Exam Solutions: The blue and yellow version exams were identical. The Multiple Choice solutions to both versions are provided below in boldfaced print and the Short Answer solutions are given below each question.
Part 1. Multiple Choice Questions (2 points each question)
1. According to how economists define investment, which one of the following statements about investment is false?
a. investment includes changes in inventories
b. investment includes the sale/purchase of all stocks and bonds
c. investment could (theoretically) be positive or negative
d. investment includes the purchase of new machinery and capital equipment
e. investment is an expenditure
2. What does the term "autonomous" mean?
a. the term refers to the use of computers in production
b. the term refers to how much we consume of certain goods
c. the term refers to expenditures that do not change with changes in income
d. the term refers to a type of transportation expenditure discussed in class
Questions #3-6 relate to data we discussed from homework #3.
3. What pattern do you observe when looking at how government spending (G) and investment (I) changed in the U.S. in years where our (annual) real GDP decreased?
a. G always increased and I always decreased
b. G always decreased and I always increased
c. both G and I always increased
d. both G and I always decreased
e. there was no consistent pattern in how G and I changed
4. Currently, in the U.S., what is the largest component of Total Consumption Expenditure (i.e. what has the largest overall share in Total Consumption)?
a. Durable Goods
b. Non Durable Goods
c. Services
5. Since the 1930s, how has the composition of U.S. exports changed?
a. Goods have an increasingly larger share in Total Exports; Services have an increasingly smaller share in Total Exports
b. Goods have an increasingly smaller share in Total Exports; Services have an increasingly larger share in Total Exports
c. both Goods and Services have increasingly larger shares in Total Exports
d. both Goods and Services have increasingly smaller shares in Total Exports
6. Since the 1960s, the share of National Defense spending in Total Government Expenditure and the share of State and Local Government spending in Total Government Expenditure have changed. How?
a. both categories have increasingly larger shares in Total Govt. Expenditure
b. both categories have increasingly smaller shares in Total Govt. Expenditure
c. the share of Defense spending in Total Govt. Expenditure has decreased; the share of State and Local Govt. spending in Total Govt. Expenditure has increased
d. the share of Defense spending in Total Govt. Expenditure has increased; the share of State and Local Govt. spending in Total Govt. Expenditure has decreased
7. Where does "equilibrium" occur in the AE model:
a. where the aggregate demand curve intersects the aggregate supply curve
b. where aggregate demand curve intersects the aggregate expenditure curve
c. where income and real GDP are equal
d. where aggregate expenditure and real GDP are equal
The information below corresponds with questions #8-11.
Assume that a certain country has the following equations describing its macroeconomy:
| C = 0.6(DI) + 800 | C = consumption, DI = disposable income |
| I = 1000 | I = investment |
| G = T = 0 | G = government spending, T = tax revenue |
| X - M = 0 | X - M = net exports |
8. When this economy produces at equilibrium GDP, what will be total consumption (C) and total savings (S)?
a. C = 2500, S = 2000
b. C = 1000, S = 2000
c. C = 3500, S = 1000
d. C = 4500, S = 2500
9. If this economy is producing at equilibrium GDP, what would be its average propensity to consume?
a. -2500/4500 (-56%)
b. 4500/4500 (100%)
c. 1000/4500 (22%)
d. 3500/4500 (78%)
10. The value associated with this country's (simple) government expenditure multiplier is:
a. 2.5
b. 1.5
c. 0.6
d. 5
e. none of the above
11. The value associated with this country's (simple) tax multiplier is:
a. - 0.6
b. - 1.5
c. - 2.5
d. - 5
e. none of the above
12. What makes the government expenditure multiplier smaller in absolute value?
a. Pre-planned investment decreases
b. Pre-planned government spending decreases
c. the marginal propensity to consume decreases
d. Lump Sum tax revenues are decreased
e. both b and c are correct
13. Which statement about the marginal propensity to save (mps) is true:
a. mps equals the change in Savings divided by the change in Consumption
b. mps equals a value of "one minus the marginal propensity to consume"
c. a larger mps is associated with larger values of the government expenditure multiplier
