Exam Solutions: The Multiple Choice solutions are provided below in
boldfaced print. The Short Answer solutions are
given below each question.
Part I. Multiple Choice (2 pts. each - 80 pts overall)
1. Which of these will not increase the supply curve associated with producing tires:
a. improvements in the machines which produce tires
b. an increase in the price of tires
c. lower wages for nonunion workers in the tire industry
d. decrease in the corporation tax rate
2. In a typical production possibilities curve (PPC) relationship, we know that:
a. decreases in unemployment cause the PPC to shift outward
b. higher demand for one product (vs. another) cause the PPC to shift outward for that product
c. lower productivity causes the PPC to shift inward
d. producing only one product is always inefficient
e. all of the above
The table below corresponds with Country W's production possibilities relationship
and should be used to answer question 3.
| Tractors | ||||||
| Automobiles |
3. Producing at point F:
a. a decrease in tractor production would lead to unemployment
b. the opportunity cost of producing an extra automobile is ten units of tractors
c. Country W is currently producing at an inefficient point
d. Country W is currently producing with full employment
4. Minimum wage laws are likely to have which of the following indirect effects:
a. there are labor shortages
5. Which of the following are one of the (proper) steps used in constructing a price index:
a. multiply the current and base year’s prices by the quantity purchased in each of those years
b. add up each year’s prices and divide by the base year’s prices
c. multiply the current and base year prices by the same quantities
d. multiply the current and base year quantities by the base year prices
6. A worker makes $50,000 in nominal income, both during 1990 and 1991. If 1990 is the base year, then what is this worker’s real income in 1991 if the inflation rate is 4% between those two years?
(if necessary, round your answer to the nearest thousand)
a. $52,000
b. $50,000
c. $44,000
d. $48,000
e. none of the above
7. Demand-pull inflation may result (directly) from:
a. large decreases in the income tax rate
b. large decreases in government expenditure
c. rising wage rates, without offsetting increases in productivity
d. large increases in the labor force
8. The U.S. government currently maintains a more than 5 trillion dollar debt. Given its sizeable debt, how does inflation affect the U.S. government?
a. the U.S. government is better off with inflation, because borrowers benefit from inflation
b. the U.S. government is worse off with inflation, because borrowers do not benefit from inflation
c. the U.S. government is no better or worse off with inflation, because inflation does not affect borrowers
d. not enough information is given to answer this question
The table below corresponds with Questions #9-10
|
Out of work, but: |
Employed, but: |
|
actively looking for a job: 40 |
with full-time jobs: 470 |
|
have given up looking for jobs: 15 |
with part-time jobs: 90 |
Of all the officially unemployed workers (above) 15 are voluntarily unemployed.
9. How many workers are involuntarily unemployed in this economy?
a. 0
b. 10
c. 15
d. 40
e. none of the above
10. If there was no change in the labor force, then what would be the natural rate of unemployment in this economy?
a. 15/470 (3.2%)
b. 15/600 (2.5%)
c. 70/600 (11.7%)
d. 40/560 (7.1%)
e. none of the above
11. Which of the following would not be included in the U.S. gross domestic product:
a. changes in inventories of foreign goods produced in the U.S.
b. new home construction in Kentucky
c. buying a new Toyota automobile at a local car dealership
d. new capital purchases made here in Kentucky
e. buying a Big Mac at the McDonalds in Moscow, Russia
12. Why is it important to adjust the consumer price index (cpi) for changes in product quality?
a. because rising quality causes the cpi to show lesser inflation than is otherwise true
b. because rising quality leads to higher demand, which causes prices to fall
c. because rising quality tends to inflate the cpi
d. because rising quality makes it necessary to change the base year less frequently
13. Potential GDP is defined as:
a. the output achieved when only voluntary unemployment exists
b. the output achieved when all factors are employed
c. the output achieved when all available factors are employed
d. the output achieved when the economy is located at a point on its PPC
14. Structural unemployment is characterized as:
a. unemployment that results from technological change
b. unemployment that results from periods of contraction in the business cycle
c. unemployment that results from workers being laid off at any time during the year
d. unemployment that results from workers leaving their jobs to seek more preferable employment
15. What happens if inventories decrease unexpectedly between this year and next year?
a. the level of aggregate expenditure increases
b. equilibrium GDP increases
c. Investment expenditure decreases
d. Consumption expenditures decrease
e. equilibrium GDP is increased above potential GDP
The following corresponds with Questions #16 and #17.
If the marginal propensity to consume is 0.7, autonomous
consumption is $800, and there are no taxes. Assume further that
the price level is fixed (constant) and that the only expenditure besides
consumption is autonomous investment of $1000.
