Economics. 14 question(s) in this unit's pool
(2 above the exam). Free up to ten a day; the coach picks which ones based on what you have
already answered and when each is next due.
Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own
explanation. Questions you have already answered correctly and confidently stay out of the way until they
are due for review again.
Question 1Exam level
An economy has a marginal propensity to consume (MPC) of 0.75. The government increases spending by $200 billion. Assuming no crowding out and a closed economy, the total change in GDP is closest to:
How sure are you?
Correct: B. Government spending multiplier = 1/(1-MPC) = 1/(1-0.75) = 1/0.25 = 4. Total change in GDP = 4 x $200B = $800B. The key formula is 1/(1-MPC), not MPC/(1-MPC). The trap answer B ($600B) reflects candidates who compute 3 x $200B. Confusing the tax multiplier magnitude with the spending multiplier.
A. You might have calculated the multiplier as MPC/(1-MPC) which equals 3, leading to $600 billion, but this confuses the spending multiplier formula, which is actually 1/(1-MPC), resulting in a multiplier of 4 and a total change in GDP of $800 billion.
C. Choosing $150 billion might tempt you if you mistakenly calculate the change in GDP as the MPC times the government spending increase, but this ignores the multiplier effect, which amplifies the initial spending beyond just the MPC.
Unit: fiscal-policy
Question 2Exam level
The MPC in an economy is 0.8. The government reduces taxes by $100 billion. All else equal, the expected change in equilibrium GDP is closest to:
How sure are you?
Correct: A. Tax multiplier = -MPC/(1-MPC) = -0.8/0.2 = -4. A tax CUT of $100B means delta_T = -$100B. Change in GDP = -4 x (-$100B) = +$400B. The negative sign on the tax multiplier is essential. A common trap is applying the spending multiplier (1/(1-MPC) = 5) giving $500B. Answer A. The tax multiplier is always smaller in absolute value than the spending multiplier by exactly 1 unit: here, |tax multiplier| = 4 vs spending multiplier = 5.
B. You get $400 billion with the right multiplier math, but the sign is backwards. The tax multiplier is negative, -0.8 divided by (1 minus 0.8) equals -4, precisely because a tax increase reduces disposable income and spending. Here the government cut taxes by $100 billion, a negative change in taxes, so a negative multiplier times a negative change gives a positive $400 billion increase in GDP, not a decrease. Losing track of the tax cut's own negative sign is what produces -$400 billion instead of +$400 billion.
C. Choosing +$100 billion might seem logical if you think the tax cut directly translates to an equal increase in GDP, but this overlooks the amplifying effect of the tax multiplier, which indicates that the initial tax cut will lead to a larger increase in GDP due to increased consumption.
Unit: fiscal-policy
Question 3Harder
A government finances a large deficit through domestic borrowing. Which of the following best describes the primary channel through which crowding out reduces the effectiveness of expansionary fiscal policy?
How sure are you?
Correct: A. Crowding out occurs specifically through the loanable funds market: government borrowing increases demand for funds, pushing up interest rates. Higher rates make private investment projects unprofitable, reducing private investment spending. The increase in G is offset (partially or fully) by a decrease in I. Answer C describes monetary offset, not crowding out. A common confusion on the exam.
B. You might be thinking that monetary policy and fiscal policy are always aligned, but choice B confuses monetary offset with crowding out; crowding out specifically involves the loanable funds market, not central bank actions.
C. You might be thinking that higher domestic income from fiscal policy would naturally lead to more imports, but this describes the income effect on trade rather than the crowding out mechanism that occurs through the loanable funds market, where government borrowing raises interest rates and reduces private investment.
Unit: fiscal-policy
Question 4Exam level
During a recession, government tax revenues fall automatically and unemployment insurance payments rise without any new legislation. This is most likely described as:
How sure are you?
Correct: A. Automatic stabilizers are fiscal mechanisms that respond to the business cycle without legislative action. Progressive income taxes collect less revenue during recessions (reducing fiscal drag) and unemployment insurance injects income. Both cushioning the downturn automatically. Discretionary policy (A) requires explicit government action such as passing a stimulus bill.
B. You might be thinking that monetary accommodation involves the central bank easing monetary policy during a recession, which can stabilize the economy, but monetary accommodation refers to actions by the central bank, not automatic fiscal responses, thus it does not describe the automatic fiscal adjustments in tax revenues and unemployment insurance payments.
C. You might be misled by the term "tightening," thinking it refers to reduced government spending during a recession, but structural fiscal tightening involves long-term budgetary constraints that do not automatically adjust to economic cycles like automatic stabilizers do.
Unit: fiscal-policy
Question 5Harder
According to the Ricardian equivalence proposition, a deficit-financed tax cut will most likely:
How sure are you?
Correct: A. Ricardian equivalence (David Ricardo, popularized by Robert Barro) holds that rational, forward-looking households recognize that a deficit today means higher future taxes. They save the full tax cut to fund those future obligations, leaving consumption and therefore aggregate demand unchanged. This implies fiscal policy is ineffective. The multiplier is zero. In practice, Ricardian equivalence is considered an extreme theoretical position; the CFA curriculum tests whether candidates know what it predicts and its key assumption (rational, forward-looking agents with perfect capital markets).
B. You might be tempted to think that higher future taxes will directly reduce current consumption, but this overlooks the Ricardian equivalence concept that rational households save the tax cut to offset future tax increases, thus leaving consumption and aggregate demand unchanged.
C. You might be thinking that printing money directly increases the money supply and thus aggregate demand, but this overlooks the Ricardian equivalence principle which focuses on household behavior and expectations of future taxes, not the method of financing the deficit.
Unit: fiscal-policy
Question 6Exam level
The government simultaneously increases spending by $50 billion and raises taxes by $50 billion. The MPC is 0.80. The net effect on equilibrium GDP is closest to:
How sure are you?
Correct: B. This is the balanced budget multiplier theorem. Spending multiplier = 1/(1-0.8) = 5. Effect of spending increase = +5 x $50B = +$250B. Tax multiplier = -MPC/(1-MPC) = -4. Effect of tax increase = -4 x $50B = -$200B. Net effect = $250B - $200B = +$50B. The balanced budget multiplier equals 1: a balanced-budget expansion raises GDP by exactly the amount of the spending increase. This is a classic exam trap. Many candidates expect zero net effect.
A. You might be tempted to think that the increases in spending and taxes cancel each other out directly, leading to no change, but this ignores the different multipliers for government spending and taxes; the spending multiplier is larger than the tax multiplier, resulting in a net positive effect on GDP.
C. You might be tempted to choose +$250 billion if you only considered the effect of the $50 billion spending increase without accounting for the offsetting tax increase, but this ignores the tax multiplier effect which reduces the net impact on GDP, leading to an overestimation of the total effect.
Unit: fiscal-policy
Question 7Exam level
Which of the following best describes the 'impact lag' in fiscal policy?
How sure are you?
Correct: B. The three fiscal policy lags are: (1) Recognition lag. Time to identify the problem; (2) Action lag (also called legislative lag), time to pass and authorize policy; (3) Impact lag, time for the policy to affect the economy after implementation. Answer A describes recognition lag; B describes the action/implementation lag; D is part of the action lag. The impact lag is often the longest for fiscal policy.
A. You might be thinking that the delay in implementation is the same as the impact lag, but choice A actually describes the action lag, which is the delay between policy authorization and implementation, not the time it takes for the policy to affect the economy after implementation.
C. You might be tempted by choice C because political disagreements can indeed slow down legislation, but this describes the action or legislative lag, not the impact lag which focuses on the delay between policy implementation and its economic effects.
