Contents
Chapter 1: Introduction to Macroeconomics
Chapter 2: The Measurement and Structure of the Canadian Economy
Chapter 3: Productivity, Output, and Employment
Chapter 4: Consumption, Saving, and Investment
Chapter 5: Saving and Investment in the Open Economy
Chapter 6: Long-Run Economic Growth
Chapter 7: The Asset Market, Money, and Prices
Chapter 8: Business Cycles
Chapter 9: The IS-LM-FE Model: A General Framework for Macroeconomic Analysis
Chapter 10: Exchange Rates, Business Cycles, and Macroeconomic Policy in
the Open Economy
Chapter 11: Classical Business Cycle Analysis: Market-Clearing Macroeconomics
Chapter 12: Keynesian Business Cycle Analysis: Non-Market-Clearing Macroeconomics
Chapter 13: Unemployment and Inflation
Chapter 14: Monetary Policy and the Bank of Canada
Chapter 15: Government Spending and Its Financing
Copyright © 2022 Pearson Canada Inc.
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 1 Introduction to Macroeconomics
1.1 Multiple-Choice Questions
1) Which of the following is a topic of macroeconomics?
A) why nations have different rates of growth
B) what causes inflation and what can be done about it
C) why unemployment periodically reaches very high levels
D) all of the above
Answer: D
Diff: 1
Type: MC
Page Ref: 1
2) The two major reasons for the tremendous growth in output in the Canadian economy over the
last 125 years are
A) population growth and budget deficit.
B) population growth and increased productivity.
C) low unemployment and budget surplus.
D) low budget deficit and low trade deficits.
Answer: B
Diff: 1
Type: MC
Page Ref: 2
3) The main reason Canada has such a high standard of living is
A) low unemployment.
B) high average labour productivity.
C) low inflation.
D) low government budget deficits.
Answer: B
Diff: 1
Type: MC
Page Ref: 2
4) Average labour productivity is
A) the amount of workers per machine.
B) the amount of machines per worker.
C) the ratio of employed to unemployed workers.
D) the amount of output per worker.
Answer: D
Diff: 1
Type: MC
Page Ref: 2
5) In analyzing macroeconomic data during the past year, you have discovered that average
labour productivity fell, but total output increased. What was most likely to have caused this?
A) Government deficit was reduced.
B) The capital/output ratio probably rose.
C) There was an increase in labour input.
D) Unemployment probably increased.
Answer: C
Diff: 3
Type: MC
Page Ref: 2
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6) The business cycle describes the
A) progression of an industry's structure from monopoly to perfect competition.
B) progression of an industry's structure from perfect competition to monopoly.
C) expansion and contraction of an individual industry within the economy.
D) expansion and contraction of economic activity in the economy as a whole.
Answer: D
Diff: 1
Type: MC
Page Ref: 3
7) The short-run, but sometimes sharp, contractions and expansions in economic activity are
called
A) recession.
B) stagnation.
C) inflation.
D) business cycles.
Answer: D
Diff: 1
Type: MC
Page Ref: 3
8) When national output declines, the economy is said to be in
A) an expansion.
B) a deflation.
C) a recovery.
D) a recession.
Answer: D
Diff: 1
Type: MC
Page Ref: 3
9) During recessions, the unemployment rate ________ and output ________.
A) rises; falls
B) rises; rises
C) falls; rises
D) falls; falls
Answer: A
Diff: 1
Type: MC
Page Ref: 3
10) The unemployment rate is the
A) number of unemployed divided by the number of employed.
B) number of employed divided by the number of unemployed.
C) number of unemployed divided by the labour force.
D) labour force divided by the number of unemployed.
Answer: C
Diff: 1
Type: MC
Page Ref: 4
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11) The highest and prolonged period of unemployment in Canada occurred during
A) the Great Depression of the 1930s.
B) the 1981-1982 recession.
C) the 1990-1991 recession.
D) the 2001 recession in the U.S.
Answer: A
Diff: 1
Type: MC
Page Ref: 5
12) A country is said to be experiencing inflation when
A) prices of most goods and services are rising over time.
B) prices of most goods and services are falling over time.
C) total output is rising over time.
D) total output is falling over time.
Answer: A
Diff: 1
Type: MC
Page Ref: 4
13) A country is said to be experiencing deflation when
A) prices of most goods and services are rising over time.
B) prices of most goods and services are falling over time.
C) total output is rising over time.
D) total output is falling over time.
Answer: B
Diff: 1
Type: MC
Page Ref: 4
14) An open economy is a national economy that
A) has good relations with its neighbouring countries.
B) has a stock market that is open to traders from anywhere in the world.
C) has extensive trading and financial relationships with other national economies.
D) has established diplomatic relations with most other nations.
Answer: C
Diff: 1
Type: MC
Page Ref: 4
15) A closed economy is a national economy that
A) doesn't interact economically with the rest of the world.
B) has a stock market that is not open to traders from outside the country.
C) has extensive trading and financial relationships with other national economies.
D) has not established diplomatic relations with other national economies.
Answer: A
Diff: 1
Type: MC
Page Ref: 4
16) Canadian exports are goods and services
A) produced abroad and sold to Canadians.
B) produced in Canada and sold to Canadians.
C) produced abroad and sold to foreigners.
D) produced in Canada and sold to foreigners.
Answer: D
Diff: 1
Type: MC
Page Ref: 4
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17) Canadian imports are goods and services
A) produced abroad and sold to Canadians.
B) produced in Canada and sold to Canadians.
C) produced abroad and sold to foreigners.
D) produced in Canada and sold to foreigners.
Answer: A
Diff: 1
Type: MC
Page Ref: 4
18) A country has a trade surplus when
A) imports exceed exports.
B) imports equal exports.
C) exports exceed imports.
D) imports are zero.
Answer: C
Diff: 1
Type: MC
Page Ref: 4
19) A country has a trade deficit when
A) imports exceed exports.
B) imports equal exports.
C) exports exceed imports.
D) exports are zero.
Answer: A
Diff: 1
Type: MC
Page Ref: 4
20) In 2001 Anchovy had imports of $50 billion, exports of $60 billion, and Anchovy's GDP was
equal to $300 billion. The trade surplus was what percent of GDP in 2001?
A) 3.3%
B) 10.0%
C) 16.7%
D) 20.0%
Answer: A
Diff: 2
Type: MC
Page Ref: 4
21) In 2005, DAMA's exports were $30 billion, imports $40 billion, and real GDP $200 billion.
DAMA had a trade ________ equal to ________ of GDP in 2005.
A) surplus; 5 percent
B) deficit; 5 percent
C) surplus; 10 percent
D) deficit; 10 percent
Answer: B
Diff: 2
Type: MC
Page Ref: 4
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22) The exchange rate is
A) the rate of return in the stock market.
B) the price index for goods and services.
C) the price of Canadian dollar in terms of foreign currencies.
D) the rate of return on investment in foreign countries.
Answer: C
Diff: 1
Type: MC
Page Ref: 4
23) Fiscal policy determines ________ while monetary policy determines ________.
A) government spending and taxation; the growth of the money supply
B) government's capital; government's investment
C) the rate of growth of the economy; the rate of growth of prices
D) the inflation rate; the rate of growth of prices
Answer: A
Diff: 1
Type: MC
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24) In Canada, monetary policy is determined by
A) the Bank of Canada.
B) the prime minister.
C) private citizens.
D) the Department of Finance.
Answer: A
Diff: 1
Type: MC
Page Ref: 5
25) The difference between microeconomics and macroeconomics is that
A) microeconomics looks at supply and demand for goods, while macroeconomics looks at
supply and demand for services.
B) microeconomics looks at prices, while macroeconomics looks at inflation.
C) microeconomics looks at individual consumers and firms, while macroeconomics looks at
national totals.
D) microeconomics looks at national issues, while macroeconomics looks at global issues.
Answer: C
Diff: 1
Type: MC
Page Ref: 6
26) The process of adding together individual economic variables to obtain economywide totals
is called
A) macroeconomics.
B) aggregation.
C) agglomeration.
D) data development.
Answer: B
Diff: 1
Type: MC
Page Ref: 6
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27) A country that has many well-trained macroeconomic analysts will not necessarily have
more beneficial macroeconomic policies because
A) economists' understanding of the economy remains poor.
B) there are few ways in which economists' complex models can be applied to the real world.
C) economists agree on so few government policies.
D) economic policy is usually made by politicians, not economists.
Answer: D
Diff: 1
Type: MC
Page Ref: 7
28) The main goal of macroeconomic research is to
A) predict how the macroeconomy will perform in the future.
B) analyze current macroeconomic data.
C) develop new data that can be used to better understand the operation of the economy.
D) make general statements about how the economy works.
Answer: D
Diff: 1
Type: MC
Page Ref: 8
29) Assumptions for economic theories and models should be
A) rejected if they are not totally realistic.
B) logical rather than empirically testable.
C) simple and reasonable rather than complex.
D) maintained until overwhelming evidence to the contrary occurs.
Answer: C
Diff: 1
Type: MC
Page Ref: 8
30) If the theory behind an economic model fits the data only moderately well, you would
probably want to
A) use the theory to predict what would happen if the economic setting or economic policies
change.
B) start from scratch with a new model.
C) enrich the model with additional assumptions.
D) restate the research question.
Answer: C
Diff: 2
Type: MC
Page Ref: 9
31) A useful macroeconomic theory
A) is based on reasonable and realistic assumptions.
B) is easy to use.
C) has implications that can be tested in the real world.
D) is consistent with the data and observed behaviour of the real-world economy.
E) all of the above.
Answer: E
Diff: 2
Type: MC
Page Ref: 9
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32) Macroeconomists disagree on normative analysis of economic issues because
A) they use different tools to study economics.
B) they have different political agenda.
C) they have different values.
D) they have different objectives.
Answer: C
Diff: 2
Type: MC
Page Ref: 11
33) Positive analysis of economic policy
A) examines the economic consequences of policies but does not address the question of whether
those consequences are desirable.
B) examines the economic consequences of policies and addresses the question of whether those
consequences are desirable.
C) generates less agreement among economists than normative analysis.
D) is rare in questions of economic policy.
Answer: A
Diff: 1
Type: MC
Page Ref: 10
34) Which of the statements below is primarily normative in nature?
A) There is an unequal distribution of income in Canada.
B) The distribution of income is more unequal in Canada than it is in Japan.
C) The inequality of income that exists in Canada is partly caused by an unequal distribution of
wealth.
D) The distribution of income in Canada should be more equal than it is.
Answer: D
Diff: 1
Type: MC
Page Ref: 10
35) Adam Smith's idea of the "invisible hand" tries to convey the idea that while there are free
markets and people conduct their economic affairs in their own best interests
A) any country can become an advanced, industrialized nation.
B) markets will eliminate problems of hunger and dissatisfaction.
C) most inequalities between the rich and the poor will be eliminated.
D) the overall economy will work well.
Answer: D
Diff: 1
Type: MC
Page Ref: 11
36) Equilibrium in the economy means
A) unemployment is zero.
B) quantities demanded and supplied are equal in all markets.
C) prices aren't changing over time.
D) tax revenues equal government spending, so the government has no budget deficit.
Answer: B
Diff: 1
Type: MC
Page Ref: 11
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37) Classical economists who assume the "invisible hand" works reasonably well do NOT argue
that
A) the government should have a limited role in the economy.
B) government policies will be ineffective and counterproductive.
C) the government should actively intervene in the economy to eliminate business cycles.
D) wages and prices adjust quickly to bring the economy back to equilibrium.
Answer: C
Diff: 2
Type: MC
Page Ref: 12
38) The classical approach to macroeconomics assumes that
A) wages, but not prices, adjust quickly to balance quantities supplied and demanded in markets.
B) wages and prices adjust quickly to balance quantities supplied and demanded in markets.
C) prices, but not wages, adjust quickly to balance quantities supplied and demanded in markets.
D) neither wages nor prices adjust quickly to balance quantities supplied and demanded in
markets.
Answer: B
Diff: 1
Type: MC
Page Ref: 11
39) The Keynesian approach to macroeconomics assumes that
A) wages, but not prices, adjust quickly to balance quantities supplied and demanded in markets.
B) wages and prices adjust quickly to balance quantities supplied and demanded in markets.
C) prices, but not wages, adjust quickly to balance quantities supplied and demanded in markets.
D) neither wages nor prices adjust quickly to balance quantities supplied and demanded in
markets.
Answer: D
Diff: 1
Type: MC
Page Ref: 12
40) John Maynard Keynes disagreed with the classical economists because he assumed that
A) wages and prices adjusted slowly.
B) international trade played a major role in the macroeconomy.
C) government intervention in the economy could not reduce business cycles.
D) unemployment would be eliminated quickly by the invisible hand of the market.
Answer: A
Diff: 1
Type: MC
Page Ref: 12
41) The critical assumptions behind the idea of Adam Smith's invisible hand are
A) wage-price flexibility and individuals pursuing their own self-interests.
B) balanced budget and balance trade.
C) zero unemployment and high economic growth.
D) high economic growth and low inflation.
Answer: A
Diff: 1
Type: MC
Page Ref: 12
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42) How did Keynes propose to solve the problem of high unemployment?
A) increase the growth rate of the money supply
B) allow wages to decline so that firms will want to hire more workers
C) put on wage and price controls so that wages won't rise and firms won't have to lay people off
to cut costs
D) have the government increase its demand for goods and services
Answer: D
Diff: 2
Type: MC
Page Ref: 13
43) Economists evaluate an economic model based on
A) the results of the model.
B) the testability of the implications of the model by empirical analysis.
C) data availability.
D) the consistency of the assumptions with the Classical model.
Answer: B
Diff: 1
Type: MC
Page Ref: 8
44) When an economist wants to develop a theory to explain the effect of the price of oil on
economic growth
A) the first step is to state the research question.
B) the first step is to examine the data.
C) the first step is to work out the implications of the theory.
D) he/she should start with microeconomic analysis.
Answer: A
Diff: 1
Type: MC
Page Ref: 9
45) Comparative static experiments
A) are conducted in social sciences labs.
B) assume the model is in equilibrium.
C) use data to compare empirical results.
D) use economic surveys to analyze economic behaviour.
Answer: B
Diff: 2
Type: MC
Page Ref: 10
46) Analyzing the effect of a shock on a macroeconomic model is called
A) forecasting.
B) disequilibrium analysis.
C) comparative static experiments.
D) shock analysis.
Answer: C
Diff: 2
Type: MC
Page Ref: 10
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47) A theoretical analysis of the effect of an oil shock on inflation is an example of
A) the Classical model.
B) the Keynesian model.
C) why economists disagree.
D) a comparative static experiment.
Answer: D
Diff: 3
Type: MC
Page Ref: 10
48) Which of the following is NOT an issue addressed by macroeconomists?
A) What determines the price of gasoline
B) What causes prices to rise
C) What causes the unemployment rate to rise
D) Why a nation's economic activity fluctuates
Answer: A
Diff: 1
Type: MC
Page Ref: 1
49) Which of the following is NOT true?
A) The average labour productivity in Canada has risen by a factor of six since 1921.
B) Canadian workers are working fewer hours but their real wages are higher, on average, than
in the past.
C) Canadian workers are, on average, much more productive than 60 years ago.
D) Today, a typical Canadian is working longer and getting paid less in real terms.
Answer: D
Diff: 2
Type: MC
Page Ref: 2
50) Which of the following is considered as a fiscal policy?
A) Fixing the exchange rate.
B) Lowering interest rates.
C) Removing energy subsidies.
D) Increasing mortgage rates.
Answer: C
Diff: 2
Type: MC
Page Ref: 5
51) Macroeconomists cannot conduct experiments in the manner of physicists or chemists,
because
A) macroeconomic subjects such as business cycles are very complex.
B) macroeconomists are not allowed to run experiments on human and firm subjects.
C) macroeconomists do not have access to the labs used in physics and chemistry.
D) results of macroeconomic experiments are not reliable.
Answer: B
Diff: 2
Type: MC
Page Ref: 9
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52) Which of the following event is NOT considered as a shock?
A) Hurricane Harvey in Texas and the Caribbean Islands.
B) An anticipated change in the interest rate.
C) A fall in the price of oil.
D) A fall in stock prices.
Answer: B
Diff: 2
Type: MC
Page Ref: 10
1.2 Essay Questions
1) Macroeconomic information for the economy of Anchovy is given below:
Output (pizzas)
Employment (workers)
Unemployed (workers)
Labour force (workers)
Price per pizza
2000
8000
700
70
770
$8.00
2001
9000
800
100
900
$9.00
a. What was the growth rate of average labour productivity in Anchovy between 2000 and
2001?
b. What was the inflation rate in Anchovy between 2000 and 2001?
c. What was the unemployment rate in 2000? In 2001?
Answer:
a. Average labour productivity: 2000: 8000/700 = 80/7; 2001: 9000/800 = 90/8;
growth rate = [(90/8)/(80/7)] - 1 = -.016 = -1.6%
b. Inflation rate: (9/8) - 1 = .125 = 12.5%
c. Unemployment rates: 2000: 70/770 = .091 = 9.1%; 2001: 100/900 = .111 = 11.1%
Diff: 3
Type: ES
Page Ref: Sec. 1.1
2) What are the four major areas in which macroeconomists work? Give an example of a job in
each.
Answer: Forecasting, analysis, research, and data development.
Forecasting: forecasting the stock market on Bay Street
Analysis: analyzing the economy for the Bank of Canada
Research: investigating the link between the trade deficit and the government budget deficit as a
university professor
Data development: working at Statistics Canada to develop better ways to measure
unemployment.
Diff: 2
Type: ES
Page Ref: Sec. 1.2
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3) Match each of the following jobs to its major area: forecasting, analysis, research, or data
development. Explain your answers.
a. economist at university, testing theories about the efficient allocation of resources in the
foreign exchange market
b. economist at Bay Street firm trying to predict the rate of inflation next year using past data
c. economist at auto firm looking at demand for new automobiles
d. economist at the Department of Finance trying to determine whether foreign firms are
dumping goods in Canada
e. economist at Statistics Canada developing new methods for calculating price indexes
f. economist consulting in Eastern Europe about how to set up free-market financial systems
Answer:
a. research
b. forecasting
c. analysis
d. analysis
e. data development
f. analysis
Diff: 2
Type: ES
Page Ref: Sec. 1.2
4) Determine whether each of the following is a positive or normative statement.
a. The Bank of Canada should lower interest rates to increase economic growth, because we're
in a recession.
b. Higher government budget deficits cause higher interest rates.
c. The trade deficit should decline because of the fall in the value of the dollar.
d. Because of our high inflation rate, we must reduce the rate of money growth.
e. A generous unemployment insurance system is a primary cause of high unemployment in
Europe.
f. Increased average labour productivity in a country should lead to faster growth.
g. Government budget deficits are too high in Canada and should be reduced.
Answer:
a. normative
b. positive
c. positive
d. normative
e. positive
f. positive
g. normative
Diff: 2
Type: ES
Page Ref: Sec. 1.3
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5) Discuss the major difference between classical and Keynesian economists. Be sure to explain
how they differ with regard to how quickly equilibrium is restored in the economy as well as
what role they see for government action in restoring equilibrium.
Answer: Classical and Keynesian economists differ most with regard to how quickly they see
wages and prices adjusting to restore equilibrium in the economy. Classical economists think that
when the economy is out of equilibrium, wages and prices adjust quickly to restore equilibrium.
As a result, there shouldn't be long periods of abnormally high unemployment. The quick return
to equilibrium means there is no reason for government action. Keynesians, on the other hand,
think wages and prices are slow to adjust. As a result, the economy may be out of equilibrium for
some time, perhaps with high unemployment. To restore equilibrium quickly may necessitate
some government action, such as increasing the government's demand for goods and services.
Diff: 2
Type: ES
Page Ref: Sec. 1.3
6) Describe what the two key assumptions are in the "invisible hand" idea.
Answer: The first assumption in the invisible hand idea is that people pursue their own
economic self-interests. The second key assumption is that the various markets in the economy
must function smoothly and without impediment. In particular, it is assumed that wages and
prices are fully flexible and must adjust rapidly enough to maintain equilibrium in all markets. If
there is a disequilibrium, the prices and wages would adjust quickly to restore the equilibrium.
Diff: 2
Type: ES
Page Ref: Sec. 1.3
7) You are asked to analyze the effect of the Bank of Canada's new interest rate policy on
housing prices. Using a comparative static experiment, describe the steps you need to follow to
produce a sound theoretical macroeconomic analysis.
Answer: First, we need to set up a macroeconomic model that includes all relevant variables and
is assumed to be in equilibrium. Second, we change the interest rate, keeping all other variables
constant, and examine the change in housing prices. Third, we observe how our macroeconomic
model responds to the interest rate changes.
Diff: 2
Type: ES
Page Ref: Sec. 1.2
8) Explain what Keynes meant by the phrase "in the long-run we are all dead."
Answer: Keynes argued that wages and prices will eventually adjust to equate demand and
supply, but this adjustment might be slow to occur. Therefore, the phrase makes the point that it
might not be good government policy to wait for that eventual adjustment in wages and prices.
He therefore proposed that governments take actions to alleviate the unemployment resulting
from the slow adjustment of wages and prices.
Diff: 2
Type: ES
Page Ref: 12
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9) Explain the main assumptions in a balanced and unified approach to macroeconomics.
Answer: The balanced and unified approach to macroeconomics has the following
characteristics:
1. Individuals, firms, and the government interact in goods markets, asset markets, and labour
markets.
2. The model's macroeconomic analysis is based on the analysis of individual behaviour.
3. In the long term, prices and wages fully adjust to achieve equilibrium in the markets for goods,
assets, and labour.
4. The basic model may be used with either the classical assumption that wages and prices are
flexible or the Keynesian assumption that wages and prices are slow to adjust.
Diff: 2
Type: ES
Page Ref: 13
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 2 The Measurement and Structure of the Canadian Economy
2.1 Multiple-Choice Questions
1) The national income accounts
A) are an accounting framework used in measuring households income.
B) are an accounting framework used in measuring firms income.
C) are an accounting framework used in measuring government income.
D) are an accounting framework used in measuring current economic activity.
Answer: D
Diff: 1
Type: MC
Page Ref: 17
2) The three approaches to measuring economic activity are the
A) cost, income, and expenditure approaches.
B) product, income, and expenditure approaches.
C) consumer, business, and government approaches.
D) private, public, and international approaches.
Answer: B
Diff: 1
Type: MC
Page Ref: 18
3) Which of the following statements is true?
A) GDP calculated by income approach is greater than GDP calculated by expenditure approach.
B) GDP calculated by product approach is greater than GDP calculated by expenditure approach.
C) GDP calculated by expenditure approach is greater than GDP calculated by product approach.
D) All three approaches for calculating GDP will result in the same value for GDP.
Answer: D
Diff: 1
Type: MC
Page Ref: 19
4) The value added of a producer is the
A) total amount for which all its products sell minus its change in inventories.
B) value of its total sales once externalities are accounted for.
C) value of its output minus the value of the inputs it purchases from other producers.
D) quality-adjusted amount of its total sales less any commissions paid.
Answer: C
Diff: 1
Type: MC
Page Ref: 18
5) The A company collects bushels of wild berries, which it sells for $2 million to the B
company to be made into jam. The B company's wild berry jam is sold for a total of $6 million.
What is the total contribution to the country's GDP from companies A and B?
A) $2 million
B) $4 million
C) $6 million
D) $8 million
Answer: C
Diff: 1
Type: MC
Page Ref: 18
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6) The A company collects bushels of wild berries, which it sells for $2 million to the B
company to be made into jam. The B company's wild berry jam is sold for a total of $6 million.
What is the value added of company B?
A) $2 million
B) $4 million
C) $6 million
D) $8 million
Answer: B
Diff: 1
Type: MC
Page Ref: 18
7) The Compagnie Naturelie sells mounted butterflies, using butterfly bait it buys from another
firm for $20 thousand. It pays its workers $35 thousand, pays $1 thousand in taxes, and has
profits of $3 thousand. What is its value added?
A) $3 thousand
B) $19 thousand
C) $39 thousand
D) $59 thousand
Answer: C
Diff: 2
Type: MC
Page Ref: 19
8) The fundamental identity of national income accounting tells us that
A) total production = total income = total expenditure.
B) total production = total income - total expenditure.
C) total production = total income + total expenditure.
D) total production < total income + total expenditure.
Answer: A
Diff: 2
Type: MC
Page Ref: 20
9) One problem with using market values to measure GDP is that
A) you cannot compare completely heterogeneous goods by using their dollar values.
B) some useful goods and services are not sold in markets.
C) prices for some goods change every year.
D) market values of export goods are usually priced in foreign currencies.
Answer: B
Diff: 1
Type: MC
Page Ref: 21
10) Which of the following statements is true?
A) Total expenditures and total income are the same measures of economic activity.
B) The product, income, and expenditure approaches must generate the same answer to the
measure of economic activity.
C) The fundamental identity of national income accounting states that the GDP measured by the
expenditure, income, and product approaches must be identical.
D) All of the above.
Answer: D
Diff: 1
Type: MC
Page Ref: 20
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11) The measurement of GDP includes
A) nonmarket goods such as homemaking and child-rearing.
B) the benefits of clean air and water.
C) estimated values of activity in the underground economy.
D) purchases and sales of goods produced in previous periods.
Answer: C
Diff: 2
Type: MC
Page Ref: 21
12) Underground activities in the economy are
A) excluded from measurements of the GDP because they are not beneficial to the nation.
B) excluded from the measurements of GDP because there is no way of measuring them.
C) included in GDP if legal and excluded from GDP if illegal.
D) estimated and included in measurements of GDP.
Answer: D
Diff: 1
Type: MC
Page Ref: 21
13) Because government services are not sold in markets
A) they are excluded from measurements of GDP.
B) the government tries to estimate their market value and uses this to measure the government's
contribution to GDP.
C) they are valued at their cost of production.
D) taxes are used to value their contribution.
Answer: C
Diff: 1
Type: MC
Page Ref: 21
14) Countries A and B have the same GDP. In country A, people eat often in restaurants, but in
country B people eat more often at home. Therefore
A) economic activities are underestimated in country A.
B) economic activities are overestimated in country B.
C) GDP represents accurate measure of economic activities in both countries.
D) GDP is underestimated in country B.
Answer: D
Diff: 2
Type: MC
Page Ref: 21
15) Intermediate goods are
A) capital goods, which are used up in the production of other goods but were produced in earlier
periods.
B) final goods that remain in inventories.
C) goods that are used up in the production of other goods in the same period that they were
produced.
D) either capital goods or inventories.
Answer: C
Diff: 1
Type: MC
Page Ref: 21
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16) Which of the following statements is true?
A) Capital goods are a type of intermediate good.
B) Capital goods are final goods because they are not used up during a given year.
C) Capital goods are produced in the same year as the related final goods, whereas intermediate
goods are produced in different years.
D) Capital goods are produced in one year and final goods are produced over a period of more
than one year.
Answer: B
Diff: 2
Type: MC
Page Ref: 23
17) Capital goods are
A) not counted in the GDP as final goods.
B) not used to produce other goods.
C) used up in the same period that they are produced.
D) goods used to produce other goods.
Answer: D
Diff: 1
Type: MC
Page Ref: 23
18) Beautiful Boating purchases five new boats at $200 thousand each to rent to vacationing
fishermen. The firm sells its old boats to the public for $500 thousand. The net increase in GDP
of these transactions was
A) $500,000.
B) $1,000,000.
C) $1,250,000.
D) $1,500,000.
Answer: B
Diff: 1
Type: MC
Page Ref: 21
19) Inventories are
A) included in the measurement of capital goods.
B) included in the measurements of intermediate goods.
C) fully included in annual measurements of GDP.
D) included in measurements of GDP only if they have changed from the preceding year.
Answer: D
Diff: 1
Type: MC
Page Ref: 23
20) GDP differs from GNP because
A) GDP = GNP - net factor payments from abroad.
B) GNP = GDP - net factor payments from abroad.
C) GDP = GNP - capital consumption allowances.
D) GNP = GDP - capital consumption allowances.
Answer: A
Diff: 1
Type: MC
Page Ref: 24
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21) Which of the following statements is true?
A) GDP and GNP are always the same because the net factor payments from abroad is always
zero.
B) GDP is always greater than GNP because the net factor payments from abroad is always
negative.
C) GNP is always greater than GDP because the net factor payments from abroad is always
positive.
D) GDP may be greater, equal, or smaller than GNP because the net factor payments from
abroad may be negative, zero, or positive.
Answer: D
Diff: 1
Type: MC
Page Ref: 24
22) If a Canadian construction company built a road in Kuwait, this activity would be
A) excluded from Canadian GNP.
B) fully included in Canadian GDP.
C) included in Canadian GNP only for that portion that was attributable to Canadian capital and
labour.
D) included in Canadian GDP but not Canadian GNP.
Answer: C
Diff: 3
Type: MC
Page Ref: 24
23) Nations such as Egypt and Turkey have wide differences between GNP and GDP because
both countries
A) have a high level of imports and exports relative to GNP.
B) have a large portion of their GNP produced by multinational corporations.
C) have a large number of citizens working abroad.
D) purchase large amounts of military wares from other countries.
Answer: C
Diff: 2
Type: MC
Page Ref: 24
24) Suppose Toyota built a new automobile plant in Mexico using Japanese management
practices, Canadian capital, and Mexican labour. Which of the following statements would be
true?
A) The portion of output contributed by Canadian capital would be included in Canadian GDP.
B) The portion of output contributed by Japanese management would be included in both
Japanese GNP and GDP.
C) The portion of output contributed by Japanese management would be included in neither
Japanese GNP nor GDP.
D) The portion of output contributed by Mexican labour would be included in both Mexican
GNP and GDP.
Answer: D
Diff: 2
Type: MC
Page Ref: 24
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25) The income-expenditure identity says that
A) Y = C + S + G.
B) Y = C + I = G.
C) Y = C + I + G + NX.
D) Y = C + I + G + NX = CA.
Answer: C
Diff: 1
Type: MC
Page Ref: 24
26) If GDP in an economy is greater than its GNP, it means that
A) net factor payment from abroad is positive.
B) net factor payment from abroad is negative.
C) net factor payment from abroad is zero.
D) there is a measurement error.
Answer: B
Diff: 2
Type: MC
Page Ref: 24
27) In using the expenditure approach to GNP, consumption includes
A) all final and intermediate goods consumed by domestic households and firms.
B) all final and intermediate goods consumed by domestic households produced at home, but not
those produced abroad.
C) all final goods consumed by domestic households produced at home, but not those produced
abroad.
D) all final goods consumed by domestic households produced at home and abroad.
Answer: D
Diff: 2
Type: MC
Page Ref: 25
28) In using the expenditure approach to GDP, consumption
A) includes consumer durables, semi-durable goods, nondurable goods, and services.
B) includes houses, consumer durables, nondurable goods, and services.
C) includes residential investment, nondurable goods, and services.
D) excludes all purchases by business firms.
Answer: A
Diff: 1
Type: MC
Page Ref: 25
29) In the expenditure approach to GDP, which of the following would be excluded from
measurements of GDP?
A) government payments for goods produced by foreign firms
B) government payments for goods produced by firms owned by state or local governments
C) government payments for welfare
D) All government payments are included in GDP.
Answer: C
Diff: 2
Type: MC
Page Ref: 26
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30) Net national income is equal to
A) GDP minus depreciation.
B) GDP minus depreciation and indirect business taxes.
C) net domestic product minus depreciation and indirect business taxes.
D) net domestic product minus indirect business taxes and employer contributions to
Unemployment Insurance.
Answer: B
Diff: 1
Type: MC
Page Ref: 27
31) Monica grows coconuts and catches fish. Last year she harvested 1500 coconuts and 600
fish. She values one fish as worth three coconuts. She gave Rachel 300 coconuts and 100 fish for
helping her to harvest coconuts and catch fish, all of which were consumed by Rachel. Monica
set aside 200 fish to help with next year's harvest. In terms of fish, Monica's income would equal
A) 700 fish.
B) 900 fish.
C) 1100 fish.
D) 2700 fish.
Answer: B
Diff: 2
Type: MC
Page Ref: 27
32) Private disposable income equals
A) GNP - taxes + transfers + interest.
B) NNP - taxes + transfers + interest.
C) national income - taxes + transfers + interest.
D) national income - taxes - transfers
Answer: A
Diff: 2
Type: MC
Page Ref: 29
33) Private saving is defined as being equal to
A) private disposable income minus consumption.
B) net national product minus consumption.
C) private disposable income minus consumption plus interest.
D) private disposable income minus consumption plus interest plus transfer payments.
Answer: A
Diff: 1
Type: MC
Page Ref: 30
34) Assume that the municipal government of Lethbridge, Alberta, has taxes of $500,
government purchases of $350, transfer payments of $150, and interest expenses of $50. The
government budget would
A) show a surplus of $100.
B) show a surplus of $50.
C) be in balance with neither a surplus nor a deficit.
D) show a deficit of $50.
Answer: D
Diff: 1
Type: MC
Page Ref: 31
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35) The government budget surplus equals
A) government purchases plus transfers.
B) government receipts minus outlays.
C) government outlays minus receipts.
D) government purchases minus transfers.
Answer: B
Diff: 1
Type: MC
Page Ref: 31
36) Assume that the municipal government of Winnipeg, Manitoba, has taxes of $1000, transfer
payments of $400, and interest payments on the government debt of $100. If government
purchases of goods and services are $300
A) government saving will be $100.
B) government saving will be $500.
C) government saving will be $200.
D) the government will not have any saving.
Answer: C
Diff: 2
Type: MC
Page Ref: 30
37) National saving equals private saving plus government saving, which in turns equals
A) C + S + T.
B) GDP + C + G.
C) GDP + NFP.
D) GDP + NFP - C - G.
Answer: D
Diff: 2
Type: MC
Page Ref: 31
38) The uses-of-saving identity says that an economy's private saving is used for
A) investment, interest expenses, and the government budget deficit.
B) investment, the government budget deficit, and the current account.
C) investment, interest expenses, the government budget deficit, and the current account.
D) investment, interest expenses, the government budget deficit, transfer payments, and the
current account.
Answer: B
Diff: 1
Type: MC
Page Ref: 32
39) The uses-of-saving identity shows that if the government budget deficit rises, then which of
the following must happen?
A) Private saving must rise, investment must fall, and/or the current account must fall.
B) Private saving must rise, investment must fall, and/or the current account must rise.
C) Private saving must rise, investment must rise, and/or the current account must fall.
D) Private saving must rise, investment must rise, and/or the current account must rise.
Answer: A
Diff: 2
Type: MC
Page Ref: 32
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40) In 2001 private saving in the country of Polity was $112 billion, investment was $114.5
billion, and the current account balance was -$26.5 billion. From the uses-of-saving identity,
how much was the government of Polity saving?
A) -$24 billion
B) -$39 billion
C) $24 billion
D) $39 billion
Answer: A
Diff: 2
Type: MC
Page Ref: 32
41) In 2001 national saving in the country of Polity was $85 billion, investment was $112 billion,
and private saving was $114 billion. How much was the current account balance?
A) $35 billion
B) $27 billion
C) -$27 billion
D) -$35 billion
Answer: C
Diff: 2
Type: MC
Page Ref: 32
42) Saving is a ________ variable, and wealth is a ________ variable.
A) stock; flow
B) stock; stock
C) flow; flow
D) flow; stock
Answer: D
Diff: 1
Type: MC
Page Ref: 33
43) Measuring GDP in nominal terms
A) is the most effective method because it accurately measures how an economy's physical
production has changed over time.
B) is unreliable because the quality of goods changes over time.
C) is the market value of an economy's final output using the market prices of a given base year.
D) does not tell us how an economy's physical production has changed over time.
Answer: D
Diff: 2
Type: MC
Page Ref: 34
44) Investment in the United States is greater than the national saving. This implies that
A) the current account is negative.
B) the current account is positive.
C) the current account is zero.
D) firms are very productive.
Answer: A
Diff: 3
Type: MC
Page Ref: 34
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45) If a country runs a current account ________, it means that its national saving is ________
than investment.
A) deficit, greater
B) deficit, less
C) surplus, greater
D) balance, less
Answer: B
Diff: 3
Type: MC
Page Ref: 34
46) Canada's current account has recently been negative. This means that
A) investment is greater than saving in Canada.
B) saving is greater than investment in Canada.
C) Canadian trade partners also have a current account deficit.
D) the interest rate is higher in Canada compared to the United States.
Answer: A
Diff: 3
Type: MC
Page Ref: 34
47) The country of Old Jersey produces milk and butter, and it has published the following
macroeconomic data, where quantities are in gallons and prices are dollars per gallon:
Between 2000 and 2001, nominal GDP grew by
A) 60.0%.
B) 65.5%.
C) 83.3%.
D) 190.0%.
Answer: D
Diff: 2
Type: MC
Page Ref: 35
48) A variable-weight price index
A) equals the value of current output at current prices divided by the value of current output at
base-year prices.
B) equals the value of a fixed basket at current prices divided by the value of a fixed basket at
base-year prices.
C) is used in the consumer price index.
D) is misleading because it cannot distinguish between nominal and real measures.
Answer: A
Diff: 1
Type: MC
Page Ref: 37
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49) The country of Old Jersey produces milk and butter, and it has published the following
macroeconomic data, where quantities are in gallons and prices are dollars per gallon:
Between 2000 and 2001, the percent change in the price level as measured by a variable-weight
price index was
A) 60.00%.
B) 81.25%.
C) 83.33%.
D) 123.08%.
Answer: B
Diff: 3
Type: MC
Page Ref: 37
50) Use the following information to answer this question about the country of Polity:
Using a fixed-weight price index with 1998 as the base year, what is the percent change in real
output from 2000 to 2001?
A) 8%
B) 10%
C) 12%
D) 15%
Answer: B
Diff: 3
Type: MC
Page Ref: 37
51) The country of Old Jersey produces milk and butter, and it has published the following
macroeconomic data, where quantities are in gallons and prices are dollars per gallon:
Between 2000 and 2001, real GDP grew by how much, using a variable-weight price index?
A) 37.5%
B) 60.05%
C) 83.3%
D) 190.0%
Answer: B
Diff: 3
Type: MC
Page Ref: 37
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52) If nominal GDP for 2000 is $6400 billion and real GDP for 2001 is $6720 billion (in 2000
dollars), then the growth rate of real GDP is
A) 0%.
B) 0.5%.
C) 5%.
D) 50%.
Answer: C
Diff: 2
Type: MC
Page Ref: 37
53) If real GDP falls by 1 percent, but the nominal GDP rises by 5 percent, then we must
conclude that
A) the price level rises by 5 percent.
B) the price level falls by 1 percent.
C) the price level rises by 6 percent.
D) the price level falls by 4 percent.
Answer: C
Diff: 2
Type: MC
Page Ref: 37
54) If the price index was 100 in 1991 and 120 in 2001, and nominal GDP was $360 billion in
1991 and $480 billion in 2001, then the value of 2001 GDP in terms of 1991 dollars would be
A) $300 billion.
B) $384 billion.
C) $400 billion.
D) $424 billion.
Answer: C
Diff: 2
Type: MC
Page Ref: 37
55) Suppose that nominal GDP in 1990 was $1,015.5 billion, and in 2000 it was $2,732.0 billion.
The GDP deflator is 42.0 for 1990 and 85.7 for 2000, where 1992 is the base year. Calculate the
percent change in real GDP in the decade from 1990 and 2000. Round off to the nearest
percentage point.
A) 32%
B) 104%
C) 132%
D) 169%
Answer: A
Diff: 2
Type: MC
Page Ref: 37
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56) Nominal personal consumption expenditures in Canada were $172.4 billion in 1980 and rose
to $399.3 billion in 1990. The implicit price deflator for personal consumption expenditures is 67
for 1980 and 118.6 for 1990, where 1986 is the base year. Calculate the percent change in real
personal consumption expenditures (rounded to the nearest percentage point) in the decade.
A) 31%
B) 61%
C) 114%
D) 133%
Answer: A
Diff: 2
Type: MC
Page Ref: 37
57) A fixed-weight price index
A) equals the value of current output at current prices divided by the value of current output at
base-year prices.
B) equals the value of a fixed basket at current prices divided by the value of a fixed basket at
base-year prices.
C) is used to calculate the GDP deflator.
D) is misleading because it cannot distinguish between nominal and real measures.
Answer: B
Diff: 1
Type: MC
Page Ref: 37
58) Say nominal GDP was $603.9 billion in 2001 and $572.3 billion in 2000, while the GDP
deflator was 121.1 in 2001 and 117.7 in 2000. What was the growth rate of real GDP between
2000 and 2001?
A) 5.5%
B) 2.9%
C) 2.6%
D) 1.0%
Answer: C
Diff: 2
Type: MC
Page Ref: 37
59) The country of Old Jersey produces milk and butter, and it has published the following
macroeconomic data, where quantities are in gallons and prices are dollars per gallon:
Between 2001 and 2002, the percent change in the price level as measured by a fixed-weight
index that uses production in 2001 as the fixed "basket" of goods was
A) 60.00%.
B) 81.25%.
C) 83.33%.
D) 123.08%.
Answer: C
Diff: 3
Type: MC
Page Ref: 37
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60) On January 1, 2001, the GDP deflator for Old York was 300, and on January 1, 2003, the
GDP deflator had risen to 330.75. Based on this information, the annual average inflation rate for
the two years was
A) 5%.
B) 5.125%.
C) 10%.
D) 10.25%.
Answer: A
Diff: 1
Type: MC
Page Ref: 38
61) If the price index last year was 1.0 and today it is 1.4, what is the inflation rate over this
period?
A) -4%
B) 1.4%
C) 4%
D) 40%
Answer: D
Diff: 1
Type: MC
Page Ref: 38
62) The consumer price index is 132 in 2004 and 112 in 2003 when the base year is 1997. The
2004 annual inflation rate, using 2003 as a base year, is
A) 17.8 percent.
B) 20 percent.
C) 12 percent.
D) unknown, as there is not sufficient information.
Answer: A
Diff: 2
Type: MC
Page Ref: 38
63) GDP deflator is
A) a price index that measures the overall level of prices of goods and services included in GDP.
B) a price index that measures the overall level of prices of goods and services included in
household baskets.
C) obtained by dividing real GDP over nominal GDP.
D) obtained by measuring the price of goods and services in a base year.
Answer: A
Diff: 1
Type: MC
Page Ref: 37
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64) You are given information on the consumer price index (CPI), where the values given are
those for December 31 of each year.
In which year was the inflation rate the highest?
A) 1998
B) 1999
C) 2000
D) 2001
Answer: A
Diff: 2
Type: MC
Page Ref: 38
65) The consumer price index (CPI) is 311.1 for 2002 when using 1975 as the base year (1975 =
100). Now suppose we switch and use 2002 as the base year (2002 = 100). What is the CPI for
1975 with the new base year?
A) 20.2
B) 32.1
C) 48.4
D) 56.2
Answer: B
Diff: 3
Type: MC
Page Ref: 38
66) The real interest rate is equal to
A) nominal interest rate + inflation rate.
B) nominal interest rate - inflation rate.
C) nominal interest rate / inflation rate.
D) nominal interest rate × inflation rate.
Answer: B
Diff: 1
Type: MC
Page Ref: 40
67) Which of the following statements is false?
A) Nominal interest rate can be either positive, zero, or negative.
B) The expected real interest rate can be either positive, zero, or negative.
C) The expected real interest rate is the correct interest rate to use for studying people's decisions
about how much to borrow or lend.
D) Nominal interest rate must exceed the expected real interest rate as long as there is a positive
expected inflation rate.
Answer: A
Diff: 1
Type: MC
Page Ref: 40
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68) By Marks buys a one-year German government bond (called a bund) for $400. He receives
principal and interest totalling $436 one year later. During the year the CPI rose from 150 to 162.
The nominal interest rate on the bond was ________, and the real interest rate was ________.
A) 9%; 1%
B) 9%; -1%
C) 36%; 24%
D) 36%; 12%
Answer: A
Diff: 2
Type: MC
Page Ref: 40
69) The expected real interest rate 7 is equal to
A) nominal interest rate minus inflation rate.
B) nominal interest rate minus expected inflation rate.
C) expected nominal interest rate minus inflation rate.
D) nominal interest rate plus expected inflation rate.
Answer: B
Diff: 1
Type: MC
Page Ref: 41
70) Mark buys a one-year German government bond (called a bund) for $400. He receives
principal and interest totalling $436 one year later. During the year the CPI rose from 150 to 162,
but he had thought the CPI would be at 159 by the end of the year. Mark had expected the real
interest rate to be ________, but it actually turned out to be ________.
A) 8%; 1%
B) 6%; 3%
C) 3%; 1%
D) 1%; 3%
Answer: C
Diff: 3
Type: MC
Page Ref: 41
71) If national savings in an economy is equal to $50 billion, exports are $10 billion, imports are
$5 billion, and net factor payments from abroad is -$2 billion, total investment will be
A) $74 billion.
B) $57 billion.
C) $45 billion.
D) $47 billion.
Answer: D
Diff: 3
Type: MC
Page Ref: 34
72) If we choose 2007 as a base year, then in 2007
A) nominal GDP will be greater than real GDP.
B) nominal GDP will be smaller than real GDP.
C) nominal GDP will be the same as real GDP.
D) we cannot compare nominal GDP and real GDP without having their actual values.
Answer: C
Diff: 2
Type: MC
Page Ref: 36
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73) The GDP deflator and the CPI
A) measure the aggregate price level.
B) measure real GDP and nominal GDP, respectively.
C) measure inflation.
D) measure nominal GDP and real GDP, respectively.
Answer: A
Diff: 1
Type: MC
Page Ref: 37
74) The fact that Dollarama's sales increased during the recent recession indicates that
A) inflation measured by the CPI understates the true increases in the cost of living.
B) the CPI is a better measure for the cost of living than the GDP deflator.
C) inflation measured by the CPI overstates the true increases in the cost of living.
D) the CPI understates the actual cost of living.
Answer: C
Diff: 2
Type: MC
Page Ref: 38
75) The real interest rate
A) is always positive.
B) can be negative.
C) is always greater than the nominal interest rate.
D) is always smaller than the nominal interest rate.
Answer: B
Diff: 2
Type: MC
Page Ref: 41
76) The expected real interest rate is
A) the ratio of nominal interest rate to the expected inflation rate.
B) the difference between the nominal interest rate and inflation rate.
C) the difference between the nominal interest rate and the expected inflation rate.
D) the ratio of nominal interest rate to the inflation rate.
Answer: C
Diff: 1
Type: MC
Page Ref: 41
77) If real interest is 2 percent and the expected inflation rate is 5 percent, then the nominal
interest rate is
A) 7 percent.
B) 3 percent.
C) 2.5 percent.
D) 0.4 percent.
Answer: A
Diff: 3
Type: MC
Page Ref: 41
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78) Which of the following transactions is part of the Canadian GDP?
A) Mary Jane buys her husband dinner in Vancouver.
B) Ali sells back his textbook (which he purchased last year) to the bookstore.
C) Amanda buys a Chinese-made laptop from an online store in Taiwan.
D) Dave sells the stocks he purchased last month in the Toronto Stock Exchange market.
Answer: A
Diff: 2
Type: MC
Page Ref: 20
79) Suppose that the national savings in an economy is $50 billion and total investment $60
billion. The country should have
A) a trade deficit in the amount of $110 billion.
B) a trade surplus in the amount of $110 billion.
C) a trade deficit in the amount of $10 billion.
D) a trade surplus in the amount of $10 billion.
Answer: A
Diff: 2
Type: MC
Page Ref: 33
80) If the GDP deflator in 2017 is 110.5 and the base year is 2016, then the inflation rate in 2017
will be
A) more than 110.5.
B) 10.5 percent.
C) less than 110.5.
D) 110.5 percent.
Answer: B
Diff: 3
Type: MC
Page Ref: 36
81) Consider that a consumer likes chicken and beef equally well and in the base year consumes
equal amounts of each. If the price of chicken rises sharply next year, she will eat beef almost
exclusively. The official CPI, which uses the base year basket as a measure the cost of living,
will
A) be biased upward.
B) be biased downward.
C) underestimate the true cost of living.
D) reflect the true changes in the cost of living.
Answer: A
Diff: 2
Type: MC
Page Ref: 38
82) Which of the following is true about the nominal and real interest rates?
A) Changes in the nominal interest rate are smoother than the real interest rate.
B) The real interest rate can be higher than the nominal interest rate.
C) The nominal and the real interest rates always move together.
D) The nominal interest rate is always positive, but the real interest rate can be negative.
Answer: D
Diff: 2
Type: MC
Page Ref: 39
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83) Which of the following is NOT a consequence of the CPI bias?
A) The state of the economy will be understated.
B) The CPI-indexed government transfer payments will be higher than the amount planned.
C) The monetary policy that targets inflation will need to adjust for the CPI bias.
D) The economic growth rate will be biased upward.
Answer: D
Diff: 2
Type: MC
Page Ref: 38
84) If nominal GDP in 2015 exceeds real GDP in 2015, then we know with certainty that
A) the price level in 2015 is less than the price level in the base year.
B) real GDP in 2015 is less than real GDP in the base year.
C) real GDP in 2015 is equal to the real GDP in the base year.
D) the price level in 2015 is greater than the price level in the base year.
Answer: A
Diff: 3
Type: MC
Page Ref: 35
2.2 Essay Questions
1) Carl's Computer Centre sells computers to business firms. Businesses then use the computers
to produce other goods and services. Over the past year, sales representatives were paid $3.5
million, $0.5 million went for taxes, $0.5 million was profit for Carl, and $10 million was paid
for computers at the wholesale level. What was the firm's total contribution to GDP?
Answer: $4.5 million. Note that the $10 million paid for computers is not part of value added.
Note also that the fact that the firm produces an intermediate good doesn't mean that it doesn't
contribute to GDP.
Diff: 2
Type: ES
Page Ref: Sec. 2.1
2) What is the main conceptual difference between GDP and GNP? How different are GDP and
GNP for Canada? For countries with many citizens who work abroad?
Answer: GDP represents output produced within a country, while GNP represents output
produced by a country's factors of production; the difference is net factor payments from abroad.
For Canada there's a three percent difference, but for countries that have many citizens working
abroad, there may be a much bigger difference.
Diff: 1
Type: ES
Page Ref: Sec. 2.2
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3) Citizens of the country of Heehaw produce hay and provide entertainment services (banjo
playing). In 1998 they produced $15 million worth of hay, with $11 million consumed
domestically and the other $4 million sold to neighbouring countries. They provided $7 million
worth of banjo-playing services, $5 million in Heehaw and $2 million in neighbouring countries.
They purchased $6 million worth of soda pop from neighbouring countries. Calculate the
magnitudes of GNP, GDP, net factor payments from abroad, net exports, and the current account
balance.