d. increases in Total Savings always makes the mps larger
14. Which statement about the marginal propensity to consume (mpc) is true:
a. the mpc determines the rate by which autonomous consumption changes
b. the mpc is typically greater than (a numerical value of) one
c. the mpc shows how consumption changes, with changes in disposable income
d. the mpc equals consumption expenditures divided by disposable income
15. What's the best response to this question, "When the mpc rises, what happens?"
a. the tax multiplier becomes positive
b. more output is produced
c. an inflationary gap occurs
d. a recessionary gap occurs
16. If the mpc were always 0.5, then by how much would disposable income change if consumption rose from $200 to $270.?
a. it increased by $70
b. it increased by $35
c. it increased by $140
d. it increased by $100
e. not enough information is given to calculate an answer
17. In the AD/AS graph, if the Aggregate Supply curve (AS) were vertical, then:
a. increases in Aggregate Demand (AD) will always lead to higher ouput
b. it is possible to use fiscal policy to permanently increase output above Potential GDP
c. fiscal policy affects inflation, but not unemployment
d. fiscal policy can close any existing output gap
18. Which statement about multipliers is true:
a. government spending multiplier is greater than zero
b. government spending multiplier is greater (in absolute value) than the tax multiplier
c. tax multiplier may or may not be greater than one (in absolute value), it depends on the size of the mpc
d. all of the above
19. Two economic models from lecture were the fixed price level, AE model and the flexible price level, AD/AS model. One key difference beween them is:
a. in the AE model, changes in the price level cause changes in AE; in the AD/AS model, changes in AD cause changes in the price level
b. in the AE model, we find equilibrium Y*; in the AD/AS model, we only find equilibrium P*
c. in the AE model, shifts in the 45 degree line cause changes in Y*; but this change has no effect on equilibrium in the AD/AS model
d. the AE model is an excellent long run tool, but the AD/AS model is better used with short run analysis
The information below concerns the Aggregate Expenditures model (AE model) and should be used to answer questions #20-22.
The AE model associated with Country A shows that the slope of the AE line is 0.75 (i.e. for every $1 increase in real GDP, AE increases by 75¢). You note that, except for consumption, there are only autonomous expenditures. Also, there are no taxes, no exports or imports, and the overall autonomous expenditures sum up to $1,200.
20. If Potential GDP is $5,000, what type of gap exists?
a. recessionary gap of $200 exists
b. recessionary gap of $3,400 exists
c. inflationary gap of $3,400 exists
d. inflationary gap of $200 exists
e. none of the above
21. What is the size of Country A's government expenditure multiplier?
a. 1.3
b. 0
c. 5
d. 4
e. 2.5
22. Country A decides to start taxing its citizens. If their government raises overall taxes by $100 (i.e. from T = 0 to T = 100), what will happen to equilibrium (real) GDP?
a. real GDP will decrease by $300
b. real GDP will increase by $100
c. real GDP will decrease by $100
d. real GDP will decrease by $400
23. Which of the following is not a belief of Supply Side economists:
a. deregulation of specific industries
b. lowering (marginal) income tax rates
c. lowering corporation tax rates
d. raising (marginal) tax rates during inflationary gaps
e. none of the above (all are beliefs of Supply Side economists)
24. In the AD/AS model, how does increasing investment affect the economy?
a. decrease AD initially, and eventually decrease AS
b. increase AD initially, and eventually increase AS
c. increase AD initially, but eventually decrease AS
d. decrease AD initially, but eventually increase AS
25. Which of the following is not an example of fiscal policy:
a. reducing the expenditure on national parks
b. increasing taxes on junk food
c. paying off part of the national debt by printing more (new) money
d. eliminating loop holes in the tax code
26. The assigned reading (Wall St. Journal) on Robert Mundell makes all but which of the following statements:
a. Mundell was once again bypassed as a recipient of the Nobel Prize
b. Mundell advocates Supply Side economic doctrines like reducing taxes
c. with the exception of a 9-month recession in the early 1990s, the economic expansion which began in the mid-1980s has continued
d. Keynesian economists were confused by Stagflation in the 1970s because they thought of there being a "trade-off" between inflation and unemployment
e. none of the above (i.e. each topic above was discussed within the article)
27. What problems exist with fiscal policy?
a. it never leads to crowding out
b. due to the political process, it may be difficult to quickly pass certain kinds of fiscal policy through Congress
c. it too frequently uses changes in interest rates
d. all of the above
28. As discussed in class, what is the basic problem associated with "pork barrel spending"?
a. the political incentives of politicians are not necessarily compatible with the economic goals of society as a whole
b. increasing spending tends to be inflationary
c. this type of spending tends to raise interest rates
d. this type of spending tends to occur more during inflationary gaps
29. During an inflationary gap, which example of fiscal policy would work best?
a. increasing the money supply
b. increasing government expenditure
c. increasing taxes
d. increasing government expenditure and taxes by the same amount
30. Which of the following best describes how the economy's self-correcting mechanism might work in an inflationary gap:
a. as workers slowly lose their jobs, they ask for wage increases which shifts AS and contracts the economy until things return to equilibrium GDP
b. as inflation reduces the purchasing power of most workers, these workers ask for wage increases which contracts the economy and returns things to Potential GDP
c. as government recognizes the threat of inflation, they pass legislation that is not considered fiscal policy, but has the effect of self-correcting the economy
d. as taxes are lowered, workers begin to save and invest more
31. The self-correcting mechanism works in all types of gap, but we would expect:
a. recessionary gaps are more difficult to correct because they involve lower output
b. inflationary gaps would take longer to correct because workers would be reluctant to ask for the wage increases necessary to close the gap
c. inflationary gaps take longer to correct since they involve output that is higher than potential
d. recessionary gaps take longer to correct because workers would hesitate in asking for the wage decreases that are necessary to close the gap
32. As discussed in class, what is the definition of the term "National Debt"?
a. the sum of all government budget deficits (i.e. over time)
b. the difference between each consumer's income and their expenditure
c. the difference between the amount our country owes other countries and what other countries owe us
d. the difference between government spending and tax revenues in a specific year
33. Within the AE model from class, what would happen to real GDP if government spending were increased by the same amount as tax revenues every year (so that
34. Which budget balancing philosophy (discussed in class) tends to be preferred by those who advocate limited government?