16. Suppose equilibrium GDP is 10,000 (i.e. Y* = 10,000).
Using this with the information above, what is the average propensity
to save (APS) in this economy?
a. 0.3
b. 800/10,000
c. 2200/10,000
d. 7800/10,000
e. unable to calculate, not enough information is provided
17. If the marginal propensity to save in this economy increases to 0.5,
then what happens to the value of this economy’s government expenditure multiplier?
a. the multiplier increases from 3.3 to 5
b. the multiplier decreases from 3.3 to 2
c. the multiplier increases from 1.4 to 2
d. the multiplier decreases from 2 to 1.4
e. not enough information is given to answer this question
18. What is the key difference between the AE model and the AD/AS models (from lecture):
a. the AE model assumes a fixed price level, AD/AS assumes a flexible price level
b. the AE model assumes that expenditures are autonomous, AD/AS does not
c. the AE model has investment that changes with changes in the interest rate,
AD/AS does not
d. the AE model does not incorporate the concept of Potential GDP, AD/AS does
incorporate this concept
19. If inventories rise unexpectedly in the AE model, then:
a. aggregate demand is greater than aggregate supply
b. aggregate demand is less than aggregate supply
c. aggregate expenditure is greater than output
d. aggregate expenditure is less than output
20. If Potential GDP is greater than equilibrium GDP, which of the following will
close that gap:
a. increase government spending by less than the amount of this inflationary gap
b. decrease government spending by less than the amount of this inflationary gap
c. increase government spending by less than the amount of this recessionary gap
d. decrease government spending by less than the amount of this recessionary gap
e. increase government spending by the same amount as this recessionary gap
21. If the slope of an economy’s AE line is equal to their marginal propensity to
consume (MPC), then under what conditions would this economy’s tax multiplier be just as
large (in absolute value) as their government spending multiplier?
a. if their MPC = 0.8
b. if their MPC = 0.75
c. if their MPC = 0.5
d. if their MPC = 0.25
e. these multipliers would never be equal, no matter what the value of the MPC
22. Assume that the slope of Country B’s AE line equals their MPC. Which of the
following is always true:
a. equilibrium output in Country B will increase by the same amount, whether government
expenditure increases by $500 or whether taxes decrease by $500
b. equilibrium output in Country B will increase by the same amount, whether
government expenditure increases by $500 or whether investment increases by $500
c. equilibrium output in Country B will increase by
the same amount, whether investment increases by $500 or whether taxes decrease by $500
d. all of the above
23. Where is debt-financed government expenditure most likely to cause crowding out?
a. when the economy produces very low levels of output
b. when the economy is experiencing unemployment
c. when the economy has neither a recessionary nor an inflationary gap
d. when the economy is experiencing a government budget surplus
e. when the economy is experiencing inflation
24. In the AD/AS model, how would we know if Supply Side economics was successful at
keeping the price level down and increasing output?
a. if AD and AS increase
b. if AD and AS decrease
c. if AD increases by more than AS
d. if AD increases by less than AS
25. If government chooses a new "budget philosophy" that causes greater
swings in the business cycle to occur, then which philosophy have they most likely adopted:
a. the balance annually approach
b. the balance over the business cycle approach
c. the functional (or fiscal) finance approach
d. the debt over demand approach
26. What causes U.S. government debt to be a burden on future U.S. taxpayers?
a. when taxes must be raised
b. when the tax increase needed to pay off interest on the debt exceeds the interest
received by U.S. citizens
c. when GDP increases, but so does the price level
d. when increased government debt causes imports to increase above exports
27. Which of the budget balancing philosophies from class focuses most strongly on
maintaining full employment and low inflation?
a. balancing the budget every (fiscal) year
b. balancing the budget in a five year cycle
c. balancing the budget over the business cycle
d. functional finance approach
e. fiscal exchange approach
28. When comparing fiscal and monetary policy, which statement is most true:
a. fiscal policy should experience a shorter inside lag
b. monetary policy should experience a shorter inside lag
c. fiscal policy would experience a shorter recognition lag
d. fiscal policy is more easily reversed than monetary policy
e. monetary policy tends to be applied more directly than fiscal policy
29. Are credit cards considered money?
a. no, because credit cards defer monetary transactions
b. no, because not every consumer can use a credit card
c. no, because credit cards do not allow for one to make anonymous transactions
d. yes, because credit cards are used to make transactions
30. What is the best definition of M2?
a. the money supply consisting of all currency and checkable accounts
b. the money supply consisting of all currency, checkable and (most) savings accounts
c. the money demand consisting of liquid forms of money (e.g. cash and checks)
d. the money supply consisting of cash, credit card transactions and checking accounts
e. the money demand consisting of all transactions and speculative demand accounts
31. In class we discussed the three functions of money, but added a fourth
function specific to currency. What fourth function does currency provide that is not
necessary provided by the other forms of money in M1?