Answer: GNP is output by citizens, which equals $15 million + $7 million = $22 million. GDP
is output produced in the country, which equals $15 million (hay) + $5 million (domestic banjo
playing) = $20 million. Net factor payments from abroad represent the difference between GNP
and GDP; this is the $2 million paid for banjo playing in other countries. Net exports are $4
million (hay sold abroad) minus $6 million (soda pop imports) = -$2 million. (Note that banjo
playing abroad is not part of GDP, so it is not part of net exports either.) The current account
balance is net exports + net factor payments = -$2 million + $2 million = 0.
Diff: 3
Type: ES
Page Ref: Sec. 2.2
4) Explain why in agricultural countries the official GDP are often underestimated.
Answer: Since in agricultural countries many people grow their own food, make their own
clothes, and provide services for each other within a family or village group, these non-market
activities are not counted in the official GDP.
Diff: 3
Type: ES
Page Ref: Sec. 2.2
5) In the country of Kwaki, people produce canoes, fish for salmon, and grow corn. In 2002 they
produced 5000 canoes using labour and natural materials only, but sold only 4000, as the
economy entered a recession. The cost of producing each canoe was $1000, but the ones that
sold were priced at $1250. They fished $30 million worth of salmon. They used $3 million of the
salmon as fertilizer for corn. They grew and ate $55 million of corn. What was Kwaki's GDP in
2002?
Answer: Inventories are valued at the cost of production, so the 1000 canoes in inventory were
valued at $1000 each, for a total of $1 million. Four thousand canoes at $1250 each totaled $5
million. Salmon as a final good were worth $27 million (the other $3 million were used up as an
intermediate good), and corn worth $55 million was grown. So total GDP (in millions) was $1 +
$5 + $27 + $55 = $88 million.
Diff: 2
Type: ES
Page Ref: Sec. 2.2
6) Pete the Pizza Man produced $87 thousand worth of pizzas in the past year. He paid $39
thousand to employees, paid $11 thousand for vegetables and other ingredients, and paid $5
thousand in taxes. He began the year with ingredient inventories valued at $1 thousand, and
ended the year with inventories valued at $2 thousand. What was Pete's (and his employees')
total contribution to GDP this year?
Answer: $87 thousand - $11 thousand paid for intermediate goods + $1 thousand change in
inventories = $77 thousand.
Diff: 2
Type: ES
Page Ref: Sec. 2.2
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7) What is the difference between nominal and real economic variables? Why do economists
tend to concentrate on changes in real magnitudes?
Answer: Nominal variables are in units of money, while real variables are in physical quantities
of output. We measure nominal variables using current market prices and real variables using
market prices in a given base year. Nominal variables may increase, but you don't know if the
increase is due to higher prices and the same quantity, or a higher quantity with unchanged
prices; real variables reflect just quantity changes. For the most part, real variables (consumption,
investment, the capital stock) affect each other in the economy, with lesser roles played by
nominal variables (money supply, price level).
Diff: 1
Type: ES
Page Ref: Sec. 2.4
8) The country of Myrule has produced the following quantity of gauges and potatoes, with the
price of each listed in dollar terms:
a. Using 2001 as the base year, what are the price indexes for 2001 and 2002?
b. What is the inflation rate using this index?
c. What is the percent change in real output using this index?
Answer:
a. 2001 price index = 1.00
2002 price index = base-year output at current prices/base-year output at base-year prices =
[(8000 × 3) + (6000 × 14)] / [(8000 × 4) + (6000 × 8)] = 108,000 / 80,000 = 1.35
b. Inflation rate = [(1.35/1) - 1] × 100% = 35%
c. Nominal GNP (2001) = (8000 × 4) + (6000 × 8) = 80,000
Nominal GNP (2002) = (10,000 × 3) + (5000 × 14) = 100,000
Real GNP (2001) = nominal GNP (2001) = 80,000
Real GNP (2002) = nominal GNP (2002)/price index = 100,000/1.35 = 74,074
Real output growth = [(74,074/80,000) - 1] × 100% = -7.4%
Diff: 3
Type: ES
Page Ref: Sec. 2.4
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9) For 2002, the Kwakian economy had the following nominal quantities (in billions of dollars)
and price indexes (1997 = 100) for each category of expenditure:
a. Calculate the real quantity for each category (to one decimal point).
b. Calculate nominal and real GDP.
c. Find the implicit price deflator (1997 = 100).
Answer:
a. Real C = 423.1/1.251 = 338.2; real fixed / = 100.9; real G = 134.5; real exports =
180.4/1.0009 = 179; real imports = 186.7/.972 = 192.1; real CPI = -3.28/1.11 = -2.95.
b. Add up the nominal quantities (but subtract imports) to get 691.32. Add up the real quantities
(but subtract imports) in part a to get 563.25.
c. The implicit deflator is nominal GDP/real GDP × 100 = 691.32/563.25 × 100 = 122.0.
Diff: 3
Type: ES
Page Ref: Sec. 2.4
10) Nominal GDP in Kwaki was $674.8 billion in 2001 and $688.4 billion in 2002. The GDP
deflator was 121.6 for 2001 and 123.3 for 2002.
a. What is the growth rate of nominal GDP between 2001 and 2002?
b. What is the inflation rate from 2001 to 2002?
c. What is the growth rate of real GDP from 2001 to 2002?
Answer:
a. 2%
b. 1.4%
c. 0.6%
Diff: 2
Type: ES
Page Ref: Sec. 2.4
11) The nominal interest rate is 750, today's price level is 150, and you expect the price level to
be 156 one year from now. What is the expected inflation rate? What is the expected real interest
rate?
Answer: Expected inflation = 156/150 - 1 = .04 = 4%; expected real interest rate = 7% - 4% =
3%.
Diff: 1
Type: ES
Page Ref: Sec. 2.4
12) Explain why CPI inflation overstates increases in the cost of living.
Answer: One reason is the quality adjustment bias, which means that CPI does not fully account
for the changes in the quality of goods and services. Another reason is the substitution bias. That
is, CPI is based on a fixed basket of goods and services, but consumers may substitute goods and
services with lower prices with those of higher prices. Therefore, higher prices may not
necessary decrease the cost of living as CPI suggests.
Diff: 1
Type: ES
Page Ref: Sec. 2.4
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13) In 2012, consumers in Saskatchewan spent $40,851 million, total investment was $18,873
million, changes in inventory were $186 million, government purchase of goods and services
was $2,220 million, exports were $39,249 million, and imports were $41,799 million. All figures
are in 2007 dollars.
a. Calculate 2012 real GDP (in 2007 dollars).
b. Nominal GDP in 2012 was $77,929. What was the GDP deflator in 2012?
c. In 2011, real GDP was $58,184 million and the GDP deflator was 126.2. What were the
growth rate and inflation rate in 2012?
d. Given a total population of 1.11 million, what was per capita GDP in Saskatchewan in 2012?
Answer:
a. Real GDP = $59,580
b. GDP deflator = 130.8
c. Growth rate = 2.4%; inflation rate = 3.64%
d. Per capita GDP = $53.68
Diff: 2
Type: ES
Page Ref: Sec. 2.2
14) Explain how changes in the inflation expectations affect the decisions on borrowing money.
Answer: Changes in inflation expectations affect the calculation of the real interest rate and,
therefore, the real cost of borrowing money. If inflation is expected to be higher, the real interest
rate and the cost of borrowing money is less.
Diff: 2
Type: ES
Page Ref: 40
15) Explain three consequences of the CPI biases.
Answer:
1. CPI is overestimated because it does not consider the quality changes in the goods and
services.
2. CPI is overestimated because it ignores the fact consumers can substitute cheaper goods or
services for more expensive ones.
3. CPI does not consider the substitution of cheaper outlets for more expensive outlets when
prices are higher.
Diff: 1
Type: ES
Page Ref: 38
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 3 Productivity, Output, and Employment
3.1 Multiple-Choice Questions
1) In the production function Y = AF(K,N), A is ________, K is ________, and N is ________.
A) total factor productivity; the capital stock; the number of workers employed
B) total factor productivity; investment; the number of workers employed
C) the productivity of labour; the capital stock; the size of the labour force
D) the productivity of labour; investment; the size of the labour force
Answer: A
Diff: 1
Type: MC
Page Ref: 48
2) In the production function Y = AF(K,N), A is
A) labour productivity.
B) total factor productivity.
C) capital productivity.
D) the marginal productivity of capital.
Answer: B
Diff: 1
Type: MC
Page Ref: 48
3) Suppose the economy's production function is Y = AK0.3N0.7. If K = 1000 and N = 50, then
Y = 2000. What is Y if K = 2000 and N = 100?
A) 4000
B) 3500
C) 3400
D) 3000
Answer: A
Diff: 3
Type: MC
Page Ref: 48
4) Under certain circumstances, the production function Y = AF(K,N) can be rewritten as Y =
ANF(K,N). In this case, suppose that both K and N double. What happens to output?
A) It remains unchanged.
B) It is reduced by one half.
C) It is increased by a factor of 4.
D) It doubles.
Answer: D
Diff: 2
Type: MC
Page Ref: 49
5) Suppose the economy's production function is Y = AK0.3N0.7. When K = 1000, N = 50, and A
= 15, what is Y?
A) 1842
B) 6106
C) 750,000
D) 123
Answer: A
Diff: 1
Type: MC
Page Ref: 49
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6) Suppose that in 2002 Freedonia had GDP equal to 2000 million, the capital stock was equal to
1700 million, the number of employees equaled 70 million. The production function is Y =
AK0.25N0.75. Total factor productivity of the economy in that year was approximately equal to
A) 0.09.
B) 2.61.
C) 4.19.
D) 12.87.
Answer: D
Diff: 3
Type: MC
Page Ref: 49
7) The total factor productivity is
A) a measure of the overall effectiveness with which capital and labour are used.
B) shown by A in the production function Y = AF(K.N).
C) used as a measure of technological improvement.
D) all of the above.
Answer: D
Diff: 1
Type: MC
Page Ref: 49
8) Technological progress is measured by
A) average labour productivity.
B) marginal product of labour.
C) total factor productivity.
D) marginal product of capital.
Answer: C
Diff: 1
Type: MC
Page Ref: 49
9) The table below represents Freedonia's macroeconomic data for 2002 and 2003.
Suppose that the production function is given by Y = AK0.25 N0.75. Between 2002 and 2003,
total factor productivity of Freedonia's economy increased by
A) -1.5%.
B) 5.0%.
C) 5.5%.
D) 12.7%.
Answer: A
Diff: 3
Type: MC
Page Ref: 51
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10) The two main characteristics of the production function are
A) it slopes downward from left to right, and the slope becomes flatter as the input increases.
B) it slopes upward from left to right, and the slope becomes steeper as the input increases.
C) it slopes upward from left to right, and the slope becomes flatter as the input increases.
D) it slopes downward from left to right, and the slope becomes steeper as the input increases.
Answer: C
Diff: 1
Type: MC
Page Ref: 51
11) In a graph of the production function relating output to capital, it is NOT true that
A) labour supply increases as capital increases.
B) the marginal product of capital can be measured as the slope of the production function.
C) the marginal product of capital falls as the capital stock increases.
D) the shape of the production function reflects diminishing marginal productivity.
Answer: A
Diff: 1
Type: MC
Page Ref: 52
12) The marginal product of capital
A) is measured by the slope of the line tangent to the production function relating output and
capital.
B) is larger when the capital stock is relatively larger.
C) is smaller when the capital stock is relatively smaller.
D) displays diminishing marginal productivity only when the capital stock is small.
Answer: A
Diff: 2
Type: MC
Page Ref: 53
13) The principle of diminishing marginal productivity implies that
A) if we increase labour and capital, the output will eventually decrease.
B) if we decrease labour and capital, the output will decrease.
C) if we increase one input while keeping other inputs constant, the productivity of variable input
will decrease.
D) if we increase one input while keeping other inputs constant, the output will decrease.
Answer: C
Diff: 2
Type: MC
Page Ref: 53
14) Which of the following statements is true?
A) The marginal product of capital is positive as long as the production function's slope is
positive.
B) The marginal product of capital is positive as long as the production function's slope is zero.
C) The marginal product of capital is negative as long as the production function's slope is
positive.
D) The marginal product of capital is negative as long as the production function's slope is zero.
Answer: A
Diff: 1
Type: MC
Page Ref: 53
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15) The principle of diminishing marginal productivity of capital implies that
A) output will diminish as capital increases.
B) output will increase first, but it will decrease as capital increases.
C) output will increase at diminishing rate as capital increases.
D) output will decrease first, but it will increase as capital increases.
Answer: C
Diff: 2
Type: MC
Page Ref: 53
16) The principle of diminishing marginal productivity of labour implies that
A) output diminishes as labour increases.
B) output will decrease first, but it will increase as labour increases.
C) output increases at diminishing rate as labour increases.
D) output will increase first, but it will decrease as labour increases.
Answer: C
Diff: 2
Type: MC
Page Ref: 54
17) The fact that the production function relating output to capital becomes flatter as we move
from left to right means that
A) the marginal product of labour is positive.
B) the marginal product of capital is positive.
C) there is diminishing marginal productivity of labour.
D) there is diminishing marginal productivity of capital.
Answer: D
Diff: 1
Type: MC
Page Ref: 53
18) The marginal product of labour
A) is measured by the slope of the production function relating capital to employment.
B) is larger when the labour supply is relatively larger.
C) is smaller when the labour supply is relatively smaller.
D) decreases as the number of workers already employed increases.
Answer: D
Diff: 1 Type: MC
Page Ref: 54
19) The fact that the production function relating output to labour becomes flatter as we move
from left to right means that
A) the marginal product of labour is positive.
B) the marginal product of capital is positive.
C) there is diminishing marginal productivity of labour.
D) there is diminishing marginal productivity of capital.
Answer: C
Diff: 1
Type: MC
Page Ref: 54
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20) In a production function where capital (K) is raised to the power 0.3 and labour (N) is raised
to the power 0.7
A) the production function relating output and labour is not as sharply bowed as the production
function relating output and capital.
B) the production function relating output and labour is as sharply bowed as the production
function relating output and capital.
C) the production function relating output and capital is not as sharply bowed as the production
function relating output and labour.
D) the production function relating output and capital is bowed, but the production function
relating output and labour is not bowed.
Answer: A
Diff: 3
Type: MC
Page Ref: 54
21) An adverse supply shock would
A) shift the production function up and decrease marginal products at every level of
employment.
B) shift the production function down and decrease marginal products at every level of
employment.
C) shift the production function down and increase marginal products at every level of
employment.
D) shift the production function up and increase marginal products at every level of employment.
Answer: B
Diff: 1
Type: MC
Page Ref: 55
22) A favourable supply shock would
A) shift the production function up and decrease marginal products at every level of
employment.
B) shift the production function down and decrease marginal products at every level of
employment.
C) shift the production function down and increase marginal products at every level of
employment.
D) shift the production function up and increase marginal products at every level of employment.
Answer: D
Diff: 1
Type: MC
Page Ref: 55
23) A supply shock that reduces total factor productivity directly affects which term in the
production function Y = AF(K,N)?
A) A
B) F
C) K
D) N
Answer: A
Diff: 1
Type: MC
Page Ref: 55
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24) Economists often treat the economy's capital stock as fixed because
A) labour is a more important factor of production than capital, so economists ignore capital.
B) it takes a long time for new investment and the scrapping of old capital to affect the overall
quantity of capital.
C) there is very little capital in the economy compared to the amount of labour.
D) unless the interest rate changes, the capital stock doesn't change.
Answer: B
Diff: 1
Type: MC
Page Ref: 56
25) Which of the following statements is true?
A) Changes in the total capital stock of the economy and in the amount of labour that firms
employ occur quickly.
B) Changes in the total capital stock of the economy and in the amount of labour that firms
employ occur slowly.
C) Changes in the total capital stock of the economy occur slowly, while changes in the amount
of labour that firms employ occur quickly.
D) Changes in the total capital stock of the economy occur quickly, while changes in the amount
of labour that firms employ occur slowly.
Answer: C
Diff: 1
Type: MC
Page Ref: 56
26) Which market determines the real wage and employment?
A) the goods market
B) the money market
C) the labour market
D) the capital market
Answer: C
Diff: 1
Type: MC
Page Ref: 58
27) An increase in the real wage rate will cause
A) the labour supply curve to shift to the right.
B) the labour demand curve to shift to the left.
C) both the labour supply curve and the labour demand curve to shift to the right.
D) a movement along the labour demand curve.
Answer: D
Diff: 1
Type: MC
Page Ref: 60
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28) A decrease in the real wage would result in a
A) movement along the labour demand curve, causing an increase in the number of workers
hired by the firm.
B) shift of the labour demand curve, causing an increase in the number of workers hired by the
firm.
C) movement along the labour demand curve, causing a decrease in the number of workers hired
by the firm.
D) shift of the labour demand curve, causing a decrease in the number of workers hired by the
firm.
Answer: A
Diff: 1
Type: MC
Page Ref: 60
29) An increase in the real wage would result in a
A) movement along the labour demand curve, causing an increase in the number of workers
hired by the firm.
B) shift of the labour demand curve, causing an increase in the number of workers hired by the
firm.
C) movement along the labour demand curve, causing a decrease in the number of workers hired
by the firm.
D) shift of the labour demand curve, causing a decrease in the number of workers hired by the
firm.
Answer: C
Diff: 1
Type: MC
Page Ref: 60
30) Expected future real wages would cause
A) the aggregate labour supply to shift left.
B) the aggregate labour demand to shift left.
C) the aggregate labour supply to shift right.
D) the aggregate labour demand to shift right.
Answer: C
Diff: 2
Type: MC
Page Ref: 66
31) A profit-maximizing firm would hire more employees if
A) marginal product of labour exceeds real wage.
B) marginal product of labour is less than real wage.
C) marginal revenue product of labour is less than real wage.
D) marginal revenue product of labour is less than nominal wage.
Answer: A
Diff: 1
Type: MC
Page Ref: 57
32) What two factors should you equate in deciding how many workers to employ?
A) the marginal product of labour and the marginal product of capital
B) the marginal product of labour and the real wage rate
C) the marginal product of labour and the real interest rate
D) the marginal product of capital and the real wage rate
Answer: B
Diff: 1
Type: MC
Page Ref: 58
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33) One reason that firms hire labour at the point where w = MPN is
A) if w < MPN, the cost (w) of hiring additional workers exceeds the benefits (MPN) of hiring
them, so they should hire fewer workers.
B) if w > MPN, the cost (w) of hiring additional workers is less than the benefits (MPN) of hiring
them, so they should hire more workers.
C) if w < MPN, the cost (w) of hiring additional workers equals the benefits (MPN) of hiring
them, so they have the right number of workers.
D) if w > MPN, the cost (w) of hiring additional workers exceeds the benefits (MPN) of hiring
them, so they should hire fewer workers.
Answer: D
Diff: 2
Type: MC
Page Ref: 58
34) Firms hire labour at the point where the
A) nominal wage rate equals the marginal product of labour.
B) real wage rate equals the marginal revenue product of labour.
C) nominal wage rate equals the marginal revenue product of labour.
D) real wage rate equals the marginal revenue product of capital.
Answer: C
Diff: 1
Type: MC
Page Ref: 58
35) Firms hire labour at the point where
A) the nominal wage is equal to the marginal revenue product of labour.
B) the real wage is equal to the marginal product of labour.
C) the cost and the benefit of hiring additional labour are the same.
D) all of the above.
Answer: D
Diff: 1
Type: MC
Page Ref: 58
36) The Grungo Company has the following production function:
If the real wage rate is 6, how many workers will the company hire?
A) 0
B) 1
C) 3
D) 5
Answer: C
Diff: 2
Type: MC
Page Ref: 58
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37) The Widget Company has the following production function:
If widgets sell for $6 each and the wage rate is $33, how many workers will the company hire?
A) 0
B) 1
C) 2
D) 4
Answer: D
Diff: 2
Type: MC
Page Ref: 58
38) Your boss wants to know if you should lay off any workers. You answer that you should lay
off workers if the
A) marginal revenue product of labour is greater than the nominal wage rate.
B) marginal product of labour is greater than or equal to the real wage rate.
C) marginal revenue product of labour is equal to the nominal wage rate.
D) marginal product of labour is less than the real wage rate.
Answer: D
Diff: 1
Type: MC
Page Ref: 59
39) Zowie! Surfboards has the following production function:
If surfboards sold for $30 and the nominal wage rate was $200, how many workers would the
firm employ?
A) 2
B) 3
C) 4
D) 5
Answer: C
Diff: 1
Type: MC
Page Ref: 59
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40) The marginal product of labour (measured in units of output) for New Age Nirvana is given
by MPN = A(200 - N) where A measures productivity and N is the number of labour hours used
in production. Assume that the price of output is $3 per unit and that A = 2.0. What will be the
demand for labour if the nominal wage is $30?
A) 170
B) 185
C) 190
D) 195
Answer: D
Diff: 2
Type: MC
Page Ref: 59
41) The marginal product of labour (measured in units of output) for New Age Nirvana is given
by MPN = A(200 - N) where A measures productivity and N is the number of labour hours used
in production. Assume that the price of output is $3 per unit and the demand for labour is 195.
What will be the level of productivity if the nominal wage is $30?
A) 5
B) 10
C) 2
D) 12
Answer: C
Diff: 2
Type: MC
Page Ref: 59
42) An adverse supply shock, such as a reduced supply of raw materials, would
A) increase the marginal product of labour.
B) decrease the marginal product of labour.
C) decrease the marginal product of capital, but have no effect on the marginal product of labour.
D) not affect the marginal product of labour.
Answer: B
Diff: 1
Type: MC
Page Ref: 55
43) A favourable supply shock, such as a fall in the price of oil, would
A) cause firms to demand less labour at any given real wage.
B) cause the labour demand curve to shift to the left.
C) increase the marginal product of labour.
D) decrease the real wage.
Answer: C
Diff: 2
Type: MC
Page Ref: 55
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44) Floods have just ravaged the countryside and cities! You would expect this supply shock to
shift the
A) marginal product of labour curve up and to the right, raising the quantity of labour demanded
at any given real wage.
B) marginal product of labour curve down and to the left, reducing the quantity of labour
demanded at any given real wage.
C) real wage curve up, reducing the quantity of labour demanded at any given real wage.
D) real wage curve down, raising the quantity of labour demanded at any given real wage.
Answer: B
Diff: 1
Type: MC
Page Ref: 55
45) A technological breakthrough in using photons for computers will increase the productivity
of those working with computers a hundredfold. You would expect this breakthrough to shift the
A) marginal product of labour curve up and to the right, raising the quantity of labour demanded
at any given real wage.
B) marginal product of labour curve down and to the left, reducing the quantity of labour
demanded at any given real wage.
C) labour supply curve up, reducing the quantity of labour demanded at any given real wage.
D) labour supply curve down, raising the quantity of labour demanded at any given real wage.
Answer: A
Diff: 1
Type: MC
Page Ref: 62
46) One's supply of labour depends primarily on
A) one's marginal productivity.
B) the quantity of capital one can work with.
C) the amount of human capital one can supply on the job.
D) the trade-off between labour income and leisure.
Answer: D
Diff: 1
Type: MC
Page Ref: 64
47) An individual's labour supply curve slopes upward because
A) an increase in the future real wage leads to an increase in the amount of labour supplied.
B) an increase in the current real wage leads to a decrease in the amount of labour supplied.
C) an increase in the future real wage leads to a decrease in the amount of labour supplied.
D) an increase in the current real wage leads to an increase in the amount of labour supplied.
Answer: D
Diff: 1
Type: MC
Page Ref: 64
48) An individual's labour supply curve might shift to the left because
A) an increase in the future real wage leads to an increase in the amount of labour supplied.
B) an increase in the current real wage leads to a decrease in the amount of labour supplied.
C) an increase in the future real wage leads to a decrease in the amount of labour supplied.
D) an increase in the current real wage leads to an increase in the amount of labour supplied.
Answer: C
Diff: 1
Type: MC
Page Ref: 65
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49) If there is an adverse supply shock,
A) the labour demand curve would shift leftward and, for any real wage, firms would demand
more labour.
B) the labour demand curve would shift leftward and, for any real wage, firms would demand
less labour.
C) the labour demand curve would shift rightward and, for any real wage, firms would demand
more labour.
D) the labour demand curve would shift rightward and, for any real wage, firms would demand
less labour.
Answer: B
Diff: 1
Type: MC
Page Ref: 61
50) An individual's labour supply curve might shift to the right because
A) an increase in the future real wage leads to a decrease in the amount of labour supplied.
B) a decrease in wealth leads to an increase in the amount of labour supplied.
C) a decrease in the future real wage leads to a decrease in the amount of labour supplied.
D) an increase in wealth leads to a decrease in the amount of labour supplied.
Answer: B
Diff: 1
Type: MC
Page Ref: 69
51) The female participation rate in Canada has been increasing since the 1960s. This implies
that, other things being equal,
A) the aggregate labour supply curve has shifted leftward.
B) the aggregate labour supply curve has shifted rightward.
C) the aggregate labour demand curve has shifted leftward.
D) the aggregate labour demand curve has shifted rightward.
Answer: B
Diff: 1
Type: MC
Page Ref: 69
52) Parliament has just passed a law allowing more immigration of young workers into Canada.
How would you expect this to affect the nation's labour supply curve?
A) The labour supply curve would shift to the right.
B) The labour supply curve would shift to the left.
C) The labour supply curve would be unaffected.
D) The labour demand curve would shift to the right.
Answer: A
Diff: 1
Type: MC
Page Ref: 69
53) Parliament has just passed a law eliminating all mandatory retirement in Canada. How would
you expect this to affect the nation's labour supply curve?
A) The labour supply curve would shift to the right.
B) The labour supply curve would shift to the left.
C) The labour supply curve would be unaffected.
D) The labour demand curve would shift to the right.
Answer: A
Diff: 1
Type: MC
Page Ref: 69
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54) For the economy of Lower Volta, the MPN is given by MPN = 400 - 0.2N where N is
aggregate employment. The aggregate quantity of labour supplied is 500 + 10(1 - t)w where t is
the income tax rate and w is the real wage. Assume that the income tax rate is 50%. What is the
before-tax real wage?
A) 150
B) 200
C) 250
D) 300
Answer: A
Diff: 3
Type: MC
Page Ref: 69
55) In WORKLAND, the marginal product of labour (MPN) is given by MPN = 100 - N, where
N is the amount of labour used, and the labour supply by NS = 10 + 5w + 2T, where w is the real
wage and T is a lump-sum tax. What is the equilibrium real wage in WORKLAND, if T = 21?
A) 6
B) 10
C) 8
D) 5
Answer: C
Diff: 3
Type: MC
Page Ref: 61
56) A new productivity breakthrough in computer technology is announced; as a result, the
marginal product of labour will double next year. What happens to current employment and the
real wage rate?
A) Both employment and the real wage rate would increase.
B) Both employment and the real wage rate would decrease.
C) Employment would increase and the real wage would decrease.
D) Employment would decrease and the real wage would increase.
Answer: D
Diff: 3
Type: MC
Page Ref: 71
57) A tremendous flood along the St. Lawrence Seaway destroys thousands of factories,
reducing the nation's capital stock by 5%. What happens to current employment and the real
wage rate?
A) Both employment and the real wage rate would increase.
B) Both employment and the real wage rate would decrease.
C) Employment would increase and the real wage would decrease.
D) Employment would decrease and the real wage would increase.
Answer: B
Diff: 2
Type: MC
Page Ref: 71
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58) Suppose the banking industry were to fail, leaving the federal government (through its
deposit guarantee programs) to pay for trillions of dollars in losses: they do so by imposing a tax
of 50% on all individuals' wealth. What happens to current employment and the real wage rate?
A) Both employment and the real wage rate would increase.
B) Both employment and the real wage rate would decrease.
C) Employment would increase and the real wage would decrease.
D) Employment would decrease and the real wage would increase.
Answer: C
Diff: 3
Type: MC
Page Ref: 71
59) A beneficial supply shock increases labour demand. What happens to current employment
and the real wage rate?
A) Both employment and the real wage rate would increase.
B) Both employment and the real wage rate would decrease.
C) Employment would increase and the real wage would decrease.
D) Employment would decrease and the real wage would increase.
Answer: A
Diff: 1
Type: MC
Page Ref: 71
60) A rise in wealth reduces labour supply. What happens to current employment and the real
wage rate?
A) Both employment and the real wage rate would increase.
B) Both employment and the real wage rate would decrease.
C) Employment would increase and the real wage would decrease.
D) Employment would decrease and the real wage would increase.
Answer: D
Diff: 1
Type: MC
Page Ref: 71
61) An increase in labour participation rate will lead to
A) a right shift in labour supply.
B) a left shift in labour supply.
C) a right shift in labour demand.
D) a left shift in labour demand.
Answer: A
Diff: 2
Type: MC
Page Ref: 69
62) The country of Timbuktoo is introducing a minimum wage for the first time in its history. It
is above the market-clearing wage rate for unskilled workers. The effect of the minimum wage
would be to
A) reduce the equilibrium real wage rate.
B) reduce the level of output.
C) shift the labour demand curve to the right.
D) shift the labour supply curve to the left.
Answer: B
Diff: 1
Type: MC
Page Ref: 75
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63) What is the unemployment rate if there are 170 million people employed, 25 million people
unemployed, and 35 million not in the labour force?
A) 14.7%
B) 13.7%
C) 12.8%
D) 10.9%
Answer: C
Diff: 2
Type: MC
Page Ref: 78
64) What is the unemployment rate if there are 125 million people in the labour force, 100
million people employed, and 25 million not in the labour force?
A) 25%
B) 20%
C) 17%
D) 15%
Answer: B
Diff: 2
Type: MC
Page Ref: 78
65) What is the participation rate if there are 125 million people in the labour force, 100 million
people employed, and 25 million not in the labour force?
A) 83%
B) 80%
C) 75%
D) 67%
Answer: A
Diff: 2
Type: MC
Page Ref: 79
66) What is the employment ratio (in percentage terms) if there are 17 million people employed,
2.5 million people unemployed, and 3.5 million not in the labour force?
A) 74%
B) 83%
C) 87%
D) 100%
Answer: A
Diff: 2
Type: MC
Page Ref: 79
67) The city of Hope has a labour force of 1000. Twenty people lose their jobs each month and
remain unemployed for exactly one month before finding jobs. On January 1, May 1, and
September 1 of each year, 50 people lose their jobs for a period of four months before finding
new jobs. What is the unemployment rate in any given month?
A) 2%
B) 3%
C) 5%
D) 7%
Answer: D
Diff: 1
Type: MC
Page Ref: 79
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68) The city of Hope has a labour force of 1000. Twenty people lose their jobs each month and
remain unemployed for exactly one month before finding jobs. On January 1, May 1, and
September 1 of each year, 50 people lose their jobs for a period of four months before finding
new jobs. What is the average duration of an unemployment spell?
A) 2.15 months
B) 2.85 months
C) 3.14 months
D) 3.43 months
Answer: A
Diff: 2
Type: MC
Page Ref: 79
69) Frictional unemployment arises when
A) unskilled or low-skilled workers find it difficult to obtain desirable, long-term jobs.
B) labour must be reallocated from industries that are shrinking to areas that are growing.
C) workers must search for suitable jobs and firms must search for suitable workers.
D) output and employment are below full-employment levels.
Answer: C
Diff: 1
Type: MC
Page Ref: 82
70) Cyclical unemployment arises when
A) unskilled or low-skilled workers find it difficult to obtain desirable, long-term jobs.
B) labour must be reallocated from industries that are shrinking to areas that are growing.
C) workers must search for suitable jobs and firms must search for suitable workers.
D) output and employment are below full-employment levels.
Answer: D
Diff: 1
Type: MC
Page Ref: 82
71) The supply of labour depends primarily on
A) the marginal productivity of workers in the economy.
B) the quantity of capital that workers can work with.
C) the amount of human capital that workers can supply on the job.
D) the trade-off between labour income and leisure.
Answer: D
Diff: 1
Type: MC
Page Ref: 64
72) Your professor has one hundred final exams to grade, so he hires you to help him grade
them, paying you twice the amount you would normally receive because few students are willing
to work during final exams week. You take the job. This would be an example of
A) the substitution effect being stronger than the income effect.
B) the income effect being stronger than the substitution effect.
C) a pure income effect.
D) the substitution effect being equal to the income effect.
Answer: A
Diff: 1
Type: MC
Page Ref: 67
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73) As a result of the superb economics essay that you wrote during this quarter, you win the
Adam Smith prize of $100. The receipt of these funds would be an example of
A) the substitution effect being stronger than the income effect.
B) the income effect being stronger than the substitution effect.
C) a pure income effect.
D) a pure substitution effect.
Answer: C
Diff: 1
Type: MC
Page Ref: 67
74) Your boss has told you that you will receive an increase in your salary next year. In response
to this news, you would reduce your labour supply because
A) the income effect would be equal to the substitution effect.
B) the substitution effect would be stronger than the income effect.
C) there would be an income effect but no substitution effect.
D) there would be a substitution effect, but no income effect.
Answer: C
Diff: 2
Type: MC
Page Ref: 67
75) Your boss has told you that because of a decrease in the demand for the designer baby food
your firm produces, he will have to cut everyone's salary next year to avoid layoffs. In response
to this news you would
A) increase your labour supply because the income effect would be equal to the substitution
effect.
B) decrease your labour supply because the substitution effect would be stronger than the income
effect.
C) increase your labour supply because there would be an income effect, but no substitution
effect.
D) decrease your labour supply because there would be a substitution effect, but no income
effect.
Answer: C
Diff: 2
Type: MC
Page Ref: 67
76) An increase in the real wage will cause an individual to increase his or her supply of labour if
A) the substitution effect is greater than the income effect.
B) the income effect is greater than the substitution effect.
C) the substitution effect is equal to the income effect.
D) the substitution effect is negative and the income effect is positive.
Answer: A
Diff: 2
Type: MC
Page Ref: 67
77) A decrease in the real wage will cause an individual to increase his or her supply of labour if
A) the substitution effect is greater than the income effect.
B) the income effect is greater than the substitution effect.
C) the substitution effect is positive and the income effect is negative.
D) the substitution effect is equal to the income effect.
Answer: B
Diff: 2
Type: MC
Page Ref: 67
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78) The more permanent an employee perceives an increase in her real wages to be
A) the larger the income effect is and the more likely it is that the quantity of labour supplied
will be increased.
B) the larger the income effect is and the more likely it is that the quantity of labour supplied will
be reduced.
C) the larger the substitution effect is and the more likely it is that the quantity of labour supplied
will be increased.
D) the larger the substitution effect is and the more likely it is that the quantity of labour supplied
will be reduced.
Answer: B
Diff: 2
Type: MC
Page Ref: 67
79) The less permanent an employee perceives an increase in her real wages to be
A) the smaller the income effect is and the more likely it is that the quantity of labour supplied
will be increased.
B) the smaller the income effect is and the more likely it is that the quantity of labour supplied
will be reduced.
C) the smaller the substitution effect is and the more likely it is that the quantity of labour
supplied will be increased.
D) the smaller the substitution effect is and the more likely it is that the quantity of labour
supplied will be reduced.
Answer: A
Diff: 2
Type: MC
Page Ref: 67
80) The skilled-bias technological change means that
A) the recent technological change has raised the productivity of highly trained or educated
workers more than that of the less skilled.
B) the recent technological change has raised the real wage of highly trained or educated workers
more than that of the less skilled.
C) the recent technological change has raised the real wage of women more than that of men.
D) all of the above.
Answer: A
Diff: 2
Type: MC
Page Ref: 75
81) Empirical evidence for Canada and other countries suggests that permanent increases in the
real wage cause workers to
A) work longer hours.
B) take less vacation time.
C) supply more labour.
D) supply less labour.
Answer: D
Diff: 1
Type: MC
Page Ref: 79
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82) The recent rise in oil price most likely will NOT cause recession in Canada, because
A) Canadian economy has shifted away from energy-intensive industries into knowledge-based
industries.
B) in response to the earlier oil price shocks, Canadian firms have become significantly more
energy efficient.
C) Canada, as a producer of oil, may benefit from the oil price shock.
D) all of the above.
Answer: D
Diff: 1
Type: MC
Page Ref: 72
83) Joe lost his job in a garment factory because of competition from overseas manufacturers.
Joe is an example of
A) structural unemployment.
B) frictional unemployment.
C) natural unemployment.
D) seasonal unemployment.
Answer: A
Diff: 1
Type: MC
Page Ref: 83
84) When an economy is in full-employment equilibrium,
A) the natural rate of unemployment is zero.
B) there is no frictional unemployment.
C) cyclical unemployment is zero.
D) the unemployment rate is zero.
Answer: C
Diff: 1
Type: MC
Page Ref: 83
85) An increase in recent wage inequality can be explained by
A) outsourcing the manufacturing of goods.
B) a higher supply of skilled workers.
C) wage discrimination.
D) skill-biased technological changes.
Answer: D
Diff: 1
Type: MC
Page Ref: 77
86) A skill-biased technological change
A) increases the MPN of unskilled workers, but reduces the MPN of skilled workers.
B) changes the MPN of unskilled and skilled workers proportionately.
C) increases the MPN of skilled workers, but reduces the MPN of unskilled workers.
D) is a main cause of unemployment.
Answer: C
Diff: 1
Type: MC
Page Ref: 77
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87) Dutch disease may be evident in Canada because
A) Canada is a resource-based economy and does not have a strong manufacturing industry.
B) inflation increases when oil prices rise.
C) the Canadian dollar appreciates with higher oil prices.
D) Canada is a major oil-exporting country.
Answer: C
Diff: 1
Type: MC
Page Ref: 74
88) The mathematical expression relating the amount of output produced to quantities of capital
and labour utilized is called
A) Factors of production
B) Production function
C) Total factor productivity
D) Productivity
Answer: B
Diff: 1
Type: MC
Page Ref: 48
89) The overall effectiveness with which capital and labour are used is called
A) Factors of production
B) Production function
C) Total factor productivity
D) Productivity
Answer: C
Diff: 1
Type: MC
Page Ref: 49
90) Which one of the following is true?
A) The marginal product of capital is positive but declining as the capital stock increases.
B) The marginal product of capital is positive and increasing as the capital stock increases.
C) The marginal product of capital is negative and declining as the capital stock increases.
D) The marginal product of capital is negative but rising as the capital stock increases.
Answer: A
Diff: 2
Type: MC
Page Ref: 53
91) The principle of the diminishing marginal productivity of capital means that
A) the total factor productivity increases with capital.
B) the total factor productivity declines with capital.
C) the marginal product of capital tends to decline as the amount of capital in use increases.
D) the marginal product of capital tends to decline as the amount of capital in use decreases.
Answer: A
Diff: 1
Type: MC
Page Ref: 53
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92) Which of the following represents a supply shock?
A) Hurricane Irma in Texas
B) Government subsidies on renewable energy investments
C) An innovation that allows a safe transportation of oil overseas
D) All the above
Answer: D
Diff: 2
Type: MC
Page Ref: 55
93) The marginal revenue product of labour (MRPN) is
A) less than the wage rate.
B) greater than the wage rate.
C) the amount of benefit of employing an additional worker in terms of the total value of output
produced.
D) the amount of benefit of employing an additional worker in terms of the extra output
produced.
Answer: D
Diff: 1
Type: MC
Page Ref: 57
94) The real wage is measured by
A) the difference between the nominal wage rate and the inflation rate.
B) the difference between the nominal wage rate the interest rate.
C) the ratio of nominal wage and price level.
D) the wage rate divided by the inflation rate.
Answer: C
Diff: 1
Type: MC
Page Ref: 59
95) Which one of the following events does NOT cause a shift in the aggregate labour demand
curve?
A) A rise of labour productivity
B) An increase in capital stock
C) An increase in the number of robots taking away workers' jobs
D) An increase in oil prices
Answer: D
Diff: 2
Type: MC
Page Ref: 64
96) The empirical evidence that the aggregate amount of labour supplied rises in response to a
temporary increase in the real wage confirms
A) the substitution effect of higher real wage.
B) the income effect of higher real wage.
C) both substitution and income effects of real wage.
D) that income effect dominates substitution effect.
Answer: A
Diff: 2
Type: MC
Page Ref: 67
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97) The empirical evidence that the aggregate amount of labour supplied declines in response to
a permanent increase in the real wage confirms
A) the substitution effect of higher real wage.
B) the income effect of higher real wage.
C) both substitution and income effects of real wage.
D) that substitution effect dominates income effect.
Answer: B
Diff: 2
Type: MC
Page Ref: 67
3.2 Essay Questions
1) Suppose the country of Prescott has the production function Y = AK0.25N0.75. The following
table shows Prescott's macroeconomic data for 2002 and 2003:
a. By how much did productivity grow between 2002 and 2003?
b. If productivity remains constant from 2003 to 2004 and the labour force increases from 75 to
80, how large will the capital stock need to be to produce output of 2200 in 2004?
Answer:
a. Calculate A in each year as A = Y / Kg.0.25 N0.75. So A is 2000 / 17000.25 700.75 = 12.8704
in 2002 and 2100 / 17850.25 750.75 = 12.6769 in 2003.
The growth rate of productivity is [(12.6769/12.8704) - 1] × 100% = -1.5%.
b. In 2004, A = 12.6769, N = 80, so K0.25 = Y / AN0.75 = 2200 / 12.6769 × 800.75 = 6.4877.
Then K = (K0.25)4 = 1771.61. So we need a reduction of the capital stock.
Diff: 3
Type: ES
Page Ref: Sec. 3.1
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2) Take an economy where in 2001 real GDP is 4861.4, the capital stock is 13,806.2 and
employment is 118.4 (in millions of workers). In 2002 the numbers were: real GDP 4986.3,
capital stock 14,040.8, employment 119.2. Suppose the production function in both years is Y =
AK0.25N0.75.
a. Calculate total factor productivity for 2001 and 2002.
b. How much did total factor productivity grow from 2001 to 2002?
c. Calculate the percent increase in real output between 2001 and 2002.
d. Suppose tax incentives had raised the capital stock in 2002, making it 10% higher, at
15,444.9. If employment didn't change, what would have been the percent increase in real output
between 2001 and 2002?
e. Instead of the increase in the capital stock in part d, suppose employment was 10% higher in
2002, making it 131.1. With the capital stock fixed at 14,040.8, what would have been the
increase in real output between 2001 and 2002?
Answer:
a. 2001: 12.49
2002: 12.70
b. +1.7%
c. +2.6%
d. Y = 5107.5, A 5.1% increase
e. Y = 5356.2, A 10.2% increase
Diff: 3
Type: ES
Page Ref: Sec. 3.1
3) What is the effect of immigration to Canada on GDP? Demonstrate the effects using the
production function.
Answer: Immigration to Canada increases the labour supply and, therefore, leads to higher GDP.
It may also increase productivity as most immigrants are highly educated and skilled workers.
The former effect can be shown by moving along the production function, and the latter by
shifting the production function upward.
Diff: 3
Type: ES
Page Ref: Sec. 3.1
4) Suppose a firm's hourly marginal product of labour is given by MPN = A(200 - N).
a. If A = .2 and the real wage is $10 per hour, how much labour will the firm want to hire?
b. Suppose the real wage rate rises to $20 per hour. How much labour will the firm want to
hire?
c. With the real wage rate at $10 per hour, how much labour will the firm want to hire if A rises
to .5?
Answer:
a. The firm will hire labour such that w = MPN, or 10 = .2(200 - N), so N = 150.
b. Now 20 = .2(200 - N), so N = 100. The firm's labour demand falls when the wage rate rises.
c. Now 10 = .5(200 - N), so N = 180. The increase in productivity increases labour demand.
Diff: 2
Type: ES
Page Ref: Sec. 3.3
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5) How would each of the following events affect Cheryl Shirker's supply of labour?
a. Cheryl's firm announces a reorganization plan in which she will get a big promotion and raise
in six months.
b. Cheryl's speculative investment in plutonium futures pays off big, netting her a profit of $300
thousand.
c. Cheryl's father, who had planned to leave her a large bequest, must spend all his wealth on
medical bills after a prolonged illness.
Answer:
a. The higher future real wage reduces current labour supply.
b. Higher wealth reduces labour supply.
c. Lower wealth increases labour supply.
Diff: 2
Type: ES
Page Ref: Sec. 3.3
6) Compare and contrast the likely income and substitution effects on labour supply of a
temporary real wage increase compared to a permanent rise in the real wage.
Answer: The temporary real wage increase has little impact on permanent income, so has almost
entirely a substitution effect increasing labour supply. For a permanent increase in the real wage,
there is both a substitution effect increasing labour supply since the reward to working is higher,
and an income effect decreasing labour supply since permanent income is higher.
Diff: 1
Type: ES
Page Ref: Sec. 3.3
7) How would each of the following events affect the level of employment and the real wage
rate?
a. A tremendous boom occurs in the stock market, increasing people's wealth by $100 billion
overnight.
b. A major government loan-guarantee program goes bust, losing $500 billion. To pay off the
loss, the government announced that tax rates will rise 30% in the future.
c. A nuclear mishap contaminates all auto plants in the Windsor area, destroying their capital.
d. Medical science cures the common cold, causing fewer work days lost to illness, thus greatly
increasing labour productivity.
Answer:
a. Increased wealth reduces labour supply; the shift of the labour supply curve to the left brings
a new equilibrium with lower employment and a higher real wage.
b. The loss of wealth increases labour supply, leading to higher employment and a lower real
wage.
c. The loss of capital lowers the marginal product of labour, reducing labour demand; the shift
of the labour demand curve to the left lowers the real wage and employment.
d. Increased productivity increases the demand for labour; in equilibrium the real wage and
employment increase.
Diff: 2
Type: ES
Page Ref: Sec. 3.4
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8) Compare the effects of the two 1973 and 2007 oil price shocks on the Canadian labour market,
output and price level. Why the effects of these two seemingly similar shocks are different?
Answer: The first oil price shock in 1973 caused the labour demand to shift leftward leading to
lower wages and higher unemployment. This adverse supply shock also shifted the aggregate
supply curve leftward leading to higher prices and lower output, that is, stagflation. The recent
oil shock in 2007, however, will likely have less adverse effect on the Canadian economy than
the first oil shock. There are three reasons for why the effects of these two oil price shocks on the
Canadian economy are different. First, the Canadian firms are now more energy efficient than
the past. Second, the structure of the economy has changed from producing the energy-intensive
products to the knowledge-based products, which rely less on energy. Finally, Canada has now
joined the oil producers club, partially benefiting from the oil price shocks.
Diff: 2
Type: ES
Page Ref: Sec. 3.4
9) Suppose oil prices fall temporarily as oil becomes more plentiful. What impact is this likely to
have on the production function, the marginal products of labour and capital, labour demand,
employment, and the real wage?
Answer: More output can now be produced by the same amounts of capital and labour, since oil
is more abundant and cheaper. The production function shifts upward, with the marginal
products of labour and capital rising. Since the marginal product of labour is higher, so is labour
demand. As a result of the shift to the right in the labour demand curve, employment rises, as
does the real wage.
Diff: 2
Type: ES
Page Ref: Sec. 3.4
10) In December 2002, Kwaki had a labour force of 14,757,000, employment of 13,097,000, and
there were 7,994,000 people not in the labour force (all numbers rounded to the nearest 1000).
a. Calculate the unemployment rate.
b. Calculate the participation rate.
c. Calculate the employment ratio.
Answer:
a. Unemployment = labour force - employment = 14,757,000 - 13,097,000 = 1,660,000 so the
unemployment rate is 1,660,000/14,757,000 = 11.2%.
b. The participation rate is the fraction of the working-age population in the labour force. The
working-age population is the labour force + the number not in the labour force = 14,757,000 +
7,994,000 = 22,751,000. The participation rate is then 14,757,000/22,751,000 = 64.9%.
c. The employment ratio is the employed fraction of the working-age population, which is
13,097,000/22,751,000 = 57.6%.
Diff: 2
Type: ES
Page Ref: Sec. 3.5
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11) The city of Hope has a labour force of 1000. Twenty people lose their jobs each month and
remain unemployed for exactly one month before finding jobs. On January 1, May 1, and
September 1 of each year 50 people lose their jobs for a period of four months before finding
new jobs.
a. What is the unemployment rate in any given month?
b. How many unemployment spells are there in a year?
c. What is the average duration of an unemployment spell?
d. On any given date, how many people are undergoing short spells, and how many are
undergoing long spells?
Answer:
a. 70/1000 = 7%.
b. Short spells: 20 each month × 12 months = 240. Long spells: 50 each × 3 times a year = 150.
Total spells = 240 - 150 = 390. Note that most are short spells.
c. The total duration of all spells is (240 spells × 1 month) 240 months + (150 spells × 4
months) 600 months = 840 months. Average duration = total duration/total spells = 840/390 =
2.15 months.
d. Short: 20; long: 50. Note that most of the unemployed at a given time are undergoing long
spells.
Diff: 2
Type: ES
Page Ref: Sec. 3.5
12) Using the labour market model and the labour demand and supply curves, show how the real
wage and the equilibrium level of employment are determined. What would happen to the real
wage and the unemployment level in an oil-importing country when oil prices fall? Explain.
Answer: Demand for labour is inversely related to the real wage and the supply of labour is
positively related to the real wage. The equilibrium real wage and employment level are
determined at the point where quantity demanded for labour is equal to the quantity of labour
supplied. If oil price falls, producers will expand their production, which increases demand for
labour and, therefore, real wages.
Diff: 3
Type: ES
Page Ref: 70
13) Explain frictional, structural, natural, and cyclical unemployment. What is the difference
between the natural and the cyclical unemployment?
Answer: The unemployment that arises as workers search for suitable jobs and firms search for
suitable workers is called frictional unemployment. The long-term and chronic unemployment
that exists even when the economy is not in a recession is called structural unemployment. The
rate of unemployment that prevails when output and employment are at the full-employment
level is called the natural rate of unemployment. The difference between the actual
unemployment rate and the natural rate of unemployment is called cyclical unemployment.
Diff: 2
Type: ES
Page Ref: 78
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14) How would each of the following affect the current level of full-employment output?
Explain.
a. The new government changes immigration policy to restrict the number of immigrants
entering the country each year.
b. New technology allows massive production of oil and gas through fracking.
c. A hurricane of unprecedented strength hits the country leaving huge damages to residential
and business properties and infrastructure.
d. Robots equipped with artificial intelligence are widely used in production.
Answer: a. Decreases. b. Increases. c. Decreases. d. Increases.
Diff: 3
Type: ES
Page Ref: 70
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 4 Consumption, Saving, and Investment
4.1 Multiple-Choice Questions
1) When a person gets an increase in current income, what is likely to happen to consumption
and saving?
