Multiple-Choice Review Questions

1. In a banking system with limited reserves, a decrease in the supply of money
(A) lowers interest rates, decreases borrowing, and thereby decreases aggregate demand.
(B) raises interest rates, increases borrowing, and thereby increases aggregate demand.
(C) raises interest rates, decreases borrowing, and thereby decreases aggregate demand.
(D) lowers interest rates, increases borrowing, and thereby increases aggregate demand.
(E) lowers interest rates, increases borrowing, and thereby decreases aggregate demand.

2. To reduce unemployment in the macroeconomy, the Fed could try
(A) to decrease interest rates in the economy.
(B) increasing the federal funds rate.
(C) decreasing income taxes.
(D) contractionary monetary policy.
(E) decreasing aggregate demand.

3. To reduce inflation in the macroeconomy, the Fed could try
(A) increasing the money supply.
(B) increasing the federal funds rate.
(C) increasing income taxes.
(D) expansionary monetary policy.
(E) increasing aggregate demand.

4. An effective contractionary monetary policy can
(A) increase employment.
(B) increase production.
(C) close a recessionary gap.
(D) decrease the price level.
(E) increase the money supply.

5. In the short run an expansionary monetary policy will cause
(A) an increase in real GDP.
(B) an increase in interest rates.
(C) a decrease in consumer spending and an increase in investment.
(D) an increase in consumer spending and a decrease in investment.
(E) a decrease in consumer spending and a decrease in investment.

6. A recessionary gap closes in the long run when wages and resource prices ________, shifting ________ to the right.
(A) fall; aggregate demand
(B) rise; long-run aggregate supply
(C) fall; long-run aggregate supply
(D) rise; short-run aggregate supply
(E) fall; short-run aggregate supply

7. In a liquidity trap, expansionary monetary policy will not work because
(A) banks do not want to make loans with their excess reserves.
(B) interest rates cannot fall much further.
(C) there is no way to liquidate government bonds.
(D) firms and households prefer to rid themselves of liquid assets.
(E) the Fed does not have the means to buy government bonds.

8. If the economy is experiencing an inflationary gap,________ monetary policy could be used to ________ aggregate demand and ________ the general price level.
(A) expansionary; decrease; decrease
(B) expansionary; increase; decrease
(C) contractionary; increase; increase
(D) contractionary; decrease; increase
(E) contractionary; decrease; decrease

9. In order to fight inflation the Fed should
(A) increase the money supply in order to increase the federal funds rate.
(B) increase the money supply in order to decrease the federal funds rate.
(C) decrease the money supply in order to increase the federal funds rate.
(D) decrease the money supply in order to decrease the federal funds rate.
(E) decrease the money supply in order to tighten up budgets.

10. If the Fed uses contractionary monetary policy, in the short run unemployment would
(A) worsen, but inflation would come down.
(B) improve, but inflation would worsen.
(C) worsen as would inflation.
(D) improve as would inflation.
(E) improve while inflation remained unchanged.

11. If an economy is producing below its long-run potential, expansionary monetary policy would
(A) increase output and prices.
(B) decrease output and prices.
(C) increase output and decrease prices.
(D) decrease output and increase prices.
(E) increase output and leave prices unchanged.

12. If an economy is producing above its long-run potential, an increase in interest rates would
(A) increase output and prices.
(B) decrease output and prices.
(C) increase output and decrease prices.
(D) decrease output and increase prices.
(E) increase output and leave prices unchanged.

13. If the federal funds rate is above the Fed’s target, the Fed should
(A) buy bonds to increase the money supply.
(B) buy bonds to decrease the money supply.
(C) sell bonds to increase the money supply.
(D) sell bonds to decrease the money supply.
(E) raise the reserve requirement to decrease the money supply.

14. If the Fed conducts an effective contractionary monetary policy, then
(A) the economy slides up the Phillips curve.
(B) the economy slides down the Phillips curve.
(C) the Phillips curve shifts right.
(D) the Phillips curve shifts left.
(E) the aggregate demand curve shifts right, but the Phillips curve is unaffected.

15. If the prices of resources increase, then
(A) the economy slides up the Phillips curve.
(B) the economy slides down the Phillips curve.
(C) the Phillips curve shifts right.
(D) the Phillips curve shifts left.
(E) the aggregate demand curve shifts right, but the Phillips curve is unaffected.

Free-Response Review Questions

1. Use the aggregate supply/aggregate demand diagram to portray an economy suffering from a recessionary gap. Be sure to label all axes and curves. Do you recommend expansionary or contractionary monetary policy in this case? On the diagram, show which curve shifts which way because of the appropriate monetary policy.

2. Use the aggregate supply/aggregate demand diagram to portray an economy suffering from an inflationary gap. If nothing is done to address the gap, will resource prices rise or fall in the long run? On the diagram, show which curve shifts which way once resource prices change.

3. Draw a short-run Phillips curve, making sure to label the axes correctly. Mark a point labeled “A” on the Phillips curve that represents an economy with a high unemployment rate. Do you recommend expansionary or contractionary monetary policy in this case? On the diagram, indicate how point A will change if the appropriate monetary policy is effective.