Fiscal, Monetary and Supply-Side Policy: practice questions

Question 1

The government of Kelbrona wants to bring down persistently high inflation. It raises the average rate of income tax and cuts its own spending on public infrastructure projects, while leaving interest rates and the money supply unchanged.

Which term best describes this combination of policy actions?

Accepted Answer

B

Question 2

Bellara's government levies income tax according to the following schedule of marginal tax rates. Each rate applies only to the portion of a person's income that falls within that band. Band of taxable income Marginal tax rate $0 – $20,000 10% $20,001 – $50,000 20% Above $50,000…

Accepted Answer

((a)) Aiden's tax is 0.10×20000 + 0.20×20000 = 2000+4000 = 6000, i.e. $6,000, so Aiden's average rate of tax is 6000/40000×100=15%  ((b)) Priya's tax is 0.10×20000+0.20×30000+0.30×30000=2000+6000+9000=17000, i.e. $17,000, so Priya's average rate of tax is 17000/80000×100=21.25%, and the marginal rate of tax on Priya's last dollar earned is 30%  ((c)) Since the average rate of tax rises from 15% at the lower income to 21.25% at the higher income, Bellara's income tax schedule is progressive  ((d)) A progressive tax follows the ability-to-pay principle, taking a larger proportion of income from those with a greater capacity to pay, which is often seen as a fairer way to share the burden of financing government spending than a proportional tax that takes the same proportion…

Question 3

The table below shows the government of Corvane's revenue and spending over two consecutive fiscal years (all figures in $ billion). Year Government revenue Government current spending Government capital spending Year 1 540 460 115 Year 2 560 430 115 (a) For each year, calculate…

Accepted Answer

((a)) In Year 1, budget balance =540-(460+115)=540-575=-35, i.e. a $35 billion budget deficit; in Year 2, budget balance =560-(430+115)=560-545=+15, i.e. a $15 billion budget surplus  ((b)) Government spending fell while revenue rose between the two years, which is a contractionary fiscal stance; using AD/AS analysis, holding AS constant, this shifts AD to the left relative to what would otherwise have occurred, lowering both the equilibrium price level and the equ…  ((c)) Year 1's $35 billion deficit had to be financed by government borrowing, adding $35 billion to the stock of Corvane's national debt and increasing the future debt-interest payments the government must make

Question 4

Nordevik's economy is experiencing rising inflation. In response, Nordevik's central bank raises its policy interest rate from 4% to 7%, while the government leaves its own spending and taxation unchanged. (a) Explain how this rise in Nordevik's central bank interest rate is lik…

Accepted Answer

((a)) A higher interest rate raises the cost of borrowing for households, reducing consumption, especially on credit-financed spending, and raises the cost of borrowing for firms, reducing investment, while also making saving more attractive than spending, so both C and I fall and AD…  ((b)) With C and I lower, Nordevik's AD curve shifts to the left; holding AS constant, this lowers both the equilibrium price level, which helps control inflation, and the equilibrium level of real output, which is a possible cost of the policy  ((c)) Monetary policy can often be changed quickly by an independent central bank and is less politically constrained than fiscal policy, but its effect on AD depends on how responsive borrowing and spending actually are to interest rates and can be slow to fully transmit, so contract…

Question 5

Amberlyn's government announces a major, sustained increase in spending on vocational training for workers and on new transport infrastructure (roads and ports), explicitly aimed at raising the economy's long-run productive capacity. (a) Explain what is meant by supply-side poli…

Accepted Answer

((a)) Supply-side policy is a set of measures aimed at increasing an economy's productivity and productive capacity by shifting the long-run aggregate supply (LRAS) curve to the right, and the two tools used here are vocational training for workers and new transport infrastructure inv…  ((b)) A successful supply-side policy shifts Amberlyn's LRAS curve to the right, allowing a higher equilibrium level of real output to be reached at a stable or even lower equilibrium price level, whereas a rise in G with LRAS unchanged shifts AD to the right along the same fixed LRAS…  ((c)) A key limitation is the long time lag before training and infrastructure investment actually raise productive capacity, since developing workers' skills and planning, building and commissioning new infrastructure can take years, so supply-side policy is much slower to affect the…

Question 6

Thornwick's government funds local road maintenance with a fixed household charge of $300 per year, charged equally to every household regardless of income. The Chen household earns $15,000 a year and the Osei household earns $60,000 a year; both households pay the same $300 charge.

Which term best describes how this charge behaves as household income rises, and how should it be classified?

Accepted Answer

C

Question 7

Silverport's government levies a fixed excise duty of $0.80 per litre on petrol, added to the pump price. Marco earns $16,000 a year and buys 1,000 litres of petrol during the year. Elena earns $64,000 a year and also buys 1,000 litres of petrol during the year. (a) Calculate th…

Accepted Answer

((a)) Marco's duty is 0.80×1000=800, i.e. $800, giving an average rate of 800/16000×100=5%; Elena's duty is also 0.80×1000=800, i.e. $800, giving an average rate of 800/64000×100=1.25%  ((b)) Since the average rate falls from 5% for Marco to 1.25% for Elena as income rises, Silverport's petrol excise duty is regressive with respect to income  ((c)) A fixed-rate indirect tax is levied on the quantity bought rather than on income, so if drivers on very different incomes buy similar quantities of the good, the same dollar amount of tax represents a much smaller proportion of a higher income than of a lower income, making the…

Question 8

Halveston's economy is in recession, with falling real GDP and rising unemployment, and the central bank's policy interest rate is already close to zero. The central bank of Halveston therefore begins a programme of quantitative easing (QE), creating new money to buy government…

Accepted Answer

((a)) The central bank creates new money electronically and uses it to buy government bonds from commercial banks, which increases the reserves and liquidity those banks hold; with more reserves available and bond yields pushed down, banks are encouraged to lend more to households and…  ((b)) More lending raises consumption and investment, shifting Halveston's AD curve to the right, which raises both the equilibrium price level and the equilibrium level of real output; because the recession has left Halveston with substantial spare capacity, firms can expand output u…  ((c)) QE might fail to raise AD by as much as intended if commercial banks choose to hold the extra reserves rather than lend them out, for example because they remain cautious about borrowers' ability to repay during a recession, or if households and firms lack the confidence to take…

Question 9

Vantoria's economy has entered a downturn: real GDP has fallen and cyclical unemployment has risen sharply, while the country's long-run productive capacity is unaffected. Vantoria's government is considering three possible responses: (i) a temporary, debt-financed increase in p…

Accepted Answer

((a)) Option (i) is fiscal policy, since it is a change in government spending; option (ii) is monetary policy, since it is a change in the central bank's interest rate; option (iii) is supply-side policy, since deregulation is intended to raise productive capacity by shifting LRAS ra…  ((b)) Options (i) and (ii) both raise AD directly and fairly quickly, through higher G and higher C and I respectively, moving the economy along its existing AS/LRAS curve to a higher level of output and lower cyclical unemployment almost as soon as the extra spending or borrowing occ…  ((c)) Option (iii) may offer a more durable long-term solution because it tackles the underlying capacity of the economy to create jobs without adding to government debt or relying on low interest rates that cannot be cut indefinitely, but options (i) and (ii) provide faster relief to…

Question 10

Which of the following is the best example of a supply-side fiscal policy measure, rather than a purely demand-side fiscal policy measure?

Accepted Answer

B

Fiscal, Monetary and Supply-Side Policy: Economics 9708 (Cambridge International AS & A Level)

Syllabus coverage

Question 1

Question 2

Question 3

Question 4

Question 5

Question 6

Question 7

Question 8

Question 9

Question 10