A) Consumption increases and saving increases.
B) Consumption increases and saving decreases.
C) Consumption decreases and saving increases.
D) Consumption decreases and saving decreases.
Answer: A
Diff: 1 Type: MC Page Ref: 96
2) Franco the economist uses data for Canada to estimate a Keynesian consumption function:
Cd = 0.46 + 0.92Y
In this equation, what is the marginal propensity to consume?
A) 0.46
B) 0.50
C) 0.92
D) 1.38
Answer: C
Diff: 2 Type: MC Page Ref: 96
3) The Canadian consumption function is given by C = 50 + 0.75 Y. This implies that
A) Canadians spend 75 percent of their income on average.
B) Each Canadian spends 75 percent of her/his income.
C) Canadians on average spend 75 cents out of each additional dollar earned.
D) Canadians spend 50 dollars of their income on average.
Answer: C
Diff: 2 Type: MC Page Ref: 96
4) If the aggregate consumption function is C = 20 + 0.75 Y, the aggregate saving function will
be
A) S = 20 - 0.75 Y.
B) S = 20 + 0.75 Y.
C) S = -20 + 0.75 Y.
D) S = -20 + 0.25 Y.
Answer: D
Diff: 2 Type: MC Page Ref: 96
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5) An increase in expected future output while holding today's output constant would
A) increase today's desired consumption and increase desired national saving.
B) increase today's desired consumption and decrease desired national saving.
C) decrease today's desired consumption and increase desired national saving.
D) decrease today's desired consumption and decrease desired national saving.
Answer: B
Diff: 2 Type: MC Page Ref: 96
6) When a person receives an increase in wealth, what is likely to happen to consumption and
saving?
A) Consumption increases and saving increases.
B) Consumption increases and saving decreases.
C) Consumption decreases and saving increases.
D) Consumption decreases and saving decreases.
Answer: B
Diff: 1 Type: MC Page Ref: 99
7) Aunt Agatha has just left her nephew $5000. The most likely response is for her nephew to
A) increase current consumption, but not future consumption.
B) decrease current consumption, but increase future consumption.
C) increase future consumption, but not current consumption.
D) increase both current consumption and future consumption.
Answer: D
Diff: 1 Type: MC Page Ref: 99
8) The stock market just crashed; the Dow Jones Industrial Average fell by 750 points. You
would expect the effect on aggregate consumption to be the largest if which of the following
facts were true?
A) The crash had been preceded by a large run-up in the price of stocks.
B) Most stocks were owned by insurance companies.
C) Most stocks were owned by pension funds that invested in the market.
D) Many individuals had invested in the stock market immediately prior to the crash.
Answer: D
Diff: 2 Type: MC Page Ref: 99
9) The housing price in Canada nearly doubled in the period 1995-2006. This implies that
A) Canadian homeowners' income has increased, leading to more consumption.
B) Canadian homeowners' wealth has increased, leading to more consumption.
C) Canadian homeowners' wealth has decreased, leading to lower consumption.
D) Canadian homeowners' income has decreased, leading to less consumption.
Answer: B
Diff: 1 Type: MC Page Ref: 99
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10) An increase in expected real interest rates would probably cause desired national saving to
rise because
A) less must be saved to reach a given saving target.
B) the increased return makes saving more attractive.
C) the government would respond by increasing expenditures.
D) current interest rates would fall in response to higher expected real interest rates in the future.
Answer: B
Diff: 1 Type: MC Page Ref: 101
11) An increase in housing prices in Canada will likely have stronger effect on the aggregate
consumption than a similar increase in the stock prices, because
A) there are more Canadian stockholders than Canadian homeowners.
B) stock prices are far more volatile than the housing prices.
C) changes in stock prices are seen as permanent changes in wealth.
D) housing prices are more volatile than the stock prices.
Answer: B
Diff: 1 Type: MC Page Ref: 100
12) The effect of changes in wealth on consumers' spending is
A) significantly higher if the change in wealth arises from the housing market rather than the
stock market.
B) significantly lower if the change in wealth arises from the housing market rather than the
stock market.
C) significantly higher if the change in wealth arises from saving rather than from the housing
market.
D) not dependent on the type of wealth.
Answer: A
Diff: 2 Type: MC Page Ref: 100
13) With a nominal interest rate of 8%, an expected inflation rate of 3%, and interest income
taxed at a 25% rate, what is the expected after-tax real interest rate?
A) 5%
B) 3.75%
C) 3%
D) 1%
Answer: C
Diff: 1 Type: MC Page Ref: 102
14) The tendency to reduce current consumption and increase future consumption as the real
interest rate increases is called
A) the substitution effect of the real interest rate on saving.
B) the income effect of the real interest rate on saving.
C) the net effect of the real interest rate on saving.
D) the substitution effect of the real interest rate on investment.
Answer: A
Diff: 1 Type: MC Page Ref: 101
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15) A temporary increase in government purchases, given the level of output, will lead to
A) a higher desired consumption and a higher desired national saving.
B) a lower desired consumption and a lower desired national saving.
C) a higher desired consumption and a lower desired national saving.
D) a lower desired consumption and a higher desired national saving.
Answer: B
Diff: 1 Type: MC Page Ref: 105
16) The effect of an increase in current consumption that results when a higher real interest rate
makes a consumer richer is called
A) the substitution effect of the real interest rate on saving.
B) the income effect of the real interest rate on saving.
C) the net effect of the real interest rate on saving.
D) the substitution effect of the real interest rate on consumption.
Answer: B
Diff: 1 Type: MC Page Ref: 101
17) The nominal interest rate is 10%, the expected inflation rate is 5%, and the combined statefederal tax is 35%.The expected real after-tax rate of return is
A) 1.50%.
B) 3.25%.
C) 5.00%.
D) 6.50%.
Answer: A
Diff: 2 Type: MC Page Ref: 102
18) Three factors that cause interest rates among different financial instruments to vary are
A) default risk, expected inflation, and taxability.
B) default risk, current inflation, and taxability.
C) default risk, maturity, and taxability.
D) default risk, expected inflation, and maturity.
Answer: C
Diff: 1 Type: MC Page Ref: 103
19) If you lend money to the government by buying a one-year Treasury bill, your interest rate is
4%, but if you lend money to XYZ Corporation by buying a one-year XYZ bond, you can earn
7%. What is the main reason for this difference in interest rates?
A) higher tax rate on the XYZ bond
B) higher inflation on the XYZ bond
C) higher default risk on the XYZ bond
D) higher expected real after-tax rate of return on the XYZ bond
Answer: C
Diff: 1 Type: MC Page Ref: 103
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20) Desired national saving would unambiguously increase if there were
A) an increase in current output and expected future output.
B) an increase in expected future output and government purchases.
C) an increase in expected future output and the expected real interest rate.
D) a fall in both government purchases and expected future output.
Answer: D
Diff: 2 Type: MC Page Ref: 105
21) The Ricardian equivalence proposition says that
A) a budget deficit caused entirely by a current tax cut has no effect on the economy.
B) a budget deficit caused entirely by an increase in government purchases has no effect on the
economy.
C) any budget deficit generated by the government has no effect on the economy.
D) an increase in government spending accompanied by an equivalent increase in taxes has no
effect on the economy.
Answer: A
Diff: 2 Type: MC Page Ref: 107
22) The Ricardian equivalence proposition suggests that a government deficit caused by a tax cut
A) causes inflation.
B) causes a current account deficit.
C) raises interest rates.
D) doesn't affect consumption.
Answer: D
Diff: 2 Type: MC Page Ref: 107
23) If the government cuts taxes today, issuing debt today and repaying the debt plus interest
next year, a rational taxpayer will
A) spend the full amount of the tax cut today and reduce consumption next year.
B) increase consumption today, before taxes go up next year.
C) increase saving today, leaving consumption unchanged.
D) leave a smaller gross bequest to her or his heirs.
Answer: C
Diff: 2 Type: MC Page Ref: 107
24) A temporary increase in government purchases, when total output is held constant, would
A) reduce desired consumption but would increase desired national saving.
B) increase desired consumption but would reduce desired national saving.
C) increase both desired consumption and desired national saving.
D) reduce both desired consumption and desired national saving.
Answer: D
Diff: 2 Type: MC Page Ref: 108
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25) Which of the factors listed below might cause the Ricardian equivalence proposition to be
violated?
A) There may be international capital inflow and outflows.
B) Consumers may not understand that increased government borrowing today is likely to lead to
higher future taxes.
C) There may be constraints on the level of government spending.
D) There may be constraints on the level of government taxation.
Answer: B
Diff: 1 Type: MC Page Ref: 107
26) The lesson to be learned from the Ricardian equivalence proposition is that
A) only government budget deficits generated by tax changes affect the macroeconomy.
B) government budget deficits do not affect the macroeconomy.
C) it is impossible for the government to actually reduce taxes.
D) the basic measure of the cost of government is the real resources that the government uses.
Answer: D
Diff: 1 Type: MC Page Ref: 107
27) The user cost of capital is given by the following formula, where PK is the real price of
capital goods, d is the depreciation rate, and r is the expected real interest rate.
A) uc = (r + d)/PK
B) uc = PK/(r + d)
C) uc = dPK/r
D) uc = (r + d)PK
Answer: D
Diff: 1 Type: MC Page Ref: 110
28) Which of the following machines has the lowest user cost? Machine A costs $15,000 and
depreciates at a 25% rate, machine B costs $10,000 and depreciates at a 20% rate, machine C
costs $20,000 and depreciates at a 10% rate, and machine D costs $17,000 and depreciates at an
11% rate. The expected real interest rate is 5%.
A) machine A
B) machine B
C) machine C
D) machine D
Answer: B
Diff: 2 Type: MC Page Ref: 110
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29) Which of the following machines has the lowest user cost? Machine A costs $15,000 and
depreciates at a 25% rate, machine B costs $10,000 and depreciates at a 20% rate, machine C
costs $10,000 and depreciates at a 10% rate, and machine D costs $17,000 and depreciates at an
11% rate. The expected real interest rate is 0%.
A) machine A
B) machine B
C) machine C
D) machine D
Answer: D
Diff: 2 Type: MC Page Ref: 110
30) You have just purchased a new VCR to show videos to your customers. The VCR cost $500,
and you depreciate the machine at a rate of 25% each year. You can borrow money from the bank
at 10%, or receive 6% for depositing money at the bank. The expected inflation rate in the
coming year is 5%. You used the company's own funds to purchase the VCR. The firm's user cost
of capital for the first year is
A) $130.
B) $150.
C) $155.
D) $175.
Answer: A
Diff: 2 Type: MC Page Ref: 110
31) You have just purchased a new VCR to show videos to your customers. The VCR cost $500,
and you depreciate the machine at a rate of 25% each year. You can borrow money from the bank
at 10%, or receive 6% for depositing money at the bank. The expected inflation rate in the
coming year is 5%. You borrowed money from the bank to purchase the VCR. The firm's user
cost of capital for the first year is
A) $130.
B) $150.
C) $155.
D) $175.
Answer: B
Diff: 2 Type: MC Page Ref: 110
32) Calculate the user cost of capital of a machine that costs $5,000 and depreciates at a 25%
rate, when the interest rate is 5%.
A) $150
B) $500
C) $1500
D) $5000
Answer: C
Diff: 1 Type: MC Page Ref: 110
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33) When firms carry out new investment, the user cost of capital
A) increases as the amount of capital increases.
B) decreases as the amount of capital increases.
C) first decreases, then increases as the amount of capital increases.
D) remains constant as the amount of capital increases.
Answer: D
Diff: 1 Type: MC Page Ref: 109
34) You are trying to figure out how much capacity to add to your factory. You will increase
capacity as long as
A) the expected marginal product of capital is positive.
B) the expected marginal product of capital is greater than or equal to the marginal product of
capital.
C) the expected marginal product of capital is greater than or equal to the expected marginal
product of labour.
D) the expected marginal product of capital is greater than or equal to the user cost of capital.
Answer: D
Diff: 1 Type: MC Page Ref: 110
35) The "q theory of investment," or "Tobin's q," states that
A) a rise in the stock market would lead firms to increase their rate of capital investment.
B) a fall in the stock market would lead firms to increase their rate of capital investment.
C) a rise in the stock market would lead firms to decrease their rate of capital investment.
D) there is no relationship between the stock price changes and the capital investment.
Answer: A
Diff: 1 Type: MC Page Ref: 112
36) According to Tobin's q,
A) when the stock market is high, firms do not change their investment.
B) when the stock market is low, firms increase their investment.
C) when the stock market is high, firms increase their investment.
D) firms' decisions on investment do not depend on the stock market.
Answer: C
Diff: 3 Type: MC Page Ref: 112
37) A decrease in the real interest rate will
A) increase the desired capital stock.
B) decrease the desired capital stock.
C) have no effect on the desired capital stock.
D) have the same effect on the desired capital stock as an increase in corporate taxes.
Answer: A
Diff: 1 Type: MC Page Ref: 111
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38) A technological improvement will
A) increase the desired capital stock.
B) decrease the desired capital stock.
C) have no effect on the desired capital stock.
D) have the same effect on the desired capital stock as an increase in corporate taxes.
Answer: A
Diff: 1 Type: MC Page Ref: 112
39) Suppose your company is in equilibrium, with its capital stock at its desired level. A
permanent decline in the real interest rate now has what effect on your desired capital stock?
A) raises it, because the future marginal productivity of capital is higher
B) lowers it, because the future marginal productivity of capital is lower
C) raises it, because the user cost of capital is now lower
D) lowers it, because the user cost of capital is now higher
Answer: C
Diff: 2 Type: MC Page Ref: 111
40) Suppose your company is in equilibrium, with its capital stock at its desired level. A
permanent increase in the depreciation rate now has what effect on your desired capital stock?
A) raises it, because the future marginal productivity of capital is higher
B) lowers it, because the future marginal productivity of capital is lower
C) raises it, because the user cost of capital is now lower
D) lowers it, because the user cost of capital is now higher
Answer: D
Diff: 2 Type: MC Page Ref: 113
41) Suppose your company is in equilibrium, with its capital stock at its desired level. A
permanent increase in the tax rate on your firm's revenues now has what effect on your desired
capital stock?
A) raises it, because the future marginal productivity of capital is higher
B) lowers it, because the future marginal productivity of capital is lower
C) raises it, because the after-tax user cost of capital is now lower
D) lowers it, because the after-tax user cost of capital is now higher
Answer: D
Diff: 2 Type: MC Page Ref: 113
42) Calculate the after-tax user cost of capital of a machine that costs $5000 and depreciates at a
25% rate, when the interest rate is 5% and the tax rate on revenue is 25%.
A) $200
B) $275
C) $2000
D) $2750
Answer: C
Diff: 2 Type: MC Page Ref: 113
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43) What key change in 1975-87 led to a faster growth rate of equipment relative to structures?
A) a change in relative tax rates
B) a change in relative depreciation rates
C) a change in relative prices
D) a change in relative marginal productivity
Answer: A
Diff: 2 Type: MC Page Ref: 114
44) What is the difference between gross investment and net investment?
A) net investment = gross investment minus taxes
B) net investment = gross investment minus net factor payments
C) net investment = gross investment minus inventory accumulation
D) net investment = gross investment minus depreciation
Answer: D
Diff: 1 Type: MC Page Ref: 115
45) In 2001 your firm's capital stock equaled $10 million, and in 2002 it equaled $15 million.
The average depreciation rate on your capital stock is 20%. Gross investment in 2002 equaled
A) $3 million.
B) $4 million.
C) $5 million.
D) $7 million.
Answer: D
Diff: 1 Type: MC Page Ref: 116
46) In 2001 your firm's capital stock equaled $10 million, and in 2002 it equaled $15 million.
The average depreciation rate on your capital stock is 20%. Net investment in 2002 equaled
A) $3 million.
B) $4 million.
C) $5 million.
D) $7 million.
Answer: C
Diff: 1 Type: MC Page Ref: 116
47) Your firm has capital stock of $15 million and a depreciation rate of 10%. Gross investment
is $2.5 million. How much is net investment?
A) $13.5 million
B) $2.5 million
C) $1.5 million
D) $1.0 million
Answer: D
Diff: 2 Type: MC Page Ref: 116
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48) The effective tax rate is
A) a single measure of tax owed by a firm.
B) a single measure of the tax credit on investment.
C) a single measure of how much tax a firm pays.
D) a single measure of the tax burden on capital.
Answer: D
Diff: 2 Type: MC Page Ref: 114
49) You have just purchased a home that cost $250 thousand. The nominal mortgage interest rate
is 8% per annum, mortgage interest payments are tax deductible, and you are in a 30% tax
bracket. The expected inflation rate is 4%.Maintenance and other expenses are 8% of the initial
value of the house. What is the real user cost of your house?
A) $20 thousand
B) $24 thousand
C) $27 thousand
D) $30 thousand
Answer: B
Diff: 1 Type: MC Page Ref: 113
50) All else equal, a decrease in effective tax rate will lead to
A) a fall in the desired investment.
B) an increase in the interest rate.
C) an increase in the desired investment.
D) an increase in inventory.
Answer: C
Diff: 3 Type: MC Page Ref: 117
51) All else equal, a decrease in the expected future MPK will lead to
A) an increase in the desired investment.
B) no change in the desired investment.
C) a fall in the desired investment.
D) an increase in the desired level of capital.
Answer: C
Diff: 3 Type: MC Page Ref: 117
52) When desired national saving equals desired national investment, what market is in
equilibrium?
A) the goods market
B) the money market
C) the foreign exchange market
D) the stock market
Answer: A
Diff: 1 Type: MC Page Ref: 118
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53) An economy has full-employment output of 5000. Government purchases are 1000. Desired
consumption and desired investment are given by
Cd = 3000 - 2000r + .10Y
Id = 1000 - 4000r
where Y is output and r is the real interest rate. The real interest rate that clears the goods market
is equal to
A) 1.25%.
B) 2.50%.
C) 8.33%.
D) 25.00%.
Answer: C
Diff: 3 Type: MC Page Ref: 119
54) An economy has government purchases of 1000. Desired national saving and desired
investment are given by
Sd = 200 + 5000r + .10Y - .20G
Id = 1000 - 4000r
When the full-employment level of output equals 5000, then the real interest rate that clears the
goods market will be
A) 1.11%.
B) 5.56%.
C) 16.67%.
D) 21.11%.
Answer: B
Diff: 3 Type: MC Page Ref: 119
55) An economy has government purchases of 2000. Desired national saving and desired
investment are given by
Sd = 200 + 5000r + 0.10 Y - 20G
Id = 1000 - 4000r
When the full-employment level of output equals 5000, then the real interest rate that clears the
goods market will be
A) 7.78%.
B) 10.00%.
C) 14.44%.
D) 23.33%.
Answer: A
Diff: 3 Type: MC Page Ref: 119
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56) Any change in the economy that raises desired national saving for a given value of the real
interest rate will shift the desired national saving curve
A) to the right and increase the real interest rate.
B) to the right and decrease the real interest rate.
C) to the left and increase the real interest rate.
D) to the left and decrease the real interest rate.
Answer: B
Diff: 1 Type: MC Page Ref: 122
57) An increase in the expected real interest rate tends to
A) raise desired savings only.
B) raise desired investment only.
C) raise both desired savings and desired investment.
D) raise desired savings, but lower desired investment.
Answer: D
Diff: 1 Type: MC Page Ref: 122
58) A higher real interest rate will
A) increase the profitability of new investment.
B) decrease lending of funds from firms to other economic agents.
C) reduce the desired investment of all firms.
D) reduce the desired investment of only those firms that have to borrow.
Answer: C
Diff: 1 Type: MC Page Ref: 122
59) The saving-investment diagram shows that a higher real interest rate due to a leftward shift
of the saving curve
A) raises the profitability of investment for firms.
B) causes the amount of firms' investment to increase.
C) increases the total amount of saving because of the increase in the real interest rate.
D) causes the total amounts of saving and investment to fall.
Answer: D
Diff: 2 Type: MC Page Ref: 122
60) A temporary increase in government purchases would cause
A) a leftward shift in the saving curve and a leftward shift in the investment curve.
B) a leftward shift in the saving curve and a rightward shift in the investment curve.
C) a leftward shift in the saving curve, but no shift in the investment curve.
D) no shift in the saving curve, but a rightward shift in the investment curve.
Answer: C
Diff: 2 Type: MC Page Ref: 122
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61) A temporary decrease in government purchases would cause
A) an increase in the real interest rate and a decrease in desired investment.
B) a decrease in the real interest rate and an increase in desired investment.
C) a decrease in the real interest rate and an uncertain effect on desired investment.
D) an uncertain effect on the real interest rate and an increase in the level of desired investment.
Answer: B
Diff: 2 Type: MC Page Ref: 122
62) If consumers foresee future taxes completely, a reduction in taxes this year that is
accompanied by an offsetting increase in future taxes would cause
A) a rightward shift in the saving curve and a rightward shift in the investment curve.
B) a shift in neither the saving nor the investment curve.
C) a leftward shift in the saving curve, but no shift in the investment curve.
D) no shift in the saving curve, but a rightward shift in the investment curve.
Answer: B
Diff: 2 Type: MC Page Ref: 123
63) If consumers foresee future taxes completely, a reduction in taxes this year that is
accompanied by an offsetting increase in future taxes would cause
A) an increase in the real interest rate and a decrease in desired investment.
B) a decrease in the real interest rate and an increase in desired investment.
C) a decrease in the real interest rate and an uncertain effect on desired investment.
D) a change in neither the real interest rate nor desired investment.
Answer: D
Diff: 2 Type: MC Page Ref: 107
64) A lump-sum increase in current taxes would cause interest rates to
A) fall if Ricardian equivalence held.
B) fall if Ricardian equivalence did not hold.
C) fall regardless of whether Ricardian equivalence held.
D) rise.
Answer: B
Diff: 2 Type: MC Page Ref: 107
65) An invention that raises the future marginal product of capital would cause an increase in
desired investment, which would cause the investment curve to shift to the ________ and would
cause the real interest rate to ________.
A) right; increase
B) right; decrease
C) left; increase
D) left; decrease
Answer: A
Diff: 1 Type: MC Page Ref: 123
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66) A temporary supply shock, such as a drought, would
A) increase the marginal product of capital and increase desired investment.
B) decrease the marginal product of capital and decrease desired investment.
C) have little or no effect on desired investment.
D) decrease both the marginal product of capital and the marginal product of labour in the longterm future.
Answer: C
Diff: 2 Type: MC Page Ref: 123
67) A higher interest rate will lead consumers to
A) increase current consumption because their income will rise.
B) increase current consumption because their wealth will increase.
C) decrease current consumption because their savings will increase.
D) decrease current consumption because their future income will increase.
Answer: C
Diff: 2 Type: MC Page Ref: 94
68) Most people would prefer
A) higher current consumption relative to future consumption.
B) higher future consumption relative to current consumption.
C) to smooth consumption over their lifetime.
D) to match current consumption to current income.
Answer: C
Diff: 1 Type: MC Page Ref: 95
69) A decline in consumer confidence will lead to
A) an upward shift in the consumption function and higher current consumption.
B) a downward shift in the consumption function and lower current consumption.
C) a downward shift in the saving function and lower current saving.
D) a downward shift in the saving function and a higher interest rate.
Answer: B
Diff: 1 Type: MC Page Ref: 96
70) The main reason that a theory cannot predict the effect of an increase in the real interest rate
on national saving is
A) for borrowers, the substitution and income effects operate in the same direction, but for
lenders they operate in the opposite direction.
B) for lenders, the substitution and income effects operate in the same direction, but for
borrowers they operate in the opposite direction.
C) for lenders and borrowers, the substitution and income effects operate in the opposite
direction.
D) for lenders and borrowers, the substitution and income effects operate in the same direction.
Answer: B
Diff: 2 Type: MC Page Ref: 102
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71) The after-tax real interest rate
A) can only be positive.
B) increases with expected inflation rates.
C) decreases with nominal interest rate.
D) can be negative.
Answer: D
Diff: 2 Type: MC Page Ref: 105
72) Suppose the interest rate is 2 percent, the capital depreciation rate is 5 percent, and the price
of a new capital is $100. What is the user cost of capital?
A) $5
B) $2
C) $3
D) $7
Answer: D
Diff: 2 Type: MC Page Ref: 108
73) Suppose the real interest rate has declined. We expect that Tobin's q will
A) increase because of higher savings.
B) decrease because of higher stock prices.
C) increase because of higher stock prices.
D) decrease because of higher expected profits.
Answer: A
Diff: 2 Type: MC Page Ref: 111
74) An increase in the real interest rate will cause
A) the expected profit of firms to rise.
B) the purchase price of capital to decrease.
C) the stock prices to rise.
D) Tobin's q to decline.
Answer: D
Diff: 2 Type: MC Page Ref: 110
75) When tax rate increases, we expect the investors
A) to require a higher before-tax future marginal product of capital in order to increase
investment.
B) to require a lower before-tax future marginal product of capital in order to increase
investment.
C) to increase the desired stock of capital.
D) to increase their investment.
Answer: A
Diff: 2 Type: MC Page Ref: 113
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76) Which of the following is true about the interest rate and saving?
A) For a saver, the income and substitution effects of an increase in interest rate work in the
same directions.
B) For a borrower, the income and substitution effects of an increase in interest rate work in the
same directions.
C) For a saver, the income effect of an increase in the interest rate is negative, but the
substitution effect is positive.
D) For a borrower, the income and substitution effects of an increase in interest rate work in the
opposite directions.
Answer: B
Diff: 2 Type: MC Page Ref: 100
77) John deposits $10,000 he earned from his summer job in a savings account. The interest rate
is now 1 percent, the tax rate on his interest income is 5 percent, and he expects prices to rise by
2 percent. What will be his interest income after one year?
A) 105
B) 115
C) -105
D) -95
Answer: C
Diff: 3 Type: MC Page Ref: 101
78) The target overnight rate is
A) the rate that chartered banks and trust companies charge on loans to their best customers.
B) the interest rate at which chartered banks make short-term loans to one another.
C) the interest rate paid on long-term bonds.
D) the interest rate central bank charges to the chartered banks.
Answer: B
Diff: 2 Type: MC Page Ref: 102
79) A temporary increase in government purchases of goods and services
A) increases desired investment.
B) increases desired consumption.
C) decreases desired consumption.
D) increases desired saving.
Answer: A
Diff: 2 Type: MC Page Ref: 103
80) The Ricardian equivalence proposition is NOT supported by evidence, because
A) consumers may respond to the current tax cut by increasing their desired consumption.
B) consumers may increase their saving to respond to future tax increase.
C) consumers do not change their consumption because they expect an increase in future tax
rates.
D) a cut in current tax does not affect the ultimate tax burden borne by consumers.
Answer: A
Diff: 2 Type: MC Page Ref: 105
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4.2 Essay Questions
1) Jane wants to save $1000 of current income. With an RRSP, no taxes are paid on income or
interest until the money is withdrawn in five years. Without an RRSP, taxes must be paid
whenever income or interest is received. Jane's tax bracket is 35%, and the nominal interest rate
is 8%.
a. How much money will Jane have if she puts her money in an RRSP and withdraws the
money in five years?
b. How much money will Jane have if she does NOT put her money in an RRSP, but rather in a
regular (taxable) savings account, for five years?
c. How much does Jane gain in five years by using an RRSP rather than a regular savings
account?
Answer:
a. $995.06 = [$1000 × (1.08)5] × .65
b. $837.51 = $650 × [1 + (.08 × .65)]5
c. $117.55 = $955.06 - $837.51
Diff: 3 Type: ES
Page Ref: Sec. 4.1
2) The one-year T-bill rate was 8% on 1/1/00, 7% on 1/1/01, and 6% on 1/1/02. The GDP
deflator (1996 = 100) was 150 on 1/1/00, 159 on 1/1/01, 165.4 on 1/1/02, and 173.6 on 1/1/03.
The tax rate on interest income is 30%.
a. Calculate the after-tax nominal rate of return for 2000, 2001, and 2002.
b. If you began with $1000 on 1/1/00 and invested in T-bills each year (paying taxes at the end
of each year), how much would you have in nominal terms on 1/1/01? How much would you
have in real terms (1996 dollars)?
c. How much was your nominal after-tax interest earned in part b over the three years? How
much did you earn in real after-tax dollars?
Answer:
a. 2000: 5.6% = .08 × .7
2001: 4.9% = .07 × .7
2002: 4.2% = .06 × .7
b. Nominal: $1154.27 = $1000 × 1.056 × 1.049 × 1.042
Real: $664.90 = $1154.27/(173.6/100)
c. Nominal: $154.27 = $1154.27 - $1000
Real: -$1.77 = $664.90 - $1000/(150/100) = $664.90 - $666.67
Diff: 3 Type: ES
Page Ref: Sec. 4.1
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3) The nominal interest rate on taxable bonds is 8%, while on municipal bonds (which aren't
taxable) it is 5%. The expected inflation rate is 3% and the tax rate on interest income is 40%.
Calculate the expected after-tax real interest rate on both bonds. Which would be the better
investment? Now suppose the actual inflation rate turned out to be 6%. Which bond was the
better investment? Would your answer change if inflation had turned out to be 0%?
Answer: ra-t (taxable bond) = (1 - .40)8% - 3% = 1.8%; ra-t (municipal bond) = 5% - 3% = 2%:
municipal bond is the best buy. Note that the same expected inflation rate is subtracted from
both, so it doesn't matter what the actual inflation rate turns out to be—the municipal bond is
always the best.
Diff: 2 Type: ES
Page Ref: Sec. 4.1
4) Suppose you divide your life into two periods—working age and retirement age. When you
work, you earn labour income Y; when retired, you earn no labour income, but must live off your
savings and the interest it earns. You save the amount S while working, earning interest at rate r,
so you have (1 + r)S to live on when retired. Because you don't need to consume as much when
retired, you want to set consumption when working twice as high as consumption when retired.
a. Suppose you earn $1 million over your working life and the real interest rate for retirement
saving is 50%. How much will you save and how much will you consume in each part of your
life?
b. Suppose your current income went up to $2 million when working. Now what will you save
and how much will you consume each period?
c. Suppose a social security system will pay you 25% of your working income when you are
retired. Now (with Y = $1 million, as in part a) how much will you save and how much will you
consume each period?
d. Suppose the interest rate rises (starting from the situation in part a). Will you save more or
less?
Answer:
a. cW = Y - S. cR = (1 + r)S, cW = 2cR. So Y - S = 2(1 + r)S, or (3 + 2r)S = Y. With r = 0.5, 3 +
2r = 4. Setting 4S = $1 million, we get S = $250,000, so cR = $375,000, and cW = $750,000.
b. Now 4S = $2 million, so S = $500,000, cR = $750,000, and cW = $1,500,000. Higher current
income yields higher saving and consumption in both the present and the future.
c. Now cR = (1 + r)S + pY, where p = .25. So Y - S = 2(1 + r)S + 2pY, or (3 + 2r)S = (1 - 2p)Y.
With r = 0.5 and p = .25, we get 4S = 0.5Y, and with Y = $1 million, this gives S = $125,000, cW
= $875,000, and cR = $437,500. The social security system reduces saving and increases
consumption in both periods.
d. The basic equation is (3 + 2r)S = Y, so as r rises, S declines, with Y held fixed.
Diff: 3 Type: ES
Page Ref: Sec. 4.1
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5) In 2001 the federal government changed the withholding amounts for personal taxes. The
change meant that people wouldn't have as much withheld from their paycheques. But there was
no change in the tax code itself, so the amount of tax due in April 2002 was not changed. How
would consumption and saving respond to this withholding change (note: you may assume a real
interest rate of 0%)?
Answer: This is just a Ricardian equivalence example. People would not change their
consumption, but would increase saving by the amount of the withholding change, so that they
would have the same consumption pattern over time.
Diff: 2 Type: ES
Page Ref: Sec. 4.1
6) A firm has current and future marginal productivity of capital given by MPK = 10,000 - 2K +
N, and marginal productivity of labour given by MPN = 50 - 2N + K. The price of capital is
$5,000, the real interest rate is 10%, and capital depreciates at a 15% rate. The real wage is $15.
a. Calculate the user cost of capital.
b. Find the firm's optimal amount of employment and the size of the capital stock.
Answer:
a. uc = (r + d)pK = .25 × $5000 = $1250.
b. Setting w = MPN gives 15 = 50 - 2N + K, or 2N = 35 + K. Setting uc = MPK gives 1250 =
10,000 - 2K + N, or N = -8750 - 2K or 2N = -17,500 + 4K. Setting = 17,500 - 4K = 35 - K gives
3K = 17,535 which yields K = 5845. Then N = 2940.
Diff: 3 Type: ES
Page Ref: Sec. 4.2
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7) Perpetual plastic plant makers cost $200 each. The number of plants that your firm expects to
produce each year for each level of capital stock is as follows:
The plants sell for $1 each and your firm faces no other costs. The real interest rate is 10% and
the depreciation rate of capital is 15%. There is a 20% tax on your firm's revenues from selling
these plants.
a. What is the firm's tax-adjusted user cost of capital?
b. What is the marginal product of capital for each number of machines (1, 2, 3, 4, and 5)?
c. How many machines should the firm buy? What is their production, pretax revenue, and
profit after deducting taxes, interest, and depreciation?
Answer:
a. Tax-adjusted user cost = (r + d)pK/1 - T) = (.10 + .15) × $200/(1 - 0.20) = $62.50
b. MPKs: one machine produces 250 plants × $1 each = $250; two produce 150 more plants ×
$1 each = $150; three: 100 × $1 = $100; four: 65 × $1 = $65; five: 35 × $1 = $35.
c. Four machines (MPK > uc); production = 565 plants, pretax revenue = $565, profit = $565 $113 (taxes = $565 × .20) - $80 (interest = $800 × .10) - $120 (depreciation = $800 × .15) = 252
Diff: 3 Type: ES
Page Ref: Sec. 4.2
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8) Consider a Keynesian consumption function with desired consumption equal to 0.9 Y, where
Y is income. Government purchases are $1000, net exports are zero, and desired investment
varies with real interest rate according to the following schedule:
Assume the interest rate adjusts so that the economy gets to equilibrium. Equilibrium output at
full employment is $50,000. Find the values of consumption, investment, and the real interest
rate at full-employment equilibrium.
Answer: Let X = Id + G. Since Y = Cd + Id + G, Y = .9Y + X, so 1Y = X. Then you can
calculate the following table, since X = Id + G.
At equilibrium, Y = $50,000, so r = 3%, Id = $4000, and G = $1000.
Diff: 3 Type: ES
Page Ref: Sec. 4.3
9) What are the economic consequences of reductions in defense spending by the government?
What happens to national saving, the interest rate, and investment?
Answer: The reduction in defense spending increases national saving, so that the desired saving
curve shifts to the right. As a result, the real interest rate declines and investment increases along
with saving.
Diff: 2 Type: ES
Page Ref: Sec. 4.3
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10) Use a saving-investment diagram to explain what happens to saving, investment, and the real
interest rate in each of the following scenarios.
a. Current output rises due to a temporary productivity increase.
b. The tax code changes so that business firms face higher tax rates on their revenue (offset by
other lump-sum tax changes so there is no overall change in tax revenue).
c. The government increases spending temporarily for a one-year project to turn mercury into
gold.
d. The average educational level rises, inducing an increase in the future marginal productivity
of capital.
Answer:
a. The rise in output raises desired saving, shifting the Sd curve to the right; in equilibrium, this
reduces the real interest rate, increasing investment as well.
b. The rise in taxes reduces desired investment, shifting the Id curve to the left; in equilibrium,
this reduces the real interest rate, reducing saving as well as investment.
c. The rise in government purchases reduces desired saving, shifting the Sd curve to the left; in
equilibrium., this raises the real interest rate, reducing investment as well as saving.
d. The rise in future marginal productivity of capital raises desired investment, shifting the Id
curve to the right; in equilibrium, this raises the real interest rate, increasing saving as well as
investment.
Diff: 2 Type: ES
Page Ref: Sec. 4.3
11) Suppose the stock price for a firm in Manitoba is $10 per share. The firm has 5 machines and
1,000 shares outstanding. Suppose the price of a new machine is $1,500.
a. What is Tobin's q for this firm?
b. Should this firm make new investment (buy new machine)? Why?
c. Assume the firm's stock price falls down to $6 per share. Should the firm buy new machine?
d. Assume the price of a new machine rises to $1,800. Using the original information for the
other variables, should the firm make new investment?
Answer:
a. Tobin's q is equal to the ratio of the stock market value of the firm to the capital stock
replacement cost. The stock market value of the firm is equal to $10,000 = $10 × 1000 shares,
and the capital replacement cost $7,500 = 5 machines × $1500. Therefore Tobin's q will be 1.33
= 10,000/7500.
b. Since Tobin's q is greater than one, the firm should make new investment. The stock market
value of the firm exceeds the replacement cost of the machines.
c. Tobin's q is 0.8 = ($6 × 1000)/(7500). Since Tobin's q is less than 1, indicating that the capital
replacement cost is greater than the stock market value of the firm, the firm should not purchase
new machine.
d. Tobin's q is 1.11 = ($10 × 1000)/(5 × $1800). The condition is similar to b, and therefore, the
firm should buy new machines.
Diff: 2 Type: ES
Page Ref: Sec. 4.2
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12) Describe how the market value of a firm's shares can determine the value of the firm's capital
stock.
Answer: Since much of the value of firms comes from the capital they own, we can use the
market value of a firm's shares as a measure of the value of the firm's capital stock. This is shown
by Tobin's q, which is the ratio of the firm's stock market value to the replacement cost of the
firm's capital stock. Formally, Tobin's q = V/pk K, where V is the value of the firm's shares, pk is
the price of new capital goods, and K is the amount of capital the firm owns.
Diff: 2 Type: ES
Page Ref: Sec. 4.2
13) Explain how and why Canadians might change their consumption in response to an increase
in wealth arising from a rise in stock prices and an increase in housing prices.
Answer: Household wealth held in the form of housing tends to fluctuate less dramatically than
wealth held in the stock market but can nonetheless be subject to large changes. The effect on
consumers' spending of increasing in wealth is significantly higher when the change in wealth is
from housing rather than financial assets.
Diff: 2 Type: ES
Page Ref: 99
14) Explain why the Ricardian equivalence proposition is not supported by data.
Answer: Many, perhaps most, consumers don't understand that increased government borrowing
today is likely to lead to higher taxes in the future. Thus, consumers may simply respond to the
current tax cut, as they would to any other increase in current income, by increasing their desired
consumption.
Diff: 2 Type: ES
Page Ref: 105
15) Using Tobin's q, explain how the central bank's policy affects a firm's decision on desired
capital.
Answer: A decrease in the expected real interest rate or any other change that lowers the user
cost of capital increases the desired capital stock.
Diff: 2 Type: ES
Page Ref: 110
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 5 Saving and Investment in the Open Economy
5.1 Multiple-Choice Questions
1) Canada's balance of payment accounts
A) are a record of all Canadian international transactions.
B) are part of the national income accounting.
C) show a flow of funds into Canada as credit and the flow of funds out of Canada as debit.
D) all of the above.
Answer: D
Diff: 1
Type: MC
Page Ref: 132
2) The merchandise trade balance is a country's
A) exports of goods.
B) net exports of goods.
C) exports of goods and services.
D) net exports of goods and services.
Answer: B
Diff: 1
Type: MC
Page Ref: 133
3) If a country's merchandise exports exceed its merchandise imports,
A) it has a trade surplus.
B) it has a trade deficit.
C) it has a current account surplus.
D) it has a current account deficit.
Answer: A
Diff: 1
Type: MC
Page Ref: 133
4) If France has a trade deficit, then
A) imports into France exceed exports from France.
B) exports from France exceed imports into France.
C) imports into Canada from France exceed exports from Canada into France.
D) imports into France from Canada exceed exports from France into Canada.
Answer: A
Diff: 1
Type: MC
Page Ref: 133
5) If all international factor payment flows are investment income, then net investment income
from abroad equals
A) net exports.
B) the current account balance.
C) the trade balance.
D) net factor payments from abroad.
Answer: D
Diff: 1
Type: MC
Page Ref: 133
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6) If Canada donates footballs to Japan, how is the transaction recorded on the Canadian balance
of payments accounts?
A) debit: merchandise trade; credit: capital account
B) debit: capital account; credit: merchandise trade
C) debit: net unilateral transfers; credit: merchandise trade
D) debit: merchandise trade; credit: net unilateral transfers
Answer: C
Diff: 2
Type: MC
Page Ref: 133
7) The current account balance consists of
A) the trade balance plus the services balance.
B) net exports of goods and services, minus net unilateral transfers.
C) net exports of goods and services, plus investment income from abroad, plus net unilateral
transfers.
D) net exports of goods and services, plus investment income from abroad, plus net unilateral
transfers, minus the capital account balance.
Answer: C
Diff: 1
Type: MC
Page Ref: 134
8) If a Canadian firm buys stereos from a Japanese firm and the Japanese firm uses the dollars it
gets to buy Canadian Treasury bonds, what items are recorded in the Canadian balance of
payments accounts?
A) credit the trade account; credit the capital account
B) credit the trade account; debit the capital account
C) debit the trade account; debit the capital account
D) debit the trade account; credit the capital account
Answer: D
Diff: 2
Type: MC
Page Ref: 135
9) Suppose a wealthy Saudi Arabian prince donates 2000 camels to the San Diego Zoo. The
Canadian trade balance ________ and the current account balance ________.
A) falls; rises
B) rises; rises
C) is unchanged; is unchanged
D) falls; is unchanged
Answer: C
Diff: 2
Type: MC
Page Ref: 134
10) If a Canadian company imports 10 Toyotas from Japan at $15,000 each, and the Japanese
company buys airline tickets on a Canadian airline with the money, how does this affect the
Canadian balance of payments accounts?
A) debit: merchandise trade; credit: capital account
B) debit: capital account; credit: merchandise trade
C) debit: merchandise trade; credit: services
D) debit: services; credit: merchandise trade
Answer: C
Diff: 2
Type: MC
Page Ref: 135
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11) If a French company sells 1000 gallons of Perrier to a Canadian company at 25 francs per
gallon and uses the money to buy stock in a Spanish cork company, how does this affect the
French balance of payments accounts?
A) debit: capital account; credit: merchandise trade
B) debit: merchandise trade; credit: capital account
C) debit: net investment income from abroad; credit: capital account
D) debit: merchandise trade; credit: net investment income from abroad
Answer: A
Diff: 2
Type: MC
Page Ref: 136
12) Which of the following would be part of the nation's current account?
A) an old house purchased by a Canadian in Croatia
B) the purchase of a Canadian Treasury bond by a foreigner
C) the interest a Canadian earns on a British bond
D) a factory built by the Japanese in Canada
Answer: C
Diff: 2
Type: MC
Page Ref: 136
13) Which of the following would be part of the nation's capital account?
A) a nightclub show seen by a Canadian in Mexico City
B) a dividend from a British equity owned by a Canadian
C) a payment to the Philippine government for the use of military bases in their country
D) one hundred shares of British Petroleum stock purchased by a Canadian
Answer: D
Diff: 2
Type: MC
Page Ref: 136
14) The difference between the current account balance and net exports is
A) the capital account.
B) net unilateral transfers plus net factor payments from abroad.
C) adjustments in net foreign assets.
D) income receipts from foreign assets.
Answer: B
Diff: 1
Type: MC
Page Ref: 136
15) Which of the following statements is true?
A) The world as a whole has a current account surplus.
B) The world as a whole has a current account balance.
C) The world as a whole has a balance of payment surplus.
D) The world as a whole has a current account deficit.
Answer: D
Diff: 2
Type: MC
Page Ref: 136
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16) The world as a whole has a current account deficit because
A) some countries export less than they import.
B) there are statistical discrepancies.
C) the United States and China have current account deficit.
D) income from assets held abroad is misreported.
Answer: D
Diff: 2
Type: MC
Page Ref: 136
17) The official settlements balance equals
A) the sum of the current account and the capital account.
B) the current account minus net unilateral transfers.
C) net investment income from abroad.
D) the net increase in a country's official reserve assets.
Answer: D
Diff: 1
Type: MC
Page Ref: 136
18) If the Bank of Canada buys $3 billion worth of Japanese yen, $4 billion of German marks,
and $2 billion of French francs, and sells $5 billion of British pounds, how does this affect the
official settlements balance?
A) falls by $4 billion
B) rises by $4 billion
C) rises by $9 billion
D) falls by $5 billion
Answer: B
Diff: 1
Type: MC
Page Ref: 136
19) Suppose the current account shows debits of $4.7 billion and credits of $5.3 billion. The
current account balance is ________, and the capital account balance is ________.
A) +$0.6 billion; -$0.6 billion
B) +$0.6 billion; +$0.6 billion
C) -$0.6 billion; -$0.6 billion
D) -$0.6 billion; +$0.6 billion
Answer: A
Diff: 2
Type: MC
Page Ref: 136
20) A capital account surplus necessarily implies
A) a balance of payments surplus.
B) a current account surplus.
C) a current account deficit.
D) an increase in the nation's official reserve assets.
Answer: C
Diff: 1
Type: MC
Page Ref: 136
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21) If Canada acquired net foreign assets of $50 billion in one year, this would be the equivalent
of
A) net imports of $50 billion.
B) net foreign borrowing of $50 billion.
C) a capital account deficit of $50 billion.
D) a current account deficit of $50 billion.
Answer: C
Diff: 1
Type: MC
Page Ref: 138
22) You just read that forecasters predict Canada will run a current account deficit in 2004. From
this you would infer that Canada will also
A) run a capital account deficit in 2004.
B) decrease its official reserve assets.
C) run a balance of payments surplus.
D) decrease its holding of net foreign assets.
Answer: D
Diff: 2
Type: MC
Page Ref: 138
23) Which of the following statement is true?
A) In each period, except for measurement errors, the current account balance and the capital
account balance must sum to zero.
B) In each period, except for measurement errors, the sum of the current account balance and the
capital account balance must be positive.
C) In each period, except for measurement errors, the sum of the current account balance and the
capital account balance must be negative.
D) In each period, except for measurement errors, the sum of the current account balance and the
capital account balance may be positive or negative.
Answer: A
Diff: 2
Type: MC
Page Ref: 137
24) If there are no factor payments from abroad and no unilateral transfers, net exports of $10
billion is the same as
A) a current account deficit of $10 billion.
B) a capital account surplus of $10 billion.
C) net acquisition of foreign assets of $10 billion.
D) net foreign borrowing of $10 billion.
Answer: C
Diff: 1
Type: MC
Page Ref: 138
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25) A friend claims that Canada is a net international debtor. The best way of testing this claim is
to
A) see whether Canadian foreign liabilities exceeded Canadian foreign income.
B) see whether Canadian receipts from foreign assets exceeded Canadian payments to foreign
owners of Canadian assets.
C) see whether Canadian official reserve assets were positive or negative.
D) see whether Canada ran a balance of payments surplus or deficit last year.
Answer: B
Diff: 2
Type: MC
Page Ref: 138
26) When a current account has a surplus of $5 billion, it means that
A) the capital account must have a deficit of $5 billion.
B) next exports must be negative.
C) net foreign lending is negative.
D) net acquisition of foreign assets is negative.
Answer: A
Diff: 2
Type: MC
Page Ref: 136
27) In goods market equilibrium in an open economy,
A) the desired amount of exports must equal the desired amount of imports.
B) the desired amount of exports must equal the desired amount of imports less the amount lent
abroad.
C) the desired amount of national saving must equal the desired amount of domestic investment.
D) the desired amount of national saving must equal the desired amount of domestic investment
plus the amount lent abroad.
Answer: D
Diff: 2
Type: MC
Page Ref: 139
28) In goods market equilibrium in an open economy,
A) the desired amount of exports must equal the desired amount of imports.
B) the desired amount of exports must equal the desired amount of imports less the amount lent
abroad.
C) the desired amount of national saving must equal the desired amount of domestic investment.
D) the desired amount of national saving must equal the desired amount of domestic investment
plus the current account balance.
Answer: D
Diff: 2
Type: MC
Page Ref: 139
29) Absorption refers to
A) the total amount of imports purchased by a country.
B) the net amount of imports purchased by a country.
C) total spending by domestic residents, businesses, and governments.
D) GDP less desired consumption, desired investment, and government purchases.
Answer: C
Diff: 1
Type: MC
Page Ref: 140
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30) Suppose output is $35 billion, government purchases are $10 billion, desired consumption is
$15 billion, and desired investment is $6 billion. Net foreign lending would be equal to
A) -$4 billion.
B) -$2 billion.
C) $2 billion.
D) $4 billion.
Answer: D
Diff: 2
Type: MC
Page Ref: 139
31) An economy in which output exceeds absorption
A) will send goods abroad and have a current account surplus.
B) is a net importer with a current account deficit.
C) is a net borrower in the international market.
D) will have a capital account deficit.
Answer: A
Diff: 2
Type: MC
Page Ref: 140
32) Sweetland economy's GDP is $2000 billion, desired consumption spending $1200 billion,
desired investment spending $500 billion, and government purchases $400 billion. The
Sweetland economy's absorption is
A) $2000 billion.
B) $1200 billion.
C) $2100 billion.
D) -$100 billion.
Answer: D
Diff: 2
Type: MC
Page Ref: 140
33) Which of the following statements about the Canadian balance of payment is true?
A) Historically, Canada has for the most part had a current account surplus.
B) Canada has always had a capital account deficit.
C) Canadians' ownership of foreign assets has always been greater than foreigners' ownership of
Canadian assets.
D) Canada has always maintained a current account balance.
Answer: A
Diff: 2
Type: MC
Page Ref: 141
34) Suppose output is $35 billion, government purchases are $10 billion, desired consumption is
$15 billion, and desired investment is $6 billion. Desired savings is equal to
A) $2 billion.
B) $10 billion.
C) $14 billion.
D) $16 billion.
Answer: B
Diff: 2
Type: MC
Page Ref: 140
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35) Suppose output is $35 billion, government purchases are $10 billion, desired consumption is
$15 billion, and desired investment is $6 billion. Absorption is equal to
A) $25 billion.
B) $31 billion.
C) $35 billion.
D) $39 billion.
Answer: B
Diff: 2
Type: MC
Page Ref: 140
36) A small open economy is an economy that
A) has a small government.
B) has a very low net exports.
C) is too small to affect the world real interest rate.
D) has a negative balance of payments.
Answer: C
Diff: 1
Type: MC
Page Ref: 140
37) For a small open economy, an increase in the world real interest rate would necessarily
A) increase net foreign lending.
B) decrease net exports.
C) decrease the current account balance.
D) worsen the balance of payments.
Answer: A
Diff: 2
Type: MC
Page Ref: 141
38) A small open economy has a current account balance of zero. A rise in the world real interest
rate causes
A) a current account surplus.
