Objectives of fiscal policy and the national debt debate — MCQs

Elena Ruiz, an economist at Northbridge Asset Management, prepares a cyclical and policy assessment of Arbordale, a developed economy with a floating exchange rate and an independent central bank. The central bank has a price-stability mandate and publicly communicates a symmetric inflation target. Ruiz must advise the firm's asset-allocation committee whether current conditions indicate continued expansion, an approaching cyclical turning point, or an established contraction. Exhibit 1 presents the indicators Ruiz considers most relevant. Consumer spending remains positive, but its growth rate has slowed during the last two quarters. Business surveys report increasingly limited spare capacity and continuing difficulty recruiting skilled workers. At the same time, manufacturers have reduced new orders, and aggregate corporate profit growth has decelerated substantially. There has not yet been a broad decline in employment or household income. The central bank currently uses a policy rate of 5.0%. For analytical purposes, Ruiz applies the simplified policy rule shown in Exhibit 2. Under this rule, both the inflation gap and output gap are measured in percentage points. A positive output gap means actual real GDP exceeds potential GDP. Ruiz assumes the estimated neutral real interest rate and all current macroeconomic readings are reliable. She does not incorporate any separate financial-stability adjustment into the calculation. The finance ministry reports that income tax receipts have increased as nominal wages and corporate earnings have risen. Existing income tax rates, brackets, and collection rules have not changed. Separately, the government proposes a two-year infrastructure package intended to support activity if private investment weakens further. The package must be debated and approved by the legislature before agencies may solicit bids or begin construction. No spending under the proposal has yet occurred. Ruiz notes that policy actions are subject to different lags. Macroeconomic data are released with delays and may be revised, creating uncertainty about the economy's current position. Once officials decide to act, monetary policy can generally be implemented more quickly than a new infrastructure program. Nevertheless, changes in interest rates may take several quarters to affect borrowing, spending, employment, and inflation. Ruiz therefore distinguishes recognition, implementation, and impact lags when assessing the timeliness of each policy response.

Elena Park, an economist at an asset-management firm, assesses the economy of Ardell, which has a floating exchange rate and an inflation-targeting central bank. Exhibit 1 presents the indicators used in her cyclical assessment. Household survey data also show declining confidence and postponement of discretionary purchases. Corporate analysts report rising inventories and reduced new orders, although no widespread liquidation of productive capacity has occurred. The government has not enacted any new tax or spending legislation during the current year. Nevertheless, income-tax receipts have declined as employment and corporate profits have weakened. Payments under existing unemployment-benefit programs have increased. As a result, the budget deficit has risen from 2.0% to 3.4% of GDP. A government adviser characterizes the larger deficit as an expansionary response to current economic conditions. The central bank reduces its policy rate from 3.0% to 2.5%. Inflation expectations are expected to remain unchanged over the next several quarters, and foreign policy rates are assumed to remain constant. Bank balance sheets are sufficiently strong to permit additional lending, and the exchange rate is allowed to adjust freely. Park expects the policy action to affect market interest rates and the currency before it has its full effect on output and employment. Park also examines two Ardell industries. Solara Consumer Brands operates in an industry with many sellers, low barriers to entry, and differentiated products. Each firm faces a downward-sloping demand curve. Solara currently earns positive economic profit, but rival firms can introduce competing brands without significant legal or capital barriers. Park expects entry to continue until Solara reaches its long-run equilibrium. At the profit-maximizing quantity, Solara sets output where marginal revenue equals marginal cost. Titan Water Network is the sole supplier in its region because duplicating the distribution network would be prohibitively expensive. Regulation does not require Titan to set price equal to marginal cost. Titan also chooses output where marginal revenue equals marginal cost, subject to its market demand curve. Park notes that Titan's market structure differs from Solara's, but both firms face downward-sloping demand and therefore have marginal revenue below price.

Elena Marik, an economist at Northstar Asset Management, assesses conditions in Norland, a developed economy with a floating exchange rate and an independent central bank. Selected data are presented in Exhibit 1. Surveys indicate that businesses are cutting production because sales have declined more rapidly than expected. Retailers are accumulating unsold goods, postponing equipment orders, and reducing employee hours. Bank lending standards have tightened, although the banking system remains adequately capitalized. Norland has a progressive personal income-tax system and a national unemployment-insurance program. Existing law requires no legislative vote for tax liabilities or unemployment benefits to adjust when household income and employment change. Marik expects these provisions to affect the government budget even if elected officials take no new action. The finance ministry has separately proposed a discretionary infrastructure program equal to 1.5% of GDP. Parliamentary approval is expected within three months, but environmental reviews, contracting, and procurement mean that most expenditures will begin approximately 18 months from now. The ministry expects private consumption and investment to begin recovering within 12 months. Government debt is sustainable, and there is currently substantial unused productive capacity. The central bank announces that it will purchase government bonds in the secondary market. Policymakers expect the purchases to increase commercial-bank reserves and reduce short-term market interest rates. Inflation expectations remain anchored near the 2.0% target, and the central bank has not committed to defending any particular exchange rate. Norland permits unrestricted cross-border portfolio flows, so changes in relative interest rates can affect demand for its currency. Marik makes three observations. First, she classifies current economic conditions using output, employment, orders, and inventories rather than relying on one quarterly GDP observation. Second, she distinguishes the budget effects of existing tax and benefit rules from the proposed infrastructure spending. Third, she warns that the infrastructure program may affect aggregate demand under conditions different from those prevailing when the program was designed. Northstar's investment committee asks Marik to evaluate each observation using standard business-cycle and stabilization-policy frameworks.