a. currency eliminates the problem of the double coincidence of wants
b. currency is a store of wealth
c. currency provides for anonymous transactions
d. currency is a medium of exchange
e. currency serves as an accounting unit
32. Gresham's Law states:
a. interest rates and money demand have a negative relationship
b. income and interest rates have a negative relationship
c. bad money chases out good money
d. greater debt leads to higher interest rates
e. a penny saved is investment spent
33. An open market purchase has what effect on the economy?
a. increases the money supply and lowers interest rates
b. increases the money supply and raises interest rates
c. decreases the money supply and lowers interest rates
d. decreases the money supply and raises interest rates
34. Assume that Bank A has $25,000 in demand deposits and $17,000 in total reserves.
The remainder of the banks assets are loans. If the required reserve ratio is 10%,
then what are this bank’s (current) required reserves?
a. $800
b. $2500
c. $4200
d. $1700
e. none of the above
35. How would a very large tax cut affect the Phillips curve (PC) initially:
a. shift the PC outward (where the inflation and unemployment rates rise)
b. shift the PC inward (where the inflation and unemployment rates fall)
c. not shift the PC, but there is movement up along the PC (where the
inflation rate rises and unemployment rate falls)
d. not shift the PC, but there is movement down
along the PC (where the inflation rate falls and unemployment rate rises)
36. When would you most likely expect the Fed to contract the money supply?
a. when the actual unemployment rate is greater than the natural rate of unemployment
and the economy is experiencing a recessionary gap
b. when the actual unemployment rate is less than the natural rate of unemployment
and the economy is experiencing a recessionary gap
c. when the actual unemployment rate is less than the natural rate of unemployment
and the economy is experiencing an inflationary gap
d. when the actual unemployment rate is greater than the natural rate of unemployment
and the economy is experiencing an inflationary gap
37. Using a PPC to illustrate your answer, what is the key difference between the
concept of short run and long run growth?
a. short run growth occurs when the PPC shifts along one axis, long run growth is when it
shifts along each axis
b. short run growth occurs when there is movement from points inside the PPC to
points on the PPC itself, long run growth occurs when the PPC shifts outward
c. short run growth occurs when there are supply-related changes in the economy,
long run growth when there are demand-related changes
d. short run growth is consistent with shifts in the PPC, long run growth is not
consistent with shifts in the PPC
In lecture, we discussed two groups of economic policymakers, the Passive group and the
Active group. Questions #38-40 address the distinctions between these two groups.
38. Which budget balancing philosophy would the Passive group most likely advocate:
a. Functional (or fiscal) finance
b. Balance over the business cycle
c. Balance annually
d. Aggregate demand management
39. The Passive group believes:
a. the economy’s self correcting mechanism operates very slowly, if at all
b. the price level is largely fixed (constant) in the short run
c. the AS curve is relatively horizontal (flat) in the short run
d. government should use rules when applying any type of policy
40. Which of the following does the Active group believe about investment:
a. investment is more sensitive to changing business conditions than changing interest rates
b. investment is largely stable over time
c. investment is more sensitive to changing interest rates than changing business conditions
d. investment is a much larger component of GDP than consumption
e. investment is very susceptible to problems like crowding out
Part II. Short Answer Questions (pts. given by each question: 60 pts. overall)
Questions #1-2 both correspond with the equations below. Show all work for full credit.
(C = consumption expenditures, I = autonomous investment, G = government expenditures, T = tax revenues, X = exports, M = imports, DI = disposable income, Y = real GDP, Yp = Potential GDP)
[8 pts] 1. Is this economy experiencing an output gap?
Solve for equilibrium GDP and then compare this result to potential GDP.
Note first, that DI = Y - T. This implies that the consumption function can be
rewritten as:
Plugging in T, we get:
Now, recalling that the economy produces where AE = Y, we plug the remaining values
into that identity as follows:
Yes, because 7800 is greater than 6000, there is an inflationary (output) gap.
[8 pts] 2. By how much would government spending have to change to close this
output gap?
There are two ways to do this problems. The first utilizes the government expenditure multiplier, where we divide 1 by the denominator from the Y* calculation above (i.e. 0.4). Calculating 1/0.4, we obtain a multiplier value of 2.5. That is, a change in government spending changes equilibrium GDP by 2.5 times the spending change.
The output gap is -1800, which gives us the following problem to solve:
That is, decrease government spending by 720.