B) a capital account surplus.
C) net borrowing from abroad.
D) absorption to exceed income.
Answer: A
Diff: 2
Type: MC
Page Ref: 141
39) A small open economy has a current account balance of zero. A rise in its investment
demand causes
A) a current account surplus.
B) a capital account deficit.
C) income to exceed absorption.
D) net borrowing from abroad.
Answer: D
Diff: 2
Type: MC
Page Ref: 143
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40) A small open economy increases its investment demand. This causes the world real interest
rate to ________ and the country's current account balance to ________.
A) rise; fall
B) remain unchanged; rise
C) rise; rise
D) remain unchanged; fall
Answer: D
Diff: 2
Type: MC
Page Ref: 143
41) A small open economy increases its desired saving. This causes the world real interest rate to
________ and the country's current account balance to ________.
A) fall; fall
B) remain unchanged; rise
C) fall; rise
D) remain unchanged; fall
Answer: B
Diff: 2
Type: MC
Page Ref: 143
42) When a temporary adverse supply shock hits a small open economy, it causes the current
account to ________ and investment to ________.
A) fall; fall
B) rise; remain unchanged
C) fall; remain unchanged
D) rise; fall
Answer: C
Diff: 2
Type: MC
Page Ref: 145
43) When future labour income falls in a small open economy, it causes the current account to
________ and investment to ________.
A) fall; rise
B) rise; remain unchanged
C) fall; remain unchanged
D) rise; rise
Answer: B
Diff: 2
Type: MC
Page Ref: 146
44) If there is an increase in the future marginal product of capital in a small open economy, it
causes the current account to ________ and saving to ________.
A) fall; rise
B) rise; remain unchanged
C) fall; remain unchanged
D) rise; rise
Answer: C
Diff: 2
Type: MC
Page Ref: 146
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45) If there is an increase in taxes on business firms in a small open economy, it causes the
current account to ________ and saving ________.
A) fall; fall
B) rise; remain unchanged
C) fall; remain unchanged
D) rise; fall
Answer: B
Diff: 2
Type: MC
Page Ref: 146
46) You have just read in the newspaper that a hurricane has destroyed Guatemala's coffee crop
for this year. Guatemala is a small open economy. Based on this information alone, you would
expect that
A) desired investment would fall in Guatemala.
B) desired investment would increase in Guatemala.
C) net foreign lending by Guatemala would increase.
D) net foreign lending by Guatemala would decrease.
Answer: D
Diff: 2
Type: MC
Page Ref: 146
47) The best weather in a decade has given Australia a bumper wheat crop. Australia is a small
open economy. Based on this information alone, you would expect that
A) desired investment would decrease.
B) desired investment would increase.
C) the current account would increase.
D) the current account would decrease.
Answer: C
Diff: 2
Type: MC
Page Ref: 146
48) An innovation will enable Haitian sugar cane farmers to harvest the sugar cane twice as
efficiently in the future. Haiti is a small open economy. Based on this information alone, you
would expect that
A) desired saving would increase.
B) net foreign borrowing would increase.
C) net exports would increase.
D) the current account balance would go further into surplus.
Answer: B
Diff: 2
Type: MC
Page Ref: 146
49) When there are two large open economies, the world real interest rate will be such that
A) desired international lending by one country equals desired international borrowing by the
other country.
B) desired international lending will be the same in both countries.
C) desired international borrowing will be the same in both countries.
D) desired international lending and borrowing will be zero in both countries.
Answer: A
Diff: 1
Type: MC
Page Ref: 150
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50) A large open economy is an economy
A) that has a large government sector.
B) that has a positive net exports.
C) that is large enough to affect the world real interest rate.
D) that has a positive balance of payments.
Answer: C
Diff: 1
Type: MC
Page Ref: 149
51) The main difference between the small open economy and the large open economy is that
A) the former faces a fixed international real interest rate, but the latter can influence it.
B) the former can influence the international real interest rate, but the latter cannot.
C) the former cannot maintain a large current account deficit, but the latter can.
D) the former can maintain a large current account deficit, but the latter cannot.
Answer: A
Diff: 2
Type: MC
Page Ref: 149
52) When there are two large open economies, if desired international lending by the domestic
country exceeds desired international borrowing by the foreign country, then
A) domestic saving must rise.
B) domestic saving must fall.
C) the world real interest rate must fall.
D) the world real interest rate must rise.
Answer: C
Diff: 2
Type: MC
Page Ref: 150
53) When there are two large open economies, if desired international borrowing by the domestic
country exceeds desired international lending by the foreign country, then
A) domestic investment must fall.
B) domestic investment must rise.
C) the world real interest rate must fall.
D) the world real interest rate must rise.
Answer: D
Diff: 2
Type: MC
Page Ref: 150
54) A large open economy increases its investment demand. This causes the world real interest
rate to ________ and the country's current account balance to ________.
A) rise; fall
B) remain unchanged; rise
C) rise; rise
D) remain unchanged; fall
Answer: A
Diff: 2
Type: MC
Page Ref: 150
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55) A large open economy increases its desired saving. This causes the world real interest rate to
________ and the country's current account balance to ________.
A) fall; fall
B) remain unchanged; rise
C) fall; rise
D) remain unchanged; fall
Answer: C
Diff: 2
Type: MC
Page Ref: 150
56) When a temporary adverse supply shock hits a large open economy, it causes the current
account to ________ and investment to ________.
A) fall; fall
B) rise; remain unchanged
C) fall; remain unchanged
D) rise; fall
Answer: A
Diff: 2
Type: MC
Page Ref: 150
57) When future labour income falls in a large open economy, it causes the current account to
________ and investment to ________.
A) fall; rise
B) rise; remain unchanged
C) fall; remain unchanged
D) rise; rise
Answer: D
Diff: 2
Type: MC
Page Ref: 150
58) If there is an increase in the future marginal product of capital in a large open economy, it
causes the current account to ________ and saving to ________.
A) fall; rise
B) rise; remain unchanged
C) fall; remain unchanged
D) rise; rise
Answer: A
Diff: 2
Type: MC
Page Ref: 150
59) If business taxes rise in a large open economy, it causes the current account to ________ and
saving to ________.
A) fall; fall
B) rise; remain unchanged
C) fall; remain unchanged
D) rise; fall
Answer: D
Diff: 2
Type: MC
Page Ref: 150
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60) Real domestic interest rates would increase in a large open economy if
A) there were a temporary negative domestic supply shock.
B) the government imposed capital controls and the capital account had been in deficit.
C) foreigners were more willing to save.
D) there were a temporary negative supply shock abroad in a small open economy.
Answer: A
Diff: 2
Type: MC
Page Ref: 150
61) Assuming no change in the effective tax rate on capital, an increase in the government
budget deficit will raise the current account deficit if and only if the increase in the budget deficit
A) reduces desired national saving.
B) increases desired national saving.
C) reduces desired national investment.
D) increases desired national investment.
Answer: A
Diff: 1
Type: MC
Page Ref: 152
62) Assume that an increase in Costa Rica's government budget deficit reduced desired national
saving by 10 million colon. Assuming Costa Rica is a small open economy, you would expect
the government's action to
A) increase the current account balance by exactly 10 million colon.
B) increase the current account balance by less than 10 million colon.
C) reduce the current account balance by exactly 10 million colon.
D) reduce the current account balance by more than 10 million colon.
Answer: C
Diff: 2
Type: MC
Page Ref: 152
63) Assume that Costa Rica, a small open economy, has increased the government budget deficit
by 10 million colon, reducing the current account balance in the process. All else being equal,
you would expect this action to cause
A) an increase in desired saving in Costa Rica.
B) an increase in the real world interest rate.
C) an increase in exports by Costa Rica.
D) an increase in Costa Rica's absorption.
Answer: D
Diff: 2
Type: MC
Page Ref: 152
64) In a large open economy like the United States, an increased government budget deficit that
reduces national saving
A) reduces investment and improves the current account balance.
B) reduces investment and reduces the current account balance.
C) has no effect on investment, but reduces the current account balance.
D) has no effect on either investment or the current account balance.
Answer: B
Diff: 2
Type: MC
Page Ref: 152
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65) If Ricardian equivalence proposition is true, a budget deficit resulting from a tax cut will
have
A) no effect on government expenditures.
B) no effect on current account because it does not affect national saving.
C) no effect on current account because people expect to pay lower taxes in the future.
D) no effect on current account because people expect to increase their consumption.
Answer: B
Diff: 2
Type: MC
Page Ref: 153
66) The term "twin deficits" refers to a situation in which there exists
A) a budget deficit as well as a current account deficit.
B) a budget deficit as well as a capital account deficit.
C) a budget deficit as well as a balance of payment deficit.
D) a current account deficit as well as a capital account deficit.
Answer: A
Diff: 2
Type: MC
Page Ref: 152
67) Justin spends his holidays in Mexico, where he spends $2500. This will
A) reduce the Canadian current account by $2500.
B) increase the Canadian current account by $2500.
C) have no change in the Canadian current account.
D) increase Canadian exports by $2500.
Answer: A
Diff: 1
Type: MC
Page Ref: 136
68) A group of Japanese tourists visits Banff National Park in Alberta and spends $20,000 on
goods and services in Canada. This will
A) reduce the Canadian current account by $20,000.
B) increase the Canadian current account by $20,000.
C) have no change in the Canadian current account.
D) increase Canadian imports.
Answer: B
Diff: 1
Type: MC
Page Ref: 136
69) An increase in the number of international students in Canada
A) has no effect on the Canadian current account.
B) decreases the Canadian current account.
C) decreases Canadian imports.
D) increases the Canadian current account.
Answer: D
Diff: 2
Type: MC
Page Ref: 136
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70) Suppose desired consumption is $10 billion and desired investment is $3 billion. If GDP is
$25 billion and government purchases are $2 billion, the desired national saving is
A) $12 billion.
B) $15 billion.
C) $14 billion.
D) $13 billion.
Answer: D
Diff: 2
Type: MC
Page Ref: 145
71) Suppose desired consumption is $10 billion and desired investment is $3 billion. If GDP is
$25 billion and government purchases are $2 billion, the desired foreign lending is
A) $10 billion.
B) $12 billion.
C) $13 billion.
D) $15 billion.
Answer: A
Diff: 3
Type: MC
Page Ref: 145
72) Suppose GDP is $20 billion and the desired absorption is $16 billion. What are the net
exports?
A) $10 billion
B) $4 billion
C) $36 billion
D) $1 billion
Answer: B
Diff: 3
Type: MC
Page Ref: 143
73) Suppose GDP is $20 billion, desired consumption $11 billion, desired investment $1 billion,
and government purchases of goods and services $4 billion. What is the desired absorption in
this economy?
A) $31 billion
B) $36 billion
C) $21 billion
D) $16 billion
Answer: D
Diff: 3
Type: MC
Page Ref: 143
74) Suppose desired consumption $11 billion, desired investment $1 billion, and government
purchases of goods and services $4 billion. If the desired foreign lending in this economy is $4
billion, what is the GDP?
A) $20 billion
B) $16 billion
C) $12 billion
D) $10 billion
Answer: A
Diff: 3
Type: MC
Page Ref: 143
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75) Which of the following is true when the expected future marginal product of capital
increases?
A) The investment and the current account rise.
B) The investment rises but the current account declines.
C) The investment and the current account declines.
D) The investment declines but the current account rises.
Answer: B
Diff: 2
Type: MC
Page Ref: 146
76) Which of the following is the true description of the impacts of a temporary positive oil price
shock on an oil-importing country like the U.S.?
A) National saving and current account surplus increase.
B) National saving decreases but current account surplus increases.
C) National saving increases but current account surplus decreases.
D) National saving and current account surplus decrease.
Answer: D
Diff: 2
Type: MC
Page Ref: 145
77) Which of the following is true for the foreign direct investment (FDI) and Canadian direct
investment abroad (CDIA)?
A) Although FDI has been historically lower than CDIA in Canada, the trend has recently
changed in favour of FDI.
B) Canadians now own a smaller amount of foreign companies than foreigners own of Canadian
companies.
C) Although CDIA has been historically lower than CDIA, the trend has recently changed in
favour of CDIA.
D) FDI has always been greater than CDIA in Canada.
Answer: A
Diff: 2
Type: MC
Page Ref: 148
78) If the Ricardian equivalence is true, a tax cut will
A) increase the current account surplus.
B) decrease the current account surplus.
C) have no effect on the current account.
D) increase national saving.
Answer: C
Diff: 2
Type: MC
Page Ref: 153
79) If Ricardian equivalence does NOT hold, a budget deficit arising from a tax cut will
A) have no effect on national saving.
B) have no effect on the current account.
C) increase national saving.
D) increase consumption.
Answer: D
Diff: 2
Type: MC
Page Ref: 152
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5.2 Essay Questions
1) Suppose a country has the following balance of payments data:
Merchandise exports
Merchandise imports
Service exports
Service Imports
Investment income receipts
Investment income payments
Transfers to other countries
Increase in home country assets abroad
Increase in foreign assets in home country
100
130
60
50
75
100
15
130
190
a. Calculate the current account balance.
b. Calculate the capital account balance.
c. Calculate the trade balance.
d. Calculate net factor payments.
Answer:
a. -60
b. 60
c. -30
d. -25
Diff: 2
Type: ES
Page Ref: Sec. 5.1
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2) Show where each of the following transactions belongs on the Canadian balance of payments
table, using an exchange rate of 100 Japanese yen per Canadian dollar.
a. A Japanese firm spends 5 billion yen to buy personal computers from IBM (a Canadian
firm).
b. A wealthy Japanese businessman gives $100 thousand to the San Diego Zoo.
c. A Canadian firm buys 1 million Sony Walkmans at 6000 yen each (Sony is a Japanese firm).
d. A Japanese investment banking firm buys 500 million dollars' worth of newly issued
Canadian government Treasury bills.
e. Canadian steel firms send 2000 executives to Japan to take courses in the Japanese method of
steel production and Japanese management techniques, paying 2 million yen per executive.
f. Repeat parts a. - e. for the balance of payments table of Japan.
Answer:
a. Credit: $50 million exports of merchandise
b. Credit: $100 thousand net unilateral transfers
c. Debit: $60 million imports of merchandise
d. Credit: $500 million increase in foreign-owned assets in Canada
e. Debit: $40 million imports of services
f. Debit: 5 billion yen imports of merchandise
Debit: 10 million yen net unilateral transfers
Credit: 6 billion yen exports of merchandise
Debit: 50 billion yen increase in Japanese-owned assets abroad
Credit: 4 billion yen exports of services
Diff: 2
Type: ES
Page Ref: Sec. 5.1
3) In a small open economy
Sd = $20 billion + ($100 billion) r%
Id = $30 billion - ($100 billion) r%
Y = $70 billion
G = $20 billion
rw = .04.
a. Calculate the current account balance.
b. Calculate net exports.
c. Calculate desired consumption.
d. Calculate absorption.
Answer:
a. -$2 billion
b. -$2 billion
c. $26 billion
d. $72 billion
Diff: 2
Type: ES
Page Ref: Sec. 5.2
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4) Consider a small open economy with desired national saving of Sd = 20 + 200 rw and desired
investment of Id = 30 - 200 rw. Calculate national saving, investment, and the current account
balance in equilibrium when the real world interest rate is
a. rw = 0.025
b. rw = 0.05
c. rw = 0.0
d. Now suppose something causes desired national saving to increase by 10, so that it is now
Sd = 30 + 200 rw. Repeat parts a, b, and c.
e. Suppose, with desired national saving at its original level of Sd = 20 + 200 rw, something
causes desired investment to rise by 10, Id = 40 - 200 rw. Repeat parts a, b, and c.
Answer:
a. S = 25, I = 25, CA = 0
b. S = 30, I = 20, CA = 10
c. S = 20, I = 30, CA = -10
d. rw = 0.025: S = 35, I = 25, CA = 10
rw = 0.050: S = 40, I = 20, CA = 20
rw = 0.000: S = 30, I = 30, CA = 0
e. rw = 0.025: S = 25, I = 35, CA = -10
rw = 0.050: S = 30, I = 30, CA = 0
rw = 0.000: S = 20, I = 40, CA = 20
S = 20, I = 40, CA = -20
Diff: 2
Type: ES
Page Ref: Sec. 5.3
5) Consider a small open economy in equilibrium with a zero current account balance. What
happens to national saving, investment, and the current account balance in equilibrium if
a. future income rises?
b. business taxes rise?
c. government expenditures decline temporarily?
d. the future marginal product of capital rises?
Answer:
a. Saving curve shifts left, so S falls, I is unchanged, CA falls.
b. Investment curve shifts left, so S is unchanged, I fails, CA rises.
c. Saving curve shifts right, so S rises, I is unchanged, CA rises.
d. Investment curve shifts right, so S is unchanged, I rises, CA falls.
Diff: 2
Type: ES
Page Ref: Sec. 5.3
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6) A large open economy has desired national saving of Sd = 20 + 200 rw and desired national
investment of Id = 30 - 200 rw. The foreign economy has desired national saving of Sd = 40 +
100 rw and desired national investment of IdFor = 75 - 400 rw.
a. Calculate the equilibrium values of rw, CA, CAFor, S, I, SFor, and IFor.
b. Suppose Sd rises by 45, so that now Sd = 65 + 200 rw. Calculate the equilibrium values of rw
CA, CAFor, S, I, SFor, and IFor.
c. Suppose with Sd back to Sd = 20 + 200 rw as in part a, that Id rises by 45, to Id = 75 - 200
rw. Calculate the equilibrium values of rw, CA, CAFor, S, I, SFor and IFor.
Answer:
a. In equilibrium, Sd + SdFor = Id + IdFor, so that 60 + 300 rw = 105 - 600 rw, or 900 rw =
45, so rw = 0.05. Using this in the formulas, we get S = 30, I = 20, CA = 10, SFor = 45,
IFor = 55, and CAFor = -10.
b. Now 900 rw = 0, so rw = 0.0. Using this in the formulas, we get S = 65, I = 30, CA = 35,
SFor = 40, IFor = 75, and CAFor = 35.
c. Now 900 rw = 90, so rw = 0.10. Using this in the formulas, we get S = 40, I = 55, CA = -15,
SFor = 50, IFor = 35, and CAFor = 15. Notice that the current account may swing from positive
to negative, depending on the value of the real interest rate.
Diff: 2
Type: ES
Page Ref: Sec. 5.4
7) Consider a large open economy that has a zero current account balance. What are the effects
on the world real interest rate, national saving, investment, and the current account balance in
equilibrium if
a. future income rises?
b. business taxes decline?
c. government purchases decline?
d. the future marginal product of capital declines?
Answer:
a. rw rises, S falls, I falls, CA falls
b. rw rises, S rises, I rises. CA falls
c. rw falls, S rises, I rises, CA rises
d. rw falls, S falls, I falls, CA rises
Diff: 2
Type: ES
Page Ref: Sec. 5.4
8) Due to a change in the regulatory structure of a small open economy, the desired capital stock
becomes higher for both private investment and government investment. Increased government
investment spending is financed by borrowing, not by higher taxes. If both desired investment
and government spending rise at the same time, will there be "twin deficits"?
Answer: Desired saving shifts left, desired investment shifts right, so the current account
balance declines; there are twin deficits.
Diff: 1
Type: ES
Page Ref: Sec. 5.5
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9) Suppose the government of a large open economy announces a major expansion of
government spending to dig a tunnel to the earth's core, to be financed entirely by borrowing.
What effect does this have on the world real interest rate, national saving, investment, and the
current account balance in equilibrium?
Answer: Desired national saving shifts left, causing the equilibrium world real interest rate to
rise, investment to fall, desired national saving to fall, and the current account balance to fall.
Diff: 2
Type: ES
Page Ref: Sec. 5.5
10) The government of a small open economy announces a tax cut of $100 this year, combined
with a tax increase of $110 next year, when the interest rate is 10%. What are the effects of this
change on the world real interest rate, national saving, investment, and the current account
balance in equilibrium when
a. Ricardian equivalence holds?
b. Ricardian equivalence does NOT hold?
Answer:
a. No effect on any of the variables.
b. Real world interest rate unchanged, national saving declines (private saving rises, but not as
much as government saving declines), investment is unchanged, and the current account balance
declines.
Diff: 2
Type: ES
Page Ref: Sec. 5.5
11) Briefly discuss the idea of "twin deficit." In your answer, include historical evidence, if any,
and explain why some economists do not agree with the idea. Is Ricardian equivalence
proposition consistent with the idea of twin deficit? Why?
Answer: The twin deficit idea is that the budget deficit is the primary cause of current deficit.
Therefore, if government runs a budget deficit, we should expect to see the current deficit as
well. The evidence on twin deficit is mixed. Although twin deficit can be observed in some
periods of the Canadian and the U.S. budget deficit and current account data, it is not evident in
some other periods. In addition, the opposite has occurred in Japan. Therefore, some economists
doubt that there is a correlation between the two deficits. The Ricardian equivalence hypothesis
is not consistent with the twin deficit. According to the Ricardian equivalence hypothesis, a
deficit caused by a tax cut will lead to higher saving and, therefore, will not lead to any deficit in
the current account.
Diff: 2
Type: ES
Page Ref: Sec. 5.5
12) Consider an economy with GDP of $100 billion, desired investment of $20 billion, desired
consumption of $50 billion, and government purchases of $2 billion. Calculate the following:
a. Desired absorption
b. Desired national saving
c. Desired foreign lending
Answer:
a. $72 billion
b. $48 billion
c. $28 billion
Diff: 2
Type: ES
Page Ref: Sec. 5.3
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13) Discuss the main differences between the small and large open economies in the impacts of a
decrease in domestic saving on the interest rate and the domestic investment.
Answer: Unlike the situation in a small open economy, for large open economies the world real
interest rate is not fixed but will change when desired national saving or desired investment
changes in either country. Generally, any factor that increases desired international lending
relative to desired international borrowing at the initial world real interest rate causes the world
real interest rate to fall. Similarly, a change that reduces desired international lending relative to
desired international borrowing at the initial world real interest rate will cause the world real
interest rate to rise.
Diff: 2
Type: ES
Page Ref: 147
14) Explain how a temporary increase in oil price affects the national saving, investment, and
current account of an oil-importing country.
Answer: Higher oil prices decreases aggregate output and income and, therefore, saving. Since
interest rate rises, investment declines. Current account decreases as exports decline.
Diff: 2
Type: ES
Page Ref: 144
15) Explain why the current account balance and the capital account balance of an economy
must sum to zero.
Answer: The reason is that every international transaction involves a swap of goods, services, or
assets between countries. The two sides of the swap always have offsetting effects on the sum of
the current and capital account balances, CA + KA. Thus, the sum of the current and capital
account balances must equal zero.
Diff: 2
Type: ES
Page Ref: 135
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Macroeconomics, Cdn. Ed., 9e (Abel et al.)
Chapter 6 Long-Run Economic Growth
6.1
Multiple-Choice Questions
1) From 1982 to 1992 North Samaria's economy grew at an annual rate of 3.5%, but from 1992
to 2002 North Samaria's economy grew by only 1% per year. In 1992 Samaria's per capita
income was $8000. How much higher would North Samaria's per capita income have been in
2002 if growth from 1992 to 2002 had been 3.5% rather than 1%?
A) $2241
B) $2448
C) $2508
D) $3285
Answer: B
Diff: 3
Type: MC
Page Ref: 163
2) An economy's output of goods and services depends on all of the following except
A) the quantity of capital input.
B) the quantity of labour input.
C) the productivity of inputs.
D) the interest rate.
Answer: D
Diff: 1
Type: MC
Page Ref: 164
3) The major source of economic growth is
A) capital.
B) labour.
C) technology.
D) all of the above.
Answer: D
Diff: 1
Type: MC
Page Ref: 164
4) The elasticity of output with respect to capital
A) is the increase in output resulting from an increase in the capital stock.
B) is the percentage increase in output resulting from a one percent increase in the capital stock.
C) is always greater than one.
D) is the inverse of the elasticity of output with respect to labour.
Answer: B
Diff: 1
Type: MC
Page Ref: 165
5) Growth accounting equation
A) measures empirically the relative importance of the sources of output growth.
B) is the production function written in growth rate form.
C) is used to calculate the total factor productivity.
D) all of the above.
Answer: D
Diff: 1
Type: MC
Page Ref: 165
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6) Suppose the current level of output is 5000, and the elasticity of output with respect to capital
is 0.4. A 10% increase in capital would increase the current level of output to
A) 5020.
B) 5050.
C) 5200.
D) 5500.
Answer: C
Diff: 2
Type: MC
Page Ref: 165
7) Suppose the current level of output is 5000, and the elasticity of output with respect to labour
is 0.7. A 10% increase in labour would increase the current level of output to
A) 5035.
B) 5070.
C) 5350.
D) 5700.
Answer: C
Diff: 2
Type: MC
Page Ref: 165
8) Suppose the current lever of output is 5000. A 10% increase in productivity would increase
the current level of output to
A) 5050.
B) 5100.
C) 5500.
D) 6000.
Answer: C
Diff: 2
Type: MC
Page Ref: 165
9) Suppose the current level of output is 5000. If the elasticities of output with respect to capital
and labour are 0.3 and 0.7 respectively, a 10% increase in capital combined with a 5% increase
in labour would increase the current level of output to
A) 5015.
B) 5325.
C) 5600.
D) 5650.
Answer: B
Diff: 2
Type: MC
Page Ref: 165
10) Suppose the current level of output is 5000. If the elasticities of output with respect to capital
and labour are 0.3 and 0.7 respectively, a 10% increase in capital combined with a 5% increase
in labour and a 5% increase in productivity would increase the current level of output to
A) 5015.
B) 5325.
C) 5575.
D) 6000.
Answer: C
Diff: 2
Type: MC
Page Ref: 165
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11) Total factor productivity growth is that part of economic growth due to
A) capital growth plus labour growth.
B) capital growth less labour growth.
C) capital growth times labour growth.
D) neither capital growth nor labour growth.
Answer: D
Diff: 1
Type: MC
Page Ref: 166
12) Over the past year, output grew 6%, capital grew 2%, and labour grew 4%. If the elasticities
of output with respect to capital and labour are 0.3 and 0.7 respectively, how much did
productivity grow?
A) 2.0%
B) 2.6%
C) 3.0%
D) 3.3%
Answer: B
Diff: 2
Type: MC
Page Ref: 166
13) Over the past year, output grew 3%, capital grew 4%, and labour grew 3%. If the elasticities
of output with respect to capital and labour are 0.3 and 0.7 respectively, how much did
productivity grow?
A) -0.6%
B) -0.3%
C) 0.0%
D) 0.3%
Answer: B
Diff: 2
Type: MC
Page Ref: 166
14) Suppose the rate of economic growth in Mainland was 25 percent, capital growth 30 percent,
and labour growth 20 percent. If the elasticities output with respect to capital and labour are 0.3
and 0.7 respectively, how much is the capital contribution to economic growth?
A) 2 percent
B) 6 percent
C) 9 percent
D) 14 percent
Answer: C
Diff: 3
Type: MC
Page Ref: 166
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15) Suppose the rate of economic growth in Mainland was 25 percent, capital growth 30 percent,
and labour growth 20 percent. If the elasticities output with respect to capital and labour are 0.3
and 0.7 respectively, how much is the labour contribution to economic growth?
A) 2 percent
B) 6 percent
C) 9 percent
D) 14 percent
Answer: D
Diff: 3
Type: MC
Page Ref: 166
16) Suppose the rate of economic growth in Mainland was 25 percent, capital growth 30 percent,
and labour growth 20 percent. If the elasticities output with respect to capital and labour are 0.3
and 0.7 respectively, how much is the productivity growth?
A) 2 percent
B) 6 percent
C) 9 percent
D) 14 percent
Answer: A
Diff: 3
Type: MC
Page Ref: 166
17) Suppose the rate of economic growth in Mainland was 25 percent, capital growth 30 percent,
and labour growth 20 percent. If capital contribution to economic growth is 9 percent, how much
is the elasticity of output with respect to capital?
A) 0.3
B) 0.7
C) 0.5
D) 0.8
Answer: A
Diff: 3
Type: MC
Page Ref: 166
18) Suppose the rate of economic growth in Mainland was 25 percent, capital growth 30 percent,
and labour growth 20 percent. If labour contribution to economic growth is 14 percent, how
much is the elasticity of output with respect to labour?
A) 0.3
B) 0.7
C) 0.5
D) 0.8
Answer: B
Diff: 3
Type: MC
Page Ref: 166
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19) Harvey Lithwick found that labour's contribution to output growth in Canada since 1891 was
attributable to all the factors below except
A) rising population.
B) an increase in the percentage of the population in the labour force.
C) an increase in the number of hours worked per person.
D) higher educational levels.
Answer: C
Diff: 1
Type: MC
Page Ref: 164
20) Analysis of the Canadian economy found that
A) total factor productivity was the largest source of economic growth since 1948.
B) the contribution of labour growth has been more variable than the contribution of capital
growth.
C) productivity growth has been positive over any period of more than five years since World
War II.
D) the contribution of labour growth has been greater than the contribution of capital growth.
Answer: D
Diff: 2
Type: MC
Page Ref: 165
21) During the period from 1984 to 1998, productivity growth was
A) positive and greater than productivity growth between 1962 and 1973.
B) positive but less than productivity growth between 1962 and 1973.
C) positive and greater than input growth.
D) negative.
Answer: B
Diff: 1
Type: MC
Page Ref: 168
22) The idea that measurement problems could explain the productivity slowdown since 1973 is
based on the fact that
A) official output measures make no adjustment for quality.
B) output can't be measured.
C) capital can't be measured.
D) quality improvements aren't fully accounted for in the data.
Answer: D
Diff: 1
Type: MC
Page Ref: 169
23) The computerization of police departments throughout the country has greatly reduced the
crime rate. What macroeconomic variable is likely to be directly affected by this change?
A) productivity
B) inflation
C) the real interest rate
D) the trade deficit
Answer: A
Diff: 1
Type: MC
Page Ref: 164
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24) Skeptics of the contribution of oil price hikes to the slowdown in economic growth after
1973 point out that
A) the productivity slowdown had begun prior to 1973.
B) the productivity slowdown occurred in only some industrial countries, but all were affected
by the oil price hikes.
C) there is no theoretical reason why an oil price hike should cause a slowdown in productivity
growth.
D) energy costs are a relatively small part of total costs in industrial countries.
Answer: D
Diff: 1
Type: MC
Page Ref: 169
25) The oil price explanation of the slowdown in economic growth after 1973 is inconsistent
with which of the following facts?
A) Prices of used capital goods that were dependent on oil did not drop sharply when oil prices
increased.
B) The productivity slowdown began just as oil prices were quadrupled in 1973.
C) The productivity slowdown occurred in all industrial countries.
D) Industry-by-industry analysis of the impact on oil prices bears out the damage done by the oil
price increases.
Answer: A
Diff: 1
Type: MC
Page Ref: 169
26) The per-worker production function in the Solow model assumes
A) constant returns to scale and increasing marginal productivity of capital.
B) constant returns to scale and diminishing marginal productivity of capital.
C) increasing returns to scale and diminishing marginal productivity of capital.
D) decreasing returns to scale and diminishing marginal productivity of capital.
Answer: B
Diff: 1
Type: MC
Page Ref: 171
27) The bowed shape of the per-worker production function is caused by
A) wealth effects that reduce labour supply.
B) diminishing marginal productivity of capital.
C) increasing marginal productivity of labour.
D) increasing marginal productivity of capital.
Answer: B
Diff: 1
Type: MC
Page Ref: 171
28) In a steady-state economy,
A) the total capital stock remains constant.
B) net investment remains constant.
C) net investment equals the depreciation rate for the economy.
D) the total capital stock grows at the same rate as the labour force.
Answer: D
Diff: 1
Type: MC
Page Ref: 172
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29) In a steady state,
A) both consumption per worker and the capital-labour ratio are constant.
B) consumption per worker is constant, but the capital-labour ratio can change.
C) capital and labour, by definition, are inversely related to one another.
D) consumption per worker can change, but the capital-labour ratio is constant.
Answer: A
Diff: 2
Type: MC
Page Ref: 173
30) In the neoclassical growth model, if productivity does NOT grow,
A) output per worker will be constant.
B) output will grow at the same rate as the population growth.
C) consumption will be constant.
D) both A and B are correct.
Answer: D
Diff: 2
Type: MC
Page Ref: 173
31) Steady-state investment per worker is positively related to the capital-labour ratio because
the higher the capital-labour ratio
A) the lower the capital depreciation rate.
B) the greater the amount of resources available for capital investment.
C) the more investment per worker is required to replace depreciating capital.
D) the less the economy needs to equip new workers with the same high level of capital.
Answer: C
Diff: 2
Type: MC
Page Ref: 173
32) In the absence of productivity growth, in a steady-state economy
A) output per worker and consumption per worker remain constant over time.
B) output per worker remains constant over time, but consumption per worker grows over time.
C) output per worker grows over time, but consumption per worker remains constant over time.
D) output per worker and consumption per worker both grow overtime.
Answer: A
Diff: 2
Type: MC
Page Ref: 173
33) Which of the following statements does NOT describe the steady state of an economy, when
technology is constant?
A) Investment per worker is equal to the requirement (break-even) investment.
B) Output per worker and consumption per worker are constant.
C) The growth rate of the output per worker is zero.
D) The capital per worker grows at a constant rate.
Answer: D
Diff: 2
Type: MC
Page Ref: 173
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34) The idea that saving equals investment in the Solow model means that a steady state can be
reached only when
A) s = k.
B) s = n + d.
C) sf(k) = (s + d)k.
D) sf(k) = (n + d)k.
Answer: D
Diff: 1
Type: MC
Page Ref: 175
35) If f(k) = 6k0.5, s = 0.1, n = 0.1, and d = 0.2, what is the value of k at equilibrium?
A) 1
B) 2
C) 3
D) 4
Answer: D
Diff: 2
Type: MC
Page Ref: 175
36) If f(k) = 6k0.5, s = 0.1, n = 0.1, and d = 0.2, what is the value of f(k) at equilibrium?
A) 6
B) 12
C) 18
D) 24
Answer: B
Diff: 3
Type: MC
Page Ref: 175
37) If f(k) = 8k0.5, s = 0.2, n = 0.3, and d = 0.1, what is the value of k at equilibrium?
A) 1
B) 4
C) 9
D) 16
Answer: B
Diff: 2
Type: MC
Page Ref: 175
38) If f(k) = 6k0.5, s = 0.1, n = 0.1, and d = 0.2, what is the value of c (consumption) at
equilibrium?
A) 10
B) 12
C) 10.8
D) 11.2
Answer: C
Diff: 3
Type: MC
Page Ref: 175
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39) If k = 10, y = 30, and s = 0.2, what is c (consumption)?
A) 24
B) 20
C) 18
D) 12
Answer: A
Diff: 2
Type: MC
Page Ref: 175
40) The Solow model demonstrates that
A) in the absence of productivity growth, economic growth will turn negative in the long run.
B) in the absence of productivity growth, economic growth will reach a steady state of zero
per-capita growth in the long run.
C) productivity growth must exceed the rate of growth in the population to avoid a steady state in
the long run.
D) productivity growth will inevitably decline due to diminishing marginal productivity.
Answer: B
Diff: 1
Type: MC
Page Ref: 175
41) One effect of the Gulf War was the destruction of a good portion of Kuwait's capital stock.
How would you expect this to affect Kuwait's capital-labour ratio in the long run? There would
be
A) a rightward movement along the saving-per-worker curve and an increase in the
capital-labour ratio.
B) no change in the long-run capital-labour ratio.
C) a downward shift in the saving-per-worker curve and a decrease in the capital-labour ratio.
D) a leftward movement along the saving-per-worker curve and a decrease in the capital-labour
ratio.
Answer: B
Diff: 2
Type: MC
Page Ref: 175
42) An increase in pollution has caused a permanent increase in the rate of capital depreciation.
This would cause
A) capital per worker to increase.
B) output per worker to fall.
C) consumption per worker to increase.
D) the total capital stock to be unaffected.
Answer: B
Diff: 1
Type: MC
Page Ref: 175
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43) An increase in the saving rate in a steady-state economy would cause
A) a rightward movement along the saving-per-worker curve and an increase in the
capital-labour ratio.
B) an upward shift in the saving-per-worker curve and an increase in the capital-labour ratio.
C) a downward shift in the saving-per-worker curve and a decrease in the capital-labour ratio.
D) a leftward movement along the saving-per-worker curve and a decrease in the capital-labour
ratio.
Answer: B
Diff: 1
Type: MC
Page Ref: 175
44) In the long run, an increase in the saving rate in a steady-state economy will cause
A) an increase in the capital-labour ratio and an increase in consumption per worker.
B) an increase in the capital-labour ratio and a decrease in consumption per worker.
C) a decrease in the capital-labour ratio and a decrease in consumption per worker.
D) a decrease in the capital-labour ratio and an increase in consumption per worker.
Answer: A
Diff: 2
Type: MC
Page Ref: 179
45) All else being equal, a permanent decrease in the saving rate in a steady-state economy
would cause
A) an increase in the capital-labour ratio and an increase in consumption per worker.
B) an increase in the capital-labour ratio and a decrease in consumption per worker.
C) a decrease in the capital-labour ratio and a decrease in consumption per worker.
D) a decrease in the capital-labour ratio and an increase in consumption per worker.
Answer: C
Diff: 2
Type: MC
Page Ref: 179
46) If the saving rate in Canada increases, the steady-state level of output
A) will grow at a higher rate.
B) will be higher.
C) will be the same.
D) will decline.
Answer: B
Diff: 2
Type: MC
Page Ref: 179
47) The higher saving rate in an economy would result in
A) the higher economic growth in the long run.
B) the higher output per capita in the long run.
C) the higher productivity growth in the long run.
D) the lower output per capital in the long run.
Answer: B
Diff: 2
Type: MC
Page Ref: 179
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48) The Golden Rule of the capital stock is the level of capital stock that
A) maximizes the output per worker in the steady state.
B) maximizes the consumption per worker in the steady state.
C) maximizes the investment per worker in the steady state.
D) maximizes the saving per worker in the steady state.
Answer: B
Diff: 2
Type: MC
Page Ref: 177
49) An increase in the growth rate of population in a steady-state economy would cause
A) a parallel shift upward in the investment line.
B) a pivot up and to the left in the investment line.
C) a pivot down and to the right in the investment line.
D) a parallel shift downward in the investment line.
Answer: B
Diff: 1
Type: MC
Page Ref: 182
50) A decline in population growth will lead to a ________ in the steady-state capital-labour
ratio and a ________ in output per worker.
A) fall; fall
B) fall; rise
C) rise; rise
D) rise; fall
Answer: C
Diff: 2
Type: MC
Page Ref: 182
51) Which of the following arguments would you make against a policy that discourages
population growth?
A) It means less total output in the economy, reducing the country's ability to defend itself or
influence world events.
B) It means less output per worker in the economy, reducing the country's ability to defend itself
or influence world events.
C) It means more total output in the economy, increasing the country's ability to defend itself or
influence world events.
D) It means more output per worker in the economy, increasing the country's ability to defend
itself or influence world events.
Answer: A
Diff: 2
Type: MC
Page Ref: 182
52) A productivity improvement raises steady-state output and consumption per worker in all the
ways given below except
A) it increases the amount that can be produced at any given capital-labour ratio.
B) it decreases the depreciation rate of capital.
C) it causes the steady-state capital-labour ratio to rise.
D) it causes saving per worker to rise.
Answer: B
Diff: 1
Type: MC
Page Ref: 184
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53) A productivity improvement will cause
A) a rightward movement along the saving-per-worker curve and an increase in the
capital-labour ratio.
B) an upward shift in the saving-per-worker curve and an increase in the capital-labour ratio.
C) a downward shift in the saving-per-worker curve and a decrease in the capital-labour ratio.
D) a leftward movement along the saving-per-worker curve and a decrease in the capital-labour
ratio.
Answer: B
Diff: 1
Type: MC
Page Ref: 184
54) In the long run, a productivity improvement will cause
A) an increase in the capital-labour ratio and an increase in consumption per worker.
B) an increase in the capital-labour ratio and a decrease in consumption per worker.
C) a decrease in the capital-labour ratio and a decrease in consumption per worker.
D) a decrease in the capital-labour ratio and an increase in consumption per worker.
Answer: A
Diff: 2
Type: MC
Page Ref: 184
55) Which of the following would cause an increase in consumption per worker in a steady state?
A) a permanent increase in the amount of immigration allowed into the country
B) a permanent decrease in energy prices
C) a reduction in the number of hours worked per person
D) a reduction in government expenditures on the nation's infrastructure
Answer: B
Diff: 1
Type: MC
Page Ref: 184
56) In the very long run, the level of consumption per worker can grow continually if
A) the saving rate continually falls.
B) the population growth rate continually rises.
C) productivity continually improves.
D) the depreciation rate continually rises.
Answer: C
Diff: 1
Type: MC
Page Ref: 184
57) Which of the following changes would lead to a higher living standard?
A) a higher saving rate, higher population rate, and higher productivity
B) a lower saving rate, higher population rate, and higher productivity
C) a lower saving rate, lower population rate, and higher productivity
D) a higher saving rate, lower population rate, and higher productivity
Answer: D
Diff: 1
Type: MC
Page Ref: 179
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58) Unconditional convergence means that in the long run
A) living standards converge only within groups of countries having similar characteristics.
B) living standards converge only for countries that have the same initial capital-labour ratio.
C) living standards around the world become the same.
D) differences persist in living standards around the world.
Answer: C
Diff: 1
Type: MC
Page Ref: 186
59) Conditional convergence means that in the long run
A) living standards converge only within groups of countries having similar characteristics.
B) living standards converge only for countries that have the same initial capital-labour ratio.
C) living standards around the world become the same.
D) living standards converge even if countries have different population growth rates.
Answer: A
Diff: 1
Type: MC
Page Ref: 186
60) How does the possibility of international trade and finance affect the convergence
conclusions of the Solow model?
A) Capital should flow from rich to poor countries.
B) Capital should flow from poor to rich countries.
C) Labour should flow from rich to poor countries.
D) Capital will flow to countries with low tariffs.
Answer: A
Diff: 1
Type: MC
Page Ref: 186
61) If there is international trade and finance, output per worker will converge in rich and poor
countries. Will consumption per worker converge?
A) Yes, with the same output, consumption must be the same.
B) Yes, in equilibrium, consumption per worker must be the same around the world.
C) No, because total output is different.
D) No, because part of the output must be used to repay foreign investors.
Answer: D
Diff: 2
Type: MC
Page Ref: 186
62) The endogenous growth theory attempts to
A) replace the Solow model with a model in which money growth plays a key role.
B) explain how societies can more easily reach the "Golden Rule."
C) show how population growth reduces capital and output.
D) explain why productivity changes.
Answer: D
Diff: 2
Type: MC
Page Ref: 188
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63) Which of the following statement is NOT true?
A) In the Solow model, the marginal productivity of capital depends on the level of capital.
B) In the endogenous growth model, the marginal productivity of capital is diminishing.
C) In the Solow model, the marginal productivity of capital diminishes as capital increases.
D) In the endogenous growth model, the marginal productivity of capital is constant.
Answer: B
Diff: 2
Type: MC
Page Ref: 188
64) The explanations for why the marginal productivity of capital is not diminishing, in the
endogenous growth model, rely on
A) constant saving rate in the steady state.
B) human capital and the R&D activities.
C) the golden rule level of capital.
D) the constant technological growth.
Answer: B
Diff: 2
Type: MC
Page Ref: 188
65) You believe that democracy is compatible with high rates of economic growth. Which of the
following arguments would you be least likely to use to justify this belief?
A) Democratic governments are more stable than dictatorships.
B) Democratic governments are less likely to start wars than dictatorships.
C) Democratic governments have better relations with advanced industrial nations than
dictatorships.
D) Democratic governments are better able to undertake unpopular but necessary economic
reforms.
Answer: D
Diff: 1
Type: MC
Page Ref: 191
66) You support an industrial policy for Canada. Which of the following would be the weakest
argument for an industrial policy?
A) The private sector is unlikely to undertake large, complex, risky investment programs without
government assistance.
B) Canada must support its industries because Japan and other countries are subsidizing their
high-tech firms.
C) Technological advance will be the primary source of economic growth in the future.
D) The government is able to take a longer view of investment strategies and is more successful
at picking "winners" than is the private sector.
Answer: D
Diff: 1
Type: MC
Page Ref: 194
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67) Government policy can improve the long-run economic growth through
A) providing an incentive for higher saving such as lower capital gain taxes.
B) encouraging more consumption and less saving.
C) increasing productivity growth by improving infrastructure, investing in human capital, and
supporting R&D activities.
D) subsidizing the manufacturing industries.
Answer: C
Diff: 2
Type: MC
Page Ref: 192
68) If in an economy the human capital increases with the increase in the physical capital,
A) there will be a diminishing marginal productivity of physical capital.
B) there will be no change in marginal productivity of physical capital.
C) the economy's growth rate will depend on its saving rate.
D) Both B and C are correct.
Answer: D
Diff: 2
Type: MC
Page Ref: 193
69) If labour productivity grows at 1.5% and total factor productivity grows at 2%, capital should
grow at
A) 1%.
B) 1.5%.
C) 2%.
D) 0.5%.
Answer: D
Diff: 2
Type: MC
Page Ref: 169
70) The fact that countries' GDP per capita does not converge indicates that
A) the neoclassical growth model fails to explain economic growth.
B) the convergence takes a long time.
C) the endogenous growth model can explain growth better than the neoclassical model.
D) living standards will converge only within groups of countries with similar characteristics.
Answer: D
Diff: 2
Type: MC
Page Ref: 186
71) The AK model implies that
A) government should invest in R&D to maintain long-run economic growth.
B) human capital increases with the accumulation of physical capital.
C) the standard of living in all countries will converge in the long-run.
D) capital growth is subject to diminishing returns.
Answer: B
Diff: 2
Type: MC
Page Ref: 189
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72) The growth-environmental quality relationship can be explained by
A) a linear graph.
B) a U-shaped graph.
C) an inverse U-shaped graph.
D) a logistical graph.
Answer: C
Diff: 1
Type: MC
Page Ref: 190
73) The government-backed Canadian Pension Plan (CPP)
A) increases national saving and therefore economic growth.
B) may not increase national saving as people may cut other forms of saving.
C) has a higher rate of return than RRSPs.
D) helps the government reduce its budget deficit.
Answer: B
Diff: 2
Type: MC
Page Ref: 192
74) The primary cause of the rapid economic growth in the East Asian countries is
A) rapid growth in total factor productivity.
B) rapid growth in exports.
C) rapid growth in capital and labour inputs.
D) rapid growth in imports.
Answer: C
Diff: 2
Type: MC
Page Ref: 165
75) One can predict that the rapid growth in the East Asian countries will run out of steam,
because
A) the growth cannot sustain over the very long term by increasing inputs alone.
B) the primary source of growth in those countries has been rapid increase in labour and capital,
not productivity.
C) the long-run growth can only be sustained by increases in total factor productivity.
D) all of the above.
Answer: D
Diff: 2
Type: MC
Page Ref: 165
76) Which is of the following is true about the productivity growth in industrialized countries?
A) Productivity has been growing at a constant rate.
B) Productivity has been growing at an increasing rate.
C) Productivity has been growing at a decreasing rate.
D) Productivity has slowed down since the 1970s.
Answer: D
Diff: 2
Type: MC
Page Ref: 167
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77) The steady state is a situation in which
A) total supply equals total demand.
B) potential GDP is equal to actual GDP.
C) full-employment level of GDP is produced.
D) output per worker, consumption per worker, and capital-labour ratio are constant.
Answer: D
Diff: 2
Type: MC
Page Ref: 170
78) In a neoclassical model of growth, an increase in the capital-labour ratio
A) raises the amount of output each worker can produce for a given level of productivity.
B) raises the amount of output per worker that must be devoted to investment.
C) generates a trade-off between the higher output per worker and the higher investment per
worker.
D) all of the above.
Answer: D
Diff: 2
Type: MC
Page Ref: 171
79) In the neoclassical theory of growth, an increase in the growth rate of population will lead to
A) a higher long-run economic growth.
B) a lower long-run economic growth.
C) no changes in economic growth.
D) a higher level of long-run standard of living.
Answer: B
Diff: 2
Type: MC
Page Ref: 177
80) Which of the following describes the difference between the neoclassical and the
endogenous growth models?
A) The neoclassical model explains the long-run growth by changes in capital and labour.
B) The neoclassical model explains the long-run growth by changes in saving rates.
C) The endogenous model explains the long-run growth by changes in capital and labour.
D) The neoclassical model takes the productivity growth as given, but the endogenous model
explains the productivity growth.
Answer: D
Diff: 2
Type: MC
Page Ref: 184
81) Assume the production function in an economy is Y = AK, where Y = output, A =
productivity, and K = capital. This means that
A) marginal productivity of capital is diminishing.
B) the marginal productivity of capital is increasing.
C) marginal productivity of capital is constant.
D) None of the above.
Answer: C
Diff: 2
Type: MC
Page Ref: 185
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82) Assume the production function in an economy is Y = AK, where Y = output, A =
productivity, and K = capital. This means that
A) the economy can grow forever.
B) the growth will come to an end because of diminishing marginal productivity.
C) the neoclassical growth model prevails.
D) the marginal product of capital depends on the size of capital stock.
Answer: A
Diff: 2
Type: MC
Page Ref: 185
83) According to the endogenous growth theory,
A) the primary source of growth is population growth.
B) the primary source of growth is capital growth.
C) the marginal productivity of capital need not decrease as capital stock increases.
D) the marginal productivity of capital decreases as capital stock increases.
Answer: C
Diff: 2
Type: MC
Page Ref: 185
84) Which of the following characterizes the endogenous growth theory?
A) The endogenous growth theory allows for government policies to impact the long-run growth.
B) The productivity growth is explained, rather than assumed.
C) The marginal productivity of capital might be constant as increase in capital leads to higher
human capital.
D) All of the above.
Answer: D
Diff: 2
Type: MC
Page Ref: 186
6.2
Essay Questions
1) In the past ten years, Patagonia's total output has increased from 2000 to 3000, the capital
stock has risen from 4000 to 5200, and the labour force has increased from 400 to 580. Suppose
aK = 0.4 and aN = 0.6.
a. How much did capital contribute to economic growth over the decade?
b. How much did labour contribute to economic growth over the decade?
c. How much did productivity contribute to economic growth over the decade?