A country has debt of LCU 300 billion and nominal GDP of LCU 500 billion. With a LCU 20 billion deficit and 4% nominal GDP growth, the next-period debt-to-GDP ratio is closest to:

Carden Global Markets advises multinational companies on foreign-exchange exposures. An analyst is reviewing transactions involving the US dollar, euro, and British pound. Carden quotes exchange rates as units of the price currency per one unit of the base currency. Thus, a USD/EUR quote is the number of US dollars per euro, and an EUR/GBP quote is the number of euros per British pound. Bid–ask spreads, taxes, transaction costs, and counterparty risk are ignored for all calculations. A UK client plans to convert GBP 5 million into USD immediately. Because no direct USD/GBP quote is displayed, the analyst must derive a cross-rate from the two spot quotations in Exhibit 1. The conversion is executed at the implied cross-rate without a dealer spread. Carden also assesses whether the observed one-year forward rate is consistent with no-arbitrage. The relevant USD and EUR interest rates are annual risk-free rates, and both borrowing and lending can occur at those rates. Interest is compounded annually, and the forward contract matures exactly one year from today. The analyst applies covered interest rate parity using the USD/EUR quotation convention. For an unhedged strategic forecast, the analyst uses relative purchasing power parity. Expected inflation over the next year is 5.00% in the United States and 2.00% in the euro area. The forecast is expressed as USD per EUR, and the exact gross-inflation-rate relationship is used rather than the linear approximation. Finally, the economics team reviews the euro area's external accounts. It reports a current account surplus and net private capital outflows of equal size. Official reserve assets do not change. For this question, net capital outflows are represented as a financial-account deficit. The team must identify how these entries reconcile in the balance-of-payments framework. All spot rates, interest rates, inflation rates, and analyst statements needed for the six independent assessments are included in Exhibits 1 and 2.

In an economy with marginal propensity to consume 0.75, proportional tax rate 20%, and marginal propensity to import 0.10, government spending rises by USD 25 million. The calculated increase in equilibrium output is closest to:

Meridian Global Strategy advises institutional investors with assets and liabilities denominated in several currencies. Its economics team is reviewing exchange-rate quotations, cross-border capital flows, relative purchasing power parity, and a proposed trade restriction. Unless otherwise indicated, currencies float freely, transaction costs are negligible, and exchange rates can adjust immediately. The team's current market observations appear in Exhibit 1. An analyst must calculate the USD price of one GBP using the two spot quotations. The quotation convention is important: USD/EUR expresses the number of US dollars required to purchase one euro, while EUR/GBP expresses the number of euros required to purchase one British pound. The cross-rate calculation must cancel the intermediate EUR units. The team also studies Norland, a financially open economy with a floating exchange rate. International investors unexpectedly revise upward their assessment of Norland's sovereign credit quality and purchase a substantial amount of its local-currency government bonds. The purchases are not offset by sales of other Norland assets, and Norland's central bank does not intervene in the foreign-exchange market. Investors must obtain Norland's currency before settling their bond purchases. No simultaneous change in expected inflation or domestic productivity occurs. For its one-year currency forecast, Meridian assumes relative purchasing power parity is the only relevant equilibrium condition. Expected inflation is 4.0% in the United States and 2.0% in the euro area. The team uses the standard approximation that the expected percentage change in the quoted exchange rate equals the price-currency inflation rate minus the base-currency inflation rate. It also recognizes that the higher-inflation currency should lose purchasing power relative to the lower-inflation currency. Finally, Norland's government proposes a tariff on an imported industrial input. Norland is too small to influence the world price, and foreign exporters do not reduce their pre-tariff price. The tariff would raise the domestic price, increase domestic production of the input, reduce domestic consumption, and generate government revenue. There is no learning-by-doing externality, national-security rationale, or other domestic market failure. Meridian's analyst must evaluate national welfare rather than the welfare of a particular producer, consumer, or government agency.

A USD-based investor earns 6.00% on an unhedged EUR asset while the EUR depreciates 4.00% against the USD. The calculated USD return is closest to: