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 Schweser Q : Monetary & Fiscal policy 
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Joined: 27 Feb 2013
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Okay so I know the answer now but can somebody PLEASE tell me exactly what the of monetary and fiscal policy is on the yield curve?
Which of the following is consistent with a flat yield curve?
A) Monetary policy is restrictive and fiscal policy is restrictive.
B) Monetary policy is expansive while fiscal policy is restrictive.
C) Monetary policy is restrictive while fiscal policy is expansive.
Your answer: B was incorrect. The correct answer was C) Monetary policy is restrictive while fiscal policy is expansive.
If monetary policy is restrictive while fiscal policy is expansive, the yield curve will be flat.
I need to visualise this better and you fine people are cut for the job!


18 Mar 2013
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Joined: 27 Feb 2013
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From what I remember, impact of monetary policy on interest rates is greater than then one of fiscal policy and whenever monetary policy is expansive (loose), yield curve is upward sloping. Here is how I remember that. One - yield curve reflects expectaion of future short-term rates + liquidity component. Two - monetary policy is more important than fiscal policy because it defines the expectation of future short-term rates.
When both monetary and fiscal policies are tight, that leads to slowing down of the economy - inverted yield curve (A is out). When both policies are loose, the economy expands - steep yield curve. When monetary policy is loose and fiscal policy is tight, the economy still expands but slower - still upward sloping yield curve (but not as steep, B is out). When monetary policy is tight and fiscal policy is loose, the yield curve might be flat (C is the answer).
I hope this helps.


18 Mar 2013
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Joined: 27 Feb 2013
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monetary policy affects short term rates mainly while fiscal policy affects long term rates.
flat means high short term rate & low long term rate
High short term rates β€” restrictive monetary policy
Low long term rates β€”- expansive fiscal policy


18 Mar 2013
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So:
Restrictive policy (whichever of the two) results in higher rates.
Expansionary policy results in lower rates.
Monetary = short-term
Fiscal = long-term
Right?


18 Mar 2013
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mcpass Wrote:
β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”-
So:

Restrictive policy (whichever of the two) results
in higher rates.
Expansionary policy results in lower rates.

Monetary = short-term
Fiscal = long-term

Right?
that’s where i got stuck.. if this is the case, what is the difference between b and c in the original question?


18 Mar 2013
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Joined: 27 Feb 2013
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If monetary is expansive you start low and with a restrictive fiscal policy you end high so the yield curve would be quite steep.
monetary expansive - fiscal expansive (normal yield curve)
monetary restrictive - fiscal restrictive (normal yield curve, just higher rates??)
monetary expansive - fiscal restrictive (steep yield curve)
monetary restrictive - fiscal expansive (flat)
If someone could please confirm this would result in a higher test score for me ;-)


18 Mar 2013
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I think looking at fiscal policy as reflection of long-term rates is flawed.
1) monetary expansive - fiscal expansive
normal steep yield curve
2) monetary restrictive - fiscal restrictive
inverted yield curve
3) monetary expansive - fiscal restrictive
normal yield curve but less steep than (1)
4) monetary restrictive - fiscal expansive
(flat)


18 Mar 2013
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I can imagine this question being asked on an actual exam..it would get ripped apart by different economist because of all the variables that affect interest rates in just a simple classic LM/IS model.


18 Mar 2013
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purelife Wrote:
β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”β€”-
I can imagine this question being asked on an
actual exam..it would get ripped apart by
different economist because of all the variables
that affect interest rates in just a simple
classic LM/IS model.
I was thinking the exact same thing. I am actually reading a chapter on IS-MP model in Romer’s Advanced Macroeconomics text right now.


18 Mar 2013
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1) Economists love pointing out all kinds of secondary effects that seem to counter primary effects. It’s not even true, so it’s not worth thinking about on the CFA exams.
2) Just common sense - what happens when the govt is trying to spend lots of money but there isn’t lots of money to spend? There’s a premium for someone who can come up with cash to feed the gov’t need to fight wars and build bridges so short-term interest rates increase relative to long term rates.


18 Mar 2013
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