Monetary and Supply-Side Policy: practice questions

Question 1

The government of Velmara is considering four different policy actions to help it meet its macroeconomic aims.

Which of these is best classified as a supply-side policy measure, rather than a monetary or fiscal policy measure?

Accepted Answer

C

Question 2

The central bank of Ostrania raises its main policy interest rate from 4% to 7% per year, in an attempt to bring the inflation rate down from 9% toward its target of 3%. A small trading company in Ostrania has an outstanding bank loan of $80,000 at a variable interest rate that…

Accepted Answer

((a)) Monetary policy is the use of changes in the interest rate, the money supply and/or the exchange rate, generally by a central bank, to help the government achieve its macroeconomic aims.  ((b)) Interest at 4%: 0.04 × 80,000 = 3,200, i.e. $3,200. Interest at 7%: 0.07 × 80,000 = 5,600, i.e. $5,600. Increase =5,600-3,200=2,400, i.e. $2,400.  ((c)) A higher interest rate makes borrowing more expensive and saving more rewarding, so households and firms borrow and spend less and save more; lower spending on goods and services reduces demand in the economy, which slows the rate at which prices rise, helping bring inflation do…

Question 3

Brindale's government has identified low labour productivity as the main obstacle to raising its long-run rate of economic growth. Over the next five years, it plans to introduce three measures: 1. increased government spending on technical and vocational education for school le…

Accepted Answer

((a)) Supply-side policy is government action designed to raise the economy's productive capacity (potential output) and improve incentives to work, save and invest, rather than to manage the level of demand directly.  ((b)) Removing the licensing rules that restrict entry into road haulage is an example of deregulation. With this barrier removed, more firms can enter the road-haulage industry, increasing competition; this should push existing and new firms to become more efficient and innovate, low…  ((c)) Supply-side measures such as training workers or letting new firms establish themselves in an industry take time to have an effect, since new entrants need time to set up and expand, and it can take years for workers to gain new skills or for productive capacity to be built. Thi…

Question 4

Kalenport is a small, open economy that trades heavily with the rest of the world. Its inflation rate has risen to 8%, well above the central bank's target of 2%, driven partly by strong consumer demand for imported goods. In response, the central bank raises its policy interest…

Accepted Answer

((a)) Percentage change =2.00-2.50/2.50×100=-20%. The number of Kalenport dollars needed to buy one US dollar has fallen by 20%, so the Kalenport dollar has appreciated.  ((b)) Because fewer Kalenport dollars are now needed to buy foreign currency, imported goods and materials become cheaper in Kalenport-dollar terms. As imported consumer goods and imported inputs used by domestic firms both become cheaper, cost and price pressures in Kalenport ease, h…  ((c)) The stronger Kalenport dollar makes Kalenport's exports more expensive for foreign buyers to purchase in their own currency, reducing their price-competitiveness abroad. If export sales fall as a result, this can worsen Kalenport's balance of payments position and reduce output…

Question 5

A country's central bank significantly increases the growth rate of the money supply, while all other economic conditions remain unchanged. Which outcome would this be most likely to cause?

Accepted Answer

B

Question 6

Kestrion's central bank cuts its main policy interest rate from 6% to 3.5% per year, aiming to boost spending and reduce unemployment. A small manufacturing firm in Kestrion has an outstanding bank loan of $60,000 at a variable interest rate that moves in line with the policy ra…

Accepted Answer

((a)) A cut in the interest rate is a monetary policy measure because it works through the price of borrowing and the reward for saving, using one of the three monetary policy instruments (the interest rate, the money supply and the exchange rate), rather than through changes in gover…  ((b)) Interest at 6%: 0.06 × 60,000 = 3,600, i.e. $3,600 a year, which is $300 a month. Interest at 3.5%: 0.035 × 60,000 = 2,100, i.e. $2,100 a year, which is $175 a month. Fall in monthly interest cost =300-175=125, i.e. $125 a month.  ((c)) A lower interest rate makes borrowing cheaper and saving less rewarding, so households and firms are encouraged to borrow and spend more and to save less; firms such as Kestrion's manufacturing firm also face lower interest costs, freeing up funds and making new investment more…

Question 7

Verdanto's central bank wants to raise economic growth and reduce unemployment. Rather than changing the interest rate, it uses the exchange rate as its monetary policy tool, taking action so that the value of the Verdanto dollar falls against other currencies (a depreciation). All other economic conditions remain unchanged.

Which of the following is the most likely direct effect of this depreciation on Verdanto's trade?

Accepted Answer

A

Question 8

Meridale's government wants to reduce structural unemployment and raise the economy's potential output. It announces two supply-side measures, both taking effect over the next three years: 1. cutting the basic rate of income tax from 25% to 20%; 2. relaxing employment protection…

Accepted Answer

((a)) Cutting the basic rate of income tax from 25% to 20% is the measure that directly strengthens the incentive to seek paid work, because workers keep a larger share of any wage they earn after tax, raising the reward from working relative to not working.  ((b)) Making it easier for firms to hire and dismiss workers lowers the cost and risk to firms of taking on new employees, so firms in expanding industries become more willing to hire workers who do not perfectly match their existing requirements, including those affected by structura…  ((c)) One limitation is that cutting the income tax rate reduces the government's tax revenue, creating an opportunity cost in the form of less funding for public services or a larger budget deficit. Also, relaxing employment protection removes a barrier to hiring but does not guarant…

Question 9

Northgate's government funds the construction of a new national high-speed rail network connecting its major cities, cutting journey times and transport costs for firms and workers across the country.

Which macroeconomic effect would this investment be most likely to have in the long run?

Accepted Answer

A

Question 10

In Sarnovia, the traditional textile industry has been in long-term decline, while the software services industry is expanding rapidly and struggling to fill vacancies. Many former textile workers remain unemployed because they do not have the skills that software firms need. Sa…

Accepted Answer

((a)) Structural unemployment occurs when workers become unemployed because their skills, industry or location no longer match the jobs available in the economy, often because one industry has declined while a different industry has grown in its place.  ((b)) A cut in the interest rate raises overall demand for goods and services across Sarnovia's economy, which can increase output and jobs in general. However, this does not directly give former textile workers the specific skills software firms need to hire them, so many of the new…  ((c)) The retraining programme directly targets the mismatch between former textile workers' skills and the skills software firms need, so it is more likely to reduce structural unemployment specifically among this group, whereas the interest-rate cut mainly raises demand without addr…

Monetary and Supply-Side Policy: Economics 0455 (Cambridge O Level / IGCSE)

Syllabus coverage

Question 1

Question 2

Question 3

Question 4

Question 5

Question 6

Question 7

Question 8

Question 9

Question 10