Macroeconomics Principles- Stabilization Policy

Quiz 4/23; Final 4/30

Q: What are stabilization (countercyclical) policies?

A: Policies that reduce the magnitude of economic fluctuations by smoothing GDP growth. (“Stabilization policies reduce the magnitude of economic fluctuations, smoothing the growth rate…”

Q: What are the two main types of stabilization policy?

A: Monetary policy and fiscal policy. (“Two types of policy: Monetary Policy… Fiscal policy…”)

Q: What is an expansionary policy?

A: Policy aimed at reducing the severity of a recession by shifting labor demand to the right. (“Expansionary policy… goal is reducing the severity of a recession… labor demand shifts right.”)

Q: Who conducts countercyclical monetary policy?

A: The Federal Reserve (the Fed). (“Countercyclical monetary policy is conducted by the Federal Reserve Bank.”)

Q: What is the primary tool of monetary policy?

A: Control of the federal funds rate via open market operations. (“The primary tool… is the Fed’s control of the federal funds rate… through open market operations.”)

Q: What is an open market purchase?

A: The Fed buys bonds, increasing bank reserves and lowering interest rates. (“The Fed can increase the supply of reserves through open market purchases.”)

Q: What is an open market sale?

A: The Fed sells bonds, decreasing bank reserves and raising interest rates. (“The Fed can decrease the supply of reserves through an open market sale.”)

Q: How does expansionary monetary policy work?

A: Increases bank reserves → lowers short‑term interest rates → boosts consumption & investment → shifts labor demand right. (“Short-term interest rates fall… consumption and investment rise… labor demand shifts right.”)

Q: What is the Fed’s role as lender of last resort?

A: Providing emergency loans to prevent liquidity crises from becoming solvency crises. (“The Fed acts as lender of last resort… provides emergency loans…”)

Q: What is quantitative easing (QE)?

A: Large‑scale purchases of long‑term bonds and MBS to lower long‑term interest rates. (“QE consists of large-scale purchases of long-term government bonds and mortgage-backed securities.”)

Q: When is QE used?

A: When short‑term rates are already near zero (ZLB). (“At the ZLB… unconventional tools—QE and forward guidance—become the primary levers.”)

Q: What is the zero lower bound (ZLB)?

A: The constraint that nominal interest rates cannot fall below zero. (“Nominal interest rates cannot fall below zero: the zero lower bound.”)

Q: What is forward guidance?

A: Fed communication promising low future interest rates to reduce long‑term rates today. (“Forward guidance is the Fed’s communication about the future path of interest rates.”)

Q: What is contractionary monetary policy?

A: Policy that raises interest rates, slows borrowing, reduces money growth, and lowers inflation. (“Contractionary… raises interest rates… reduces borrowing… reduces inflation.”)

Q: What does the Taylor Rule prescribe?

A: A formula for setting the federal funds rate based on inflation and the output gap. (“A Taylor-type rule gives a formula… as a function of inflation and the output gap.”)

Q: What is the Taylor principle?

A: The Fed raises nominal rates more than one‑for‑one when inflation rises, increasing real rates. (“The coefficient on inflation exceeds 1… real rate actually increases…”)

Q: How does the Taylor Rule respond to a negative output gap?

A: It lowers the federal funds rate to stimulate the economy. (“FFR falls by 0.5 pp for every 1 pp GDP falls below trend.”)

Q: How does expansionary fiscal policy work?

A: Government spending rises or taxes fall → disposable income rises → consumption rises → labor demand shifts right. (“Government spending rises… consumption and investment rise… labor demand shifts right.”)

Q: What are automatic stabilizers?

A: Policies that respond automatically to economic conditions, such as unemployment insurance and progressive taxes. (“Automatic stabilizers operate without new legislation…”)

Q: What is discretionary fiscal policy?

A: New legislation that changes spending or taxes, such as ARRA (2009) or the CARES Act (2020). (“Discretionary fiscal policy requires Congress to pass new legislation…”)

Q: What is the trade‑off between automatic and discretionary fiscal policy?

A: Automatic stabilizers are fast but limited; discretionary policy is powerful but slow. (“Automatic stabilizers are timely but limited… discretionary policy… suffers from delays.”)

Q: What is the recognition lag?

A: Time needed to identify a recession because GDP data is delayed and revised. (“Recognition lag… takes time to determine whether the economy has entered a recession.”)

Q: What is the implementation lag?

A: Time required to enact policy—fast for monetary policy, slow for fiscal policy. (“Implementation lag… monetary policy is faster… fiscal policy requires Congressional action.”)

Q: What is the impact lag?

A: Time before policy affects spending and investment (often 6–18 months). (“Impact lag… spending and investment take time to respond—often 6–18 months.”)

Q: What happens to deficits during recessions?

A: They widen automatically as revenues fall and spending rises. (“Deficits tend to widen automatically during recessions…”)

Q: Why are tax revenues procyclical?

A: They rise in expansions and fall in recessions even without tax law changes. (“Federal tax revenues… fluctuate with the business cycle… rising incomes push revenues up…”)

Q: What is federal debt?

A: The accumulation of past deficits, expressed as a share of GDP. (“Each year’s deficit adds to the accumulated federal debt… expressed as a share of GDP.”)

Q: Why is high federal debt a concern?

A: It can limit future fiscal policy and raise borrowing costs. (“High debt can limit future fiscal policy… markets may demand higher interest rates…”)