The second way to do this problem involves recalculating equilibrium GDP, but finding
the new value of G that makes Y* = 6000. If x represents the change in government spending,
the initial problem would be set up to look like this (after setting up the problem, we
substitute the desired level of Y* and solve for x):
Again, we see that we want to cut government spending by 720.
[7 pts] 3. Briefly define the term opportunity cost and describe the
opportunity cost associated with your attending UofL this semester.
Opportunity cost is the implicit cost associated with making choices. It was defined in class as the "cost of the next best alternative". The opportunity cost of attending UofL this semester could be any number of things, depending upon what you gave up in order to attend. Some examples (you would want to select one for your answer) are: watching television, working more hours, playing sports or working out, time with friends or family, etc.
Questions 4 and 5 (below) correspond with the following information. Answer
each as completely as you are able.
Bill and Ted perform two different tasks, washing and waxing cars. Each two hours, Bill can do one of the following: (a) wash 0 cars and wax 8 cars, (b) wash 5 cars and wax 4 cars , or (c) wash 10 cars and wax 0 cars.
In the same amount of time, Ted can also do one of the following: (i) wash 0 cars and wax 10 cars, (ii) wash 4 cars and wax 5 cars, or (iii) wash 8 cars and wax 0 cars.
[8 pts] 4. Show who has the comparative advantage in performing each task (washing vs. waxing).
Let’s first arrange this data in a table.
| Bill |
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| Washing cars |
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| Waxing cars |
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| Ted |
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| Washing cars |
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| Waxing cars |
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Bill has the comparative advantage in washing cars, Ted has it in waxing cars.
[8 pts] 5. Explain how Bill and Ted can utilize the Law of Comparative
Advantage and why this "Law" would allow them to maximize the
amount of work they complete in two hours.
The Law of Comparative Advantage dictates that each individual should specialize in the activity where their opportunity cost is lowest (i.e. where the person has a comparative advantage). That said, Bill should specialize in washing cars while Ted should specialize in waxing cars. In doing so, Bill and Ted are able to "consume" at a point that is outside their current production possibilities curve. In other words, more work will be done overall if Bill and Ted specialize in the activity where they have a comparative advantage and then combine their efforts. If both specialize, then Bill will wash 10 cars and Ted will wax 10 cars. Overall, 20 cars get worked on. If neither specializes, then no more than 18 cars get worked on. Obviously, specialization allows a greater return.
[6 pts] 6. What makes even simple comparisons between a household’s
indebtedness and the U.S. government’s debt invalid?
There are several reasons why household indebtedness is different from that of the Federal government. The most important reason is that the Federal government derives revenue from sources that are not available to households. Two obvious sources are taxation and printing money. The Federal government can always raise taxes to pay off existing debt or merely print more money to pay off existing debt. This is not to say that such actions demonstrate good economic sense, but they are available.
Answer the three questions below as completely as you are able.
[4 pts] 7. What is one limitation associated with using monetary policy to stabilize the economy and why is this a limitation?
One limitation associated with using monetary policy is the nature of how that policy is applied. Monetary policy involves changes in the discount rate and open market operations. These instruments affect variables in a more decentralized manner. If the need for stimulus occurs in a particular region, then it is not clear that monetary policy will necessarily affect that region very directly. Fiscal policy, on the other hand, may directly impact a specific region.
[4 pts] 8. What is one advantage associated with using monetary policy to
stabilize the economy and why is this an advantage?
One key advantage associated with using monetary policy is that such policy is more quickly implemented than fiscal policy (excepting automatic stabilizers). There is a short inside lag, the monetary policy decision-makers are free to operate outside the pressures of political life. Decisions are made, and within a short period of time may be easily reversed. This is an important advantage because there may be times when it is necessary to act quickly and monetary policy is very capable of doing so. If a wrong decision is made, then it is also fairly simple to reverse course. Anytime the political process or political pressures are allowed to interfere with decision-making, that decision-making will usually take much longer.
[7 pts] 9. What does the Active (macroeconomic policymaking) group most
likely believe about crowding out.
The Active group most likely believes that crowding out is not a problem. Crowding out occurs when fiscal policy causes public sector investment and borrowing to "crowd out" private sector borrowing and investment. Although theoretically possible, the Active group would argue that we are not likely to see crowding out because investment is more sensitive to business conditions than interest rates anyway.
This implies that the investment demand curve is relatively steep (assume the investment supply curve to be horizontal). Any increase in interest rates, e.g. an increase brought on by the government conducting some debt-financed expenditure. As interest rates rise, the vertical nature of the investment demand curve dictates that even large changes in interest rates will have little to no effect on the quantity of investment.