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Lesson #14 : Monetary and Fiscal Policy part 2

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Yesterday’s lesson contained two parts – information re. monetary and fiscal policy as well as a quiz (ten questions) based on that information.

As promised here are the answers to this short quiz plus some explanation as required.

1. Even though all are possible answers to this question, the correct answer is (C), due to the fact that managing and controlling our money supply is the Bank of Canada’s most important function in its role as “stabilizer” of our national economy.

2. The money supply, as stated in Lesson #13, has two components – the money held in banks’ chequing accounts plus the amount of money (coins and bills) in circulation. When a client deposits money in a chequing account, this transaction increases the amount of money that a bank has to lend out which leads to the creation of money. Note that banks are not permitted to lend out 100% of the money they hold in chequing accounts. They are legally required to retain a percentage of each chequing account deposit in reserve, to deal with withdrawals. Regulating the percentage of money that banks are required to hold in their reserves is established by the Bank of Canada. The answer here is (C).

3. The answer to this question is (A). To stimulate an economy which is required during recessionary periods in the business cycle, the government implements expansionary monetary policy, including increasing its spending, cutting taxes, buying bonds, lowering interest rates as well as transferring money to the chartered banks. Numbers 2 and 4 here will cause an economy to contract even more.

4. The answer is (C).

5. The selling of bonds to consumers by government will cause the economy to contract. This action would be taken to restrain an economy in times of too much inflation. Slowing down the economy will have certain consequences including a decreased inflation rate, answer (C). The other three possible answers here would occur as results of expansionary monetary and fiscal policy – expansion of the economy (A), increased demand (B), and decreased interest rates according to the law of supply and demand (D).

The latter (D) requires further clarification. According to one law of supply and demand, if the supply of money, for instance increases, interest rates would decrease (Supply Up; Price (Interest Rates in this case) Down.) However, the question portrays the opposite scenario, i.e. Money Supply Down; Interest Rates Up. Answer (D) states that interest rates would naturally decrease which therefore makes this response incorrect.

6. As a result of expansionary monetary and fiscal policy, the economy will obviously expand thus causing increased demand for goods and services on the part of consumers which, in turn, will theoretically cause the unemployment rate to decrease since more workers will have to be hired to increase the production of goods to meet this increased demand. Hence the answer to this question is (A). The other three will likely increase as results of expansionary economic policy.

7. The answer is (C). Even though (B) is an appropriate policy to fight inflation, this is a monetary not a fiscal policy as is (A); however (A) is wrong for another reason. The buying of bonds is expansionary and is thus an inappropriate inflation fighter. Increased government spending (D), although a fiscal policy, is not a correct way to combat inflation as this action would be expansionary rather than restrictive. In times of high inflation, restraint is called for.

8. Increased interest rates will cause a rise in the costs of borrowing money. This will in turn result in a decrease in demand for commercial loans (2) and decreased demand for consumer goods (4). Answer again is (C). According to the law of supply and demand, when the cost of a good increases, quantity demanded for that good decreases or Price Up; Quantity demanded Down. If the price (interest rate) of borrowing money increases, quantity demanded goes down.

9. The answer to this question is (A). The other three possible answers – Transferring funds (B), the buying (C) and selling (D) of government bonds – are monetary policies. The question asks for a fiscal rather than a monetary policy.

10. Answer is A.

This is the end of our JuicyLesson for today.

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