a. balancing annually
b. balancing over the business cycle
c. the functional finance approach
d. the counter-cyclical approach
35. Which of the statements below is the most direct reason why the following comment is a bad analogy: "If U.S. citizens must balance their checkbook, then so should the U.S. Federal government!"
a. the U.S. government has fewer constraints on its ability raise finances for expenditure than do U.S. citizens
b. the U.S. government's budget is much larger than that of the typical U.S. citizen
c. the U.S. government is involved in exporting and importing goods, but the typical U.S. citizen is not
d. the U.S. government has a larger debt to income ratio than typical U.S. citizens
36. Why is it misleading to use a country's total debt when determining whether that country has borrowed too much money?
a. total debt is measured as the accumulated budget deficits of the government
b. the level of a country's debt tells us nothing about the country's ability to pay off that debt
c. because debt is positively related to a country's GDP
d. because debt is negatively related to a country's GDP
e. because debt increases whenever a country runs budget deficits
37. When the number of government bonds increases, what is the most likely general result?
a. bond prices will rise, interest rates will fall
b. bond prices will fall, interest rates will rise
c. both bond prices and interest rates will rise
d. both bond prices and interest rates will fall
38. When the number of government bonds increases, what is the most likely cause (below)?
a. the government is trying to correct an inflationary gap
b. the government is experiencing a budget surplus
c. the government is trying to correct a situation where the economy is producing at an output level greater than Potential GDP
d. the government is trying to correct a situation where the economy's actual unemployment rate is greater than its Natural Rate of Unemployment
39. In its effort to balance the budget, government has decided to lower taxes during recessionary gaps and raise taxes during inflationary gaps. Which budget balancing philosophy is closest to what they've adopted:
a. the balance annually approach
b. the balance over the business cycle approach
c. the functional finance approach
d. the demand management approach
e. the tax change approach
40. As discussed in class, what is crowding out?
a. where government borrowing tends to lower (private) investment expenditure
b. where higher taxes lead to lower consumption expenditure
c. where higher taxes lead to lower savings
d. where increases in nominal wages lead to firms laying off more employees
Part 2. Short Answer Questions (5 points per question)
The equations below describe a particular economy. They correspond with Questions #1-3. To ensure that you receive full credit on each question, please show all your work.
| C = 0.8(DI) + 400 | C = consumption expenditure, DI = disposable income |
| I = 800 | I = investment |
| G = 200 | G = government expenditure |
| X - M = 600 | X - M = net exports |
| T = 200 | T = tax revenues |
| Yp = 10,000 | Yp = potential (real) GDP |
1. Show whether this economy is experiencing a recessionary gap when it produces at equilibrium (real) GDP.
Calculate equilibrium GDP
Question #2 relates to Question #1. Take your answer in #1 as given, right or wrong, and use it as the basis for answering Question #2.
2. What change in T is necessary to close this gap?
There are two possible approaches to answering this problem.
Approach #1: The multiplier approach
Plug in the MPC from above and simplify
Plug in the amount of the gap (800) and solve for
DT
Approach #2: The long way
Use the equation Y = C + I + G + (X - M) again, set Y = 10000 and T = 200 +
Question #3 relates to Question #1 also. Again, take your answer in #1 as given, right or wrong, and use it as the basis for answering Question #3.
3. Suppose that instead of changing taxes (as you did in #2) the government increased G by $200. How would this
DG affect equilibrium GDP?Once again, there are two possible approaches to answering this problem.
Approach #1: The multiplier approach
Approach #2: The long way
Use Y = C + I + G + (X - M), but change G from 200 to 400
Find the difference between the equilibrium here, and what you got in #1
4. Explain the validity of the following statement: "government borrowing today is a burden on the taxpayers of tomorrow".
It is generally true that if the government borrows "today", then the government must raise taxes "tomorrow". However, when we define burden as the difference between the cost of borrowing (higher taxes) and the benefit of borrowing (interest payments from the government), then the answer depends upon whether foreign citizens are helping finance our government's debt.
If foreign citizens help finance the debt, then some of the benefit leaks out of the economy. The cost of borrowing is unchanged, while the benefit (domestically) of borrowing decreases. Consequently, taking society's perspective, there is a burden on future generations of taxpayers when the government borrows from foreign citizens.