QUESTION 1

A macroeconomic policy is calledprocyclicalif it is expansionary during business-cycle booms and contractionary during troughs. Acountercyclical policy, on the other hand, is contractionary during booms and expansionary during troughs. If the expansion and contraction of a macroeconomic policy is uncorrelated with business cycle ups and downs, it is consideredacyclical.

If the source of macroeconomic fluctuations is a demand shock, then:

a. Optimal fiscal policy is procyclical and optimal monetary policy is countercyclical.

b. Optimal fiscal policy is countercyclical and optimal monetary policy is procyclical.

c. Optimal fiscal and monetary policies are both countercyclical.

d. Optimal fiscal and monetary policies are both procyclical.

e. Optimal fiscal and monetary policies are both acyclical.

QUESTION 2

Consider an economy that has been steadily expanding for several years and is expected to continue growing at the same pace in the next couple of years. In this period, the ratio of budget deficit to GDP has been about 3 percent and public debt-GDP ratio has hovered around 100 percent. Both ratios as well as the interest rate and the inflation rate have been steady and are expected to remain so if economic growth continues at its current pace.

However, this year a temporary reduction in the prices of imported production inputs is generating above-trend incomes in the private sector, which is raising tax revenues. Everyone expects this favorable shock to be limited to this year. They also realize that there could be unforeseen shocks in the coming years that may shift the IS curve to the right or to the left, requiring the government to change fiscal policy to ensure the economy's stability. Assume that the country's creditors would be willing to lend more to the government at the current interest rates only if the government commits to raise tax rates in the following three years and pay back any additional debt that it takes on.

In this situation, if the government wants to pursue optimal fiscal policy, this year it should

a. keep the tax rate steady and raise fiscal expenditure to maintain the deficit-GDP ratio.

b. keep the tax rate and expenditure on course to let the deficit-GDP ratio to decline this year and provide room for increased expenditure in future years if need arises.

c. lower the tax rate, while keeping fiscal expenditure on course to maintain the deficit-GDP ratio.

d. lower the tax rate and raise fiscal expenditure by borrowing more to stimulate aggregate demand.

QUESTION 3

The German economy has been hit by an outbreak of COVID-19 and its GDP has shrunk. This has reduced the government's tax revenues at current tax rates. At the same time, the government has had to spend a sizeable sum (about 9 percent of 2019 GDP) to contain the virus outbreak and moderate its economic consequences.

If the government does not contain the virus, the loss of output would be more than 12 percent of 2019 GDP. With the public debt-GDP ratio of 57 percent in 2019, the German government has an excellent credit rating in global financial markets and is believed to be able to borrow well over 150 percent of its GDP billion without any notable change in the interest rate, which is currently practically equal to zero. The government has been following an optimal fiscal policy in the past several years so that its current expenditures fund projects that are all valued more than their costs.

In this situation, if the government wants tocontinue its optimal fiscal policy, which of the following would be a better option?

a. The government should spend the amount needed to contain the outbreak and finance it by cutting its current project expenditures, so that the public debt does not rise.

b. The government should refrain from spending more to contain the outbreak and make sure that the public debt does not rise any further.

c. The government should spend the amount needed to contain the outbreak and finance it by raising tax rates.

d.T he government should spend the amount needed to contain the outbreak and finance it by borrowing more.

QUESTION 4

In considering the response to this question, please keep in mind the definitions of expected inflation gap (defined as^e- *, or the distance of expected inflation, ^e, from the desired level of inflation,*) and output gap (defined asy^e- y-bar, or the deviation of (log of) expected aggregate output,y^e, from (log of) production capacity,y-bar). (These are also defined in Background Notes, Module 8, p. 1).

Under the optimal monetary policy, the central bank should let the nominal interest rate:

a. rise when the expected inflation gap rises and decline when the expected output gap rises.

b. decline when the expected inflation gap rises and rise when the expected output gap declines.

c. decline when the expected inflation gap or the expected output gap decline.

d. rise when the expected inflation gap or the expected output gap decline.

e. decline only when the expected inflation gap declines.

QUESTION 5

In countries where fiscal policy is determined by a large group of politicians with different constituencies and without an effective institutional mechanism for coordination,

a. there is a tendency to overspend because the politicians have an incentive to form a minimum winning coalition and push for higher spending and less taxation for their own constituencies.

b. there is a tendency to underspend because in that situation all politicians coalesce (form an alliance) and vote for lower taxation of their constituencies, resulting in a lower budget pool to spend.

c. there is a tendency to underspend because in that situation each politician tries to lower the taxation of his/her constituency by voting against spending for other constituencies.

d. there is a tendency to overspend because in that situation all politicians coalesce (form an alliance) and vote for higher spending and lower taxation for their constituencies.

QUESTION 6

Fiscal golden rule is a policy that requires:

a. the money supply to be backed by gold.

b. the fiscal expenditure to be backed by gold.

c. using gold to pay for government expenditure.

d. restriction of government borrowing to capital expenditures.

e. restriction of government expenditure to government revenues.