Answer:
a. ΔaK△K/K = 0.4 (1200/4000) = 12%
b. ΔaN△N/N = 0.6(180/400) = 27%
c. ΔY/Y = 50%
ΔA/A = ΔY/Y - ΔaKΔK/K - ΔaNΔN/N = 50% - 12% - 27% - 11%
Diff: 3
Type: ES
Page Ref: Sec. 6.1
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2) From 2000 to 2001 a country's output rose from 4000 to 4500, its capital stock rose from
10,000 to 12,000, and its labour force declined from 2000 to 1750. Suppose Suppose aK = 0.3
and aN = 0.7.
a. How much did capital contribute to economic growth over the year?
b. How much did labour contribute to economic growth over the year?
c. How much did productivity contribute to economic growth over the year?
Answer:
a. ΔaKΔK/K = 0.3 (2000 / 10,000) = 6%
b. ΔaNΔN/N = 0.7 (250 / 2000) = -8.75%
c. ΔY/Y = 500/4000 = 12.5%
ΔA/A = ΔY/Y - ΔaKΔK/K - ΔaNΔN/N = 12.5% - 6% - (-8.75%) = 15.25%
Diff: 3
Type: ES
Page Ref: Sec. 6.1
3) A country has the per-worker production function yt = 5kt0.5, where yt is output per worker
and kt is the capital-labour ratio. The depreciation rate is 0.2 and the population growth rate is
0.05. The saving function is
, where St is total national saving and yt is total output.
a. What is the steady-state value of the capital-labour ratio?
b. What is the steady-state value of output per worker?
c. What is the steady-state value of consumption per worker?
Answer:
a. sf(k) = (n + d)k, so 0.2 × 5 k0.5 = 0.25 k, or k0.5 = 4, so k = 16
b. y = 5k0.5 = 20.
c. c = (1 - s)y = 0.8y = 16
Diff: 3
Type: ES
Page Ref: Sec. 6.2
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4) Suppose the aggregate production function in ADANAC is Yt = AK1/3 L2/3. Assume A is
constant and equal to 2.
a. What are the returns to scale in this production function?
b. Are there decreasing returns to labour and capital?
c. Write the aggregate production function in per worker terms.
d. Assume that saving rate is equal to 0.32, population growth 0.03, and the depreciation rate
0.05. What is the steady state level of output per worker?
e. If the saving rate decreases to 0.20, what would happen to the steady state level of output per
worker?
Answer:
a. The production function is characterized by constant returns to scale, because the capital
elasticity (1/3) and labour elasticity (2/3) add up to 1. Alternatively, if you double the levels of
capital and labour, the level of output will double: A(2K)1/3 (2L)2/3 = 2AK1/3 L2/3 = 2Y.
b. There are decreasing returns to capital and worker. Given the level of labour (capital), the
output will increase at slower rate as the level of capital (labour) increases. [You can show this
by taking the second derivatives of the production function with respect to K and L, i.e., the
slope of the marginal product of K and L, and showing that they are negative.]
c. Divide both sides by L to obtain yt = Akt1/3.
d. sf(k) = (n + d)k, so 0.32 × 2k1/3 = (0.03 + 0.05)k, or k2/3 = 8, so k = 22.63, and y = 5.66.
e. 0.2 × 2k1/3 = (0.03 + 0.05)k, or k2/3 = 5, so k = 11.18, and y = 4.47.
Diff: 3
Type: ES
Page Ref: Sec. 6.2
5) A country has the per-worker production function yt = 3kt2/3, where yt is output per worker
and kt is the capital-labour ratio. The depreciation rate is 0.1 and the population growth rate is
0.05. The saving function is St = 0.2Yt, where St is total national saving and Yt is total output.
a. What is the steady-state value of capital-labour ratio?
b. What is the steady-state value of output per worker?
c. What is the steady-state value of consumption per worker?
Answer:
a. sf(k) = (n + d)k, so 0.2 > 3k2/3 = 0.15 k; or k1/3 = 4, so k = 6.4
b. y = 3k2/3 = 48
c. c = (1 - s)y = 0.8y = 38.4.
Diff: 3
Type: ES
Page Ref: Sec. 6.2
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6) a. Draw figures showing the relationship in the Solow model between the capital-labour ratio
and (1) output per worker and steady-state investment per worker, (2) consumption per worker,
and (3) steady-state investment per worker and saving per worker
b. Show what happens to each of your figures in part (a) when each of the following changes
occur, and explain what happens to the capital-labour ratio, output per worker, and consumption
per worker.
(1) population growth rises
(2) the depreciation rate falls
(3) the saving rate rises
(4) productivity declines
Answer: a. See text Figs. 6.2 and 6.3.
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b. (1) k, y, and c all fall
(2) k, y, and c all rise
(3) k, y, and c all rise
(4) k, y, and c all fall
Diff: 1
Type: ES
Page Ref: Sec. 6.2
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7) Country A has a capital-labour ratio that is initially twice as big as that of country B, but
neither is yet in a steady state. Both countries have the same production function,
.
Country A has a 10% saving rate, 10% population growth rate, and 5% depreciation rate, while
country B has a 20% saving rate, 10% population growth rate, and 20% depreciation rate.
a. Calculate the steady-state capital- labour ratio for each country. Does the initial
capital-labour ratio affect your results?
b. Calculate output per worker and consumption per worker for each country. Which country
has the highest output per worker? The highest consumption per worker?
c. In general, do all the fundamental characteristics of different countries need to be identical
for convergence of output per worker?
Answer:
a. Using the formula sf(k) = (n + d)k, country A: 0.1 × 6 k1/2 = 0.15k, or k1/2 = 4, so k = 16;
country B: 0.2 × 6 k1/2 = 0.3k, or k1/2 = 4, so k = 16 also. The initial capital labour ratios have
no effect on the steady-state capital-labour ratios.
b. y = 6 k1/2 = 24 for both countries c = (1 - s)y, so country A has c = 0.9y = 21.6, while
country B has c = 0.8y = 19.2. The two countries have the same capital-labour ratio and output
per worker, but different consumption per worker.
c. Convergence can arise even if the fundamental characteristics of different countries are
different.
Diff: 3
Type: ES
Page Ref: Sec. 6.2
8) How would each of the following changes affect the steady-state values of the capital-labour
ratio, output per worker, and consumption per worker?
a. A change in the composition of the capital stock raises the depreciation rate.
b. A change in social norms lowers the population growth rate.
c. Government tax policies change to encourage a higher saving rate.
d. A supply shock reduces productivity sharply.
Answer:
a. The rise in d reduces the capital-labour ratio, as well as output per worker and consumption
per worker.
b. The decline in n raises the capital-labour ratio, as well as output per worker and consumption
per worker.
c. The rise in s raises the capital-labour ratio, as well as output per worker and consumption per
worker.
d. The decline in productivity shifts the production function down, reducing the capital-labour
ratio, as well as output per worker and consumption per worker.
Diff: 2
Type: ES
Page Ref: Sec. 6.2
9) What is the empirical evidence on whether or not rich and poor countries converge?
Answer: There is little evidence for unconditional convergence; indeed, in many cases, rich
countries get richer and poor countries get poorer. But there is some evidence supporting the idea
of conditional convergence, as countries with similar fundamentals seem to end up with about
the same level of output per worker.
Diff: 1
Type: ES
Page Ref: Sec. 6.2
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10) Describe the main ideas of the endogenous growth theory. What does it have to say about the
role of government in economic growth?
Answer: The endogenous growth theory explains the main sources of productivity growth:
human capital (the knowledge, skills, and training of individuals) and technological innovation
(caused by research and development programs and learning by doing). Government may play a
positive role, because policies that increase the capital-labour ratio may lead to a virtuous circle
of growth, raising living standards. Also, the government may foster education and research and
development.
Diff: 1
Type: ES
Page Ref: Sec. 6.2
11) Describe the pros and cons of industrial policy. Which type of economist is more likely to
support industrial policy, a Keynesian or a classical economist? Why?
Answer: Proponents of industrial policy claim that government help is needed to ensure
economic growth. They believe that borrowing constraints on small firms prevent them from
undertaking the optimal amount of research and development. Further, government support for
research leads to spillover effects that help other firms. But opponents of industrial policy claim
that the free market allocates scarce resources far better than government. Politicians tend to
make decisions for noneconomic reasons, so industrial policy is likely to become politicized.
Keynesians are more likely to support government intervention, so they would be most likely to
believe in industrial policy. Classical economists believe more in market efficiency.
Diff: 1
Type: ES
Page Ref: Sec. 6.3
12) What are the industrial policy and market policy? Explain how they might affect long-run
economic growth.
Answer: Industrial policy is a growth strategy by which government promotes certain
industries, usually "high-tech industries," to boost long-run economic growth. Market policy is a
growth policy that allows the market to operate freely. Industrial policy can be justified by
market failure because of borrowing constraints and spillovers from high-tech industries, but it is
subject to a danger of making wrong choices and the influence of political powers. Market policy
can be justified based on the respect for property rights and free choices of citizens, but may not
lead to an efficient outcome when the market fails because of market power (monopoly or
oligopoly) or public goods and services provisions such as environmental quality and health care.
Diff: 2
Type: ES
Page Ref: Sec. 6.3
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13) Discuss what government policies can affect long-run economic growth. Do your answers
depend on what growth model you use? Explain.
Answer: Government policies to raise long-run living standards include raising the rate of
saving and increasing productivity. Possible ways of increasing productivity involve investing in
public capital (infrastructure), encouraging the formation of human capital, and increasing
research and development. A more aggressive strategy is industrial policy, in which the
government uses subsidies and other tools to influence the pattern of industrial development and,
in particular, to stimulate high-tech industries. Critics of this approach contend that in practice,
the government cannot successfully pick and subsidize only "winning" technologies. The most
important source of productivity gains is via the effective use of market policies. Market policies
include the choice between free and regulated markets and the choice between free trade and
protectionism. The endogenous growth model includes many factors that can be influenced by
government policies in the long run, whereas the neoclassical model focuses only on
technological changes driven by the market.
Diff: 2
Type: ES
Page Ref: 189
14) What is social insurance? How does it affect the long-run economic growth in an economy?
Answer: Social insurance includes a well-designed social "safety net", which is important for
redistributing the gains from economic growth and necessary to win support for
growth-enhancing public policies in the first place. Thus, citizens may vote in favour of
growth-enhancing policies only if they are convinced that they will be "caught" by a
comprehensive social safety net should growth cause them to be disadvantaged.
Diff: 2
Type: ES
Page Ref: 192
15) What is market policy? How does it affect the long-run economic growth in an economy?
Answer: Market policy is the productivity-related policy a society and its government establish
to restrict the free operation of markets. Societies must choose between communism and
capitalism and, hence, choose whether to respect property rights. This choice is not black and
white, of course, as there are many shades of market policy between the extremes of communism
and unfettered capitalism.
Diff: 2
Type: ES
Page Ref: 191
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 7 The Asset Market, Money, and Prices
7.1 Multiple-Choice Questions
1) A system in which people trade goods they don't want to consume for goods they do want to
consume is called
A) an indirect exchange economy.
B) a commodity money system.
C) a barter system.
D) a flat money system.
Answer: C
Diff: 1 Type: MC Page Ref: 200
2) The use of money is more efficient than barter because the introduction of money
A) reduces the need for economic specialization.
B) reduces the need to exchange goods.
C) reduces the need for other stores of value.
D) reduces transaction costs.
Answer: D
Diff: 1 Type: MC Page Ref: 200
3) The following are all functions of money except
A) medium of exchange.
B) store of value.
C) source of anxiety.
D) unit of account.
Answer: C
Diff: 1 Type: MC Page Ref: 200
4) Cigarettes were used as money among the prisoners of war in the German camps at the end of
World War II because
A) cigarettes could be used as a medium of exchange.
B) cigarettes could be used as store of value.
C) cigarettes could be used as unit of accounts.
D) all of the above.
Answer: D
Diff: 1 Type: MC Page Ref: 200
5) Money's primary role in the economy comes from the benefits of lowering transaction costs
and allowing specialization. This function of money is called
A) store of value.
B) medium of exchange.
C) standard of deferred payment.
D) unit of account.
Answer: B
Diff: 1 Type: MC Page Ref: 200
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6) For something to satisfy the medium of exchange function of money, it must be
A) backed by gold.
B) readily exchangeable for other goods.
C) issued by a Central Bank.
D) an inherently valuable commodity.
Answer: B
Diff: 1 Type: MC Page Ref: 200
7) In some countries the U.S. dollar is used as a unit of account rather than the local currency.
The primary reason for this is that
A) the nation has been running a trade surplus.
B) the nation has been running a trade deficit.
C) the U.S. inflation rate is higher than the local inflation rate.
D) U.S. dollars reduce the need to change prices frequently.
Answer: D
Diff: 1 Type: MC Page Ref: 201
8) Debit card
A) is money since it can be used for purchasing goods and services.
B) is money since it shows how much money one has in her/his banking account.
C) is not money because it does not look like money.
D) is not money because it cannot be used a medium of exchange, store of value, and unit of
account.
Answer: D
Diff: 1 Type: MC Page Ref: 202
9) Why do people keep currency in their pockets when bank deposits pay interest?
A) because banks might steal your money
B) because currency is more liquid
C) because bank deposits lose value due to inflation
D) because bank deposits lose value due to changes in interest rates
Answer: B
Diff: 1 Type: MC Page Ref: 204
10) One of money's primary roles in the economy comes from the use of money to transfer
purchasing power to the future. This role of money is called
A) store of value.
B) unit of account.
C) medium of exchange.
D) standard of deferred payment.
Answer: A
Diff: 1 Type: MC Page Ref: 201
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11) Which of the following measures is the best measure of money as a medium of exchange?
A) M1
B) M2
C) M3
D) L
Answer: A
Diff: 1 Type: MC Page Ref: 202
12) Suppose your bank lowers its minimum-balance requirement on personal chequing accounts
by $500. You take $500 out of your personal chequing account and put it in a money market
mutual fund account. What is the overall effect on M1 and M2?
A) M1 falls by $500, M2 rises by $500.
B) M1 is unchanged, M2 is unchanged.
C) M1 falls by $500, M2 is unchanged.
D) M1 is unchanged, M2 rises by $500.
Answer: C
Diff: 3 Type: MC Page Ref: 202
13) Which of the following is NOT part of M1?
A) currency
B) personal chequing accounts
C) personal savings deposits
D) current accounts
Answer: C
Diff: 1 Type: MC Page Ref: 202
14) Which of the following statements about M1 and M2 is NOT true?
A) Current accounts are part of M1.
B) M2 is more liquid than M1.
C) M2 is larger than M1.
D) Savings accounts are part of M2.
Answer: B
Diff: 1 Type: MC Page Ref: 202
15) M2 includes
A) large-denomination time deposits.
B) institutional MMMFs.
C) commercial paper.
D) M1.
Answer: D
Diff: 1 Type: MC Page Ref: 202
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16) M2 does NOT include
A) Treasury bonds.
B) passbook savings accounts.
C) small-denomination time deposits.
D) M1.
Answer: A
Diff: 1 Type: MC Page Ref: 202
17) Money Market Mutual Funds (MMMFs) are similar to money because
A) they pay a high rate of interest.
B) they are as liquid as all other components of money.
C) holders can write cheques on them.
D) they cannot be liquidated except at great cost.
Answer: C
Diff: 1 Type: MC Page Ref: 202
18) Personal fixed-term savings deposits are included in M2+ rather than M1 because
A) they are available only to institutions, not to individuals.
B) they can be used as a medium of exchange, but are not as useful as the components of M1 as a
store of value.
C) they can be used as a medium of exchange, but are less useful because of restrictions on their
use for transactions.
D) they can easily be turned into cash for transaction purposes, but cannot be used directly as a
medium of exchange.
Answer: C
Diff: 1 Type: MC Page Ref: 202
19) Which of the following is NOT included in M2+?
A) money market mutual funds
B) deposits at trust and mortgage companies
C) non-personal fixed-term deposits
D) small-denomination personal fixed-term deposits
Answer: C
Diff: 1 Type: MC Page Ref: 202
20) Suppose you read in the paper that the Central Bank of Canada plans to expand the money
supply. The Central Bank is most likely to do this by
A) printing more currency and distributing it.
B) purchasing government bonds from the public.
C) selling government bonds to the public.
D) buying newly issued government bonds directly from the government itself.
Answer: B
Diff: 1 Type: MC Page Ref: 203
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21) A developing country does not have enough taxes to cover its expenditures and is unable to
borrow. This government would be most likely to cover its deficit by
A) purchasing government bonds from the public.
B) selling government bonds to the public.
C) selling newly issued government bonds directly to the Central Bank.
D) buying newly issued government bonds directly from the Central Bank.
Answer: C
Diff: 2 Type: MC Page Ref: 203
22) You are putting together a portfolio of assets. The three most important characteristics of the
assets you will choose are
A) expected return, risk, and liquidity.
B) expected return, risk, and collateral.
C) expected return, risk, and maturity.
D) expected return, liquidity, and maturity.
Answer: A
Diff: 1 Type: MC Page Ref: 204
23) Which of the following types of money is more liquid?
A) M1
B) M2+
C) M3
D) Currency
Answer: D
Diff: 1 Type: MC Page Ref: 204
24) AAA Company stock has a higher expected rate of return than ZZZ Company stock. All else
being equal, you would expect that relative to ZZZ, AAA company stock provides
A) less risk and less liquidity.
B) less risk and more liquidity.
C) more risk and less liquidity.
D) more risk and more liquidity.
Answer: C
Diff: 1 Type: MC Page Ref: 204
25) Between 1992 and 2002, Mr. Junius Morgan's real income increased from $100,000 to
$200,000. All else being equal, his real demand for money probably
A) decreased.
B) increased, but by less than the increase in real income.
C) increased proportionately to the increase in real income.
D) increased by more than the increase in real income.
Answer: B
Diff: 1 Type: MC Page Ref: 212
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26) During the past year, Lotusland saw an increase in the price level and increase in interest
rates on financial assets, but a fall in personal incomes. The overall demand for money fell.
Which of the following factors was most likely to have contributed to this fall in the demand for
money?
A) changes in the price level and in interest rates
B) changes in interest rates and personal incomes
C) changes in the price level and personal incomes
D) changes in personal incomes only
Answer: B
Diff: 2 Type: MC Page Ref: 212
27) The opportunity cost of holding currency decreases when
A) income decreases.
B) the interest rate on bonds decreases.
C) the interest rate on money decreases.
D) wealth decreases.
Answer: B
Diff: 1 Type: MC Page Ref: 212
28) An increase in the real interest rate would cause an increase in the real demand for money
A) no matter what the change in expected inflation.
B) if expected inflation fell by less than the rise in the real interest rate.
C) if expected inflation fell by the same amount as the rise in the real interest rate.
D) if expected inflation fell by more than the rise in the real interest rate.
Answer: D
Diff: 2 Type: MC Page Ref: 212
29) Higher interest rates lower the real quantity of money demanded
A) by making alternative nonmonetary assets look relatively more attractive to wealth holders.
B) by causing an increase in the issuance of corporate debt.
C) by changing the distribution of wealth toward the poor who have a lower demand for money.
D) by increasing government interest payments, which in turn increase taxes, lowering
disposable income.
Answer: A
Diff: 1 Type: MC Page Ref: 212
30) Money demand is given by Md/P = 1000 + .2Y - 1000i. Given that P = 200, Y = 2000, and
i = .10, nominal money demand is equal to
A) 1,300.
B) 1,500.
C) 260,000.
D) 300,000.
Answer: C
Diff: 2 Type: MC Page Ref: 213
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31) Mr. Pierpont has wealth of $200,000. He wants to keep at least $80,000 in bonds at all times
and will shift $10,000 into bonds from his chequing account for each percentage point that the
interest rate on bonds exceeds the interest rate on his chequing account. If the interest rate on
chequing accounts is 4% and the interest rate on bonds is 9%, how much does Mr. Pierpont keep
in his chequing account?
A) $50,000
B) $70,000
C) $130,000
D) $150,000
Answer: B
Diff: 1 Type: MC Page Ref: 213
32) Mr. Pierpont has wealth of $200,000. He wants to keep at least $80,000 in bonds at all times,
and will shift $10,000 into bonds from his chequing account for each percentage point that the
interest rate on bonds exceeds the interest rate on his chequing account. Currently he keeps
$100,000 in bonds, which pay him 7%. What is the current interest rate on chequing accounts?
A) 5%
B) 7%
C) 9%
D) 10%
Answer: A
Diff: 1 Type: MC Page Ref: 213
33) Over time, the wealth of society increases and payments technologies get more efficient.
What is the effect on money demand of these two changes?
A) Money demand rises proportionately to the rise in wealth.
B) Money demand rises, but less than proportionately to the rise in wealth.
C) The overall effect is ambiguous.
D) Money demand declines.
Answer: C
Diff: 2 Type: MC Page Ref: 213
34) If there is a financial panic and increased uncertainty about the returns in the stock market
and bond market, what is the likely effect on money demand?
A) Money demand declines first, then rises when inflation increases.
B) Money demand rises.
C) The overall effect is ambiguous.
D) Money demand declines.
Answer: B
Diff: 2 Type: MC Page Ref: 213
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35) Suppose a new law imposes a tax on all trades of bonds and stock. What is the likely effect
on money demand?
A) Money demand declines first, then rises when inflation increases.
B) Money demand rises.
C) The overall effect is ambiguous.
D) Money demand declines.
Answer: B
Diff: 2 Type: MC Page Ref: 213
36) If the income elasticity of money demand is 3/4, by what percent does money demand rise if
income rises 10%?
A) 10.00%
B) 7.50%
C) 2.50%
D) 0.75%
Answer: B
Diff: 2 Type: MC Page Ref: 213
37) If the interest elasticity of money demand is -1/4, by what percent does money demand rise if
the nominal interest rate rises from 4% to 5%?
A) 6.25%
B) 0.25%
C) -0.25%
D) -6.25%
Answer: D
Diff: 2 Type: MC Page Ref: 213
38) If the income elasticity of money demand is 3/4 and the interest elasticity of money demands
is -1/4, by what percent does money demand rise if income rises 10% and the nominal interest
rate rises from 4% to 5%?
A) 7.50%
B) 6.25%
C) 5.00%
D) 1.25%
Answer: D
Diff: 3 Type: MC Page Ref: 216
39) Which of the following is the most likely explanation for the causes behind the fall in the
demand for M1 in the 1970s?
A) Higher prices in the 1970s reduced the demand for money.
B) Government deficits increased the demand for money, draining it out of the private sector.
C) Financial innovations, such as money market mutual funds, changed the demand for narrow
definitions of money such as M1.
D) Increases in Eurodollar deposits drew money out of the banking system.
Answer: C
Diff: 2 Type: MC Page Ref: 218
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40) An introduction of ATMs (automatic teller machines), other things being constant
A) reduces interest rates since it shifts money demand leftward.
B) reduces interest rates since it shifts money demand rightward.
C) increases interest rates since it shifts money demand leftward.
D) increases interest rates since it shifts money demand rightward.
Answer: A
Diff: 2 Type: MC Page Ref: 214
41) Velocity is defined as
A) nominal money stock/nominal GDP.
B) nominal GDP/nominal money stock.
C) real money stock/real GDP.
D) E = mc2.
Answer: B
Diff: 1 Type: MC Page Ref: 217
42) If nominal GDP is $500 billion, real GDP is $250 billion, and the nominal money stock is
$100 billion, then velocity is
A) 2.
B) 2.5.
C) 5.
D) 10.
Answer: C
Diff: 1 Type: MC Page Ref: 217
43) Money demand is given by Md/P= 1000 + .2Y - 1000i. Given that P = 200, Y = 2000, and i =
.10, velocity is equal to
A) 0.65.
B) 0.75.
C) 1.33.
D) 1.54.
Answer: D
Diff: 2 Type: MC Page Ref: 217
44) Suppose velocity is 3, real output is 6000, and the price level is 20. What is the level of real
money demand in this economy?
A) 100
B) 2,000
C) 40,000
D) 120,000
Answer: B
Diff: 1 Type: MC Page Ref: 217
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45) Velocity of money is
A) the ratio of nominal money stock to nominal GDP.
B) the ratio of nominal GDP to nominal money stock.
C) the nominal money stock multiplied by the nominal GDP.
D) the ratio of nominal money stock to real GDP.
Answer: B
Diff: 1 Type: MC Page Ref: 217
46) The quantity theory of money assumes that
A) real income is constant.
B) price level is constant.
C) velocity is constant.
D) money demand is constant.
Answer: C
Diff: 2 Type: MC Page Ref: 217
47) Which of the following is true about velocity?
A) Velocity is constant.
B) M1 velocity is more stable than M2 velocity.
C) M2 velocity is more stable than M1 velocity.
D) All else equal, velocity increases as demand for money rises.
Answer: C
Diff: 2 Type: MC Page Ref: 217
48) The asset market equilibrium condition indicates that
A) the price level in an economy is determined by the ratio of money supply to the real demand
for money.
B) the price level in an economy is determined by the ratio of the real demand for money to
money supply.
C) the price level in an economy is determined by the ratio real demand for money to interest
rates.
D) the price level in an economy is determined by the ratio of money supply to real GDP.
Answer: A
Diff: 2 Type: MC Page Ref: 218
49) Which of the following is true about the asset market equilibrium?
A) The asset market is in equilibrium only if the labour market is in equilibrium.
B) The asset market is in equilibrium when the money market is in equilibrium.
C) The money market is in equilibrium only if the non-monetary asset market is in equilibrium.
D) The asset market is in equilibrium, even if the money market is not.
Answer: B
Diff: 1 Type: MC Page Ref: 218
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50) Suppose velocity is constant at 3, real output is 6000, and the price level is 20. From this
initial situation, the government increases the nominal money supply to $50,000. If velocity and
output remain unchanged, by how much will the price level increase?
A) 10%
B) 20%
C) 25%
D) 50%
Answer: C
Diff: 3 Type: MC Page Ref: 217
51) Under a situation of asset market equilibrium,
A) the quantity of money supplied equals the quantity of money demanded.
B) the quantity of money supplied equals the quantity of nonmonetary assets demanded.
C) the quantity of nonmonetary assets supplied equals the quantity of monetary assets demanded.
D) the quantity of money supplied equals the quantity of nonmonetary assets supplied.
Answer: A
Diff: 1 Type: MC Page Ref: 217
52) If the quantity of money demanded exceeds the quantity of money supplied, then
A) the quantity of nonmonetary assets demanded exceeds the quantity supplied.
B) the quantity of nonmonetary assets supplied exceeds the quantity demanded.
C) the quantity of nonmonetary assets demanded will still equal the quantity supplied, all else
being equal.
D) you can make no conclusions about the relative supply and demand of nonmonetary assets.
Answer: B
Diff: 2 Type: MC Page Ref: 217
53) Suppose the real money demand function is Md/P = 2000 + 0.2Y - 10,000 (i - im). Assume
M = 4000, P = 2.0, im = .04, πe = .03, and Y = 5000. The real interest rate that clears the asset
market is
A) 3%.
B) 6%.
C) 11%.
D) 14%.
Answer: C
Diff: 3 Type: MC Page Ref: 220
54) Suppose the real money demand function is Md/P = 2000 + 0.2Y - 10,000 (i - im). Assume
M = 5000, im = .04, πe = .03, and Y = 5000. If the price level were to increase from 2.0 to 2.5,
then the real interest rate would increase by how many percentage points?
A) 4
B) 5
C) 9
D) 14
Answer: B
Diff: 3 Type: MC Page Ref: 220
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55) Suppose the real money demand function is Md/P = 2000 + 0.2Y - 10,000 (i - im). Assume
M = 5000, P = 2.0, im = .04, and πe = .03. If Y were to increase from 4000 to 5000, then the real
interest rate would increase by how many percentage points?
A) 2
B) 4
C) 5
D) 7
Answer: A
Diff: 3 Type: MC Page Ref: 220
56) Suppose the nominal money supply is 5000 and real money demand is 2500. What is the
price level?
A) 200
B) 20
C) 2
D) 1/2
Answer: C
Diff: 1 Type: MC Page Ref: 220
57) If the nominal money supply doubles while real money demand is unchanged, what happens
to the price level?
A) The price level increases by a factor of four.
B) The price level doubles.
C) The price level is unchanged.
D) The price level falls by one-half.
Answer: B
Diff: 1 Type: MC Page Ref: 220
58) If real money demand doubles while the nominal money supply is unchanged, what happens
to the price level?
A) The price level increases by a factor of four.
B) The price level doubles.
C) The price level is unchanged.
D) The price level falls by one-half.
Answer: D
Diff: 1 Type: MC Page Ref: 220
59) If real money demand increases 5%, and real money supply remain unchanged, by about
how much does the price level change?
A) falls 5%
B) falls 50%
C) rises 50%
D) rises 5%
Answer: A
Diff: 1 Type: MC Page Ref: 220
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60) If real money demand increases 5% and real money supply increases 10%, by about how
much does the price level change?
A) falls 5%
B) unchanged
C) rises 2%
D) rises 5%
Answer: D
Diff: 1 Type: MC Page Ref: 220
61) If the income elasticity of money demand is 3/4 and income increases 8%, by about how
much does the price level change?
A) falls 6%
B) unchanged
C) rises 6%
D) rises 8%
Answer: A
Diff: 1 Type: MC Page Ref: 220
62) If the income elasticity of money demand is 3/4, income increases 8%, and real money
supply increases 10%, by about how much does the price level change?
A) falls 4%
B) unchanged
C) rises 4%
D) rises 6%
Answer: C
Diff: 1 Type: MC Page Ref: 220
63) When a government prints money to finance its expenditures, it is likely to cause
A) unemployment.
B) inflation.
C) deflation.
D) reductions in the use of barter.
Answer: B
Diff: 1 Type: MC Page Ref: 220
64) Although rapid money growth causes inflation, some countries keep increasing their money
growth. We can explain this by noting that
A) inflation in those countries is low enough to be ignored by the policymakers.
B) printing money is the only and easy way to finance the government expenditures in those
countries.
C) in rich countries inflation does not hurt the economy.
D) policymakers do not know the relationship between inflation and money growth.
Answer: B
Diff: 2 Type: MC Page Ref: 221
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65) Which of the following statements about the historical relationship between nominal interest
rates and inflation in Canada is true?
A) The nominal interest rate has always been smaller than the inflation rate.
B) The nominal interest rate has always moved with the inflation rate.
C) The nominal interest rate and the inflation rate have tended to move together, but the
movements are not perfectly matched because the real interest rate has not been constant.
D) The observed relationship is not consistent with the theory.
Answer: C
Diff: 2 Type: MC Page Ref: 223
66) Bank of Canada measures inflation expectations by
A) gathering data by means of a survey of private firms.
B) comparing two long run bonds with the nominal and the real yields to maturity.
C) looking at the past inflation rates in Canada.
D) Both A and B are correct.
Answer: D
Diff: 2 Type: MC Page Ref: 223
67) When price rises,
A) money loses its function as a medium of exchange.
B) money loses its function as a store of value.
C) money loses its function as a unit of account.
D) money keeps all its functions.
Answer: B
Diff: 2 Type: MC Page Ref: 201
68) A credit card is
A) the most liquid asset.
B) money.
C) a means of payment, but not money.
D) a store of value.
Answer: C
Diff: 2 Type: MC Page Ref: 201
69) The demand for money
A) refers to how much money people want to have.
B) is a measure of people's financial assets.
C) shows how much cash and demand deposits people want to hold.
D) is determined by the Bank of Canada.
Answer: C
Diff: 1 Type: MC Page Ref: 211
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70) The rise of electronic money will
A) increase the demand for money.
B) have no effect on the demand for money.
C) increase the interest rate.
D) decrease the demand for money.
Answer: D
Diff: 2 Type: MC Page Ref: 212
71) Income elasticity of money demand
A) is larger than the interest elasticity of money demand.
B) is smaller than the interest elasticity of money demand.
C) is the same as the interest elasticity of money demand.
D) is greater than one.
Answer: A
Diff: 2 Type: MC Page Ref: 214
72) Which of the following assets is more liquid?
A) Your car.
B) Your money in the savings account.
C) Your money in the chequing account.
D) Your stock of a company.
Answer: C
Diff: 2 Type: MC Page Ref: 204
73) One of main reasons why lenders and borrowers in the sub-prime mortgage market were
willing to exchange risky loans prior to the 2008 financial crisis in the U.S. was
A) low housing prices.
B) lack of regulations.
C) the expectations of higher housing prices.
D) willingness to own a house.
Answer: C
Diff: 2 Type: MC Page Ref: 209
74) One of the major contributing factors to the 2008 financial crisis in the U.S. was
A) low housing prices.
B) high interest rates.
C) failure of effective regulation in the financial market.
D) willingness to own a house.
Answer: C
Diff: 2 Type: MC Page Ref: 210
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75) For any real interest rate, an increase in the expected inflation
A) increases the nominal interest rate and reduces the demand for money.
B) increases the nominal interest rate and increases the demand for money.
C) decreases the nominal interest rate and reduces the demand for money.
D) decreases the nominal interest rate and increases the demand for money.
Answer: A
Diff: 2 Type: MC Page Ref: 214
76) New technology allows people to pay for their purchases using their cell phones. This
A) increases the demand for money.
B) increases the supply of money.
C) decreases the demand for money.
D) decreases the supply of money.
Answer: C
Diff: 2 Type: MC Page Ref: 215
77) When the interest rate rises from 2 percent to 3 percent, it means that
A) it has increased by 1 percent.
B) it has increased by 50 percent.
C) it has increased by 0.1 percent.
D) it has increased by 33 percent.
Answer: B
Diff: 2 Type: MC Page Ref: 216
78) Which of the following is true about the velocity of M1 and M2 in Canada?
A) M1 velocity has been less than M2 velocity.
B) M1 velocity has been greater than M2 velocity
C) M1 velocity has been increasing but M2 velocity has been decreasing.
D) The change in the M1 velocity has been smoother than the change in the M2 velocity.
Answer: B
Diff: 2 Type: MC Page Ref: 217
79) For a given value of real output, the real interest rate, and the expected inflation rate, the
economy's price level depends on
A) nominal money supply.
B) GDP.
C) real demand for money.
D) the unemployment rate.
Answer: A
Diff: 2 Type: MC Page Ref: 220
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80) Which of the following measures represent inflation expectations?
A) the current inflation rate
B) an index of GDP and unemployment rate
C) the difference between the yields paid to owners of the government of Canada's long-term
bond and the real return bond
D) government budget deficit
Answer: C
Diff: 2 Type: MC Page Ref: 224
7.2 Essay Questions
1) What happens to M1 and M2+ due to each of the following changes?
a. You take $500 out of your chequing account and put it into a passbook savings account.
b. You take $1000 out of your chequing account and put it into a current account.
c. You take $1500 out of your money-market mutual fund and deposit into your chequing
account.
d. You cash in $2000 in savings bonds and invest the money in a certificate of deposit.
Answer:
a. M1 falls $500, M2+ is unchanged (remember that M1 is part of M2+).
b. M1 and M2+ are both unchanged.
c. M1 rises $1500, M2+ is unchanged.
d. M1 is unchanged, M2+ rises $2000.
Diff: 2 Type: ES
Page Ref: Sec. 7.1
2) In each of the following cases, one factor affecting money demand changes. You must tell how
the second factor would have to change if real money demand were to remain unchanged overall.
a. Expected inflation rises; real income ________.
b. Nominal interest rate on money rises; wealth ________.
c. Risk on stocks and bonds rises; efficiency of payments technology ________.
d. Risk on money rises; real interest rate ________.
e. Liquidity of nonmonetary assets rises; expected inflation ________.
f. Wealth rises; risk on nonmonetary assets ________.
Answer:
a. rises
b. falls
c. rises
d. falls
e. falls
f. falls
Diff: 2 Type: ES
Page Ref: Sec. 7.2
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3) What happens to real money demand (rises, falls, no change) due to a change in each of the
following factors?
a. A tax on stock market transactions is introduced.
b. Computerized bond trading reduces transaction costs.
c. People's average level of wealth rises.
d. The threat of a recession increases the riskiness of stocks and bonds.
e. The interest rate paid on chequing account balances declines.
f. The price level falls in a one-time jump.
Answer:
a. rises
b. falls
c. rises
d. rises
e. falls
f. no change
Diff: 1 Type: ES
Page Ref: Sec. 7.3
4) Suppose the income elasticity of money demand is 0.75 and the interest elasticity of money
demand is -0.2. By what percentage does real money demand change in each of the following
circumstances?
a. Income rises 2%.
b. The interest rate rises from 4% to 5%.
c. Income falls 4%.
d. The interest rate falls from 6% to 4%.
e. Income rises 3% at the same time that the interest rate rises from 2% to 3%.
Answer: Use the formula %△md = ηY%△Y + ηi%△i
a. 1.5%
b. -5.0%
c. -3.0%
d. 6.7%
e. -7.75%
Diff: 2 Type: ES
Page Ref: Sec. 7.3
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5) Calculate the appropriate (income or interest) elasticity of money demand for each of the
following cases:
a. Income rises 2% while real money demand rises 1%
b. Interest rate rises from 4% to 5% while real money demand falls 1%
c. Income rises 3% and the interest rate rises from 5% to 6%, while real money demand rises
1% during one year; in another year, income falls 3.5%, the interest rate falls from 4% to 3%,
while real money demand falls 1%
Answer: Use the formula %△md = ηY%△Y + ηi%△i
a. Income elasticity of money demand = 0.5
b. Interest elasticity of money demand = 0.04
c. Solve two equations: ηY + ηi (2)
Multiply equation (1) by 5 and equation (2) by 4 to get
.05 = .15 ηY + ηi (3)
-.04 = -.14 ηY - ηi (4)
Add equations (3) and (4) together to get .01 = .01 ηY, which has the solution ηY = 1.
Plugging this back into any of equations (1) to (4) and solving gives ηi = -0.1.
Diff: 3 Type: ES
Page Ref: Sec. 7.3
6) Describe the Bank of Canada's policy of gradualism in the 1970s. What money aggregate did
they attempt to target. What led to great difficulties in their targeting? How long was this policy
followed?
Answer: The Bank of Canada began the policy of gradualism in 1975, attempting to control the
growth rate of M1 in order to slowly bring down the rate of inflation. The major difficulty they
encountered was that demand for M1 fell substantially in the late 1970s. This was due to
financial innovation, especially improved cash management for firms and more liquid interest
bearing accounts offered to households. The Bank abandoned the policy of gradualism in 1982.
Diff: 1 Type: ES
Page Ref: Sec. 7.3
7) Suppose the money demand function is Md/P = 1000 + 0.2Y - 1000i.
a. Calculate velocity if Y: 2000 and i = 0.10.
b. If the money supply (Ms) is 2600, what is the price level?
c. Now suppose the nominal interest rate rises to 0.15, but Y and Ms are unchanged. What
happens to velocity and the price level? So if the nominal interest rate were to rise from 0.10 to
0.15 over the course of a year, with Y remaining at 2000, what would the inflation rate be?
Answer:
a. V = PY / M = Y / (M/P). From the money demand function, M/P = 1300. So V = 2000/1300 =
1.54.
b. P = Ms/(Md/P) = 2600/1300 = 2.
c. Now Md/P = 1250. So V = 2000/1250 = 1.6. P = Ms/(Md/P) = 2600/1250 = 2.08. The
inflation rate would be 4%.
Diff: 3 Type: ES
Page Ref: Sec. 7.3
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8) Suppose the money demand function is given by Md/P = 640 + 0.1 Y - 5000i. Suppose the
Central Bank changes the nominal money supply depending on income and inflation:
Ms = 1000 + 0.1Y – 4000p.
a. If expected inflation equals actual inflation = 0.03, Y = 1000, and r = 0.02, calculate the price
level.
b. If inflation rises to 0.04 while the other variables remain as in part a, calculate the price level.
c. If expected inflation rises to 0.04 while the other variables remain as in part a, calculate the
price level.
d. If the real interest rate rises to 0.03 while the other variables remain as in part a, calculate the
price level.
Answer:
Plug in the value of Y and use text Eq. (7.10) to get P = [1100 - 4000π]/[740 - 5000(r + πe)].
When r = 0.02, this becomes P = [1100 - 4000π]/[640 - 5000π].
a. P = 980/490 = 2
b. P = 940/490 = 1.92
c. P = 980/440 = 2.23
d. P = 980/440 = 2.23.
Diff: 2 Type: ES
Page Ref: Sec. 7.4
9) Calculate the change in the price level for each of the following events, taken one at a time,
with other variables unchanged.
a. money supply increases 10%
b. money demand increases 5%
c. money supply decreases 5% while money demand increases 5%
d. money supply increases 15% while money demand increases 5%
Answer:
a. 10%
b. -5%
c. -10%
d. 10%
Diff: 1 Type: ES
Page Ref: Sec. 7.5
10) Why did some of the countries of Eastern Europe have inflation rates over 100%, while
others didn't? Which factor was more important in explaining the differing inflation rates, real
money demand or nominal money supply? Why did the countries with high inflation rates allow
inflation to get so high?
Answer: Some countries had high inflation while others didn't because of differences in rates of
money growth. Real money demand didn't vary enough to explain the differences in inflation
rates; instead, nominal money supply growth was strongly correlated with inflation. The
countries allowed inflation to get so high because they were trying to finance government
expenditures by printing money.
Diff: 1 Type: ES
Page Ref: Sec. 7.5
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11) Suppose that the money supply and real GDP in 2006 were $80 billion and $220 billion,
respectively. In 2007, the central bank increased money supply to $88 billion and real GDP rose
to $231 billion. Assume the income elasticity of money is 0.5.
a. What are the rates of growth in money supply and real GDP?
b. What is the inflation rate?
c. If, in 2008, the money supply level remains the same level as 2007, but real GDP grows at
another 5 percent, what will be the inflation rate in 2008?
Answer:
a. Money supply growth = 10 percent, the real GDP growth = 5 percent.
b. inflation rate (2007) = money growth - (income elasticity × economic growth) = 10 - 0.5 × 5
= 7.5 percent.
c. inflation rate = 0 - 0.5 × 5 = -2.5 percent.
Diff: 2 Type: ES
Page Ref: Sec. 7.5
12) Explain how growth in the money supply and inflation are related.
Answer: The quantity theory of money explains the relationship between the growth rate of the
money supply and inflation. Specifically, M V = P Y, where M is money, V is velocity, P is price,
and Y is real income. Given V and Y, if money grows, P will have to grow proportionally.
Diff: 2 Type: ES
Page Ref: Sec. 7.3
13) Suppose the nominal money supply in an economy is $100 billion and the real demand for
money is $85 billion.
a. What is the price level in this economy?
b. If nominal money supply increases by 2 percent, how much will the price level change?
c. If the real demand for money declines by 2 percent and nominal money remains unchanged,
how much will the price level change?
Answer: a. 117.64, b. Increases by 2.35, c. Increases by 2.35
Diff: 2 Type: ES
Page Ref: Sec. 7.4
14) Explain the main factors contributing to the 2008 financial crisis in the U.S. How did this
crisis impact the Canadian economy?
Answer: See "The U.S. Housing Crisis and its Aftermath" on page 208. A major contributing
factor was a failure of effective regulation in U.S. financial markets generally and the U.S.
mortgage market in particular. Canadian financial institutions avoided the worst of the financial
crisis because regulation of the mortgage market by the Bank of Canada and the Office of the
Superintendent of Financial Institutions (OSFI) discouraged the proliferation of sub-prime
mortgages and thereby the development of MBSs, the complex financial instruments designed to
make them more palatable to lenders.
Diff: 2 Type: ES
Page Ref: Sec. 7.2
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15) Many economic models use the expected inflation rate to explain changes in macroeconomic
variables. Yet the expected inflation rate cannot be observed directly. Explain how the expected
inflation is measured by economists.
Answer: One approach is to simply ask people what their expectations are for inflation. A
second way is to compare the nominal yields on two different types of Government of Canada
bonds: The conventional long-term bond and the real return bond. Therefore, by subtracting the
variable nominal yield on the real return bond from the fixed nominal yield on the conventional
bond, one can obtain a measure of inflation expectations.
Diff: 2 Type: ES
Page Ref: Sec. 7.5
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 8 Business Cycles
8.1 Multiple-Choice Questions
1) The low point in the business cycle is referred to as the
A) contraction.
B) recession.
C) trough.
D) depression.
Answer: C
Diff: 1
Type: MC
Page Ref: 229
2) The high point in the business cycle is referred to as the
A) expansion.
B) boom.
C) peak.
D) turning point.
Answer: C
Diff: 1
Type: MC
Page Ref: 229
3) When aggregate economic activity is increasing, the economy is said to be in
A) an expansion.
B) a contraction.
C) a peak.
D) a turning point.
Answer: A
Diff: 1
Type: MC
Page Ref: 229
4) When aggregate economic activity is declining, the economy is said to be in
A) a contraction.
B) an expansion.
C) a trough.
D) a turning point.
Answer: A
Diff: 1
Type: MC
Page Ref: 229
5) Turning points in business cycles occur when
A) a new business cycle is initiated at the trough.
B) the economy hits the peak or trough in the business cycle.
C) the business cycle begins to follow a new pattern that differs from previous business cycles.
D) a new business cycle is initiated at the peak.
Answer: B
Diff: 1
Type: MC
Page Ref: 230
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6) Research on the effects of recessions on the real level of GDP shows that
A) recessions cause only temporary reductions in real GDP, which are offset by growth during
the expansion phase.
B) recessions cause large, permanent reductions in the real level of GDP.
C) recessions cause both temporary and permanent declines in real GDP, but most of the decline
is temporary.
D) recessions cause both temporary and permanent declines in real GDP, but most of the decline
is permanent.
Answer: C
Diff: 1
Type: MC
Page Ref: 230
7) Business cycles all display the following characteristics except
A) a period of expansion followed by one of contraction.
B) co-movement of many economic variables.
C) rising prices during an expansion and falling prices during the contraction.
D) they last a period of one to twelve years.
Answer: C
Diff: 1
Type: MC
Page Ref: 230
8) The tendency of many different economic variables to have regular and predictable patterns
across industries over the business cycle is called
A) persistence.
B) comovement.
C) periodicity.
D) recurrence.
Answer: B
Diff: 1
Type: MC
Page Ref: 230
9) The fact that business cycles are periodic but not recurrent means that
A) business cycles occur at predictable intervals, but do not last a predetermined length of time.
B) the business cycle's standard contraction-trough-expansion-peak pattern has been observed to
recur over and over again, but not at predictable intervals.
C) business cycles occur at predictable intervals, but do not all follow a standard contractiontrough-expansion-peak pattern.
D) business cycles last a predetermined length of time, but do not all follow a standard
contraction-trough-expansion-peak pattern.
Answer: B
Diff: 1
Type: MC
Page Ref: 230
10) The tendency for declines in economic activity to be followed by further declines, and for
growth in economic activity to be followed by more growth is called
A) persistence.
B) comovement.
C) periodicity.
D) recurrence.
Answer: A
Diff: 1
Type: MC
Page Ref: 230
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11) The longest contraction in Canadian history occurred
A) during the 1870s.
B) in the years right before World War I began.
C) during the 1930s.
D) during the 1970s.
Answer: A
Diff: 1
Type: MC
Page Ref: 231
12) The deepest contraction in Canadian history occurred
A) during the 1870s.
B) in the years right before World War I began.
C) during the 1930s.
D) during the 1970s.
Answer: C
Diff: 1
Type: MC
Page Ref: 231
13) By 1937, when a new recession began in the midst of the Great Depression,
A) GDP had almost recovered to its 1929 level, but unemployment was still above the 1929
level.
B) unemployment had almost fallen back to its 1929 level, but GDP had yet to recover to its
1929 level.
C) neither GDP nor unemployment had returned to near their 1929 levels.
D) both GDP and unemployment had returned to near their 1929 levels.
Answer: A
Diff: 1
Type: MC
Page Ref: 231
14) The worst recessions after World War II occurred
A) during 1945-1946 and 1973-1975.
B) during 1957-1958 and 1973-1975.
C) during 1953-1954 and 1981-1982.
D) during 1945-1946 and 1981-1982.
Answer: C
Diff: 1
Type: MC
Page Ref: 231
15) The longest economic expansion in Canada occurred during the
A) 1920s.
B) 1940s.
C) 1960s.
D) 1980s.
Answer: C
Diff: 1
Type: MC
Page Ref: 231
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16) Which of the following variables is procyclical?
A) unemployment
B) nominal interest rate
C) real interest rate
D) real wage
Answer: B
Diff: 2
Type: MC
Page Ref: 233
17) An economic variable that moves in the same direction as aggregate economic activity (up in
expansions, down in contractions) is called
A) procyclical.
B) countercyclical.
C) acyclical.
D) a leading variable.
Answer: A
Diff: 1
Type: MC
Page Ref: 233
18) An economic variable that moves in the opposite direction as aggregate economic activity
(down in expansions, up in contractions) is called
A) procyclical.
B) countercyclical.
C) acyclical.
D) a leading variable.
Answer: B
Diff: 1
Type: MC
Page Ref: 233
19) An economic variable that doesn't move in a consistent pattern with aggregate economic
activity is called
A) procyclical.
B) countercyclical
C) acyclical.
D) a leading variable.
Answer: C
Diff: 1
Type: MC
Page Ref: 233
20) A variable that tends to move in advance of aggregate economic activity is called
A) a leading variable.
B) a coincident variable.
C) a lagging variable.
D) an acyclical variable.
Answer: A
Diff: 1
Type: MC
Page Ref: 233
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21) A variable that tends to move at the same time as aggregate economic activity is called
A) a leading variable.
B) a coincident variable.
C) a lagging variable.
D) an acyclical variable.
Answer: B
Diff: 1
Type: MC
Page Ref: 233
22) A variable that tends to move later than aggregate economic activity is called
A) a leading variable.
B) a coincident variable.
C) a lagging variable.
D) an acyclical variable.
Answer: C
Diff: 1
Type: MC
Page Ref: 233
23) Which of the following macroeconomic variables is procyclical and coincident with the
business cycle?
A) residential investment
B) nominal interest rates
C) industrial production
D) unemployment
Answer: C
Diff: 2
Type: MC
Page Ref: 234
24) Which of the following macroeconomic variables is procyclical and leads the business cycle?
A) business fixed investment
B) the money supply
C) nominal interest rates
D) unemployment
Answer: B
Diff: 2
Type: MC
Page Ref: 234
25) Which of the following macroeconomic variables is countercyclical?
A) real interest rates
B) unemployment
C) the money supply
D) consumption
Answer: B
Diff: 1
Type: MC
Page Ref: 234
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26) Which of the following macroeconomic variables is procyclical and lags the business cycle?
A) business fixed investment
B) employment
C) stock prices
D) nominal interest rates
Answer: D
Diff: 2
Type: MC
Page Ref: 234
27) Industries that are extremely sensitive to the business cycle are the
A) durable goods and service sectors.
B) nondurable goods and service sectors.
C) capital goods and nondurable goods sectors.
D) capital goods and durable goods sectors.
