C) a slower rate of innovation and diffusion of new and improved products
D) lower real incomes
E) higher unemployment
Ans: E
Dif: E
2. A country charges a 15% tax rate on their citizens’ first $30,000 of income and then a 25% tax
rate on any additional income. If annual inflation in the country is 9%, which of the following
individuals suffers a decline in real after tax wages as a result?
I.
Individual X whose pre-inflation annual income is $28,000 and post-inflation
income is $31,000.
II. Individual Y whose pre and post-inflation annual income is $26,000.
III. Individual Z whose pre-inflation annual income is $29,000 and his income
increases at the inflation rate.
A) I only
B) II only
C) I and II only
D) II and III only
E) I, II and III
Ans: D
Dif: D
Rules versus Discretion — Can Policymakers Stick to Their Promises?
3. Suppose that in recent years prescription drug costs have been rising at about 200% of the annual
inflation rate. Expected inflation is expected to be 3% this year. A senior citizen on a fixed
income of $35,000 per year who spent 10% of their annual income on prescription drugs last year
can expect to pay how much for drugs this year?
A) 10.0%
B) 13.0%
C) 16.0%
D) 10.6%
E) 10.3%
Ans: D
Dif: M
4. Internal goals of a central bank may include all but which one of the following?
A) low or even zero inflation
B) highest feasible growth rate of real GDP
C) maintaining a stable currency value
D) preventing sharp swings in inflation and GDP
E) minimizing unemployment
Ans: C
Dif: E
5. Which of the following statements about mercantilism is correct?
A) Imports of a nation are a prime source of national wealth.
B) Mercantilism fell out of favor in the eighteenth century.
C) Game theory would imply that if one country attempted mercantilism, all would and
international trade would be reduced.
D) No one advocates mercantilist policies today.
E) Because of the desire to avoid accusations of mercantilism, central banks do not consider
export and import levels in their monetary policy decisions.
Ans: C
Dif: M
6. If __________ industries have a sufficiently powerful lobby, a central bank may feel pressured to
__________ the nation’s currency value.
A) export; depreciate
B) export; appreciate
C) import; depreciate
D) mercantilist; maintain
E) inelastic; increase
Ans: A
Dif: E
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Chapter 13 — Test Bank
7. If the world experienced a global depression accompanied by stable prices and countries’ central
banks followed strict policy rules to limit inflation then the banks are likely to
A) substantially increase the global supply of money in response to the depression.
B) substantially reduce global interest rates in response to the depression.
C) depreciate the nations’ currency values.
D) increase bank reserve requirements to promote safety and stability.
E) none of the above
Ans: E
Dif: D
8. If a central bank suddenly decides to change the money supply in response to a perceived change
in the economy the bank is engaging in
A) discretionary policymaking.
B) formulaic policymaking.
C) application of the policy rule.
D) mercantilism.
E) improving policy credibility.
Ans: A
Dif: E
9. Increasing inventory buildups and growing unemployment claims in the early summer are first
thought to be normal seasonal changes, but after several months of these variables continuing
their trend the Federal Reserve realizes economic growth is slowing. This is an example of the
__________ lag.
A) overall policy time
B) response
C) recognition
D) transmission
E) feedback
Ans: C
Dif: E
10. After the Federal Reserve realizes that economic growth may be slowing the Fed meets to discuss
what must be done. Internal disagreements about the probable extent of economic decline delay
any action for several weeks however. This is an example of the __________ lag.
A) overall policy time
B) response
C) recognition
D) transmission
E) feedback
Ans: B
Dif: E
Rules versus Discretion — Can Policymakers Stick to Their Promises?
11. The Federal Reserve realizes that economic growth is slowing and decides to change the money
supply. The effects of the change are not fully felt in the economy for 18 months. This is an
example of the __________ lag.
A) overall policy time
B) response
C) recognition
D) transmission
E) feedback
Ans: D
Dif: E
12. Increasing inventory buildups and growing unemployment claims in the early summer are first
thought to be normal seasonal changes, but after three months of these variables continuing their
trend the Federal Reserve realizes economic growth is slowing. After the Federal Reserve
realizes that economic growth may be slowing the Fed meets to discuss what must be done and
debates the issue for one month before deciding to act and lower interest rates. The effects of the
interest rate change are not fully felt in the economy for another 14 months. This is an example
of the __________ lag.