Unit: fiscal-policy
Question 8Exam level
An economy is experiencing a recession. The government's budget deficit is $300 billion. Analysts estimate that if the economy were at full employment, the deficit would be $80 billion. The cyclical deficit is closest to:
How sure are you?
Correct: B. Total deficit = Structural deficit + Cyclical deficit. $300B = $80B + Cyclical deficit. Cyclical deficit = $300B - $80B = $220B. The structural deficit ($80B) is the deficit that would exist even at full employment. This reflecting policy choices. The cyclical deficit ($220B) reflects the recession's automatic impact on revenues and expenditures. The exam tests whether candidates can decompose total deficit into these two components.
A. You might be tempted to choose $80 billion because it represents the deficit at full employment, but this is actually the structural deficit, not the cyclical deficit, which is the difference between the total deficit and the structural deficit during the recession.
C. Choosing $300 billion might seem logical if you think the total deficit equals the cyclical deficit, but this overlooks the distinction between the total deficit and its components, where the total deficit of $300 billion includes both the structural deficit of $80 billion and the cyclical deficit.
Unit: fiscal-policy
Question 9Harder
A monetarist economist would most likely argue that expansionary fiscal policy financed by government borrowing:
How sure are you?
Correct: A. Monetarists believe the loanable funds market adjusts quickly so that government borrowing crowds out private investment dollar-for-dollar. This complete crowding out means the net effect on AD is zero. The multiplier is zero. Keynesians (answer A) believe the multiplier exceeds 1, especially with idle resources. Answer C describes the New Classical view for supply-side effects. The CFA exam frequently tests the contrast: Keynesian (multiplier > 1, policy effective) vs Monetarist (complete crowding out, multiplier = 0).
B. You might be tempted by choice B if you think fiscal policy can boost output temporarily, but monetarists argue that such policies are ineffective due to complete crowding out, which means there is no short-run boost in output as the increase in government spending is offset by a dollar-for-dollar decrease in private investment.
C. You might be tempted by choice C if you confuse monetarist views with the New Classical perspective, which suggests that supply-side effects adjust proportionally. However, monetarists focus on the demand side and argue that complete crowding out negates any increase in output, making proportional rises in both output and price level inconsistent with monetarist theory.
Unit: fiscal-policy
Question 10Exam level
Which of the following is most consistent with contractionary fiscal policy?
How sure are you?
Correct: B. Contractionary fiscal policy reduces aggregate demand through lower government spending or higher taxes. Reducing infrastructure spending (C) directly lowers G. Answer A (extending unemployment insurance) is expansionary. Answer B (reducing corporate taxes) is expansionary. Answer D describes monetary policy, not fiscal policy. A common distractor testing whether candidates distinguish the two policy domains.
A. You might be tempted to think that reducing the corporate income tax rate boosts government revenue, but in fact, this action decreases government revenue and stimulates economic activity, making it expansionary rather than contractionary fiscal policy.
C. You might be tempted by C because increasing the money supply can reduce interest rates and stimulate spending, but this describes monetary policy, not fiscal policy, which focuses on government spending and taxation to influence the economy.
Unit: fiscal-policy
Question 11Harder
Supply-side economists argue that lower marginal tax rates will most likely increase long-run potential GDP by:
How sure are you?
Correct: A. Supply-side fiscal policy operates through the LRAS (Long-Run Aggregate Supply) curve, not the AD curve. Lower marginal tax rates improve incentives: workers supply more labor (more after-tax earnings per hour), firms invest more (higher after-tax returns), and households save more (higher after-tax returns on savings). This rightward LRAS shift raises potential real GDP permanently. Demand-side (Keynesian) fiscal policy works through AD. Supply-side works through LRAS. The exam tests this distinction.
B. You might be tempted by B because reducing the budget deficit seems like a positive outcome, but B confuses fiscal balance with supply-side incentives; the structural budget deficit is not directly impacted by tax rate changes in the way supply-side economics predicts increased GDP through work, savings, and investment incentives.