Answer: D
Diff: 1
Type: MC
Page Ref: 234
28) You want to invest in a firm whose profits show small fluctuations throughout the business
cycle. Which of the following would you invest in?
A) a corporation that depended heavily on business fixed investment
B) a corporation that depended heavily on residential investment
C) a corporation that depended heavily on consumer nondurables
D) a corporation that depended heavily on consumer durables
Answer: C
Diff: 1
Type: MC
Page Ref: 234
29) Inventory investment displays business cycle patterns that differ from other forms of
expenditure because
A) inventory investment is countercyclical, but expenditures are generally procyclical.
B) inventory investment is procyclical, but expenditures are generally coincident with the
business cycle.
C) inventory investment displays large fluctuations that are not associated with business cycle
peaks and troughs.
D) inventory investment lags the business cycle, but expenditures generally lead the business
cycle.
Answer: C
Diff: 2
Type: MC
Page Ref: 241
30) Which of the following is true?
A) Employment and unemployment are both coincident with the business cycle.
B) Employment and unemployment are both procyclical.
C) Employment is procyclical and unemployment is coincident with the business cycle.
D) Employment is procyclical and unemployment is countercyclical.
Answer: D
Diff: 1
Type: MC
Page Ref: 241
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31) Some economists contend that the economywide average real wage may NOT be a good
indicator of the real wage because
A) when previously unemployed workers enter the work force, the average real wage could
decline even if all workers' wages have increased.
B) it fails to reflect productivity changes.
C) it fails to reflect qualitative changes in goods.
D) data used to calculate the average real wage is not collected from all sectors of the economy.
Answer: A
Diff: 1
Type: MC
Page Ref: 241
32) Using the seasonal business cycle as your guide, during which quarter would you be most
likely to expect a drop in your corporation's sales?
A) the first quarter of the year (January-March)
B) the second quarter of the year (April-June)
C) the third quarter of the year (July-September)
D) the fourth quarter of the year (October-December)
Answer: A
Diff: 1
Type: MC
Page Ref: 241
33) Which of the following macroeconomic variables is NOT seasonally procyclical?
A) the nominal money stock
B) average labour productivity
C) the unemployment rate
D) government spending
Answer: C
Diff: 2
Type: MC
Page Ref: 234
34) Which of the following macroeconomic variables doesn't vary much over the seasons?
A) the nominal money stock
B) the unemployment rate
C) the real wage
D) average labour productivity
Answer: C
Diff: 2
Type: MC
Page Ref: 234
35) Which of the following statements is true?
A) Both nominal and real interest rates are procyclical and leading.
B) Both nominal and real interest rates are procyclical and lagging.
C) Nominal interest rates are procyclical and real interest rates are countercyclical.
D) Nominal interest rates are procyclical and real interest rates are acyclical.
Answer: D
Diff: 1
Type: MC
Page Ref: 234
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36) What are the two main components of business cycle theories?
A) a description of shocks and a model of how the economy responds to them
B) a model of how people decide to spend and a description of the government's role in the
economy
C) a model of how equilibrium is reached and a description of the government's role
D) a description of shocks and a description of the government's role in the economy
Answer: A
Diff: 1
Type: MC
Page Ref: 234
37) Economists use the term shocks to mean
A) unexpected government actions that affect the economy.
B) typically unpredictable forces that have major impacts on the economy.
C) sudden rises in oil prices.
D) the business cycle.
Answer: B
Diff: 1
Type: MC
Page Ref: 241
38) Wars, new inventions, harvest failures, and changes in government policy are examples of
A) the business cycle.
B) economic models.
C) shocks.
D) opportunity costs.
Answer: C
Diff: 1
Type: MC
Page Ref: 241
39) Which of the following statements is NOT true about the Canadian business cycle?
A) In the early 20th century, there were almost as many months of contraction as months of
expansion.
B) From 1945 to 2001, the number of months of expansion outnumbered the months of
contraction by more than five to one.
C) The worst economic contraction in the history of Canada was the Great Recession of 2008.
D) Strong economic recoveries were associated with World War I and World War II.
Answer: C
Diff: 1
Type: MC
Page Ref: 230
40) Which of the following best describes the Canadian index of leading indicators?
A) The index heavily relies on the Toronto Stock Exchange 300.
B) The index's components are not sensitive to business cycles.
C) It provides information on the exact timing and the severity of future recessions.
D) The index is a weighted average of 10 economic variables that lead the business cycles in
Canada.
Answer: D
Diff: 1
Type: MC
Page Ref: 230
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41) Which of the following statements is true?
A) Financial variables are procyclical, but real variables are countercyclical.
B) The nominal interest rate is procyclical and lagging, but the real interest rate is acyclical.
C) Average labour productivity is acyclical, but the real wage is procyclical.
D) Both exports and imports are procyclical.
Answer: B
Diff: 2
Type: MC
Page Ref: 241
42) The two deepest recessions in Canada's history occurred in
A) 2000 and 2008.
B) 1981 and 1991.
C) 1961 and 1981.
D) 1920 and 1929.
Answer: D
Diff: 1
Type: MC
Page Ref: 230
43) Which of the following is true about the business cycles in Canada?
A) The largest contractions were experienced in 1920 and 1929.
B) The economy grew strongly after World War II.
C) The 1991 recession was longer but shallower than the 1981 recession.
D) All of the above.
Answer: D
Diff: 1
Type: MC
Page Ref: 231
44) One of the reasons for less volatility in the economy is
A) better monetary policy.
B) increasing financial market activities.
C) higher productivity.
D) advances in technology.
Answer: A
Diff: 2
Type: MC
Page Ref: 232
45) Which of the following sectors respond strongly to the business cycles?
A) food products
B) clothing products
C) education services
D) computer products
Answer: D
Diff: 2
Type: MC
Page Ref: 233
46) Which of the following activities is less sensitive to the business cycles?
A) car manufacturing
B) computer industry
C) insurance services
D) building material
Answer: C
Diff: 2
Type: MC
Page Ref: 233
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47) Which of the following is true about the business cycles?
A) Production and expenditures are procyclical.
B) Employment is procyclical, but unemployment is countercyclical.
C) Inflation and money growth are procyclical.
D) All of the above.
Answer: D
Diff: 2
Type: MC
Page Ref: 233
48) Which of the following is NOT true about the business cycles?
A) Nominal interest rates are procyclical and lagging.
B) Real interest rates are countercyclical and leading.
C) Stock prices are procyclical and leading.
D) Inflation is procyclical and lagging.
Answer: B
Diff: 2
Type: MC
Page Ref: 234
8.2 Essay Questions
1) Describe the major features of the business cycle. Be sure to discuss what variables are
affected by the cycle, a description of the key features that are apparent in the data, how
variables are related to one another, how regular the cycle is, and how predictable the cycle is.
Answer: The business cycle is defined as a fluctuation of aggregate economic activity. There are
recurrent but not periodic movements of aggregate activity, with many variables moving in the
same direction at the same time (comovement). Increases in aggregate economic activity are
expansions, while reductions in aggregate economic activity are contractions, or recessions. Both
expansions and contractions exhibit persistence, so once an expansion or contraction begins, it
tends to last some time.
Diff: 1
Type: ES
Page Ref: Sec. 8.1
2) When a recession occurs, do economists expect it to be a temporary phenomenon? Or is there
some degree of permanence? What is the empirical evidence?
Answer: Recent research suggests that recessions may contain permanent components. Some
economists argue that only the 1981-1982 recession led to a permanent change in the Canadian
economy. Other studies suggest that perhaps 70% of changes in real output are permanent and
30% are temporary for postwar Canada.
Diff: 1
Type: ES
Page Ref: Sec. 8.1
3) How has the severity and duration of business cycles changed over time in Canada?
Answer: Though it is a controversial subject, it appears that business cycles have become less
severe over time. Recessions have certainly been shorter since World War II than they were
before 1929. There is some disagreement about how severe they were before 1929, with
Christina Romer arguing that measurement problems in the old data misled economists about
how severe those recessions were. But others find that the old data is just about right and
conclude that the business cycle is much less severe today.
Diff: 1
Type: ES
Page Ref: Sec. 8.2
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4) What are some of the problems with using the leading indicators to forecast recessions? If you
were a policymaker, would you rely on them?
Answer: Although the leading indicators seem to be useful for forecasting the future state of the
economy, there are a number of problems in using them. First, the data is usually revised,
sometimes substantially, so a signal from the leading indicators may be reversed later. Second,
they sometimes give incorrect signals. Third, they don't provide much information on the
severity or exact timing of the coming recession. Finally, structural changes in the economy
mean the set of indicators must be revised periodically. Policymakers should use the leading
indicators as additional information, but should not rely on them alone.
Diff: 1
Type: ES
Page Ref: Sec. 8.3
5) For each outcome below, tell what type of shift must have taken place in either the aggregate
demand curve or the long-run aggregate supply curve.
a. In the short run, the price level is unchanged and output rises.
b. In the long run, the price level declines and output is unchanged.
c. In the long run, the price level rises and output declines.
Answer:
a. The aggregate demand curve shifts to the right.
b. The aggregate demand curve shifts to the left.
c. The long-run aggregate supply curve shifts to the left.
Diff: 2
Type: ES
Page Ref: Sec. 8.4
6) Describe briefly what are the major differences between the classical economists and the
Keynesian economists with regard to causes of business cycles, long-run adjustments to shock,
and the government policies in restoring the full employment.
Answer: The classical economists argue that the major causes of business cycles are the supply
shocks, and that the economy reaches its long-run equilibrium rapidly, because prices adjust
quickly. Therefore, they see little role for government policies to fight recessions. The Keynesian
economists, however, argue that aggregate demand shocks are able to affect output and price
levels in the short run and that it takes a long time for the economy to return to full employment
equilibrium. Therefore, they see an important role for government policies to restore the long-run
equilibrium.
Diff: 2
Type: ES
Page Ref: Sec. 8.4
7) Explain the index of leading indicators, its applications, and its potential problems.
Answer: The index of leading indicators is a weighted average of important economic variables
that lead the business cycles. It is used to forecast recessions and to design a proper response by
policymakers. However, the index does not provide much information about the exact timing of
the recession and its severity. The index is also subject to regular revisions, which might lead to
economists changing the forecast when new data become available. Furthermore, because some
of the components of the index are cyclically sensitive, it may also produce wrong signals.
Finally, the index is sensitive to changes in the structure of the economy, so it may give a wrong
warning because some variables may become better predictors of the economy and others
become worse.
Diff: 2
Type: ES
Page Ref: Sec. 8.3
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8) List five macroeconomic variables which are procyclical and indicate whether they are
leading, lagging, or coincident variables.
Answer: Production (coincident), consumption (coincident), imports (leading), exports
(coincident), employment (coincident).
Diff: 2
Type: ES
Page Ref: 233
9) Explain why durable goods are more sensitive than semi- and non-durable goods to the
business cycles.
Answer: Durable goods are considered as investment in fixed capital, which expands strongly
during booms and contracts rapidly during recessions.
Diff: 2
Type: ES
Page Ref: 234
10) Explain how nominal money growth varies across the business cycles and why it is volatile.
Answer: Money growth is procyclical and a leading indicator. It responds to economic
conditions but is also a policy instrument used by the Bank of Canada to influence the economy.
Diff: 2
Type: ES
Page Ref: 239
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 9 The IS-LM-FE Model: A General Framework for Macroeconomic Analysis
9.1 Multiple-Choice Questions
1) The FE line shows the level of output at which the ________ market is in equilibrium.
A) goods
B) asset
C) labour
D) money
Answer: C
Diff: 1
Type: MC
Page Ref: 245
2) The FE line is vertical because the level of output at full employment doesn't depend on the
A) real wage rate.
B) level of employment.
C) marginal product of labour.
D) real interest rate.
Answer: D
Diff: 1
Type: MC
Page Ref: 245
3) A temporary supply shock, such as a bumper crop, would
A) shift the FE line to the right and leave the IS curve unchanged.
B) shift the FE line to the left and shift the IS curve up.
C) shift the FE line to the left and leave the IS curve unchanged.
D) have no effect on the FE line.
Answer: A
Diff: 2
Type: MC
Page Ref: 246
4) Which of the following would shift the FE line to the left?
A) a beneficial supply shock
B) a decrease in labour supply
C) an increase in the capital stock
D) a decrease in the future marginal productivity of capital
Answer: B
Diff: 1
Type: MC
Page Ref: 246
5) Which of the following would shift the FE line to the right?
A) an adverse supply shock
B) a decrease in labour supply
C) an increase in the capital stock
D) an increase in the future marginal productivity of capital
Answer: C
Diff: 1
Type: MC
Page Ref: 246
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6) Classical economists argue that an increase in government expenditures will
A) shift FE line to right increasing full-employment output.
B) shift FE line to left decreasing full-employment output.
C) shift FE line to right increasing interest rate.
D) shift FE line to right decreasing labour supply.
Answer: A
Diff: 2
Type: MC
Page Ref: 246
7) A tax cut on capital will
A) shift the IS curve down and to the left.
B) shift the LM curve up and to the right.
C) shift the IS curve up and to the right.
D) shift the LM curve down and to the left.
Answer: C
Diff: 2
Type: MC
Page Ref: 247
8) The IS curve shows the combinations of output and the real interest rate for which
A) the goods market is in equilibrium.
B) the labour market is in equilibrium.
C) the financial asset market is in equilibrium.
D) an increase in output will cause the market-clearing interest rate to be bid up.
Answer: A
Diff: 1
Type: MC
Page Ref: 251
9) Which of the following will shift IS curve down and to the left?
A) an increase in expected future output
B) a decrease in expected future marginal product of capital
C) a fall in taxes
D) an increase in wealth
Answer: B
Diff: 2
Type: MC
Page Ref: 251
10) Any change that reduces desired saving relative to desired investment (for a given level of
output) causes the real interest rate to ________ and shifts the IS curve ________.
A) increase; down
B) increase; up
C) decrease; down
D) decrease; up
Answer: B
Diff: 2
Type: MC
Page Ref: 251
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11) A temporary increase in government purchases causes the real interest rate to ________ and
output to ________.
A) rise; rise
B) rise; fall
C) fall; rise
D) rise; remain unchanged
Answer: D
Diff: 2
Type: MC
Page Ref: 256
12) A temporary supply shock, such as an increase in oil prices, would
A) shift the IS curve down and leave the FE line unchanged.
B) shift the IS curve down and shift the FE line to the left.
C) shift the IS curve up but leave the FE line unchanged.
D) have no effect on the IS curve.
Answer: D
Diff: 2
Type: MC
Page Ref: 256
13) The IS curve would unambiguously shift up if there were
A) an increase in both government purchases and corporate taxes.
B) an increase in both government purchases and the expected future marginal product of capital.
C) an increase in the expected future marginal product of capital and a decrease in expected
future output.
D) a decrease in both corporate taxes and the expected future marginal product of capital.
Answer: B
Diff: 2
Type: MC
Page Ref: 259
14) A rise in expected future output that doesn't affect labour supply would shift the IS curve
________ and the FE line ________.
A) down; is unchanged
B) down; right
C) up; is unchanged
D) up; right
Answer: C
Diff: 1
Type: MC
Page Ref: 259
15) A decline in wealth that doesn't affect labour supply would shift the IS curve ________ and
the FE line ________.
A) down; is unchanged
B) down; left
C) up; is unchanged
D) up; left
Answer: A
Diff: 1
Type: MC
Page Ref: 259
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16) Which of the following would shift the LM curve up?
A) an increase in consumer spending
B) an increases in taxes
C) a decrease in supply of money
D) a decrease in taxes
Answer: C
Diff: 1
Type: MC
Page Ref: 256
17) Because of a widespread fraud, people have decided not to use their debit card for their
purchases anymore. This will cause
A) the LM curve to shift down and to the right.
B) the LM curve to shift up and to the left.
C) the IS curve to shift down and to the right.
D) the IS curve to shift up and to the left.
Answer: B
Diff: 2
Type: MC
Page Ref: 259
18) A temporary decline in government purchases would shift the IS curve ________ and the LM
curve ________.
A) down; is unchanged
B) down; left
C) up; is unchanged
D) up; left
Answer: A
Diff: 1
Type: MC
Page Ref: 259
19) A decrease in the effective tax rate on capital would shift the IS curve ________ and the LM
curve ________.
A) down; is unchanged
B) down; left
C) up; is unchanged
D) up; left
Answer: C
Diff: 1
Type: MC
Page Ref: 259
20) A rise in the price of a bond causes the yield of the bond to
A) rise.
B) fall.
C) remain unchanged.
D) rise if it's a short-term bond and fall if it's a long-term bond.
Answer: B
Diff: 1
Type: MC
Page Ref: 260
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21) Suppose Bank of Canada sells government bonds to the banks and public. This will cause
A) the LM curve to shift up.
B) the IS curve to shift up.
C) the LM curve to shift down.
D) the IS curve to shift down.
Answer: A
Diff: 1
Type: MC
Page Ref: 260
22) An expansionary fiscal policy will lead to
A) an increase in output and an increase in the interest rate.
B) an increase in output and a decrease in the interest rate.
C) a decrease in output and an increase in the interest rate.
D) a decrease in output and a decrease in the interest rate.
Answer: A
Diff: 1
Type: MC
Page Ref: 264
23) A contractionary monetary policy combined with an expansionary fiscal policy will lead to
A) an increase in output and an ambiguous effect on the interest rate.
B) an increase in output and an increase in the interest rate.
C) an ambiguous effect on output and an increase in the interest rate.
D) an ambiguous effect on output and an ambiguous effect on the interest rate.
Answer: C
Diff: 1
Type: MC
Page Ref: 264
24) A fall in the price of a bond causes the yield of the bond to
A) rise.
B) fall.
C) remain unchanged.
D) rise if it's a short-term bond and fall if it's a long-term bond.
Answer: A
Diff: 1
Type: MC
Page Ref: 263
25) Looking only at the asset market, an increase in output would cause
A) the LM curve to shift down.
B) the LM curve to shift up.
C) an increase in real interest rates along the LM curve.
D) a decrease in real interest rates along the LM curve.
Answer: C
Diff: 1
Type: MC
Page Ref: 263
26) A change that increases the real money supply relative to real money demand causes
A) the LM curve to shift down.
B) the LM curve to shift up.
C) the IS curve to shift down.
D) the IS curve to shift up.
Answer: A
Diff: 1
Type: MC
Page Ref: 264
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27) A change that increases real money demand relative to the real money supply causes
A) the LM curve to shift down.
B) the LM curve to shift up.
C) the IS curve to shift down.
D) the IS curve to shift up.
Answer: B
Diff: 1
Type: MC
Page Ref: 264
28) You have just read that the Bank of Canada has increased the money supply to avoid a
recession. For a given price level, you would expect the LM curve to
A) shift up as the real money supply falls.
B) shift up as the real money supply rises.
C) shift down as the real money supply falls.
D) shift down as the real money supply rises.
Answer: D
Diff: 2
Type: MC
Page Ref: 264
29) Looking at the macroeconomic statistics for Friedmanland, you discover that at the
beginning of the year, the national money supply was equal to $400 million and by the end of the
year it was equal to $420 million. You also found out that the inflation rate in Friedmanland was
7%. In this case, you would expect the LM curve to
A) shift up as the real money supply falls.
B) shift up as the real money supply rises.
C) shift down as the real money supply falls.
D) shift down as the real money supply rises.
Answer: A
Diff: 2
Type: MC
Page Ref: 264
30) Banks decide to raise the interest rate they pay on chequing accounts from 4.75% to 5.25%.
This action would
A) increase money demand, shifting the LM curve up.
B) increase money demand, shifting the LM curve down.
C) decrease money demand, shifting the LM curve up.
D) decrease money demand, shifting the LM curve down.
Answer: A
Diff: 2
Type: MC
Page Ref: 266
31) A financial innovation, such as money market mutual funds, which increases the liquidity of
alternatives to money, would
A) increase money demand, shifting the LM curve up.
B) increase money demand, shifting the LM curve down.
C) decrease money demand, shifting the LM curve up.
D) decrease money demand, shifting the LM curve down.
Answer: D
Diff: 2
Type: MC
Page Ref: 266
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32) The Bank of Canada has announced that it plans to lower the rate of monetary growth from
10% per year to 2% per year. You would expect this announcement to directly
A) increase money demand, shifting the LM curve up.
B) increase money demand, shifting the LM curve down.
C) decrease money demand, shifting the LM curve up.
D) decrease money demand, shifting the LM curve down.
Answer: A
Diff: 2
Type: MC
Page Ref: 266
33) The probable effect of introducing automatic teller machines is to
A) increase money demand, shifting the LM curve up.
B) increase money demand, shifting the LM curve down.
C) decrease money demand, shifting the LM curve up.
D) decrease money demand, shifting the LM curve down.
Answer: D
Diff: 2
Type: MC
Page Ref: 266
34) People have reduced their expectations of inflation from 5% to 3%, directly causing
A) a relative increase in real money demand, shifting the LM curve up.
B) a relative decrease in real money demand, shifting the LM curve down.
C) a relative increase in real money demand, shifting the LM curve down.
D) a relative decrease in real money demand, shifting the LM curve up.
Answer: A
Diff: 2
Type: MC
Page Ref: 266
35) People have increased their expectations of inflation from 3% to 5%, directly causing
A) a relative increase in real money demand, shifting the LM curve up.
B) a relative decrease in real money demand, shifting the LM curve down.
C) a relative increase in real money demand, shifting the LM curve down.
D) a relative decrease in real money demand, shifting the LM curve up.
Answer: B
Diff: 2
Type: MC
Page Ref: 266
36) When all markets in the economy are simultaneously in equilibrium, we say
A) markets are complete.
B) markets are perfect.
C) there is disequilibrium.
D) there is general equilibrium.
Answer: D
Diff: 1
Type: MC
Page Ref: 267
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37) To reach general equilibrium, the price level adjusts to shift the ________ until it intersects
with the ________.
A) IS curve; FE line and LM curve
B) FE line; LM and IS curves
C) LM curve; FE line and IS curve
D) ND curve; FE line and NS curve
Answer: C
Diff: 1
Type: MC
Page Ref: 267
38) What adjusts to restore general equilibrium after a shock to the economy?
A) the LM curve
B) the IS curve
C) the FE line
D) the labour supply curve
Answer: A
Diff: 1
Type: MC
Page Ref: 267
39) The IS-LM model predicts that a temporary adverse supply shock
A) reduces output, national saving, and investment, but not the real interest rate.
B) reduces output, national saving, and the real interest rate, but not investment.
C) reduces the real interest rate, investment, and output, but not national saving.
D) reduces output, national saving, investment, and the real interest rate.
Answer: A
Diff: 2
Type: MC
Page Ref: 268
40) You have just read that Australia has suffered a drought, destroying its wheat crop for this
year. The effect of this adverse supply shock on Australia would probably be
A) an increase in prices and an increase in real interest rates.
B) an increase in prices, an increase in nominal interest rates, but a decrease in real interest rates.
C) a decrease in prices and a decrease in real interest rates.
D) a decrease in prices, a decrease in nominal interest rates, but an increase in real interest rates.
Answer: A
Diff: 2
Type: MC
Page Ref: 268
41) A temporary adverse supply shock directly causes
A) a downward shift of the IS curve.
B) a shift to the left of the FE line.
C) a downward shift of the LM curve.
D) an upward shift of the IS curve.
Answer: B
Diff: 1
Type: MC
Page Ref: 268
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42) After a temporary adverse supply shock hits the economy, general equilibrium is restored by
A) a downward shift of the IS curve.
B) a shift to the left of the FE line.
C) an upward shift of the LM curve.
D) a downward shift of the LM curve.
Answer: C
Diff: 1
Type: MC
Page Ref: 268
43) An adverse supply shock to the economy would
A) decrease investment and raise the real interest rate whether the shock were temporary or
permanent.
B) decrease investment, but might not raise the real interest rate if the shock were permanent.
C) decrease investment, but might not raise the real interest rate if the shock were temporary.
D) decrease investment, but definitely not raise the real interest rate.
Answer: B
Diff: 2
Type: MC
Page Ref: 268
44) An adverse supply shock that is permanent shifts which curve in addition to the curves
shifted by one that is temporary?
A) the LM curve
B) the IS curve
C) the FE line
D) the labour demand curve
Answer: B
Diff: 1
Type: MC
Page Ref: 268
45) Which market adjusts the most quickly in response to shocks to the economy?
A) the asset market
B) the labour market
C) the goods market
D) The asset, labour, and goods markets adjust at about the same speed to eliminate a
disequilibrium in the macroeconomy.
Answer: A
Diff: 1
Type: MC
Page Ref: 268
46) An increase in money supply causes the real interest rate to ________ and output to
________ in the short run, before prices adjust to restore equilibrium.
A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall
Answer: C
Diff: 2
Type: MC
Page Ref: 268
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47) A temporary decrease in government purchases causes the real interest rate to ________ and
output to ________ in the short run, before prices adjust to restore equilibrium.
A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall
Answer: D
Diff: 2
Type: MC
Page Ref: 268
48) An increase in money demand causes the real interest rate to ________ and output to
________ in the short run, before prices adjust to restore equilibrium.
A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall
Answer: B
Diff: 2
Type: MC
Page Ref: 268
49) A decrease in taxes (when Ricardian equivalence doesn't hold) causes the real interest rate to
________ and output to ________ in the short run, before prices adjust to restore equilibrium.
A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall
Answer: A
Diff: 2 Type: MC
Page Ref: 270
50) An increase in expected inflation causes the real interest rate to ________ and output to
________ in the short run, before prices adjust to restore equilibrium.
A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall
Answer: C
Diff: 2
Type: MC
Page Ref: 269
51) Suppose the intersection of the IS and LM curves is to the right of the FE line. An increase in
the price level would most likely eliminate a disequilibrium among the asset, labour, and goods
markets by
A) shifting the LM curve up.
B) shifting the IS curve up.
C) shifting the IS curve down.
D) shifting the FE curve to the left.
Answer: A
Diff: 1
Type: MC
Page Ref: 269
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52) Suppose the intersection of the IS and LM curves is to the left of the FE line. What would
most likely eliminate a disequilibrium among the asset, labour, and goods markets?
A) a rise in the price level, shifting the LM curve up
B) a fall in the price level, shifting the LM curve down
C) a rise in the price level, shifting the IS curve up
D) a fall in the price level, shifting the IS curve down
Answer: B
Diff: 2
Type: MC
Page Ref: 269
53) Suppose the intersection of the IS and LM curves is to the right of the FE line. What would
most likely eliminate a disequilibrium among the asset, labour, and goods markets?
A) a rise in the price level, shifting the LM curve up
B) a fall in the price level, shifting the LM curve down
C) a rise in the price level, shifting the IS curve up
D) a fall in the price level, shifting the IS curve down
Answer: A
Diff: 2
Type: MC
Page Ref: 269
54) Classical economists think general equilibrium is attained relatively quickly because
A) the real interest rate adjusts quickly.
B) the level of output adjusts quickly.
C) the real wage rate adjusts quickly.
D) the price level adjusts quickly.
Answer: D
Diff: 1
Type: MC
Page Ref: 270
55) Keynesian economists think general equilibrium is not attained quickly because
A) the real interest rate adjusts slowly.
B) the level of output adjusts slowly.
C) the real wage rate adjusts slowly.
D) the price level adjusts slowly.
Answer: D
Diff: 1
Type: MC
Page Ref: 270
56) Which of the following best describes the classical and the Keynesian views on the monetary
neutrality?
A) Classical economists believe that money is neutral, but Keynesians do not.
B) Both classical and Keynesian economists believe in monetary neutrality, but they differ in the
speed of price adjustment.
C) Classical economists believe in slow adjustment of prices, but Keynesians argue that price
adjustment does not take long.
D) Keynesians believe that money affects employment and output in short run and long run, but
classical economists argue that money is neutral only in the long run.
Answer: B
Diff: 3
Type: MC
Page Ref: 270
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57) Under an assumption of monetary neutrality, a change in the nominal money supply has
A) no effect on the price level.
B) a less than proportionate effect on the price level.
C) a proportionate effect on the price level.
D) a more than proportionate effect on the price level.
Answer: C
Diff: 1
Type: MC
Page Ref: 272
58) Keynesian economists believe that in the short run,
A) money neutrality exists and prices adjust rapidly.
B) money neutrality does not exist and prices adjust rapidly.
C) money neutrality exists and prices do not adjust rapidly.
D) money neutrality does not exist and prices do not adjust rapidly.
Answer: D
Diff: 1
Type: MC
Page Ref: 272
59) Classical economists believe that in the short run,
A) money neutrality exists and prices adjust rapidly.
B) money neutrality does not exist and prices adjust rapidly.
C) money neutrality exists and prices do not adjust rapidly.
D) money neutrality does not exist and prices do not adjust rapidly.
Answer: A
Diff: 1
Type: MC
Page Ref: 272
60) The aggregate demand curve shows
A) the demand for goods depending on the relative price of goods compared to financial assets.
B) the amount of output that can be obtained given the current production function in the
economy.
C) the relation between the aggregate quantity of goods demanded and the price level.
D) the relation between the real interest rate and output when the goods market clears.
Answer: C
Diff: 1
Type: MC
Page Ref: 273
61) The aggregate demand curve shows the combinations of output and the price level that put
the economy on
A) the FE line and the IS curve.
B) the FE line, the IS curve, and the LM curve.
C) the IS curve.
D) the IS curve and the LM curve.
Answer: D
Diff: 1
Type: MC
Page Ref: 273
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62) The aggregate demand curve
A) is vertical.
B) slopes upward.
C) is horizontal.
D) slopes downward.
Answer: D
Diff: 1
Type: MC
Page Ref: 272
63) Which of the following changes shifts the AD curve to the right?
A) a temporary decrease in government purchases
B) a decline in the nominal money supply
C) an increase in corporate taxes
D) an increase in consumer confidence
Answer: D
Diff: 2
Type: MC
Page Ref: 273
64) Which of the following changes shifts the AD curve to the left?
A) a decline in the nominal money supply
B) a decrease in income taxes
C) a decrease in the risk on nonmonetary assets
D) an increase in the future marginal productivity of capital
Answer: A
Diff: 2
Type: MC
Page Ref: 273
65) When the money supply declines by 10%, in the short run, output ________ and the price
level ________.
A) is unchanged; is unchanged
B) declines; falls
C) is unchanged; falls
D) declines; is unchanged
Answer: D
Diff: 2
Type: MC
Page Ref: 273
66) When the money supply declines by 10%, in the long run, output ________ and the price
level ________.
A) is unchanged: is unchanged
B) declines: falls
C) is unchanged; falls
D) declines; is unchanged
Answer: C
Diff: 2
Type: MC
Page Ref: 273
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67) The aggregate demand curve slopes downward because
A) people tend to substitute cheaper goods with more expensive goods.
B) the SRAS curve is horizontal.
C) an increase in the price level reduces the aggregate quantity of goods demanded.
D) the LRAS curve is vertical.
Answer: C
Diff: 2
Type: MC
Page Ref: 273
68) The IS-LM model
A) represents both the aggregate demand and aggregate supply of the economy.
B) represents the aggregate demand of the economy.
C) cannot be used when the assumption of fixed prices is relaxed.
D) represents both the goods and labour markets.
Answer: B
Diff: 2
Type: MC
Page Ref: 245
69) The main reason for the IS curve having a downward slope is
A) higher output raises saving, which leads to a lower market-clearing interest rate.
B) higher output raises saving, which leads to a higher market-clearing interest rate.
C) higher output decreases saving, which leads to a lower market-clearing interest rate.
D) higher output decreases saving, which leads to a higher market-clearing interest rate.
Answer: A
Diff: 2
Type: MC
Page Ref: 245
70) Which one of the following shifts the IS curve?
A) an increase in the money supply
B) an increase in the real interest rate
C) an expansionary monetary policy
D) a temporary increase in government purchases
Answer: D
Diff: 2
Type: MC
Page Ref: 248
71) An increase in wealth
A) increases real money demand and the real interest rate, and shifts the LM curve up.
B) decreases real money demand and the real interest rate, and shifts the LM curve down.
C) increases real money demand and the real interest rate, but does not shift the LM curve.
D) decreases real money demand and the real interest rate, but does not shift the LM curve down.
Answer: A
Diff: 2
Type: MC
Page Ref: 248
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72) A decrease in government purchases will lead to
A) a lower output and price level in the short run but a higher output and price level in the long
run.
B) a lower output and price level in the short run but the same output and price level in the long
run.
C) a lower output and price level in the short run but a higher output and lower price level in the
long run.
D) a lower output and price level in the short run but the same output and lower price level in the
long run.
Answer: D
Diff: 3
Type: MC
Page Ref: 248
73) The multiplier effect arises because
A) the IS curve is downward sloping.
B) the LM curve is upward sloping.
C) prices are flexible.
D) the initial increase in government purchases increases the number of transactions over time.
Answer: D
Diff: 1
Type: MC
Page Ref: 248
74) The crowding-out effect occurs when
A) an expansion of the government's budget raises the interest rate.
B) a contraction of the government's budget raises the interest rate.
C) an expansionary monetary policy decreases the interest rate.
D) a contractionary monetary policy increases the interest rate.
Answer: A
Diff: 2
Type: MC
Page Ref: 248
75) The IS-LM-FE model
A) is a framework for Keynesian analysis only.
B) is a framework for classical analysis only.
C) is a framework for both Keynesian and classical analysis.
D) is used to analyze only the short-term changes in the economy.
Answer: C
Diff: 2
Type: MC
Page Ref: 245
76) The full-employment (FE) line shifts right if
A) unemployment declines.
B) technology advances.
C) net exports increase.
D) GDP rises.
Answer: B
Diff: 2
Type: MC
Page Ref: 245
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77) The full-employment (FE) line shifts left if
A) labour supply declines.
B) productivity decreases.
C) there is an adverse supply shock.
D) all of the above.
Answer: D
Diff: 2
Type: MC
Page Ref: 246
78) An increase in labour supply
A) shifts FE to the right.
B) shifts IS to the right.
C) shifts LM to the right.
D) increases capital.
Answer: A
Diff: 2
Type: MC
Page Ref: 246
79) In an oil-importing country, a permanent fall in oil prices
A) shifts IS to the right.
B) shifts LM to the left.
C) shifts FE to the left.
D) shifts IS to the left.
Answer: C
Diff: 2
Type: MC
Page Ref: 246
80) An increase in the expected future marginal product of capital, MPK,
A) shifts FE to the right.
B) shifts IS to the right.
C) shifts LM to the right.
D) shifts FE to the left.
Answer: B
Diff: 2
Type: MC
Page Ref: 251
81) The LM curve is derived from
A) investment-saving market.
B) money market.
C) labour market.
D) goods market.
Answer: B
Diff: 2
Type: MC
Page Ref: 254
82) When demand for money increases, interest rate rises. This can be shown by
A) moving along the LM curve.
B) shifting the LM curve.
C) moving along the IS curve.
D) shifting the IS curve.
Answer: A
Diff: 2
Type: MC
Page Ref: 253
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83) The LM curve shifts up when
A) price level falls.
B) nominal interest rate on money declines.
C) expected inflation decreases.
D) nominal money supply rises.
Answer: D
Diff: 2
Type: MC
Page Ref: 255
84) Which of the following is true for a temporary adverse supply shock effects?
A) lower output, higher interest rate and price level
B) lower output, lower interest rate and price level
C) higher output, lower interest rate and price level
D) lower output, higher interest rate and lower price level
Answer: A
Diff: 2
Type: MC
Page Ref: 261
9.2 Essay Questions
1) Draw a saving-investment diagram to show how each of the following changes shift the IS
curve.
a. Future income declines.
b. The future marginal productivity of capital declines.
c. Government purchases increase temporarily.
d. The effective corporate tax rate declines.
Answer:
a. IS shifts down.
b. IS shifts down.
c. IS shifts up.
d. IS shifts up.
Diff: 2
Type: ES
Page Ref: Sec. 9.2
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2) For each of the following changes, which equilibrium curve (IS, LM, or FE) is shifted? Draw
the change in the underlying demand or supply curves (for example, money demand and supply
for the LM curve) and show how the equilibrium curve changes.
a. Expected inflation increases.
b. The future marginal productivity of capital increases.
c. Labour supply decreases.
d. Future income declines.
e. There's a temporary beneficial supply shock.
f. The nominal interest rate on money rises.
Answer:
a. LM shifts down.
b. IS shifts up.
c. FE shifts left.
d. IS shifts down.
e. FE shifts right.
f. LM shifts up.
Diff: 2
Type: ES
Page Ref: Sec. 9.1, 2, 3
3) Oil prices have risen temporarily, due to political uncertainty in the Middle East. An advisor
to the Bank of Canada suggests, "Higher oil prices reduce aggregate demand. To offset this we
must increase the money supply. Then the price level won't need to adjust to restore equilibrium,
and we'll prevent a recession." Analyze this statement using the IS-LM model.
Answer: This is a change in the FE line, not aggregate demand, so the policy is incorrect.
Instead, to keep the price level fixed, money supply should decrease so output falls and the real
interest rate rises.
Diff: 3
Type: ES
Page Ref: Sec. 9.4
4) For each of the following changes, what happens to the real interest rate and output in the very
short run, before the price level has adjusted to restore general equilibrium?
a. Wealth declines.
b. Money supply declines.
c. The future marginal productivity of capital declines.
d. Expected inflation rises.
e. Future income rises.
Answer:
a. The IS curve shifts down, so r falls and Y falls.
b. The LM curve shifts up, so r rises and Y falls.
c. The IS curve shifts down, so r falls and Y falls.
d. The LM curve shifts down, so r falls and Y rises.
e. The IS curve shifts up, so r rises and Y rises.
Diff: 2
Type: ES
Page Ref: Sec. 9.2, 3, 4
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5) Desired consumption is Cd = 2000 + 0.9Y - 100,000r - G, and desired investment is Id = 1000
- 45,000r. Real money demand is Md/P = Y - 6000i. Other variables are πe = 0.03, G = 500, Y =
1000, and M = 2100.
a. Find the equilibrium values of the real interest rate, consumption, investment, and the price
level.
b. Suppose government purchases decline to 400. What happens to the variables listed in part
(a)?
c. Suppose government purchases rise to 600. What happens to the variables listed in part (a)?
d. What feature in this example leads to the result that you don't need to know the amount of
taxes collected by the government to find the equilibrium?
Answer:
a. r = 0.02, C = 400, I = 100, P = 3
b. C = 500, other variables are unchanged.
c. C = 300, other variables are unchanged.
d. Desired consumption depends on the level of government purchases, not taxes. This is an
example of a classical view in which people realize that government purchases must be paid for
by taxes today or in the future, so it's the level of government purchases that affects consumption
decisions, not the level of taxes.
Diff: 2
Type: ES
Page Ref: Sec. 9.4
6) Analyze the following statement, and show what would happen in the long run if such advice
were followed by the Bank of Canada: "The increase in the stock market has increased people's
wealth. As a result, their consumption has increased, increasing aggregate demand and output.
So the Bank of Canada needs to increase the money supply, since with higher income, people's
demand for real money balances will be higher."
Answer: Assuming resources are fully utilized, there will be no increase in output. Higher
wealth will reduce saving, shifting the IS curve to the right. Increasing the money supply shifts
the LM curve to the right as well. But general equilibrium will require the LM curve to shift to
the left. So the price level must rise, and it rises even more because of the monetary policy
suggested by the statement. The correct monetary policy for preventing inflation is to reduce, not
increase, the money supply.
Diff: 3
Type: ES
Page Ref: Sec. 9.4
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7) Use the IS-LM model to determine the effects of each of the following on the general
equilibrium values of the real wage, employment, output, the real interest rate, consumption,
investment, and the price level.
a. Tougher immigration laws reduce the working-age population.
b. There's increased volatility in the prices of stocks and bonds.
c. The government tries to achieve tax equity by an increase in the corporate tax rate.
d. Increased computerization reduces stock market brokerage costs.
Answer:
a. The decline in labour supply increases the real wage and reduces employment and output,
shifting the FE line to the left. The LM curve shifts up as the price level rises to restore
equilibrium. As a result, the real interest rate rises, reducing consumption and investment.
b. Real money demand rises, which shifts the LM curve up. To restore equilibrium, the price
level must decline, shifting the LM curve down. There's no effect on any other variable.
c. The higher tax rate reduces investment, shifting the IS curve down. To restore equilibrium,
the LM curve shifts down as the price level falls. As a result, the real interest rate declines, so
consumption increases. There's no change in the real wage, employment, or output.
d. Increased liquidity on nonmoney assets reduces money demand, shifting the LM curve down.
The price level rises to restore equilibrium by shifting the LM curve back up. There's no effect on
the other variables.
Diff: 2
Type: ES
Page Ref: Sec. 9.5
8) Suppose the Bank of Canada's short-run response to any change in the economy is to change
the money supply to maintain the existing real interest rate. What would happen to money supply
if there were a reduction in government purchases? Given the Bank of Canada's policy, what
would happen in the very short run (before general equilibrium is restored) to output and the real
interest rate? What must happen to the LM curve and the price level to restore general
equilibrium?
Answer: The decrease in G shifts the IS curve down. The Bank of Canada's policy decreases the
money supply and shifts the LM curve up, so the real interest rate doesn't change. But output
declines in the very short run. To restore general equilibrium, the price level must decline to shift
the LM curve down. If the Bank of Canada wanted to keep the price level from changing so
much, its correct policy would have been to increase the money supply, not decrease it.
Diff: 3
Type: ES
Page Ref: Sec. 9.5
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9) Suppose you were a forecaster of the real wage rate, employment, output, the real interest rate,
consumption, investment, and the price level. A shock hits the economy, which you think is a
temporary adverse supply shock.
a. What are your forecasts for each of the variables listed above (rise, fall, no change)?
b. What if the shock was really due to people's reduced expectations about their future income?
Which variables did you forecast correctly, and which did you forecast incorrectly?
Answer:
a. The real wage rate, employment, output, consumption, and investment decline, while the real
interest rate and the price level rise.
b. The IS curve shifts down, instead of the FE line shifting left, so you are wrong about every
variable except consumption. The real wage, employment, and output won't change, the real
interest rate and the price level will decline, and investment will rise.
Diff: 3
Type: ES
Page Ref: Sec. 9.5
10) Suppose monetary policymakers decide they will increase output in the economy by
increasing the money supply. Beginning from a position of general equilibrium, what effect does
this have in the very short run (before general equilibrium is restored)? What must happen to
restore general equilibrium? What would happen if the monetary policymaker persistently
increased the money supply to try to increase output?
Answer: In the very short run, output increases and the real interest rate declines. But the price
level must rise and the LM curve must shift up to restore general equilibrium. An attempt to
persistently increase the money supply causes persistent inflation.
Diff: 2
Type: ES
Page Ref: Sec. 9.5
11) Suppose the economy is initially in long-run equilibrium. For each of the shocks listed
below, explain the short-run effects on output and the price level.
a. A stock market crash reduces consumers' wealth.
b. Businesses decide to hold larger inventories.
c. The government cuts defense spending.
d. Foreign countries buy more Canadian goods.
Answer:
a. Output declines and the price level is unchanged.
b. Output rises and the price level is unchanged.
c. Output declines and the price level is unchanged.
d. Output rises and the price level is unchanged.
Diff: 2
Type: ES
Page Ref: Sec. 9.6
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12) Suppose the economy is initially in long-run equilibrium. For each of the shocks listed
below, explain the long-run effects on output and the price level.
a. Labour supply decreases.
b. Productivity increases.
Answer:
a. Output declines and the price level rises.
b. Output rises and the price level falls.
Diff: 2
Type: ES
Page Ref: Sec. 9.6
13) Describe the effects, in both the short run and the long run, of a decline in the money supply.
Explain what happens to real output and the price level.
Answer: In the short run, a decline in the money supply reduces output and has no effect on the
price level. In the long run, a decline in the money supply has no effect on output and reduces the
price level.
Diff: 1
Type: ES
Page Ref: Sec. 9.6
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14) Suppose that the following IS-LM model represents the ATA economy.
Y = Cd + Id + G
Cd = 180 + 0.7 (Y - T)
Id = 100 - 18r - 0.1Y
T = 400
G = 400
M/P = L
L = 6Y - 120i
M = 5400
Assume expected inflation is zero and P = 1.
a. Find the equation for the IS curve.
b. Find the equation for the LM curve.
c. Find the equilibrium values for output and the interest rate.
d. At this equilibrium, what is the level of consumption and investment?
e. If government purchases (G) increases to $410, find the new equilibrium values for output
and the interest rate.
f. What are the effects of the fiscal expansion above on consumption and investment?
Answer:
a. Y = 180 + 0.7(Y - 400) + 100 - 18r + 0.1Y + 400, Therefore, IS equation is Y = 2000 - 90r
b. 5400 = 6Y-120i. The LM equation is i = 0.05Y - 45
c. To find the equilibrium values of Y and r, substitute i from the LM equation into the IS
equation. Y = 2000 - 90(0.05Y - 45), solving for Y you get: Y = 1100 and i = 0.05(110) - 45 = 10
d. Substituting the equilibrium values of Y and i into the C and I equations, you get Cd = 670,
and Id = 30
e. Using the new value for G, repeat steps a to d to get new equilibrium values for Y and i. Y =
1109.1 and i = 0.46
f. Cd = 676.4, and Id = 22.6
Diff: 1
Type: ES
Page Ref: Sec. 9.6
15) Using the IS-LM and AD curves, analyze the effect of a contractionary monetary policy
(reducing the money supply) on output, the interest rate, and the price level.
Answer: A cut in the money supply shifts the LM curve up and to the left. Given prices, the
quantity of output demanded decreases, which means that the AD curve will shift to the left.
Under the fixed price assumption, output decreases and the interest rate rises.
Diff: 2
Type: ES
Page Ref: Sec. 9.6
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16) Suppose that the following IS-LM model represents the ATA economy.
Y = Cd + Id + G
Cd = 180 + 0.7 (Y - T)
Id = 100 - 18i - 0.1Y
T = 400
G = 400
M/P = L
L = 6Y - 120i
M = 5400
Assume expected inflation is zero and P = 1.
a. Find the equilibrium values for output and the interest rate.
b. Find the new equilibrium values for output and the interest rate if the central bank of ATA
increases the money supply to 5600.
c. What are the effects of the monetary expansion above on consumption and investment?
Answer:
a. Y = 110, i = 10
b. Y = 1127.3, i = 9.7
c. Consumption increases from 670 to 689.1 and investment from 30 to 38.1.
Diff: 2
Type: ES
Page Ref: Sec. 9.4
17) Using an IS-LM graph, illustrate the effects of an increase in the price level on output.
Explain what effects the rise in price has on real money, interest rate, and investment.
Answer: The LM curve shifts up and to the left. The real money supply falls, raising the real
interest rate that clears the asset market and lowering investment.
Diff: 2
Type: ES
Page Ref: Sec. 9.4
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 10 Exchange Rates, Business Cycles, and Macroeconomic Policy
in the Open Economy
10.1 Multiple-Choice Questions
1) The exchange rate is
A) the price of one currency in terms of another.
B) the price of domestic goods relative to foreign goods.
C) the quantity of gold that can be purchased by one unit of currency.
D) the difference in interest rates between two countries.
Answer: A
Diff: 1
Type: MC
Page Ref: 295
2) The nominal exchange rate between the Canadian dollar and the Japanese yen is 80. It means
that
A) a dollar can buy 80 yen in the foreign exchange market.
B) a yen can buy 80 cents in the foreign exchange market.
C) a dollar cay buy about 0.012 yen in the foreign exchange market.
D) a yen can buy 0.20 cents in the foreign exchange market.
Answer: A
Diff: 1
Type: MC
Page Ref: 295
3) An exchange-rate system in which the nominal exchange rate is set by the government is
known as
A) a flexible-exchange-rate system.
B) a floating-exchange-rate system.
C) a fixed-exchange-rate system.
D) an exchange-rate union.
Answer: C
Diff: 1
Type: MC
Page Ref: 295
4) Which of the following statements is false?
A) The Bretton Woods system is the most recent example of a fixed exchange rate system.
B) Under the gold standard system, each country agreed to buy or sell gold in exchange for
currency at a fixed exchange rate.
C) Under the Bretton Woods system, the values of various currencies were fixed in terms of the
U.S. dollar, which was set at $35 per ounce of gold.
D) The recession in the U.S. economy was the main reason for the breakdown of the Bretton
Woods system in the early 1970s.
Answer: D
Diff: 1
Type: MC
Page Ref: 295
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5) The Bretton Woods system relied on
A) a flexible-exchange-rate system.
B) a floating-exchange-rate system.
C) a fixed-exchange-rate system.
D) an exchange-rate union.
Answer: C
Diff: 1
Type: MC
Page Ref: 297
6) The European Monetary System is an example of
A) a flexible-exchange-rate system.
B) a floating-exchange-rate system.
C) a fixed-exchange-rate system.
D) an exchange-rate union.
Answer: D
Diff: 1
Type: MC
Page Ref: 297
7) The real exchange rate is
A) the price of one currency in terms of another.
B) the price of domestic goods relative to foreign goods.
C) the quantity of gold that can be purchased by one unit of currency.
D) the difference in interest rates between two countries.
Answer: B
Diff: 1
Type: MC
Page Ref: 297
8) The real exchange rate is
A) the number of foreign goods that can be obtained in exchange for one unit of the domestic
good.
B) the nominal exchange rate minus the rate of inflation.
C) the amount of foreign currency.
D) the amount of domestic currency that can be obtained in exchange for one unit of the foreign
currency.
Answer: A
Diff: 1
Type: MC
Page Ref: 297
9) Three-wheel cars made in North Edsel are sold for 5000 pounds. Four-wheel cars made in
South Edsel are sold for 10,000 marks. The real exchange rate between North and South Edsel is
four three-wheel cars for three four-wheel cars. The nominal exchange rate between the two
countries is
A) 0.50 marks/pound.
B) 0.66 marks/pound.
C) 1.50 marks/pound
D) 2.00 marks/pound.
Answer: C
Diff: 3
Type: MC
Page Ref: 298
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10) Three-wheel cars made in North Edsel are sold for 5000 pounds. Four-wheel cars made in
South Edsel are sold for 10,000 marks. The nominal exchange rate between the two countries is
three marks per pound. The real exchange rate is
A) 0.50 three-wheel cars per four-wheel car.
B) 0.66 three-wheel cars per four-wheel car.
C) 1.50 three-wheel cars per four-wheel car.
D) 2.00 three-wheel cars per four-wheel car.
Answer: B
Diff: 3 Type: MC
Page Ref: 298
11) When the domestic currency strengthens under a fixed-exchange rate system, this is called
A) a depreciation.
B) an appreciation.
C) a devaluation.
D) a revaluation.