A) overall policy time
B) response
C) recognition
D) transmission
E) feedback
Ans: A
Dif: E
13. The average length of the monetary policy transmission lag is (about)
A) 6 weeks.
B) 12 months.
C) 18 months
D) 2 years.
E) 3 years.
Ans: B
Dif: M
14. The tendency for the economy to experience ongoing inflation when central banks follow
discretionary monetary policy is called the
A) inflation bias.
B) time inconsistency problem.
C) monetary policy lag.
D) fiscal policy lag.
E) conservative man rule.
Ans: A
Dif: E
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Chapter 13 — Test Bank
15. If workers believe that any increase in aggregate demand brought about by monetary policy is
inflationary then which of the following is likely to occur when workers believe the central bank
is pursuing a goal of increasing real output?
I. Workers will demand higher wages, reducing aggregate supply.
II. Inflation will occur as prices rise with wages.
III. Real output will rise, but only at the cost of inflation.
A) I only
B) II only
C) III only
D) II and III only
E) I and II only
Ans: E
Dif: D
16. Suppose that an economy is facing weak aggregate demand. If the central bank promises not to
increase aggregate demand but workers do not find this promise credible, which of the following
is the most likely outcome (ceteris paribus) if the central bank does stick to its promise?
I. Real output will fall.
II. Inflation will increase.
III. The value of the nation’s currency will fall.
A) I only
B) II only
C) I and II only
D) II and III only
E) I, II and III
Ans: E
Dif: D
17. The time inconsistency problem of monetary policy refers to the
A) time lag between the occurrence of a problem and the recognition of the problem.
B) ability of the policymaker to alter its strategy later on in a way inconsistent with its
announced strategy.
C) time lag between the implementation of monetary policy until the policy affects the economy.
D) difficulty in getting policymakers to fairly respond to the needs of the citizens.
E) lack of independence of the central bank from the political process.
Ans: B
Dif: M
Rules versus Discretion — Can Policymakers Stick to Their Promises?
NARRBEGIN: Figure 1, Price and Real Output Levels in the Economy
Price Level
AS2
AS1
C
P2
B
D
A
P1
AD2
AD1
y1
y*
Real Output
NARREND
18. Refer to Figure 1 to answer the following question: The economy is at equilibrium at Point A, but
capacity output is y* and unemployment exists and workers correctly believe that the central bank
will increase aggregate demand to AD2. Which of the following final solutions will occur?
A) The final solution will occur at point C with price level P2.
B) The final solution will occur at point A with price level P1.
C) The final solution will occur at point B with the new price level between P1 and P2.
D) The final solution will occur at point D with the new price level between P1 and P2.
E) The final solution will occur between points A and B, with the new price level between
P1 and P2.
Ans: A
NAR: Figure 1 Price and Real Output Levels in the Economy
Dif: D
19. Refer to Figure 1 to answer the following question: The economy is at equilibrium at Point A, but
capacity output is y* and unemployment exists and workers correctly believe that the central bank
will increase aggregate demand to AD2. Which of the following answers is correct?
A) The time inconsistency bias is measured by ABCD.
B) y* – y1 is the real output bias.
C) P2 – P1 is the inflation bias.
D) AS1 and AS2 are the long run aggregate supply curves.
E) The flatter the AS curves the larger the inflation bias.
Ans: C
NAR: Figure 1 Price and Real Output Levels in the Economy
Dif: E
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Chapter 13 — Test Bank
20. Refer to Figure 1 to answer the following question: The economy is at equilibrium at Point A, but
capacity output is y* and unemployment exists and workers believe that the central bank will
increase aggregate demand to AD2, even though the central bank promises not to. Which of the
following final solutions will occur if the central bank keeps its promise?
A) Real output will increase and there will be no inflation.
B) Real output will decrease and there will be no inflation.
C) Real output will increase and there will be inflation.
D) Real output will decrease and there will be inflation.
E) Real output will not change and there will be inflation.
Ans: D
NAR: Figure 1 Price and Real Output Levels in the Economy
Dif: D
21. Refer to Figure 1 to answer the following question: The economy is at equilibrium at Point A, but
capacity output is y* and unemployment exists, but the central bank promises not to increase AD
to AD2 and the workers believe this promise is credible. Which of the following final solutions
will occur if the central bank keeps its promise?
A) Point A
B) Point B
C) Point C
D) Point D
E) Some point between A, B and C
Ans: A
NAR: Figure 1 Price and Real Output Levels in the Economy
Dif: M
22. The U.S. has helped limit the inflation bias by employing which of the following?
I.
II.
III.
IV.
constitutional limits on discretionary monetary policy
a central bank with a reputation of keeping inflation low as its primary goal
a central bank headed by a conservative central banker
a central bank that is politically and economically independent
A) I and II only
B) II and III only
C) II, III and IV only
D) III and IV only
E) I, III and IV only
Ans: C
Dif: D
23. For a central bank to be considered independent all but which one of the following must be true?
A) The central bank must be able to control its own budget.
B) Monetary policy decisions must be made independently of the political process.
C) The central bankers must be appointed for life.
D) The central bank must not be in the habit of making loans to the government.
E) The central bank must use monetary policy to affect the outcomes of elections.
Ans: C
Dif: M
Rules versus Discretion — Can Policymakers Stick to Their Promises?
24. Which one of the following statements about central banking contracts is incorrect?
A) They are legally binding agreements between governments and central banking officials.
B) Their purpose is to limit the inflation bias.
C) They hold the central bank official(s) responsible for a nation’s level of inflation.
D) One is in use in New Zealand.
E) They hold the central bank official(s) responsible for a nation’s real output.
Ans: E
Dif: M
25. The more independent a central bank is then the __________ the level of inflation and the
__________ the variability of inflation.
A) higher; higher
B) lower; lower
C) higher; lower
D) lower; higher
Ans: B
Dif: M
26. Linkages between nations’ markets for goods, services and financial assets can lead to:
I. structural interdependencies.
II. international negative externalities.
III. locomotive effects.
A) I only
B) II only
C) I and II only
D) II and III only
E) I, II and III
Ans: E
Dif: E
27. When central banks of various nations engage in strategic policymaking they are acting as
__________ and when they engage in international policy coordination concerning currency
values they are acting as __________.
A) monopolistic competitors; monopolies
B) oligopolies; a cartel
C) competitors in perfect competition; oligopolies
D) international policy cooperators; BIS bankers
Ans: B
Dif: D
28. The institution that serves as an international loan trustee and an agent for central banks is the
A) IMF
B) World Bank
C) BIS
D) WTO
E) G10
Ans: C
Dif: E
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Chapter 13 — Test Bank
29. Benefits of international policy coordination include all but which one of the following?
A) limiting negative international externalities
B) promoting locomotive effects
C) elimination of the inflation bias with discretionary monetary policy
D) gaining support to withstand local political pressures
E) increasing countries’ ability to promote both domestic and international monetary policy
goals
Ans: C
Dif: M
30. Which of the following are drawbacks of international policy coordination?
I.
Coordinating policy can result in a loss of a certain amount of national
sovereignty.
II. Game theory predicts that other countries in the coordinating group will
always cheat and act in their own self interest.
III. Not all central bankers can be trusted to competently perform their part of the
agreement.
IV. Even if all parties to the agreement do their part, all countries in the group
may still be worse off because of the coordination.
A) I and II only
B) II and III only
C) II, III and IV only
D) III and IV only
E) I, III and IV only
Ans: E
Dif: M
31. A common currency should not be used in an area if
A) the risks arising from exchange rate changes are high.
B) the costs of converting currencies in the area are high.
C) labor and capital cannot move from inside to outside the currency area.
D) exchange rates have traditionally been allowed to float within the proposed currency area.
E) labor and capital cannot move relatively freely within the currency area.
Ans: E
Dif: M
Rules versus Discretion — Can Policymakers Stick to Their Promises?
32. If a geographic region of countries creates a common currency area and labor and capital cannot
move between the countries in the currency area then which of the following are likely to occur
over time as relative supply demand conditions change within the countries?
I.
Prolonged periods of unemployment in some countries within the currency
area.
II. Chronic balance of payments problems in some countries within the currency
area.
III. Lower currency value against other countries than there would have been
otherwise.
A) I only
B) II only
C) I and II only
D) II and III only
E) I, II and III
Ans: E
Dif: M
33. Under the Maastricht Treaty countries wishing to join the EU must meet certain conditions.
Which one of the following criteria they must meet is correctly stated?
A) The applicant’s budget deficit can be no more than 5% of total national debt.
B) The maximum debt to GDP ratio allowed is 60%.
C) The applicant’s inflation rate can be no more than 2.5% higher than the EU average.
D) The applicant’s long term interest rate can be no more than 2% higher than the EU average.
E) None of the above is correct.
Ans: B
Dif: M
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