C. You might be thinking that lower taxes reduce government borrowing and thus decrease crowding out, but this choice confuses demand-side effects with supply-side impacts; the correct focus is on how lower taxes directly enhance incentives for work, saving, and investment, shifting LRAS rightward.
Unit: fiscal-policy
Question 12Exam level
In an open economy, the fiscal multiplier is most likely smaller than in a closed economy because:
How sure are you?
Correct: A. In an open economy, the marginal propensity to import (MPM) creates a leakage from the spending circular flow. When incomes rise due to fiscal stimulus, households and firms spend some of that increase on imported goods. Money that leaves the domestic economy and does not generate further rounds of domestic spending. The effective multiplier in an open economy is 1/(1-MPC+MPM), which is smaller than the closed-economy 1/(1-MPC). Answer D (exchange rate appreciation) is also a real mechanism (the Mundell-Fleming model), but B is the primary direct channel tested at CFA Level 1.
B. You might be thinking that government spending crowds out private consumption, making the multiplier smaller, but this overlooks the direct leakage to imports in an open economy, which is the key factor reducing the multiplier compared to a closed economy.
C. You might be thinking that exchange rate appreciation makes exports less competitive and imports cheaper, thus reducing net exports. However, this choice confuses the effects of exchange rate movements with the direct leakage from domestic spending to imports, which is the key mechanism that reduces the fiscal multiplier in an open economy.
Unit: fiscal-policy
Question 13Above the exam
A government increases spending by $50 billion, financed entirely by issuing new debt, during a recession when the economy has significant slack. A critic argues the stimulus will be completely offset by Ricardian equivalence, since households will save more today to pay the anticipated future taxes. Combining the assumptions behind Ricardian equivalence with real-world limitations on it, the critic's claim is most likely:
How sure are you?
Correct: B. Ricardian equivalence is a theoretical proposition resting on strong assumptions: households are fully rational and forward-looking, face no borrowing or liquidity constraints, and fully internalize the government's future tax obligations tied to today's deficit spending. In practice, many households are liquidity-constrained or do not fully anticipate future taxes, so deficit-financed spending typically has SOME real stimulative effect rather than being perfectly and completely offset by private saving.
A. Ricardian equivalence is a theoretical result, not an empirically proven law that holds exactly under all conditions; its strict assumptions (perfect foresight, no borrowing constraints) are frequently violated in the real economy, which is precisely why economists debate how much offset actually occurs.
C. Ricardian equivalence logic applies symmetrically to deficit-financed spending increases and to deficit-financed tax cuts; both are financed by government debt that implies future taxes, so the same household-behavior argument applies to either policy tool.
Unit: fiscal-policy
Question 14Above the exam
A country with an already high debt-to-GDP ratio and a fiscal multiplier estimated near zero is debating a large deficit-financed infrastructure program. Combining the concept of crowding out with the size of the fiscal multiplier, the program's net effect on aggregate output is most likely to be:
How sure are you?
Correct: B. Crowding out occurs when increased government borrowing pushes up interest rates (or otherwise competes for scarce loanable funds/resources), reducing private investment that would otherwise have occurred. A near-zero estimated multiplier already signals that other forces (including crowding out, and possibly limited economic slack) are offsetting much of the direct spending effect; combined with an already-high debt burden that can further pressure interest rates and investor confidence, the program's net effect on output is likely to be muted or even negative rather than strongly stimulative.
A. Infrastructure spending does not automatically carry the highest possible multiplier regardless of context; the question explicitly states the ESTIMATED multiplier here is near zero, which directly contradicts assuming a strongly positive effect just because the category is 'infrastructure.'
C. Fiscal multipliers are not fixed at exactly 1 for any spending category; they vary with economic conditions (slack in the economy, crowding out, the marginal propensity to consume, and more), which is exactly why the multiplier is described here as an estimated, near-zero figure rather than assumed to equal 1.