Answer: D
Diff: 1
Type: MC
Page Ref: 296
12) When the nominal exchange rate falls
A) the domestic currency buys more units of foreign currency, and the domestic currency has
depreciated.
B) the domestic currency buys fewer units of foreign currency, and the domestic currency has
depreciated.
C) the domestic currency buys more units of foreign currency, and the domestic currency has
appreciated.
D) the domestic currency buys fewer units of foreign currency, and the domestic currency has
appreciated.
Answer: B
Diff: 2
Type: MC
Page Ref: 296
13) When the nominal exchange rate rises
A) the domestic currency buys more units of foreign currency, and the domestic currency has
depreciated.
B) the domestic currency buys fewer units of foreign currency, and the domestic currency has
depreciated.
C) the domestic currency buys more units of foreign currency, and the domestic currency has
appreciated.
D) the domestic currency buys fewer units of foreign currency, and the domestic currency has
appreciated.
Answer: C
Diff: 2
Type: MC
Page Ref: 296
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14) From January 1989 to January 1991, the yen/dollar exchange rate rose from 111 yen/dollar to
115 yen/dollar, while the dollar/pound exchange rate rose from 2.09 dollars/pound to 2.24
dollars/pound. As a result
A) the dollar appreciated relative to the yen, but depreciated relative to the pound.
B) the dollar depreciated relative to the yen, but appreciated relative to the pound.
C) the dollar appreciated relative to both the yen and the pound.
D) the dollar depreciated relative to both the yen and the pound.
Answer: A
Diff: 2
Type: MC
Page Ref: 298
15) A fall in the real exchange rate is called
A) a real depreciation.
B) a real appreciation.
C) a real revaluation.
D) a real devaluation.
Answer: A
Diff: 1
Type: MC
Page Ref: 298
16) If all countries produce the same good (or the same set of goods) and goods are freely traded
among countries, so that the real exchange rate equals one, then the relationship between
domestic and foreign prices and the nominal exchange rate is
A) P = PFor / enom.
B) P = enom × PFor.
C) enom = P × PFor.
D) P = PFor.
Answer: A
Diff: 1
Type: MC
Page Ref: 298
17) An index that shows the nominal exchange rate for the Canadian dollar against the currencies
of Canada's trading partners is called
A) real exchange rate.
B) purchasing power parity.
C) effective exchange rate.
D) nominal exchange rate.
Answer: C
Diff: 1
Type: MC
Page Ref: 299
18) The Canada-U.S. nominal exchange and Canadian-dollar effective exchange rate are
expected to move together because
A) most of Canada's trade is with the U.S.
B) the trade deficit between the U.S. and Canada is not significant.
C) the U.S. dollar and Canadian dollar are closely related to each other.
D) the trade deficits between Canada and its trading partners are not significant.
Answer: A
Diff: 1
Type: MC
Page Ref: 299
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19) The idea that similar foreign and domestic goods, or baskets of goods, should have the same
price when priced in terms of the same currency is called
A) equity.
B) purchasing power parity.
C) efficiency.
D) the tragedy of the commons.
Answer: B
Diff: 1
Type: MC
Page Ref: 299
20) Purchasing power parity means that
A) enom = PFor / P.
B) P = PFor.
C) P = enom / PFor.
D) enom = mc2.
Answer: A
Diff: 1
Type: MC
Page Ref: 299
21) Empirical evidence shows that in the short run, purchasing power parity ________, and in
the long run, purchasing power parity ________.
A) holds; does not hold
B) holds; holds
C) does not hold; holds
D) does not hold; does not hold
Answer: C
Diff: 1
Type: MC
Page Ref: 299
22) Purchasing power parity does NOT hold in the short to medium run because
A) exports don't equal imports.
B) exchange rates fluctuate too much.
C) most business cycles are caused by shocks to aggregate demand.
D) countries produce different goods.
Answer: D
Diff: 1
Type: MC
Page Ref: 299
23) Purchasing power parity does NOT hold in the short to medium run because
A) exports don't equal imports.
B) exchange rates aren't internationally traded.
C) some goods aren't internationally traded.
D) most business cycles are caused by shocks to aggregate demand.
Answer: C
Diff: 1
Type: MC
Page Ref: 299
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24) Suppose the Big Macs are more expensive in Canada than in China, when measured by U.S.
dollar. According to the purchasing power parity theorem,
A) the Canadian dollar will appreciate against the Chinese yuan.
B) the Chinese yuan will appreciate against the Canadian dollar.
C) the Chinese yuan will depreciate against the Canadian dollar.
D) both Canadian dollar and the Chinese yuan will depreciate against the U.S. dollar.
Answer: B
Diff: 2
Type: MC
Page Ref: 299
25) If the real exchange rate rises 2%, domestic inflation is 3%, and foreign inflation is 4%, what
is the percent change in the nominal exchange rate?
A) 5%
B) 3%
C) 1%
D) -1%
Answer: B
Diff: 2
Type: MC
Page Ref: 299
26) If the nominal exchange rate rises 2%, domestic inflation is 3%, and foreign inflation is 4%,
what is the percent change in the real exchange rate?
A) 5%
B) 3%
C) 1%
D) -1%
Answer: C
Diff: 2
Type: MC
Page Ref: 298
27) Relative purchasing power parity occurs when
A) purchasing power parity holds between two countries.
B) purchasing power parity only holds in recessions.
C) the nominal exchange rate is constant.
D) the real exchange rate is constant.
Answer: D
Diff: 1
Type: MC
Page Ref: 299
28) When the rate of appreciation of the nominal exchange rate equals the foreign inflation rate
minus the domestic inflation rate, we say there is
A) relative purchasing power parity.
B) purchasing power parity.
C) a Phillips curve.
D) an aggregate supply shock.
Answer: A
Diff: 1
Type: MC
Page Ref: 299
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29) Suppose the dollar/franc exchange rate falls. Then
A) French firms will import more from Canada into France.
B) Canadian firms will export more to France.
C) the dollar is more valuable relative to the franc.
D) the franc is more valuable relative to the dollar.
Answer: C
Diff: 2
Type: MC
Page Ref: 300
30) An appreciation of the dollar causes
A) an increase in Canadian exports.
B) a reduction in Canadian exports.
C) an increase in the prices of Canadian imports.
D) an increase in the prices of Canadian exports.
Answer: D
Diff: 1
Type: MC
Page Ref: 301
31) When the British pound rises in value relative to other currencies, then
A) goods imported into Britain rise in price.
B) British exports rise in price.
C) neither British exports nor imports rise in price.
D) both British exports and imports rise in price.
Answer: B
Diff: 1
Type: MC
Page Ref: 301
32) Suppose the French franc rises against the British pound but falls against the German mark.
What happens to the prices of goods imported into France?
A) Both British and German goods fall in price.
B) Both British and German goods rise in price.
C) British goods rise in price while German goods fall in price.
D) British goods fall in price while German goods rise in price.
Answer: D
Diff: 2
Type: MC
Page Ref: 301
33) Suppose the dollar/franc exchange rate rises. Then
A) French firms will import more from the United States into France.
B) Canadian firms will export less to France.
C) the dollar is more valuable relative to the franc.
D) the franc is less valuable relative to the dollar.
Answer: A
Diff: 2
Type: MC
Page Ref: 301
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34) There's been a real depreciation of the dollar over the past month. In the long run, you would
expect the quantity of Canadian imports to ________ and the quantity of Canadian exports to
________.
A) fall; fall
B) rise; rise
C) fall; rise
D) rise; fall
Answer: C
Diff: 1
Type: MC
Page Ref: 302
35) Which of the following statements best describes the movement of the Canadian dollar
during the 1970s?
A) The dollar rose steadily.
B) The dollar was stable.
C) The dollar was stable until 1976 and fell thereafter.
D) The dollar fell until 1976 and rose thereafter.
Answer: C
Diff: 2
Type: MC
Page Ref: 302
36) Which of the following statements best describes the movement of the Canadian dollar
against the U.S. dollar in the period 2002-2008?
A) The Canadian dollar appreciated because demand for natural resources such as oil increased.
B) The Canadian dollar depreciated because demand for commodity decreased.
C) The Canadian dollar appreciated because the U.S. exports to Canada increased.
D) The Canadian dollar depreciated because the interest rate in Canada was lower than U.S.
Answer: A
Diff: 2
Type: MC
Page Ref: 302
37) According to the "beachhead effect," in order to undo the effects of a strong-dollar period,
the real value of the dollar
A) must fall to at least half of its value before appreciation of the dollar began.
B) must fall to the value it had before appreciation of the dollar began.
C) must fall to a much lower level than it had before appreciation of the dollar began.
D) must actually appreciate before it depreciates to undo the effects of a strong-dollar period.
Answer: C
Diff: 1
Type: MC
Page Ref: 304
38) Under a flexible-exchange-rate system, an increase in the demand for Japanese yen would
cause the Canadian dollar/Japanese yen exchange rate to
A) fall.
B) rise.
C) remain unchanged because supply also increases.
D) remain unchanged because the exchange rate is set by the Central Bank.
Answer: B
Diff: 2
Type: MC
Page Ref: 304
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39) In a flexible-exchange-rate system, the value of a currency is determined by
A) the government.
B) the intersection of the IS and LM curves.
C) the demand and supply for the currency in the foreign exchange market.
D) Swiss gnomes.
Answer: C
Diff: 1
Type: MC
Page Ref: 304
40) A decline in domestic output would cause a ________ in net exports and a ________ in the
exchange rate.
A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall
Answer: A
Diff: 2
Type: MC
Page Ref: 304
41) A decline in the domestic real interest rate would cause a ________ in net exports and a
________ in the exchange rate.
A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall
Answer: B
Diff: 2
Type: MC
Page Ref: 306
42) Which of the following changes would cause Canadian net exports to increase?
A) an increase in the real value of the dollar
B) an increase in Canadian income
C) an increase in foreign income
D) a shift in demand by Canadian consumers away from domestically produced goods
Answer: C
Diff: 1
Type: MC
Page Ref: 306
43) Which of the following changes would cause Canadian net exports to decrease?
A) a decrease in the real value of the dollar
B) a decrease in Canadian income
C) an increase in foreign income
D) a shift in demand by Canadian consumers away from domestically produced goods
Answer: D
Diff: 1
Type: MC
Page Ref: 306
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44) The net export crowding out effect refers to a situation in which
A) a fiscal expansion causes the local currency to appreciate, reducing the net exports.
B) a fiscal contraction causes the local currency to depreciate, reducing the net exports.
C) a monetary expansion causes the local currency to appreciate, reducing the net exports.
D) a monetary expansion causes the local currency to depreciate, increasing the net exports.
Answer: A
Diff: 1
Type: MC
Page Ref: 320
45) The Canadian real interest rate rises relative to the British real interest rate. British net
exports ________ and the British exchange rate ________.
A) increase; rises
B) increase; falls
C) decrease; rises
D) decrease; falls
Answer: B
Diff: 2
Type: MC
Page Ref: 309
46) The Canadian interest rate is 4 percent and the U.S. interest rate is 6 percent. If the interest
parity condition holds, we expect
A) the Canadian dollar to appreciate by 2 percent.
B) the Canadian dollar to depreciate by 6 percent.
C) the U.S. dollar to depreciate 2 percent.
D) the U.S. dollar to appreciate by 2 percent.
Answer: D
Diff: 2
Type: MC
Page Ref: 311
47) Which of the following statements describes the interest parity condition?
A) In the equilibrium, all the prices must be the same in the international market.
B) In the equilibrium, the inflation rates must be the same in the international market.
C) In the long run, the exchange rates must be the same in the international market.
D) In the equilibrium, the rates of return on assets of comparable risk and liquidity must be the
same in the international market.
Answer: D
Diff: 2
Type: MC
Page Ref: 307
48) Under a fixed exchange rate system, if the nominal interest parity condition holds,
A) the nominal interest rates in domestic and foreign economies must be the same.
B) the inflation rates in domestic and foreign economy must be the same.
C) the real exchange rates in domestic and foreign economies must be the same.
D) the net exports in domestic and foreign economies must be the same.
Answer: A
Diff: 2
Type: MC
Page Ref: 311
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49) Which of the following is NOT a reason for why domestic and foreign interest rates might
differ?
A) differences in transaction costs
B) differences in default risk
C) expected changes in exchange rate
D) differences in the bonds interest rate
Answer: D
Diff: 2
Type: MC
Page Ref: 311
50) Which of the following statements is true?
A) The open-economy IS curve is derived in the same way that the closed-economy IS curve is
derived.
B) The closed-economy IS curve is downward sloping, but the open-economy IS curve is upward
sloping.
C) Some factors that shift the IS curve in the closed economy in one direction will shift the IS
curve in the open economy in the opposite direction.
D) Factors that raise a country's current net exports, given domestic output and the domestic real
interest rate, shift the open-economy IS curve up.
Answer: D
Diff: 1
Type: MC
Page Ref: 312
51) Goods market equilibrium in the open economy occurs when
A) desired saving equals desired investment.
B) output equals desired consumption plus desired investment plus government spending.
C) desired consumption equals desired investment.
D) desired saving minus desired investment equals net exports.
Answer: D
Diff: 1
Type: MC
Page Ref: 312
52) In an open economy, an increase in net exports because of increased demand for domestic
products by foreigners should cause the domestic real interest rate to ________ and should cause
desired saving minus desired investment to ________.
A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall
Answer: A
Diff: 3
Type: MC
Page Ref: 317
53) A decrease in foreign output would cause the domestic country's net exports to ________
and cause the domestic country's IS curve to ________.
A) rise; shift up
B) rise; shift down
C) fall; shift up
D) fall; shift down
Answer: D
Diff: 2
Type: MC
Page Ref: 318
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54) A decrease in the foreign real interest rate would cause the domestic country's net exports to
________ and cause the domestic country's IS curve to ________.
A) rise; shift up
B) rise; shift down
C) fall; shift up
D) fall; shift down
Answer: D
Diff: 2
Type: MC
Page Ref: 318
55) A temporary decrease in government purchases would ________ the domestic real interest
rate and ________ net desired saving (desired saving less desired investment) in the economy.
A) lower; increase
B) lower; decrease
C) raise; increase
D) raise; decrease
Answer: A
Diff: 2
Type: MC
Page Ref: 318
56) In a Keynesian model, a temporary decrease in government purchases would cause output to
________ and the domestic real interest rate to ________.
A) not change; increase
B) not change; decrease
C) decrease; increase
D) decrease; decrease
Answer: D
Diff: 1
Type: MC
Page Ref: 318
57) All else being equal in a classical model, a temporary decrease in government expenditures
in the United States would cause the Canadian real interest rate to ________ and the Canadian
price level to ________.
A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall
Answer: D
Diff: 3
Type: MC
Page Ref: 318
58) In the short run in the Keynesian model, an increase in the domestic money supply would
cause domestic output to ________ and the domestic real interest rate to ________.
A) rise; rise
B) fall; rise
C) rise; fall
D) fall; fall
Answer: C
Diff: 2
Type: MC
Page Ref: 322
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59) An increase in the Canadian money supply would cause the value of the dollar to ________
and net Canadian exports to ________ in the short run using a Keynesian model.
A) rise; rise
B) fall; rise
C) rise; fall
D) fall; fall
Answer: B
Diff: 2
Type: MC
Page Ref: 322
60) In a small open economy with flexible exchange rates, a fiscal contraction would
A) increase domestic output.
B) decrease domestic output.
C) have no effect on domestic output.
D) cause an exchange rate appreciation.
Answer: C
Diff: 2
Type: MC
Page Ref: 318
61) In a small open economy with flexible exchange rates, a contractionary monetary policy
would
A) cause an exchange rate depreciation in the short run.
B) increase domestic output in the short run.
C) decrease domestic output in the short run.
D) decrease domestic output in the long run.
Answer: C
Diff: 2
Type: MC
Page Ref: 322
62) An increase in the Canadian money supply would cause Canadian output to ________ and
the Canadian net exports to ________ in the short run using a Keynesian model.
A) rise; rise
B) fall; rise
C) rise; fall
D) fall; fall
Answer: C
Diff: 2
Type: MC
Page Ref: 322
63) According to the classical model, an increase in the Canadian nominal money supply would
cause the nominal exchange rate to ________ and the real exchange rate to ________.
A) depreciate; appreciate
B) appreciate; depreciate
C) depreciate; not change
D) appreciate; not change
Answer: C
Diff: 1
Type: MC
Page Ref: 322
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64) You have just noticed that the dollar depreciated and you suspect that the Canadian
government was behind this change. Which would you choose as the most likely cause of this
depreciation in the real exchange rate?
A) an increase in the money supply
B) a decrease in the money supply
C) a temporary increase in government purchases
D) a temporary decrease in taxes
Answer: A
Diff: 3
Type: MC
Page Ref: 322
65) An overvalued currency arises when
A) the demand for the currency exceeds the supply.
B) the Central Bank gains reserves while maintaining the exchange rate.
C) the Central Bank keeps the official rate above the fundamental value.
D) the Central Bank keeps the official rate below the fundamental value.
Answer: C
Diff: 1
Type: MC
Page Ref: 325
66) Under a system of fixed exchange rates, what happens if a country's currency is overvalued?
A) The Central Bank loses official reserve assets.
B) The Central Bank gains official reserve assets.
C) The currency appreciates.
D) The exchange rate rises.
Answer: A
Diff: 1
Type: MC
Page Ref: 325
67) Under a system of fixed exchange rates, what happens if a country's currency is
undervalued?
A) The Central Bank loses official reserve assets.
B) The Central Bank gains official reserve assets.
C) The currency depreciates.
D) The exchange rate falls.
Answer: B
Diff: 1
Type: MC
Page Ref: 325
68) International businesses like a fixed-exchange-rate system because
A) they like large swings in currency values when devaluation or revaluation occur.
B) they profit by speculating on devaluation or revaluation.
C) they can plan better if they know what the exchange rate will be.
D) fixed exchange rates are economically efficient.
Answer: C
Diff: 1
Type: MC
Page Ref: 325
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69) The Intertemporal external balance curve will be shifted down if
A) foreign income rises.
B) domestic income rises.
C) the money supply expands.
D) there is a shift in demand away from home goods.
Answer: B
Diff: 1
Type: MC
Page Ref: 326
70) If investors are to hold both Canadian and foreign bonds, the interest rate on Canadian bonds
A) must equal that of foreign bonds.
B) must always exceed that on foreign bonds.
C) must equal that on foreign bonds plus the expected rate of depreciation.
D) must equal that on foreign bonds, on average.
Answer: C
Diff: 1
Type: MC
Page Ref: 326
71) The equilibrium real exchange rate will rise
A) if there is a rise in domestic income.
B) if there is a rise in foreign interest rates.
C) if there is a rise in foreign income.
D) if there is a shift in demand away from the home good.
Answer: C
Diff: 1
Type: MC
Page Ref: 303
72) When a group of countries agree to share a common currency, they are said to have formed a
A) currency union.
B) welfare state.
C) monetary alliance.
D) monetary cartel.
Answer: A
Diff: 1
Type: MC
Page Ref: 334
73) Currency unions are rare because
A) they're to no one's advantage.
B) countries are reluctant to give up having their own currencies.
C) having flexible exchange rates has the same benefits and none of the costs.
D) speculative attacks are likely to occur.
Answer: B
Diff: 1
Type: MC
Page Ref: 334
74) Compared to a system of fixed exchange rates, currency unions are beneficial because they
A) allow exchange rates to float.
B) allow every country to have an independent monetary policy.
C) reduce the costs of trading goods and assets.
D) restrict what countries can do with fiscal policy.
Answer: C
Diff: 1
Type: MC
Page Ref: 334
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75) Compared to a system of fixed exchange rates, currency unions are beneficial because they
A) restrict what countries can do with fiscal policy.
B) allow exchange rates to float.
C) allow every country to have an independent monetary policy.
D) eliminate the possibility of speculative attacks.
Answer: D
Diff: 1
Type: MC
Page Ref: 334
76) Compared to a system of flexible exchange rates, currency unions have the disadvantage of
A) requiring all its members to share a common monetary policy.
B) allowing exchange rates to float.
C) requiring every country to share a common fiscal policy.
D) decreasing the sacrifice ratio.
Answer: A
Diff: 1
Type: MC
Page Ref: 334
77) Which of the following best represents Canada's fiscal and monetary policies in response to
the 2008-2009 financial crisis and recession?
A) Government followed a contractionary fiscal policy, but Bank of Canada followed an
expansionary monetary policy.
B) Government followed an expansionary fiscal policy, but Bank of Canada followed a
contractionary monetary policy.
C) Both government and Bank of Canada followed an expansionary policy.
D) Both government and Bank of Canada followed a contractionary policy.
Answer: C
Diff: 1
Type: MC
Page Ref: 334
78) Which of the following statements about the effectiveness of the fiscal and the monetary
policies in response to a recession in a small open economy is true?
A) In recession, fiscal policy is ineffective, but monetary policy is effective.
B) In recession, fiscal policy is effective, but monetary policy is ineffective.
C) In recession, both fiscal and monetary policies are effective.
D) In recession, both fiscal and monetary policies are ineffective.
Answer: A
Diff: 2
Type: MC
Page Ref: 336
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79) The reason that fiscal policy is ineffective during a recession is that
A) an expansionary fiscal policy will lead to higher interest rates, appreciation of exchange rate,
and a reduction in net exports.
B) an expansionary fiscal policy will lead to lower interest rates, depreciation of exchange rate,
and an increase in net exports.
C) an expansionary fiscal policy will lead to lower interest rates, appreciation of exchange rate,
and a reduction in net exports.
D) an expansionary fiscal policy will lead to higher interest rates, appreciation of exchange rate,
and an increase in net exports.
Answer: A
Diff: 2
Type: MC
Page Ref: 336
80) Despite the fact that fiscal policy is not effective when dealing with recession, Canadian
government conducted an expansionary fiscal policy in response to the 2008-2009 financial
crisis and recession. What might explain best the rationale for this policy?
A) Since the U.S. did not conduct an expansionary fiscal policy, Canada had to do it.
B) Canada had a budget surplus and could afford to conduct an aggressive expansionary policy.
C) The muted response proved politically unpopular, and it was increasingly apparent that the
recession was worldwide in scope, requiring a coordinated response internationally.
D) No other countries conducted an expansionary fiscal policy, so Canada had to do it.
Answer: C
Diff: 2
Type: MC
Page Ref: 336
81) Why can a worldwide coordinated expansionary fiscal policy be an effective policy in
response to recession?
A) A worldwide coordinated expansionary policy would avoid exchange rate depreciation.
B) A worldwide coordinated expansionary policy would avoid exchange rate appreciation.
C) A worldwide coordinated expansionary policy would lead to a higher interest rate.
D) A worldwide coordinated expansionary policy would lead to a lower interest rate.
Answer: B
Diff: 2
Type: MC
Page Ref: 336
82) A Big Mac costs $5.25 in Canada, but $4.66 in the Euro area. This implies that
A) the Canadian dollar is expected to depreciate against the euro.
B) the Canadian dollar is expected to appreciate against the euro.
C) 1 Canadian dollar can be exchanged for 1.126 euro in the international market.
D) 1 Canadian dollar can be exchanged for 0.89 euro in the international market.
Answer: A
Diff: 2
Type: MC
Page Ref: 300
83) The purchasing power parity theory holds in the long run because
A) countries have different exchange rate systems.
B) countries need time to adjust to international market regulations.
C) in the long run, prices are often subject to government-led disturbances.
D) it is difficult to calculate the real exchange rates in the short run.
Answer: C
Diff: 2
Type: MC
Page Ref: 299
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84) Because of the rising level of debt in the United States after the 2008 recession, the nominal
interest rate is expected to rise in the United States more than in Canada. According to the
interest rate parity theorem,
A) the Canadian nominal exchange rate is expected to depreciate.
B) the Canadian nominal exchange rate is expected to appreciate.
C) U.S. inflation is expected to rise slower than Canadian inflation.
D) the rate of return on financial assets is expected to be higher in the United States than in
Canada.
Answer: B
Diff: 2
Type: MC
Page Ref: 307
85) A decrease in government purchases
A) shifts the IS curve up and to the right, leading to a higher interest rate and an appreciation of
the exchange rate.
B) shifts the IS curve down and to the left, leading to a lower interest rate and a depreciation of
the exchange rate.
C) shifts the LM curve left, leading to a lower interest rate and a depreciation of the exchange
rate.
D) shifts the LM curve right, leading to a lower interest rate and a depreciation of the exchange
rate.
Answer: B
Diff: 2
Type: MC
Page Ref: 312
86) Which statement is true?
A) In the open economy IS-LM-FE model, the impacts of an expansionary fiscal policy are the
same in the Keynesian short run, Keynesian long run, and Classical model.
B) In the open economy IS-LM-FE model, the impacts of an expansionary fiscal policy are the
same in the Keynesian short run and Keynesian long run, but different in the Classical model.
C) In the open economy IS-LM-FE model, the impacts of an expansionary fiscal policy are the
same in the Keynesian short run and the Classical model, but different in the Keynesian long run.
D) In the open economy IS-LM-FE model, the impacts of an expansionary fiscal policy are the
same as those in the closed economy IS-LM-FE model.
Answer: A
Diff: 2
Type: MC
Page Ref: 312
87) A decrease in the exchange rate under the fixed exchange rate system is called
A) revaluation.
B) depreciation.
C) devaluation.
D) appreciation.
Answer: C
Diff: 1
Type: MC
Page Ref: 298
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88) An increase in the exchange rate is called appreciation under the
A) fixed exchange rate system.
B) flexible exchange rate system.
C) contractionary monetary policy.
D) expansionary monetary policy.
Answer: B
Diff: 1
Type: MC
Page Ref: 298
89) The Big Mac price is $4 in Britain and $6.6 in Switzerland. We then expect
A) the British currency to depreciate and the Swiss currency to appreciate.
B) the British currency to appreciate and the Swiss currency to depreciate.
C) the British and Swiss currencies both to depreciate.
D) the British and Swiss currencies both to appreciate.
Answer: B
Diff: 2
Type: MC
Page Ref: 300
90) The relative purchasing power parity is
A) a relationship between the real exchange rates in two countries.
B) a relationship between the nominal exchange rates in two countries.
C) a relationship between the price levels in two countries.
D) a relationship between the inflation rates in two countries.
Answer: D
Diff: 2
Type: MC
Page Ref: 300
91) When the Canadian economy grows, other things being equal, we expect
A) the Canadian dollar to appreciate because of an increase in net exports.
B) the Canadian dollar to depreciate because of an increase in net exports.
C) the Canadian dollar to depreciate because of a decrease in net exports.
D) the Canadian dollar to appreciate because of a decrease in net exports.
Answer: C
Diff: 2
Type: MC
Page Ref: 304
92) Which of the following is true when the foreign real interest rate decreases, assuming
everything else remains constant?
A) The exchange rate rises and net exports declines.
B) The exchange rate rises and net exports increases.
C) The exchange rate falls and net exports declines.
D) The exchange rate falls and net exports increases.
Answer: A
Diff: 2
Type: MC
Page Ref: 305
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93) Which of the following is true when the foreign real interest rate rises, assuming everything
else remains constant?
A) The exchange rate rises, and net exports decline.
B) The exchange rate rises, and net exports increase.
C) The exchange rate falls, and net exports decline.
D) The exchange rate falls, and net exports increase.
Answer: B
Diff: 2
Type: MC
Page Ref: 305
94) Which of the following is true when the foreign GDP rises, assuming everything else
remains constant?
A) The net exports decline, and exchange rate rises.
B) The net exports increase, and exchange rate rises.
C) The net exports decline, and exchange rate falls.
D) The net exports increase, and exchange rate falls.
Answer: B
Diff: 2
Type: MC
Page Ref: 305
10.2 Essay Questions
1) The nominal exchange rate is 15 crowns per florin, the domestic price level is 6 florins/bottle,
and the foreign price level is 2 crowns/bushel.
a. What is the real exchange rate?
b. What is the real exchange rate in the foreign country?
c. If the domestic price level rises to 8 florins/bottle, what must the nominal exchange rate
become if the real exchange rate remains unchanged?
Answer:
a. 45 bushels/bottle
b. 1/45 bottles/bushel
c. 11.25 crowns per florin
Diff: 2
Type: ES
Page Ref: Sec. 10.1
2) Suppose the real exchange rate is 10, the domestic price level is 8, and the foreign price level
is 4.
a. What is the nominal exchange rate?
b. Suppose the real exchange rate rises 10%, the inflation rate in the domestic country is 6%,
and the inflation rate in the foreign country is 4%. By what percentage does the nominal
exchange rate change?
c. Suppose the nominal exchange rate rises 5%, the real exchange rate rises 8%, and domestic
inflation is 3%. What is the foreign inflation rate?
Answer:
a. 5
b. 8%
c. 0%
Diff: 2
Type: ES
Page Ref: Sec. 10.1
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3) When the real exchange rate rises, what happens to net exports in the short run? In the long
run? What explains the difference between the short-run effect and the long-run effect?
Answer: In the short run, net exports rise, while in the long run net exports fall.
Diff: 2
Type: ES
Page Ref: Sec. 10.1
4) What happens to the exchange rate and net exports in each of the following cases?
a. The foreign real interest rate rises.
b. Foreign output falls.
c. Foreign demand for domestic goods falls.
d. Domestic output falls.
e. The domestic real interest rate rises.
Answer:
a. exchange rate falls, net exports rise
b. exchange rate falls, net exports fall
c. exchange rate falls, net exports fall
d. exchange rate rises, net exports rise
e. exchange rate rises, net exports fall
Diff: 2
Type: ES
Page Ref: Sec. 10.3
5) Describe the effects of a rise in the domestic real interest rate on the exchange rate and on
both domestic and foreign net exports.
Answer: The rise in the domestic real interest rate leads to a rise in the demand for domestic
assets, raising the exchange rate. The rise in the exchange rate reduces domestic net exports and
raises foreign net exports.
Diff: 2
Type: ES
Page Ref: Sec. 10.3
6) Describe the effects of contractionary fiscal policy by the domestic government on output, the
real interest rate, and net exports in both the domestic and foreign country, using a Keynesian
model.
Answer: Domestic country: output falls, real interest rate falls, net exports rise; foreign country:
output falls, real interest rate falls, net exports fall.
Diff: 2
Type: ES
Page Ref: Sec. 10.5
7) Describe the effects of contractionary monetary policy by the domestic Central Bank on
output, the real interest rate, and net exports in both the domestic and foreign country, using a
Keynesian model in the short run. What happens in the long run?
Answer: Domestic country: output falls, real interest rate rises, net exports rise; foreign country:
output falls, real interest rate falls, net exports fall. There are no real effects in the long run.
Diff: 2
Type: ES
Page Ref: Sec. 10.5
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8) A classical economy is described by the equations AD Y = 1000 + 100M/P AS Y = 1500. The
real exchange rate is 3 bushels/bottle, the domestic nominal money supply is 30 florins, and the
foreign price level is 8 crowns/bushel.
a. What is the nominal exchange rate?
b. If the government wants to maintain an official nominal exchange rate of 6 crowns/florin,
what must the nominal money supply be?
Answer:
a. 4 crowns/florin
b. 20 florins
Diff: 2
Type: ES
Page Ref: Sec. 10.6
9) a. What happens to the fundamental value of a country's exchange rate when it raises its
money supply in a fixed-exchange-rate system? Does this make the currency overvalued or
undervalued if originally the official rate equaled the fundamental value?
b. What happens to the fundamental value of a country's exchange rate when the foreign
country raises its money supply? Does this make the currency overvalued or undervalued if
originally the official rate equaled the fundamental value?
c. So, if a country wants to maintain its official rate equal to its fundamental value, what must it
do when the foreign country raises its money supply? What happens to inflation?
Answer:
a. Fundamental value falls below the official rate; the currency is overvalued.
b. Fundamental value increases above the official rate, so the currency is undervalued.
c. The country must raise its money supply. This leads to inflation worldwide.
Diff: 3
Type: ES
Page Ref: Sec. 10.6
10) Why are European countries planning to unify their currencies? What are the benefits of
doing so? What are the potential costs?
Answer: The European countries are planning to unify their currencies to reduce the costs of
trading goods and assets. This would be beneficial as it would reduce transactions costs and
increase the mobility of labour, capital, and goods across the countries. The potential costs are
that there may be political conflict if countries disagree about monetary policy, or if inflation
isn't as stable or low as some countries, like Germany, desire.
Diff: 1
Type: ES
Page Ref: Sec. 10.6
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11) Using the IS-LM model for a small open economy, analyze the effects of the following
events on output and the real interest rate in the short run and the long run. In each case, discuss
the differences between the classical and the Keynesian models.
a. A rise in taxes.
b. A boom in the economy of the major trading partner.
c. The central bank follows a contractionary monetary policy.
Answer:
a. A rise in taxes will shift the IS curve to the left, lowering both real interest rate and output in
the short run. The lower interest rate will cause domestic currency to depreciate and net exports
to increase. In the long run adjustment, the IS curve will shift to the right, back to its original
position. There will be no change in output and the real interest rates in the long run. Both
classical and Keynesian models predict the same results.
b. A boom in the economy of the major trading partner will cause exports to increase and the IS
curve to shift up. The short run effect will be higher output and higher real interest rates. The
higher interest rate will lead to the exchange rate appreciation and a lower net export, shifting IS
curve back to its original position. In the long run, there will be no changes in the output and the
real interest rate. Both classical and Keynesian models predict the same results.
c. A contractionary monetary policy will shift the LM curve to the left leading to a temporary
rise in the real interest rate and a decline in output. In the classical model, prices will fall,
because output is lower than its full employment level, and the LM curve will shift right to its
original position to restore the full employment level of output and the real interest rate. In the
Keynesian model, however, since the price adjustment is slow, the higher interest rate will cause
the domestic currency to appreciate and net export to fall. This will shift IS curve to the left
meeting the new LM curve at the original interest rate. Since the output is less than its full
employment level, the price will fall and the LM curve will shift back to its original position. As
a result, the interest rate declines and the net export rises, the IS curve will shift to the right to
restore the full employment position.
Diff: 2
Type: ES
Page Ref: Key Diagram 9
12) The financial crisis and recession that started in the U.S. in 2008 spread worldwide rapidly.
Explain what government and Bank of Canada could do in response to recession, and comment
on the fiscal and the monetary policies conducted in Canada.
Answer: Both government and Bank of Canada followed expansionary policies in response to
the financial crisis. Fiscal policy is not an effective response to a recession in a small open
economy like Canada, because it leads to high interest rates, an appreciation of currency, and a
fall in exports. However, since many countries agreed to adopt the expansionary fiscal policy at
the same time, any individual country, including Canada, was not subject to the currency
appreciation and the fall in exports. The expansionary monetary policy was what was needed in
response to the recession as it reduced interest rates and stimulated the economy.
Diff: 2
Type: ES
Page Ref: 384-385
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13) Describe the pros and cons of the fixed exchange rate system.
Answer: A fixed exchange rate system avoids market fluctuations in the exchange rate markets
and, therefore, might be beneficial to international trade stability. However, under a fixed
exchange rate system, monetary authorities lose control over monetary policy in response to
unexpected events and, therefore, the economy might experience instability in its financial
sector.
Diff: 2
Type: ES
Page Ref: Sec. 10.7
14) List three factors which cause the exchange rate to rise. Explain the reasons for the effects.
Answer:
1. An increase in foreign output raises demand for exports and increases demand for domestic
currency.
2. An increase in domestic real interest rate makes domestic assets more attractive and increases
demand for domestic currency.
3. An increase in world demand for domestic goods increases demand for domestic currency.
Diff: 2
Type: ES
Page Ref: 305
15) List two factors which cause net exports to fall. Explain the reasons for the effects.
Answer:
1. An increase in domestic output raises demand for imports.
2. An increase in domestic real interest rate raises the real exchange rate and makes domestic
goods more expensive relative to foreign goods.
Diff: 2
Type: ES
Page Ref: 305
16) Describe the arbitrage in the financial markets and how it affects the exchange rate.
Answer: With the domestic interest rate above the foreign interest rate, there exist arbitrage
opportunities. Canadian financial assets are now paying a higher interest rate than foreign assets,
causing the demand for Canadian financial assets to increase. When savers take advantage of
these arbitrage opportunities, there is a capital inflow into Canada. Because those foreigners who
seek to purchase Canadian financial assets must purchase dollars in order to do so, the Canadian
dollar appreciates in value.
Diff: 2
Type: ES
Page Ref: 310
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 11 Classical Business Cycle Analysis: Market-Clearing Macroeconomics
11.1 Multiple-Choice Questions
1) Which of the following is NOT a primary cause of business cycle fluctuations, according to
real business cycle theory?
A) a change in the production function
B) a change in the size of the labour force
C) a change in the money supply
D) a change in the real quantity of government purchases
Answer: C
Diff: 1
Type: MC
Page Ref: 353
2) The distinction between real and nominal shocks is that
A) real shocks directly affect only the IS curve, but not the FE line or LM curve.
B) real shocks directly affect only the FE line, but not the LM curve.
C) real shocks directly affect only the IS curve or the FE line, but not the LM curve.
D) real shocks have a large direct effect on the IS curve and the FE line, but only a small direct
effect on the LM curve.
Answer: C
Diff: 2
Type: MC
Page Ref: 354
3) Real business cycle theorists think that most business cycle fluctuations are caused by shocks
to
A) the production function.
B) the size of the labour force.
C) the real quantity of government purchases.
D) the spending and saving decisions of consumers.
Answer: A
Diff: 1
Type: MC
Page Ref: 354
4) Which of the following is an example of a real shock?
A) an increase in the money supply
B) a stock market crash
C) a rise in oil prices
D) a decrease in the money supply
Answer: C
Diff: 1
Type: MC
Page Ref: 354
5) Which one of the following is an example of a real shock?
A) a shock to the money supply
B) a shock to the money demand
C) a shock to the production function
D) a shock to the price level
Answer: C
Diff: 1
Type: MC
Page Ref: 354
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6) By real shock, economists mean
A) shocks to the money supply.
B) shocks to the money demand.
C) a shock to the real side of the economy.
D) shocks that shift the LM curve.
Answer: C
Diff: 1
Type: MC
Page Ref: 354
7) A real shock to an economy will shift
A) the IS curve.
B) the LM curve.
C) both the IS and LM curves.
D) neither the IS nor LM curve.
Answer: A
Diff: 1
Type: MC
Page Ref: 354
8) Which of the following would NOT be an example of a productivity shock?
A) the introduction of new management techniques
B) a change in government regulations affecting production
C) a change in the level of government transfer programs
D) a spell of unusually good or unusually bad weather
Answer: C
Diff: 1
Type: MC
Page Ref: 354
9) Which of the following is NOT an example of the productivity shock?
A) an increase in oil price because of oil supply disruption that came after a political turmoil in a
major oil-exporting country
B) severe weather that caused an adverse effect on farming
C) development of new software that allows firms to keep track of their services
D) a 2 percent rise in nominal wages
Answer: B
Diff: 1
Type: MC
Page Ref: 354
10) Which of the following is an example of a nominal shock?
A) an increase in money supply
B) an increase in population growth
C) a rise in oil price
D) a decline in demand for labour
Answer: A
Diff: 1
Type: MC
Page Ref: 354
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11) A temporary adverse productivity shock would not
A) shift the labour demand curve downward.
B) shift the labour supply curve upward.
C) reduce the level of employment.
D) reduce the amount of output that can be produced at any level of employment.
Answer: B
Diff: 2
Type: MC
Page Ref: 354
12) A temporary adverse productivity shock would
A) shift the labour supply curve upward.
B) reduce the level of employment.
C) decrease future income.
D) decrease the expected future marginal product of capital.
Answer: B
Diff: 2
Type: MC
Page Ref: 354
13) A beneficial productivity shock would ________ output, ________ the real interest rate, and
________ the price level.
A) increase; decrease; increase
B) increase; decrease; decrease
C) increase; increase; decrease
D) decrease; decrease; increase
Answer: B
Diff: 2
Type: MC
Page Ref: 354
14) Real business cycle theory is unable to predict that
A) employment is procyclical.
B) the price level is procyclical.
C) the real wage is mildly procyclical.
D) investment is more volatile than consumption.
Answer: B
Diff: 2
Type: MC
Page Ref: 355
15) Which of the following observed procyclical behaviour of variables can be accounted for by
the real business cycles theory?
A) real wages
B) employment
C) productivity
D) all of the above
Answer: D
Diff: 2
Type: MC
Page Ref: 355
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16) A business cycle fact that does NOT seem to be consistent with the simple RBC theory is
that
A) inflation tends to slow during or immediately after a recession.
B) inflation tends to increase during or immediately after a recession.
C) inflation tends to remain the same during or immediately after an expansion.
D) inflation tends to slow during or immediately after an expansion.
Answer: B
Diff: 2
Type: MC
Page Ref: 355
17) An adverse supply shock would directly ________ labour productivity by changing the
amount of output that can be produced with any given amount of capital and labour. It would
also indirectly ________ average labour productivity through changes in the level of
employment.
A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease
Answer: C
Diff: 2
Type: MC
Page Ref: 355
18) What do RBC economists mean by the term calibration?
A) modifying the structure of an economic theory to strengthen its logic
B) changing a theory as the economy changes
C) working out a detailed numerical example of a more general theory
D) writing out the implication of a theory for all the main economic variables
Answer: C
Diff: 2
Type: MC
Page Ref: 356
19) When RBC economists compare the volatility in their models to the data, what are they
looking at?
A) the degree to which variables lead output over the business cycle
B) the strength of procyclicality of different variables
C) the amount of random variation in economic variables
D) the degree to which different economic variables move together
Answer: C
Diff: 2
Type: MC
Page Ref: 356
20) When RBC economists compare the correlations in their models to the data, what are they
looking at?
A) the degree to which variables lead output over the business cycle
B) the strength of procyclicality of different variables
C) the amount of random variation in economic variables
D) the degree to which different economic variables move together
Answer: D
Diff: 2
Type: MC
Page Ref: 356
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21) Critics of the RBC approach argue that it's hard to find productivity shocks large enough to
cause business cycles. What is the RBC counterargument to this criticism?
A) Business cycles are always and everywhere a monetary phenomenon.
B) Wars and military buildups could be considered productivity shocks.
C) Business cycles could be caused by the accumulation of small productivity shocks.
D) Business cycles are often caused by unobservable productivity shocks, which aren't apparent
at the time they occur.
Answer: C
Diff: 2
Type: MC
Page Ref: 356
22) The most common measure of productivity shocks is known as
A) the Solow residual.
B) the Lucas supply curve.
C) the Prescott productivity parameter.
D) the Kydland factor.
Answer: A
Diff: 1
Type: MC
Page Ref: 359
23) The Solow residual is
A) the waste from the production process.
B) the most common measure of productivity shocks.
C) a measure of the efficiency of the production process.
D) a measure of the proportion of involuntarily unemployed workers.
Answer: B
Diff: 1
Type: MC
Page Ref: 360
24) Given data on capital (K), labour (N), and output (Y), and estimates of capital's share of
output (a), the Solow residual is measured as
A) YKaN1-a.
B) (YKa)/N1-a.
C) Y/(KaN1-a).
D) 1/(YKaN1-a).
Answer: C
Diff: 1
Type: MC
Page Ref: 360
25) The formula Y/(KaN1-a) provides a calculation of
A) x-efficiency.
B) dynamic efficiency.
C) economywide monopoly power.
D) the Solow residual.
Answer: D
Diff: 1
Type: MC
Page Ref: 360
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26) Measures of the Solow residual show it to be
A) strongly procyclical.
B) mildly procyclical.
C) mildly countercyclical.
D) strongly countercyclical.
Answer: A
Diff: 1
Type: MC
Page Ref: 362
27) One important reason why the Solow residual may be strongly procyclical even if the actual
technology used in production doesn't change is that
A) employment is procyclical.
B) resource utilization is procyclical.
C) demand shocks are the dominant force determining the business cycle.
D) the coefficients (a and l-a) on capital and labour in the production function are procyclical.
Answer: B
Diff: 1
Type: MC
Page Ref: 362
28) If the utilization rates of capital and labour are procyclical, then
A) output will rise in recessions and decline in expansions.
B) measured productivity will be constant.
C) the Solow residual will be procyclical.
D) prices will be countercyclical.
Answer: C
Diff: 1
Type: MC
Page Ref: 361
29) Labour hoarding occurs
A) when firms keep good workers so other firms can't hire them.
B) when the unemployment rate exceeds the natural rate of unemployment.
C) when involuntary unemployment exceeds voluntary unemployment.
D) when, because of hiring and firing costs, firms retain workers in a recession that they would
otherwise lay off.
Answer: D
Diff: 1
Type: MC
Page Ref: 362
30) When, because of hiring and firing costs, firms retain workers in a recession that they would
otherwise lay off, there is said to be
A) labour hoarding.
B) a decline in capacity utilization.
C) voluntary unemployment.
D) involuntary unemployment.
Answer: A
Diff: 1
Type: MC
Page Ref: 362
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31) An increase in government purchases in the classical model would
A) shift the production function.
B) shift the marginal product of labour curve.
C) shift the labour demand curve.
D) shift the labour supply curve.
Answer: D
Diff: 1
Type: MC
Page Ref: 364
32) Why does a temporary increase in government purchases increase labour supply in the
classical model?
A) The rise in government spending increases labour demand, increasing the real wage, and so
people increase their labour supply.
B) Increased government purchases make people better off, so they work more hours.
C) The increase in current or future taxes needed to pay for the increase in government purchases
reduces people's wealth.
D) People prefer to work harder when the government is doing more for them.
Answer: C
Diff: 2
Type: MC
Page Ref: 364
33) In the classical model, a temporary increase in government purchases causes
A) a decrease in output and the real interest rate.
B) a decrease in output and an increase in the real interest rate.
C) an increase in output and a decrease in the real interest rate.
D) an increase in output and the real interest rate.
Answer: D
Diff: 2
Type: MC
Page Ref: 364
34) In the classical model, a temporary decrease in government spending would cause a decrease
in
A) output, the real interest rate, real wages, and the price level.
B) employment, the real interest rate, real wages, and the price level.
C) output, employment, the real interest rate, and the price level.
D) output, employment, real wages, and the price level.
Answer: C
Diff: 3
Type: MC
Page Ref: 364
35) Classical economists oppose government intervention in the economy for all the reasons
below except that
A) policies to smooth out the business cycle are undesirable in principle.
B) increased government expenditures will lower the real wages of workers.
C) government policy is incapable of smoothing out the business cycle.
D) increases in government spending cannot increase the level of output and employment in the
economy.
Answer: D
Diff: 2
Type: MC
Page Ref: 365
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36) Classical economists would cite all of the following as reasons why the government cannot
smooth out the business cycle except that
A) only productivity shocks can cause real fluctuations in the business cycle.
B) the government has imperfect knowledge of the economy.
C) political constraints on policy actions prevent the government from carrying out effective
policies.
D) time lags between the onset of a recession and the implementation of effective
countermeasures make anti-recessionary macroeconomic policies impractical.
Answer: A
Diff: 2
Type: MC
Page Ref: 365
37) According to classical economists, the government should increase government purchases
when
A) the benefits of the spending exceed the costs.
B) the economy is in a recession.
C) the economy is likely to go into a recession in the next six months to a year.
D) inflation is lower than its targeted level.
Answer: A
Diff: 2
Type: MC
Page Ref: 365
38) According to classical economists, the increase in unemployment in recessions is caused by
A) slack aggregate demand.
B) the failure of wages to adjust to restore equilibrium in the labour market.
C) the power of labour unions, which prevent firms from cutting wages.
D) a mismatch of workers and jobs.
Answer: D
Diff: 2
Type: MC
Page Ref: 366
39) According to classical economists, unemployment rises in recessions due to an increase in
________ unemployment, NOT ________ unemployment.
A) cyclical; frictional and structural
B) frictional and cyclical; structural
C) structural; frictional and cyclical
D) frictional and structural; cyclical
Answer: D
Diff: 2
Type: MC
Page Ref: 366
40) Assuming that money is neutral, a reduction in the nominal money supply would cause
A) an excess demand for goods.
B) a decrease in the real money supply.
C) a fall in the price level.
D) a rise in nominal wages.
Answer: C
Diff: 1
Type: MC
Page Ref: 368
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41) Assuming money neutrality in the classical model, a 10% increase in the nominal money
supply would cause
A) a 10% increase in the real money supply.
B) a 10% decrease in the real money supply.
C) no change in the real money supply.
D) a less than 10% change in the price level due to a shift in the aggregate supply curve.
Answer: C
Diff: 1
Type: MC
Page Ref: 368
42) Classical economists would explain the fact that money is a leading, procyclical
macroeconomic variable by pointing out that
A) money is not neutral, and changes in the nominal money supply affect real variables.
B) increasing the money supply shifts the LM curve, reducing real interest rates and causing an
economic expansion.
C) increasing the money supply increases aggregate demand, causing higher levels of
employment and output.
D) when money demand rises because of a beneficial productivity shock, the Central Bank
increases the money supply to prevent the price level from falling.
Answer: D
Diff: 2
Type: MC
Page Ref: 368
43) The basic classical model can account for the procyclical behaviour of money if there
A) are real business cycles caused by productivity shocks.
B) is reverse causation from future output to money.
C) are rational expectations among the public.
D) are propagation mechanisms in the economy.
Answer: B
Diff: 1
Type: MC
Page Ref: 368
44) Reverse causation means that
A) expected future increases in output cause increases in the current employment.
B) expected future increases in output cause increases in the current money supply.
C) expected future increases in money supply cause increases in the current output.
D) expected future increases in employment cause increases in the current output.
Answer: B
Diff: 1
Type: MC
Page Ref: 368
45) Friedman and Schwartz argue that money is NOT neutral because
A) theoretical models of the economy don't show monetary neutrality.
B) money is a leading, procyclical variable.
C) they found several historical incidents in which changes in the money supply were not
responses to macroeconomic conditions, and output moved in the same direction as money.
D) they found no evidence that productivity changes or changes in government spending
contributed to business cycles; only monetary changes preceded every recession.
Answer: C
Diff: 1
Type: MC
Page Ref: 368
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46) You and a friend are arguing over the issue of the nonneutrality of money. You believe that
money is not neutral, and to prove your point you would cite all of the following except
A) large gold discoveries that increased the money supply preceded an economic boom.
B) a change in monetary institutions preceded a boom or recession.
C) a change in the leadership of the Central Bank and its policy was followed by noticeable
changes in the money supply and a recession or inflation.
D) the fact that every recession was preceded by a drop in the money supply.
Answer: D
Diff: 2
Type: MC
Page Ref: 368
47) Which of the following can be taken as an evidence for the reverse causation between the
money growth and the changes in output?
A) Bank of Canada regularly increases money supply during the Christmas shopping season.
