PART I: Multiple Choice

PART I: Multiple Choice. 10 points (each question worth ½ point)

1. In the long-run the Aggregate Supply curve will have a ( vertical ) slope.

2. If the Phillips Curve is vertical in the long run, then an increase in the money supply from year to year will _______ the unemployment rate and will _________inflation rate.

(a) increase; increase

(b) increase; not change

(d) not change; not change

Ans. (c)

3. If the United States were to pass legislation that would make it easier for people to emigrate to the United States, this would cause

(a) the short-run aggregate supply curve to shift to the right

(b) the short-run aggregate supply curve to shift to the left

(d) the short-run aggregate supply curve to become nearly vertical at all levels of output

Ans. (a)

4. An increase in aggregate demand when the economy is operating at full capacity is likely to result in

(a) an increase in output but no increase in the overall price level

(b) an increase in both output and the overall price level

(d) an increase in the overall price level but no increase in output

Ans. (d)

5. According to the classical economists, those who are not working

(a) are unable to find a job at the current wage rate

(b) are too productive to be hired at the current wage

(d) have given up looking for a job, but would accept a job at the current wage if one were offered to them.

Ans. (c)

6. If inflationary expectations increase, the Phillips curve will

(a) shift to the right

(b) shift to the left

(d) become upward sloping

Ans. (a)

7. Potential GDP is the level of aggregate output

(a) that can be produced at a zero unemployment rate

(b) that can be sustained in the long run, if the capacity utilization is below 100%

(d) that can be sustained in the long run without inflation

Ans. (d)

8. The government of Springdon would like to balance the budget by changing government spending. Current tax revenue stands at $250 million and government spending is at $375 million. If spending decreased by $125 million, the resultant change in deficit would be:

(a) 0

(b) –125* the deficit response index (DRI)

(d) None of the above

Ans. (c)

9. Automatic de-stabilizing policies would tend to

(a) negate inflation and stimulate expansion

(b) reinforce inflationary pressures and deepen recessionary conditions

(d) reduce frictional unemployment

Ans. (b)

10. The Federal deficit tends to rise when

(a) GDP decreases

(b) GDP increases

(d) exports increase

Ans. (a)

11. For spending cuts of a certain amount to reduce the deficit by the same amount the government

(a) spending multiplier must be 2

(b) tax multiplier must be 0

(d) tax multiplier must be 2

Ans. (c)

12. An economic condition characterized by high unemployment and excessive inflation is called ( stagflation )

13. The velocity of money is defined as ( V=GDP/M ):

14. If you buy a bond from a firm, you are

(a) borrowing money from the firm

(b) a partial owner form the firm and have a claim on the firm’s profits

(d) sacrificing future consumption for current consumption

Ans. (c)

15. If interest rates fall, bond prices ________ and bond holders _______

(a) fall; suffer a capital loss

(b) fall; experience a capital gain

(d) rise; experience a capital gain

Ans. (d)

16. A decrease in the income tax rate has a _______ effect on labor supply if the ____ effect dominates.

(a) positive: income

(b) negative; income

(d) positive; substitution

Ans. (b) or (d)

17. The proportion of income households spend on consumption is known as the

(a) marginal propensity to consume

(b) household spending multiplier

(d) average standard of living

Ans. (c)

18. An unexpected increase in nonlabor income will have a ( positive ) effect on a household’s consumption and a ( negative ) effect on labor supply.

19. Inflation cannot continue indefinitely without

(a) increases in the money supply

(b) increases in aggregate output

(d) increases in the interest rate

Ans. (a)

20. People are said to have rational expectations if they

(a) assume that this year’s inflation rate will be the same as last year’s inflation rate

(b) assume that this year’s inflation rate will be equal to the average inflation rate over the past 10 years

(d) use all available information in forming their expectations about inflation

Ans. (d)

PART II: Short Answer Questions. 10 points (each question worth 2 points)

1. Describe what is meant, in policy making, as an implementation lag and why monetary policy may sometimes be preferable to fiscal policy to address macroeconomic concerns.

Ans. The implementation lag is the time between recognition of an economic problem that the government would like to address and the initiation of a policy or program to address it. Fiscal policy is more prone to implementation lags than monetary policy due to the time it takes to legislate proposed measures. It is therefore more difficult to target some economic problems with fiscal policy as the time until the policy takes effect can be somewhat uncertain.

2. Suppose the budget is required by law to be balanced. Now suppose investment spending falls because of business pessimism.

(a) What will happen to the budget?

(b) What would you recommend, given the balanced budget requirement?

Ans. Tax collection will fall. Hence, to keep the budget balanced government expenditure will have to fall, or taxes will have to rise reinforcing the recessionary tendency of the economy.

3. Explain the Quantity Theory of Money, espoused by Monetarists. What assumptions does the theory depend on?

Ans. The quantity theory of money depends on the assumption of the velocity of money, where V=P*Y/M. Monetarists assume this is constant. As a result, changes in the money supply lead to equal changes in nominal GDP. The interest rate has no effect.

4. “Economists know nothing. Interest rates only directly effect investment and nothing else. Any other effect in the economy happens through changes in investment.” Comment.

Ans. False. Interest rates affect the consumption and savings of households. As interest rates rise the opportunity cost of today consumption rises and they induce savings. Also if the household is a net lender there is an income effect by which if interest rates rise consumption will rise. The opposite applies for the case when a household is a net borrower.

5. What is the basic principle behind supply-side economics? What policies do supply-side economists recommend?

Ans. Supply-side economists argue that the real problem with the economy is that high rates of taxation and heavy regulation have reduced incentives to work, to save, and to invest. They argue that what is needed is between incentives to stimulate supply, both by firms and by households.

PART III: Essay – 10 points

Essay # 1 (each graph worth 1 point)

Illustrate graphically in both in a Phillips Curve and in an AD/AS diagram the following phenomena. Make sure you label all your graphs and axes. Mark clearly in which direction the variables are moving and/or the curves are shifting.

Note: each scenario is independent of each other.

1. The economy is below its long run equilibrium. Now the government starts an expansionary fiscal policy. Show the effects.

2. The economy is in its long run equilibrium. Now there is a discovery of a new technology for transforming orange juice into fuel at very cheap costs.

3. The economy is in its long run equilibrium. A cost shock in the form of higher oil prices together with an expansionary policy from the government to counteract the fall in output.

inflation

Essay # 2 (each question worth 2 points)

Although the challenges facing Social Security as the baby boomers reach retirement age are routinely described as a crisis, that characterization seems overblown. The 75-year projections give Social Security another 38 years during which the full promised benefits can be paid; even after the trust fund disappears, the annual Social Security tax revenue would be enough to finance some 70 percent of the benefits until 2078. Those worried that Social Security will not be there for them when they retire are simply mistaken.

No one should be complacent with a long-term projection that winds up with Social Security falling 30 percent short of the money it needs to pay for promised benefits. Fortunately, there is time to cope with this problem. The fixes that are needed appear modest, and they can be kept modest by making the changes sooner rather than later so the savings have time to accumulate.

Paul Krugman, NYT, March 26th

1. How does Social Security differ from a pension fund?

In the Social Security system current workers transfer their payments to a pooled fund that finances old (retired) workers. A standard pension fund keeps the contribution of current workers in an individual savings account, and the worker can access the full benefits of those savings when old age comes.

2. Why do people worry that within the next 20 years Social Security disbursements will far exceed Social Security tax collections?

As the number of current workers to retirees shrinks (i.e. the baby boomers will be retiring) there will be fewer funds to finance the benefits of the old workers.