B) Bank of Canada regularly adjusts the level of money supply based on its forecast of the
economic activity.
C) Prices are procyclical.
D) Productivity is procyclical.
Answer: A
Diff: 2
Type: MC
Page Ref: 368
48) Which of the following restates the basic business cycle fact that money is procyclical?
A) Changes in the behaviour of the money stock has been closely associated with changes in
economic activity, nominal income, and prices.
B) Monetary changes have often had an independent origin; they have not been a reflection of
changes in economic activity.
C) The interrelation between monetary and economic changes have been highly stable.
D) Both A and C are correct.
Answer: D
Diff: 2
Type: MC
Page Ref: 369
49) If producers have imperfect information about the general price level and sometimes
misinterpret changes in the general price level as changes in relative prices, then
A) the short-run aggregate supply curve is vertical.
B) the short-run aggregate supply curve slopes upward.
C) the aggregate demand curve is vertical.
D) the aggregate demand curve is horizontal.
Answer: B
Diff: 1
Type: MC
Page Ref: 370
50) The short-run aggregate supply curve can slope upward because
A) prices are fixed in the short run.
B) wages adjust immediately to changing economic circumstances.
C) producers have misperceptions about the aggregate price level.
D) prices adjust instantaneously.
Answer: C
Diff: 1
Type: MC
Page Ref: 371
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51) According to the misperceptions theory, when the aggregate price level is higher than
expected, the aggregate quantity of ________ the full-employment level.
A) output supplied rises above
B) output supplied falls below
C) output demanded falls below
D) output demanded rises above
Answer: A
Diff: 2
Type: MC
Page Ref: 370
52) According to the misperceptions theory, when the price level falls below the expected price
level,
A) the economy's SRAS curve shifts to the left.
B) the economy moves along its AD curve.
C) the economy moves along its LRAS curve.
D) the economy moves along its SRAS curve.
Answer: D
Diff: 1
Type: MC
Page Ref: 371
53) If you expect a general price increase of 5% this year and the price of the hamburgers you
sell increases by 10%, you would conclude that the relative price of your good has
A) declined, and you would increase your output.
B) declined, and you would decrease your output.
C) increased, and you would increase your output.
D) increased, and you would decrease your output.
Answer: C
Diff: 1
Type: MC
Page Ref: 372
54) You are likely to think that the relative price of your good has declined and you should
decrease your output if
A) you expected inflation of 10% and the price of your good rose 7%.
B) you expected inflation of 10% and the price of your good rose 10%.
C) you expected inflation of 10% and the price of your good rose 13%.
D) you expected inflation of 0% and the price of your good rose 10%.
Answer: A
Diff: 1
Type: MC
Page Ref: 375
55) Short-run aggregate supply is greater than long-run aggregate supply in the misperceptions
theory if
A) the actual price level is greater than the expected price level.
B) the actual price level equals the expected price level.
C) the actual price level is less than the expected price level.
D) output is less than its full-employment level.
Answer: A
Diff: 1
Type: MC
Page Ref: 373
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56) Which of the following equations is most likely to represent short-run aggregate supply
according to the misperceptions theory?
A) Y = 6000
B) Y = 6000 + 50(P - Pe)
C) P = 2
D) PY = 12,000
Answer: B
Diff: 1
Type: MC
Page Ref: 373
57) According to the misperceptions theory, when P < Pe, output is ________ its fullemployment level and the short-run aggregate supply curve must shift to the ________ to restore
full employment.
A) below; left
B) below; right
C) above; left
D) above; right
Answer: B
Diff: 2
Type: MC
Page Ref: 377
58) According to the misperceptions theory, an unanticipated decrease in the money supply shifts
the AD curve to the ________, causing output to ________ in the short run.
A) right; rise
B) right; fall
C) left; rise
D) left; fall
Answer: D
Diff: 2
Type: MC
Page Ref: 377
59) According to the misperceptions theory, after an unanticipated increase in the money supply
has occurred, the SRAS curve must shift to the ________ to restore general equilibrium; as it
does so, the price level ________.
A) right; rises
B) right; falls
C) left; rises
D) left; falls
Answer: C
Diff: 2
Type: MC
Page Ref: 377
60) According to the misperceptions theory, an anticipated decline in the money supply leads to
a shift of the AD curve to the ________ and a shift of the SRAS curve to the ________.
A) left; right
B) left; left
C) right; right
D) right; left
Answer: A
Diff: 2
Type: MC
Page Ref: 377
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61) According to the misperceptions theory, an anticipated 10% decrease in the money supply
leads to a short-run reduction in the price level of
A) 0%.
B) 5%.
C) some amount between 0% and 10%.
D) 10%.
Answer: D
Diff: 2
Type: MC
Page Ref: 377
62) Which of the following statements is true about the misperceptions theory?
A) Both anticipated and unanticipated changes in the nominal money supply have real effects on
the economy.
B) Neither anticipated nor unanticipated changes in the nominal money supply has real effects on
the economy.
C) Unanticipated changes in the nominal money supply have real effects, but anticipated changes
are neutral.
D) Anticipated changes in the nominal money supply have real effects, but unanticipated
changes are neutral.
Answer: C
Diff: 1
Type: MC
Page Ref: 370
63) The Central Bank had announced that it would allow M2 to grow by 8% this year, and M2
did grow by 8% this year. You would NOT expect
A) money to be neutral in the short run.
B) money to be neutral in the long run.
C) output to remain unchanged.
D) a movement along the short-run aggregate supply curve.
Answer: D
Diff: 1
Type: MC
Page Ref: 379
64) According to the misperceptions theory, if the Bank wanted to use monetary policy to
influence the real economy, it would have to
A) increase the money supply whenever the economy was in a recession.
B) decrease the money supply whenever the economy was in an inflationary boom.
C) surprise the public with unexpected changes in monetary policy.
D) abide by its announced monetary targets.
Answer: C
Diff: 1
Type: MC
Page Ref: 377
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65) The reason why some economists believe that attempts by the Central Bank to surprise the
public in a systematic way cannot be successful is that
A) information about the Bank's plans will inevitably be leaked to the public.
B) the Bank announces its goals and publishes its policy actions six weeks after they take place.
C) the public would eventually figure out what the Bank's policies were, negating the Bank's
surprise.
D) competition in the money markets would neutralize the Bank's intervention.
Answer: C
Diff: 1
Type: MC
Page Ref: 380
66) The primary reason why the Central Bank cannot systematically surprise the public with its
monetary policy is
A) the nonneutrality of money.
B) the presence of productivity shocks that generate real business cycles independently of the
monetary side of the economy.
C) the presence of rational expectations among the public.
D) the presence of propagation mechanisms within the economy.
Answer: C
Diff: 1
Type: MC
Page Ref: 380
67) The theory of rational expectations suggests that
A) people never make forecast errors.
B) people make intelligent use of available information.
C) people make systematic forecast errors.
D) people are slow to incorporate new information into their forecasts.
Answer: B
Diff: 2
Type: MC
Page Ref: 380
68) According to rational expectations,
A) people never make mistakes when they forecast the future.
B) people never make systematic mistakes when they forecast the future.
C) people always overestimate the inflation rate.
D) people always underestimate the money supply effects.
Answer: B
Diff: 2
Type: MC
Page Ref: 380
69) Money is neutral in both the short and long runs, if we assume
A) people form their expectations based on the rational expectations hypothesis.
B) people forecast the effect of the money supply correctly.
C) people never make mistake when they make forecast.
D) the change of money supply is unanticipated.
Answer: A
Diff: 2
Type: MC
Page Ref: 381
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70) According to the misperceptions theory, short-lived shocks may have long-term effects on
the economy because of
A) multiplier effects.
B) propagation mechanisms.
C) accelerator effects.
D) automatic stabilizers.
Answer: B
Diff: 1
Type: MC
Page Ref: 381
71) The primary reason that short-lived shocks can have long-run effects is
A) the nonneutrality of money.
B) misperceptions by the public over the actual price level and the expected price level.
C) the presence of rational expectations among the public.
D) the presence of propagation mechanisms.
Answer: D
Diff: 1
Type: MC
Page Ref: 381
72) Dynamic Stochastic General Equilibrium (DSGE) models are models that allow analysis of
A) productivity shocks only.
B) productivity as well other shocks that have impacts on the economy.
C) fiscal policy shocks only.
D) monetary policy shocks only.
Answer: B
Diff: 1
Type: MC
Page Ref: 363
73) The real business cycle theory argues that
A) nominal shocks are the main cause of business cycles.
B) nominal shocks are neutral only in the long run.
C) real shocks change output in the short run but not in the long run.
D) real shocks are the main cause of business cycles.
Answer: D
Diff: 2
Type: MC
Page Ref: 354
74) Which of the following is an example of a real shock?
A) an announcement by the Bank of Canada that it is changing its policy on the interest rate
B) a new technology making electricity generation by renewable energies much cheaper
C) stock markets falling because of a decline in oil prices
D) the Bank of Canada increasing the money supply by buying bonds
Answer: B
Diff: 2
Type: MC
Page Ref: 354
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75) The argument that an increase in government purchases increases labour supply relies on the
assumption that
A) government purchases are substitutes for consumer purchases.
B) government purchases decrease the interest rate.
C) government purchases decrease the wealth of individuals.
D) government purchases are neutral.
Answer: C
Diff: 2
Type: MC
Page Ref: 375
76) Which of the following is consistent with the rational expectations theory?
A) John is always right on his predictions of stock market prices.
B) Janice always underestimates inflation rates.
C) Michael always overestimates the effect of government purchases on GDP during recessions.
D) Mona is rarely right in her predictions of stock prices, but her errors are random.
Answer: D
Diff: 3
Type: MC
Page Ref: 379
77) Which of the business cycle facts below cannot be explained unquestionably by the Real
Business Cycle model?
A) The average labour productivity is procyclical.
B) Employment is procyclical.
C) Inflation slows down during or immediately after recession.
D) Recurrent fluctuations in aggregate output.
Answer: C
Diff: 2
Type: MC
Page Ref: 355
78) According to the RBC theory of business cycles,
A) inflation is procyclical.
B) periods of inflation should also be periods of recession .
C) employment is countercyclical.
D) labour productivity is acyclical.
Answer: B
Diff: 2
Type: MC
Page Ref: 355
79) To support the RBC approach according which productivity shocks generate inflation and
recession at the same time, the RBC theorists argue that
A) the conventional approach that inflation is procyclical is consistent with the pre-World War II
economy.
B) the structure of the economy and the types of shocks have changed since the Great
Depression.
C) the oil supply shocks in the 1970s caused the price level to rise while output fell.
D) all of the above.
Answer: D
Diff: 2
Type: MC
Page Ref: 354
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80) Which of the following is NOT part of calibration method used by the RBC theorists to
analyze the business cycles?
A) Write a specific classical model of the economy.
B) Use the previous studies to assign the parameters of the model.
C) Examine the effects of random shocks on the main variables of the model.
D) Estimate the parameters of the model to predict the future values of the model.
Answer: D
Diff: 2
Type: MC
Page Ref: 356
81) Which of the following is NOT considered as a real supply shock?
A) The 2008 financial crisis.
B) The rise in oil prices in the 1970s.
C) The fall in oil prices in 2014.
D) The digital tech revolution in the 1990s.
Answer: A
Diff: 2
Type: MC
Page Ref: 358
82) Which of the following is NOT true about the Solow residual?
A) The Solow residual is part of the output that cannot be directly explained by capital and
labour inputs.
B) The Solow residual may include factors such as government purchases and monetary policy.
C) The Solow residual represents technology shocks.
D) The Solow residual can be measured directly similar to labour and capital inputs.
Answer: D
Diff: 2
Type: MC
Page Ref: 360
83) The Solow residual estimated from a production function for Canada shows
A) a linear upward trend.
B) a procyclical trend and leads the cycle.
C) a linear downward trend.
D) no significant changes through time.
Answer: B
Diff: 2
Type: MC
Page Ref: 360
84) Which of the following is NOT true about the effects of the utilization of inputs on the
business cycles?
A) Even though technology remains constant, utilization of labour and capital leads to business
cycles.
B) Utilization of production input is procyclical.
C) Labour hoarding occurs during recessions.
D) Capital utilization is procyclical, but labour utilization is countercyclical.
Answer: D
Diff: 2
Type: MC
Page Ref: 362
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85) According to the RBC theorists,
A) an increase in money supply cause output to grow.
B) an expected increase in money supply cause current level of output to grow.
C) an expected change in output causes the current money supply to change.
D) an increase in money supply cause output to decline.
Answer: C
Diff: 2
Type: MC
Page Ref: 367
11.2 Essay Questions
1) Use the classical (RBC) IS-LM-FE model to show the effects on the economy of a temporary
beneficial supply shock—for example, a decrease in the price of oil. You should show the impact
on the real wage, employment, output, the real interest rate, consumption, investment, and the
price level.
Answer: The marginal productivity of labour is increased, shifting the labour demand curve to
the right. As a result, the real wage rises and employment increases. Both the higher productivity
and increased employment increase output. The FE line shifts right, with the IS curve
unchanged, so the LM curve must shift down (the price level declines) to restore equilibrium. As
a result, the real interest rate declines, increasing consumption and investment.
Diff: 2
Type: ES
Page Ref: Sec. 11.1
2) How is the Solow residual measured? What problems arise in its measurement when resource
utilization varies over the business cycle? What implications do these measurement issues have
for evidence supporting the RBC model?
Answer: The Solow residual is measured as Y/(KaN1-a). But when resource utilization varies
over the business cycle, this isn't the correct measure of productivity. As a result, productivity
appears to be procyclical, but in fact productivity might be constant. Thus the fact that the
measured Solow residual is strongly procyclical, which has been taken as evidence in support of
RBC models, may not be proof that productivity shocks drive the business cycle.
Diff: 1
Type: ES
Page Ref: Sec. 11.1
3) Use the classical (RBC) IS-LM-FE model to show the effects on the economy of a temporary
decrease in government spending. You should show the impact on the real wage, employment
output, the real interest rate, consumption, investment, and the price level.
Answer: The decrease in government spending reduces current or future taxes, so there's a
positive wealth effect that increases people's desire for leisure and reduces their labour supply.
The decline in labour supply leads to a rise in the real wage and a decline in employment. The
fall in employment leads to less output, so the FE line shifts left. However, the decline in
government spending increases national saving, so the IS curve shifts to the left, most likely by
more than the FE lines does. As a result, the price level must decline to restore equilibrium by
shifting the LM curve down. This results in a decline in the real interest rate, so investment
increases. The effect on consumption is ambiguous.
Diff: 2
Type: ES
Page Ref: Sec. 11.1
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4) Suppose the economy's production function is Y = A(300N - N2). The marginal product of
labour is MPN = A(300 - 2N). Suppose that A = 10. The supply of labour is NS = 0.05w +
0.005G.
a. If G is 26,000, what are the real wage, employment, and output?
b. If G rises to 26,400, what are the real wage, employment, and output?
c. If G falls to 25,600, what are the real wage, employment, and output?
d. In cases (b) and (c), what is the government purchases multiplier; that is, what is the change
in output divided by the change in government purchases?
Answer:
a. Setting labour supply equal to labour demand gives N = 0.05 × 10 × (300 - 2N) + 0.005G,
which can be simplified to get N = 75 + 0.0025G. With G = 26,000, N = 140. Then
w = 10[300 – (2 × 140)] = 200 and Y = 10 × [(300 × 140) - 1402] = 224,000.
b. Following the same procedure gives N = 141, w = 180, and Y = 224,190.
c. N = 139, w = 220, and Y = 223,790.
d. In part (b) the multiplier is 190/400 = 0.475. In part (c) the multiplier is 210/400 = 0.525.
Diff: 2
Type: ES
Page Ref: Sec. 11.1
5) Suppose the money demand of individuals and firms depends on what they perceive to be the
probabilities that the economy will expand or contract over the following six months. Suppose
their money demand is given by the equation L = 0.5 Y - 100i + 20z, where z is the probability
that the economy is expanding six months in the future. If z = 1 the economy will certainly be in
recovery; if z = 0 the economy will certainly be in recession, and for z between 0 and 1 there is
some uncertainly about the future state of the economy. Use a classical (RBC) model of the
economy. If the Central Bank moves the money supply to target the price level, how does the
money supply relate to the expected future state of the economy? Is this an example of reverse
causation?
Answer: For a given level of real output and the nominal interest rate, to target the price level
means that the nominal money supply moves directly with z (so that △M = 20△z). This is a
version of reverse causation because the probability of higher future output affects the money
supply today.
Diff: 2
Type: ES
Page Ref: Sec. 11.2
6) Why do many economists believe that money affects output? What is the empirical evidence
in support of that belief?
Answer: Except for the classical (RBC) model of the economy, other models provide theoretical
reasons for the effect of money on output. These include the misperceptions theory, which finds
that unanticipated changes in money growth, influence output, and the Keynesian theory, which
shows that the failure of prices to adjust to return the economy to equilibrium leads money to
affect output. Friedman and Schwartz looked at historical episodes in which independent
changes in the money supply led to changes in output. This is supported by the work of Romer
and Romer, who reviewed and updated the Friedman and Schwartz analysis, and the Volcker
episode in the early 1980s.
Diff: 1
Type: ES
Page Ref: Sec. 11.3
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7) A classical economy is described by the following equations:
Cd = 500 + 0.5(Y - T) - 100r
Id = 350 - 100r
L = 0.5Y - 200I
Y = 1850
πe = 0.05
Government spending and taxes are equal where T = G = 200. The nominal money supply M =
3560.
a. What are the equilibrium values of the real interest rate, the price level, consumption, and
investment?
b. Suppose an economic shock increases desired investment by 10, so it is now Id = 360 - 100r.
How does this affect the equilibrium values of the real interest rate, the price level, consumption,
and investment?
c. Returning to the initial situation in part (a), suppose an economic shock increases desired
consumption by 10, so it is now Cd = 510 + 0.5 (Y - T) - 100r. How does this affect the
equilibrium values of the real interest rate, the price level, consumption, and investment?
Answer:
a. Sd = Y - Cd - G = 0.5Y - 400 + 100r - 200. Set Sd = Id: 0.5Y - 600 + 100r = 350 - 100r, so
200r = 950 – 0.5Y(IS). With Y = 1850, r = .125. Then C = 1312.5 and I = 337.5. From the money
demand equation, 3560/P = (0.5 × 1850) - (200 × .175) = 925 - 35 = 890, so P = 4.
b. Set Sd = Id: 0.5Y - 600 + 100r = 360 - 100r, so 200r = 960 - 0.5Y(IS). With Y = 1850,
r = .175. Then C = 1307.5 and I = 342.5. From the money demand equation,
3560/P = (0.5 × 1850) - (200 × .225) = 925 - 45 = 890, so P = 4.045.
c. Set Sd = Id: 0.5Y - 610 + 100r = 350 - 100r, so 200r = 960 - 0.5Y(IS). With Y = 1850,
r = .175. Then C = 1317.5, I = 332.5, and P = 4.045.
Diff: 2
Type: ES
Page Ref: Sec. 11.3
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8) Suppose the economy is characterized by the following equations:
IS curve: r = 10.10 - 0.002Y
LM curve: M/P = Y - 250(r + πe)
SRAS curve: Y = Y + 50(P - Pe)
The nominal money supply is M = 9,900, expected inflation is πe = .10, and full-employment
output is Y = 5000.
a. If the economy begins in general equilibrium, what are the equilibrium values of the price
level, output, and the real interest rate?
b. If the expected price level is the price level you found in part (a), what happens to the price
level, output, and the real interest rate in the short run if there's an unanticipated decrease in the
nominal money supply to 7368.75?
c. If the expected price level is the price level you found in part (a), what happens to the price
level, output, and the real interest rate in the short run if there's an unanticipated increase in the
nominal money supply to 12,468.75?
Answer:
a. P = 2, Y = 5000, r = .10
b. P = 1.5, Y = 4975, r = .15
c. P = 2.5, Y = 5025, r = .05
Diff: 2
Type: ES
Page Ref: Sec. 11.3
9) Analyze the short-run and long-run effects of an unanticipated decrease in the money supply
in the misperceptions model. Tell what happens to output, the price level, and the expected price
level in both the short run and long run.
Answer: The reduction in money supply shifts the AD curve left, reducing output and the price
level, while the expected price level is unchanged, since the decrease in money supply was
unanticipated. In the long run, the SRAS curve shifts down as people reduce their expected price
level. The economy returns to full-employment output, but at a lower price level.
Diff: 2
Type: ES
Page Ref: Sec. 11.3
10) Why doesn't stabilization policy work, according to economists using the misperceptions
theory?
Answer: Stabilization policy requires taking systematic action to combat recessions (using
policy) or to fight inflation (using restrictive policy). But policy works only if it is unanticipated,
according to the misperceptions theory. So the use of stimulative policy in a recession would be
anticipated and have no effect. Only unanticipated policy would work, but such a policy would
have to be random, and could not be used to smooth the business cycle.
Diff: 2
Type: ES
Page Ref: Sec. 11.3
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11) An economist takes a survey of people on the street and asks them for forecasts of inflation
over the next year. He takes this survey every month for several years, and finds that people's
forecasts of inflation are biased. People seem to make systematic errors in forecasting inflation.
Also, their forecast errors are correlated: if their forecast was too high one month, it also tended
to be too high the next month. Is this evidence against rational expectations?
Answer: Perhaps not, since people on the street may have little incentive to provide good
forecasts: they may not need to know much about future inflation. If the survey were one of
professional forecasters, whose living depends on their forecasts, then it would suggest a lack of
rational expectations.
Diff: 2
Type: ES
Page Ref: Sec. 11.3
12) Briefly explain the rational expectation hypothesis. What are the basic assumptions of the
hypothesis? What are the implications of the rational expectation hypothesis for the monetary
policy effects on output? Do empirical studies support the idea of rational expectations?
Answer: The rational expectation hypothesis states that the people's forecasts of economic
variables are based on reasoned and intelligent examination of economic data. The hypothesis
assumes that people will use all the relevant information when they forecast economic variables
and that people understand the relationship between economic variables. The rational expectation
hypothesis implies that anticipated policies will have no effect on the real economic activities,
because people understanding the effects of the announced policies will react accordingly.
Diff: 2
Type: ES
Page Ref: Sec. 11.3
13) Use the AD-AS model to describe the short-run and the long-run effects of an unexpected
decrease in the money supply by the Bank of Canada on GDP, the price level, and real wages.
Answer: An unexpected decrease in the money supply will shift the AD curve down and to the
left, leading to lower GDP, a lower price level, and higher real wages in the short-run. In the
long-run, however, people realize that the true price level is shifting the short-run aggregate
supply curve down and to the right. Therefore, in the long-run, the economy will be back to
equilibrium with the same GDP level, a lower price level, and the same real wages.
Diff: 2
Type: ES
Page Ref: Sec. 11.3
14) Suppose the production function in an economy is given by Y = AK0.3 L0.7, where Y is
output, K capital, L labour and A measures productivity. If K = 20 and L = 80 and Y = 100:
a. Find the Solow residual.
b. Find the Solow residual for next year when Y = 120.
c. What is the productivity growth in year 2 measured by the Solow residual.
d. How do capital and labour utilization rates affect Solow residual?
Answer:
a. 1.89, b. 2.27, c. 20 percent,
d. The conventional Solow residual does not include capital and labour utilization rates and,
therefore, it may overestimate the productivity changes. In other words, the conventional Solow
residual assumes that capital and labour are fully utilized.
Diff: 3
Type: ES
Page Ref: 360
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 12 Keynesian Business Cycle Analysis: Non-Market-Clearing Macroeconomics
12.1 Multiple-Choice Questions
1) Keynesians are skeptical of the classical theory that recessions are periods of increased
mismatch between workers and jobs because
A) help-wanted advertising falls during recessions.
B) help-wanted advertising rises during recessions.
C) workers spend a lot of time searching for work in recessions.
D) people are indifferent between being employed or not.
Answer: A
Diff: 1 Type: MC Page Ref: 431
2) Which of the following statements is false?
A) Keynesians, like classicals, believe that people's expectations are formed based on the rational
expectations hypothesis.
B) Keynesians, like classicals, recognize the effect of productivity shocks on the business cycles.
C) Keynesians, like classicals, believe that the free market is able to respond quickly and
efficiently to the aggregate demand shocks.
D) Keynesians, unlike classicals, believe that aggregate demand shocks are the main source of
the business cycles.
Answer: C
Diff: 2 Type: MC Page Ref: 402
3) In the Keynesian model,
A) the short-run aggregate supply slopes upward because of price misperception by firms.
B) the short-run aggregate supply slopes upward because the actual price may be different from
the expected price during the term of wage contract.
C) the short-run aggregate supply is horizontal because of price misperception by firms.
D) the short-run aggregate supply is horizontal because the actual price may be different from the
expected price during the term of wage contract.
Answer: B
Diff: 2 Type: MC Page Ref: 396
4) According to Keynesian theory, the SRAS curve is positively sloped because
A) employers and employees fail to predict prices correctly.
B) employers and employees have misperception about the change in relative price level.
C) labour contracts are signed for a period in which labour market conditions are not known.
D) wages are flexible, but prices are not.
Answer: C
Diff: 2 Type: MC Page Ref: 394
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5) The main difference between classical economists and the Keynesians in explaining the SRAS
curve is that
A) classicals argue that prices are rigid, but Keynesians argue that wages are rigid.
B) classicals argue that wages are rigid, but Keynesians argue that prices are rigid.
C) classicals argue that output changes with price changes as long as there is misperception about
relative price levels, but Keynesians argue that the SRAS curve is positively sloped for the term
of the labour contracts.
D) classicals argue that the SRAS curve is positively sloped because of rational expectations, but
Keynesians argue that it is because of the failure of rational expectations.
Answer: C
Diff: 2 Type: MC Page Ref: 394
6) Which one of the following describes Keynesians' rationale for the positively sloped SRAS
curve?
A) Nominal wages are fixed for the term of labour contracts, but price level changes, leading to a
change in real wages and output.
B) Demand for labour increases as prices increase and therefore profits increase.
C) Workers prefer longer term contracts because of job security.
D) There is misperception about the relative price levels.
Answer: A
Diff: 2 Type: MC Page Ref: 394
7) In the Keynesian model of the business cycles,
A) unanticipated changes in government expenditures cause output to change by change in real
wage.
B) anticipated changes in government expenditures cause output to change by changes in real
wage.
C) anticipated changes in money supply cause output to change by changes in real wage.
D) anticipated or unanticipated changes in money supply cause output to change by changes in
real wage.
Answer: A
Diff: 2 Type: MC Page Ref: 400
8) In the Keynesian model, the economy can be off the FE line and the LRAS curve in the short
run because
A) the interest rate is slow to adjust.
B) the unemployment rate is high during recession.
C) the actual price level differs from what was expected when nominal wage contracts were
signed.
D) real wage is sticky in short run.
Answer: C
Diff: 2 Type: MC Page Ref: 396
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9) In the Keynesian model, wages and prices are
A) sticky in the short run, but flexible in the long run.
B) sticky in the long run, but flexible in the short run.
C) forecast accurately by both employees and employers.
D) flexible in the short run and the long run.
Answer: A
Diff: 2 Type: MC Page Ref: 392
10) Anticipated changes in the aggregate demand, in the Keynesian model
A) would affect the output in the short run.
B) would affect the output in the long run.
C) would not affect the output in the short and long runs.
D) would affect the output in the case of the money supply changes.
Answer: C
Diff: 2 Type: MC Page Ref: 410
11) An unanticipated increase in the money supply would
A) shift the LM curve to the right and the AD curve up and to the right.
B) shift the LM curve to the left and the AD curve up and to the right.
C) shift the LM curve to the right and the AD curve down and to the left.
D) shift the IS curve to the right and the AD curve up and to the right.
Answer: A
Diff: 2 Type: MC Page Ref: 399
12) Unanticipated increase in the government expenditures would
A) shift the LM curve to the right, and the AD curve up and to the right.
B) shift the IS curve to the right, and the AD curve up and to the right.
C) shift the IS curve to the left, and the AD curve up and to the right.
D) shift the IS curve to the right, and the AD curve down and to the left.
Answer: B
Diff: 2 Type: MC Page Ref: 400
13) The Keynesian theory of nominal wage rigidity predicts that
A) the real wage is countercyclical.
B) the real wage is procyclical.
C) the real wage is acyclical.
D) the real wage is constant.
Answer: A
Diff: 2 Type: MC Page Ref: 408
14) Which of the following is true in the Keynesian model?
A) An easy fiscal policy affects output despite the effect of fiscal policy on the interest rates.
B) An easy monetary policy is associated with an increase in interest rates.
C) An easy fiscal policy is associated with a decrease in interest rates.
D) An easy monetary policy will lead to crowding-out effect.
Answer: A
Diff: 2 Type: MC Page Ref: 404
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15) The crowding-out effect will probably occur when
A) the government budget is in surplus.
B) the government follows an easy fiscal policy.
C) the government follows a tight fiscal policy.
D) the government crowds out the economy by lowering the interest rate.
Answer: B
Diff: 2 Type: MC Page Ref: 404
16) The crowding-out effect refers to a situation where
A) an easy fiscal policy reduces interest rate and increases investment.
B) an easy monetary policy reduces interest rate and increases investment.
C) an easy fiscal policy increases interest rate and decreases investment.
D) an easy monetary policy increases interest rate and decreases investment.
Answer: C
Diff: 1 Type: MC Page Ref: 404
17) When consumption and investment is reduced because of the higher interest rates induced by
the government expansionary fiscal policy, the effect is called
A) the crowding-in effect.
B) the crowding-out effect.
C) the multiplier effect.
D) the budget effect.
Answer: B
Diff: 2 Type: MC Page Ref: 404
18) The crowing-out effect occurs because of
A) higher prices induced by the expansionary fiscal policy.
B) higher interest rates induced by the expansionary fiscal policy.
C) higher inflation induced by the expansionary fiscal policy.
D) higher output induced by the expansionary fiscal policy.
Answer: B
Diff: 2 Type: MC Page Ref: 404
19) Which of the following statements about the behaviour of the real wages in the business
cycles is true?
A) The sticky wage theory can produce procyclical real wages.
B) The sticky wage theory along with the price rigidity theory can explain the fact that the real
wages are procyclical.
C) The sticky wage theory along with the price rigidity theory can explain the fact that the real
wages are countercyclical.
D) The sticky wage theory can explain the fact that the real wages are acyclical.
Answer: B
Diff: 2 Type: MC Page Ref: 412
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20) Keynesian business cycle theory cannot account for the procyclical behaviour of
A) employment, money, inflation, and labour productivity with the labour hoarding assumption.
B) unemployment, money, inflation, and labour productivity with the labour hoarding
assumption.
C) employment, money, real interest rates, and real wages with sticky wages.
D) unemployment, money, inflation, and real wages.
Answer: A
Diff: 2 Type: MC Page Ref: 413
21) A model in which individual producers act as price setters, because there are only a few
sellers and the product they sell is not standardized, is called
A) imperfect competition.
B) perfect competition.
C) monopoly.
D) monopsony.
Answer: A
Diff: 1 Type: MC Page Ref: 408
22) When the demand for an imperfect competitor's product is greater than it planned, the firm
will
A) increase the price of the product until supply equals demand.
B) meet the demand at its set price.
C) reduce the price until supply equals demand.
D) allow a shortage of the product to develop, without changing the product's price.
Answer: B
Diff: 1 Type: MC Page Ref: 408
23) The theory that firms will be slow to change their products' prices in response to changes in
demand because there are costs to changing prices is called
A) transactions cost theory.
B) cost-benefit theory.
C) menu cost theory.
D) gift exchange theory.
Answer: C
Diff: 1 Type: MC Page Ref: 409
24) The short run aggregate supply curve is
A) positively sloped in both Keynesian and the classical models.
B) positively sloped in the Keynesian model, but horizontal in the classical model.
C) positively sloped in the classical model, but horizontal in the Keynesian model.
D) horizontal in both Keynesian and the classical models.
Answer: A
Diff: 1 Type: MC Page Ref: 395
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25) Consider the following short run aggregate supply equation: Y = + b (P - Pe), where Y is
the real output, is the full employment output, P and Pe are the actual and expected price
levels, respectively. Which of the following is correct?
A) In the Keynesian model, b is positive because of the sticky wage assumption.
B) In the Keynesian model, b is zero because of the sticky wage assumption.
C) In the classical model, b is zero because of the price misperception assumption.
D) Both A and C are correct.
Answer: A
Diff: 2 Type: MC Page Ref: 395
26) Consider the following short run aggregate supply equation: Y = + b (P - Pe), where Y is
the real output, is the full employment output, P and Pe are the actual and expected price
levels, respectively. Which of the following is correct?
A) In the Keynesian model, P is always equal to Pe because of sticky-wage assumption.
B) In the Keynesian model, P may be different than Pe because of sticky-wage assumption.
C) In the Keynesian model, P is always greater than Pe because of sticky-wage assumption.
D) In the Keynesian model, P is always less than Pe because of sticky-wage assumption.
Answer: B
Diff: 2 Type: MC Page Ref: 395
27) Consider the following short run aggregate supply equation: Y = + b (P - Pe), where Y is
the real output, is the full employment output, P and Pe are the actual and expected price
levels, respectively. Which of the following is correct?
A) In the classical model, P is always equal to Pe because of price misperception assumption.
B) In the classical model, P may be different than Pe because of price misperception assumption.
C) In the classical model, P is always greater than Pe because of price misperception
assumption.
D) In the classical model, P is always less than Pebecause of price misperception assumption.
Answer: B
Diff: 2 Type: MC Page Ref: 395
28) According to the menu cost theory, firms will be slow in changing their prices because
A) if prices changed frequently, individuals would reduce their demand for that good because of
uncertainty.
B) frequent price changes would be a sign of monopolistic behaviour.
C) the cost of changing the price might exceed the additional revenue the price change would
generate.
D) demand for their product would fall because consumers would purchase goods from firms
that had not raised their prices.
Answer: C
Diff: 1 Type: MC Page Ref: 409
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29) If the menu cost theory is true, then firms that change prices less frequently than other firms
are likely to be in
A) more competitive industries.
B) service, rather than manufacturing, industries.
C) growing, rather than declining, industries.
D) less competitive industries.
Answer: D
Diff: 2 Type: MC Page Ref: 409
30) In setting the price of its product, a monopolistic competitor sets the price equal to its
marginal cost plus an amount called the
A) markup.
B) profit.
C) rent.
D) menu cost.
Answer: A
Diff: 1 Type: MC Page Ref: 408
31) In the Keynesian model in the short run, the amount of employment is determined by the
effective labour demand curve and the level of
A) prices.
B) output.
C) the real interest rate.
D) the supply of labour.
Answer: B
Diff: 1 Type: MC Page Ref: 397
32) In the Keynesian model, short-run equilibrium occurs
A) where the IS and LM curves intersect.
B) where the IS curve, LM curve, and FE lines intersect.
C) where the IS curve intersects the FE line.
D) where the LM curve intersects the FE line.
Answer: A
Diff: 1 Type: MC Page Ref: 397
33) In the Keynesian model in the short run, an increase in the money supply will cause
A) an increase in output and a decrease in the real interest rate.
B) a decrease in the real interest rate but no change in output.
C) an increase in the real interest rate and an increase in output.
D) no change in either the real interest rate or output.
Answer: A
Diff: 1 Type: MC Page Ref: 398
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34) Which of the following is true about the short run effects of a contractionary monetary policy
in Keynesian model?
A) Output declines, price level declines, real interest rate rises.
B) Output increases, price level increases, real interest rate declines.
C) Output increases, price level increases, real interest rate increases.
D) Output declines, price level declines, real interest rate declines.
Answer: A
Diff: 2 Type: MC Page Ref: 398
35) Which of the following is true about the long run effects of a contractionary monetary policy
in Keynesian model?
A) Output declines, price level declines, real interest rate rises.
B) Output increases, price level increases, real interest rate declines.
C) Output does not change, price level decreases, real interest rate does not change.
D) Output declines, price level declines, real interest rate declines.
Answer: C
Diff: 2 Type: MC Page Ref: 398
36) In the Keynesian model, money is
A) neutral in both the short run and the long run.
B) neutral in neither the short run nor the long run.
C) neutral in the short run, but not in the long run.
D) neutral in the long run, but not in the short run.
Answer: D
Diff: 1 Type: MC Page Ref: 400
37) In the Keynesian model in the long run, an increase in the money supply will cause
A) an increase in output and a decrease in the real interest rate.
B) a decrease in the real interest rate but no change in output.
C) an increase in the real interest rate and an increase in output.
D) no change in either the real interest rate or output.
Answer: D
Diff: 2 Type: MC Page Ref: 400
38) In the Keynesian model, the short run aggregate supply curve is
A) perfectly horizontal.
B) upward sloping, but relatively flat.
C) upward sloping, but relatively steep.
D) perfectly vertical.
Answer: A
Diff: 1 Type: MC Page Ref: 399
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39) In the Keynesian model, a decrease in the money supply would cause prices to ________ in
the short run and ________ in the long run.
A) remain unchanged; remain unchanged.
B) remain unchanged; decrease
C) decrease; remain unchanged
D) decrease; decrease
Answer: B
Diff: 2 Type: MC Page Ref: 400
40) In the Keynesian model in the long run, an increase in the money supply will cause
________ in the real interest rate and ________ the price level.
A) an increase; an increase
B) a decrease; an increase
C) no change; an increase
D) no change; no change
Answer: C
Diff: 2 Type: MC Page Ref: 400
41) According to Keynesians, the primary reason money is NOT neutral is
A) rational expectations.
B) price stickiness.
C) reverse causation.
D) misperceptions over the aggregate price level.
Answer: B
Diff: 1 Type: MC Page Ref: 406
42) In the Keynesian model in the long run, an increase in the money supply will
A) raise the price level but not the level of output.
B) raise the level of output but not the price level.
C) raise both the level of output and the price level.
D) raise neither the level of output nor the price level.
Answer: A
Diff: 1 Type: MC Page Ref: 410
43) Using the Keynesian model, the effect of an increase in corporate taxes would be to cause
________ in the real interest rate and ________ in output in the short run.
A) a decrease; a decrease
B) a decrease; no change
C) a decrease; an increase
D) no change; a decrease
Answer: A
Diff: 2 Type: MC Page Ref: 402
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44) Using the Keynesian model, the effect of a government-imposed ceiling on interest rates paid
on personal chequing accounts that is lower than the current market interest rate would be to
cause ________ in the real interest rate and ________ in output in the short run.
A) a decrease; a decrease
B) a decrease; no change
C) a decrease; an increase
D) an increase; a decrease
Answer: C
Diff: 3 Type: MC Page Ref: 402
45) In the Keynesian model, an increase in government purchases affects output by
A) increasing labour supply, because workers feel effectively poorer.
B) increasing saving to pay for future taxes, lowering the real interest rate and shifting the IS
curve to the left.
C) increasing the real interest rate due to crowding out, reducing aggregate demand.
D) increasing aggregate demand as national saving declines.
Answer: D
Diff: 2 Type: MC Page Ref: 402
46) In the Keynesian model in the short run, a decrease in government purchases causes output
to ________ and the real interest rate to ________.
A) fall; rise
B) fall; fall
C) rise; rise
D) rise; fall
Answer: B
Diff: 2 Type: MC Page Ref: 402
47) In the Keynesian model in the long run, a decrease in taxes causes the price level to
________ and the real interest rate to ________.
A) fall; rise
B) fall; fall
C) rise; rise
D) rise; fall
Answer: C
Diff: 2 Type: MC Page Ref: 402
48) Suppose the government decided to tighten monetary policy and decrease government
expenditures. In the short run in the Keynesian model, the effect of these policies would be to
________ the real interest rate and ________ the level of output.
A) lower; decrease
B) lower; have an ambiguous effect on
C) have an ambiguous effect on; decrease
D) raise; decrease
Answer: C
Diff: 2 Type: MC Page Ref: 403
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49) Suppose the government decided to ease monetary policy, then increase taxes. In the short
run in the Keynesian model, the effect of these policies would be to ________ the real interest
rate and ________ the level of output.
A) lower; increase
B) lower; decrease
C) lower; have an ambiguous effect on
D) have an ambiguous effect on; increase
Answer: C
Diff: 2 Type: MC Page Ref: 402
50) According to Keynesians, the primary source of business cycle fluctuations is
A) aggregate demand shocks.
B) productivity shocks.
C) oil price shocks.
D) consumer confidence shocks.
Answer: A
Diff: 1 Type: MC Page Ref: 412
51) The Keynesian theory is consistent with the business cycle fact that inflation is
A) procyclical and leading.
B) procyclical and lagging.
C) countercyclical and leading.
D) countercyclical and lagging.
Answer: B
Diff: 1 Type: MC Page Ref: 412
52) The idea that firms retain some workers in a recession, whom they would otherwise lay off,
to avoid the costs of hiring and training, is called
A) the gift exchange motive.
B) worker pooling.
C) labour hoarding.
D) union busting.
Answer: C
Diff: 1 Type: MC Page Ref: 413
53) Keynesians explain the procyclical behaviour of average labour productivity by introducing
the concept of
A) menu costs.
B) sticky prices.
C) sticky wages.
D) labour hoarding.
Answer: D
Diff: 1 Type: MC Page Ref: 413
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54) The economy is currently in a recession due to a reduction in consumer confidence. Output
and the real interest rate are below their levels prior to the recession. Six months later the
economy has returned to its equilibrium level of output and the previous interest rate. Which of
the following must have happened?
A) The government did not intervene in the economy.
B) The government increased the money supply.
C) The government decreased the money supply.
D) The government increased purchases of goods.
Answer: D
Diff: 2 Type: MC Page Ref: 415
55) In the Keynesian model, the difference between using monetary and fiscal policy to eliminate
a recession is that
A) monetary policy will eliminate a recession quicker than fiscal policy will.
B) fiscal policy will eliminate a recession quicker than monetary policy will.
C) an expansionary monetary policy will leave the economy with a lower real interest rate than
an expansionary fiscal policy.
D) an expansionary fiscal policy will leave the economy with a lower real interest rate than an
expansionary monetary policy.
Answer: C
Diff: 2 Type: MC Page Ref: 404
56) To use fiscal expansion to fight a recession without discouraging investment, we must have
________ monetary policy and ________ fiscal policy
A) tight; easy
B) tight; tight
C) easy; easy
D) easy; tight
Answer: C
Diff: 2 Type: MC Page Ref: 404
57) The recent experience in Japan was characterized by ________ monetary policy and
________ fiscal policy.
A) tight; easy
B) tight; tight
C) easy; easy
D) easy; tight
Answer: D
Diff: 2 Type: MC Page Ref: 404
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58) In the Keynesian model, the difference between no intervention by the government during a
recession and intervention using expansionary monetary or fiscal policy is that no intervention
will return the economy to its equilibrium level of output ________ than intervention will and at
a ________ price level.
A) faster; lower
B) slower; higher
C) slower; lower
D) faster; higher
Answer: C
Diff: 2 Type: MC Page Ref: 414
59) A problem with the use of aggregate demand management to stabilize the business cycle is
that
A) monetary policy isn't available to use when interest rates are already rising because of higher
inflation.
B) fiscal policy takes a long time to have any impact on the economy.
C) monetary policy is difficult to use, because the decision-making process is long and
complicated.
D) the precise amount that output will change in response to monetary or fiscal policy isn't
known.
Answer: D
Diff: 2 Type: MC Page Ref: 413
60) In the long run in the Keynesian model, a beneficial supply shock would leave the economy
with a higher level of output, but also a ________ real interest rate and a ________ price level.
A) higher; lower
B) lower; higher
C) lower; lower
D) higher; higher
Answer: C
Diff: 2 Type: MC Page Ref: 411
61) In the short run in the Keynesian model, an oil price shock would leave the economy with a
________ level of output and a ________ real interest rate.
A) higher; lower
B) lower; higher
C) lower; lower
D) higher; higher
Answer: B
Diff: 2 Type: MC Page Ref: 414
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62) The main difference between the short-run and the long-run aggregate supply in the
Keynesian model is
A) in the short run prices and wages are assumed fixed, but in the long run they are assumed
flexible.
B) in the short run prices are assumed flexible but wages fixed, whereas in the long run both are
assumed flexible.
C) in the short run wages are assumed flexible but prices fixed, whereas in the long run both are
assumed flexible.
D) in the short run potential GDP is equal to actual GDP, but in the long run the former exceeds
the latter.
Answer: B
Diff: 2 Type: MC Page Ref: 393
63) The short-run aggregate supply curve is upward sloping
A) in both the Classical and Keynesian models, but for different reasons.
B) in the Classical model, but not in the Keynesian model.
C) in the Keynesian model, but not in the Classical model.
D) in neither the Classical nor the Keynesian model.
Answer: A
Diff: 1 Type: MC Page Ref: 392
64) The upward-sloping short-run aggregate supply curve implies that
A) money is neutral in the short run but has a real effect in the long run.
B) money is neutral in the long run but has a real effect in the short run.
C) money is neutral in both the short run and the long run.
D) money has real effects in both the short run and the long run.
Answer: B
Diff: 2 Type: MC Page Ref: 393
65) The main difference between the Keynesian and Classical models is that
A) the Keynesian model assumes wages are rigid in the short run, but the Classical model
assumes economic agents experience price misperception.
B) the Classical model assumes expectations are rational, but the Keynesian model assumes
economic agents do not have rational expectations.
C) the Keynesian model suggests that anticipated changes in policies have real effects, but the
Classical model suggests that only unanticipated changes in policies have real effects.
D) the aggregate supply curve is upward sloping in the Keynesian model but vertical in the
Classical model.
Answer: A
Diff: 2 Type: MC Page Ref: 399
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66) Which one of the following is NOT a criticism of the nominal-wage rigidity assumption?
A) Less than one-third of the labour force in Canada is covered by a labour contract.
B) Some labour contracts contain cost-of-living adjustments.
C) Real wages are procyclical.
D) Both employees and employers make their decisions based on rational expectations.
Answer: D
Diff: 2 Type: MC Page Ref: 406
67) The equation Y = Y* + b(P - Pe), where Y is output, Y* full-employment output, P and Pe are
price and expected price levels, respectively, and b is a parameter,
A) represents Keynesian model of nominal-wage rigidity.
B) represents Classical model of price misperception.
C) represents aggregate supply.
D) All of the above.
Answer: D
Diff: 2 Type: MC Page Ref: 395
68) According to the Keynesian model of nominal-wage rigidity,
A) if actual and expected prices are the same, output gap will be zero.
B) even if actual and expected prices are the same, output gap will be positive.
C) even if actual and expected prices are the same, output gap will be negative.
D) output gap exists because of price misperception.
Answer: A
Diff: 2 Type: MC Page Ref: 395
69) The reason for disequilibrium in the short run in the Keynesian model of nominal-wage
rigidity is
A) employers and employees do not know about the actual relative prices.
B) the contracts according which wages are set for a specific period and can be negotiated only
when the contract term ends.
C) unions which supports fixed wages during the contracts.
D) that prices and wages move together in the long run.
Answer: B
Diff: 2 Type: MC Page Ref: 396
70) Which of the following is true about the Keynesian aggregate supply (AS) curve?
A) The short-run AS is flat, but the long-run AS is vertical.
B) The short-run AS is upward sloping but the long-run AS is flat.
C) The short-run AS is upward sloping but the long-run AS is vertical.
D) The short-run and the long-run AS are upward sloping.
Answer: C
Diff: 1 Type: MC Page Ref: 396
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71) The analysis that monetary policy is effective in the short-run but not in the long-run can be
presented by which of the following statement?
A) The short-run AS curve is flat, but the long-run AS is vertical.
B) The short-run AS curve is positively sloped, but the long-run AS is flat.
C) The short-run and the long-run AS are both positively sloped.
D) The short-run AS curve is positively sloped, but the long-run AS is vertical.
Answer: D
Diff: 2 Type: MC Page Ref: 398
72) An anticipated change in monetary policy does not have any effect on output because
A) employees and employers negotiate a nominal wage according to the anticipated change in
the price levels.
B) employees and employers cannot negotiate a nominal wage during the contract period.
C) employees and employers do not agree on the effect of the anticipated monetary policy.
D) unions always push for higher wages in their negotiations.
Answer: A
Diff: 2 Type: MC Page Ref: 309
73) According to the Classical model, an anticipated fiscal policy
A) cannot affect output and employment.
B) can affect output and employment in the short run.
C) can effect output and employment in the long run.
D) changes labour supply and therefore full-employment level of output.
Answer: D
Diff: 2 Type: MC Page Ref: 400
74) An anticipated fiscal policy in the form of a tax hike
A) increases labour supply and full-employment level of output in the Classical model.
B) increases full-employment level of output through higher aggregate demand in the Keynesian
model.
C) increases leisure and decreases labour supply and output in the Classical model.
D) has the same effect in the Keynesian and Classical models.
Answer: A
Diff: 2 Type: MC Page Ref: 401
75) The reason for different effects of an anticipated fiscal policy on the full-employment output
in the Keynesian and Classical models is
A) the Keynesian model assumes perfect insight, but the Classical model assumes rational
expectations.
B) the Keynesian model assumes rational expectations, but the Classical model assumes perfect
insight.
C) the Keynesian model assumes perfect insight, but the Classical model assumes rational
D) contrary to the Classical model, the Keynesian model assumes that policy has no wealth
effect.
Answer: D
Diff: 2 Type: MC Page Ref: 402
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76) An easy fiscal policy generates
A) multiplier effect only.
B) crowding effect only.
C) both multiplier effect and crowding out effect.
D) neither multiplier effect nor crowding out effect.
Answer: C
Diff: 2 Type: MC Page Ref: 404
12.2 Essay Questions
1) The effort of a firm's workers depends on their real wage according to the following schedule:
The marginal product of labour is MPN = E(400 - 4N)/30.
a. What is the efficiency wage?
b. How many workers will the firm hire?
c. Suppose an adverse productivity shock reduces the marginal product of labour to
MPN = E(360 - 4N)/30. How would your answers to parts (a) and (b) change?
Answer: The following table shows the real wage (w), the effort level (E), and the effort per unit
of real wages (E/w).
a. The firm will pay a wage of 20, since that wage provides the maximum effort per unit of the
real wage (E/w = 1.25).
b. The firm will employ 94 workers, since that is the number of workers for which w = MPN;
20 = 25(400 - 4N)/30, so 4N = 376, so N = 94.
c. No effect on efficiency wage; employment falls to N = 84.
Diff: 2 Type: ES
Page Ref: Sec. 12.A
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2) A monopolistically competitive firm prices its product using the markup pricing formula P =
1.25MC, where MC is the marginal cost of producing an additional unit. Suppose the demand for
the firm's product is given by Q = 2000 - 0.1P, so the revenue from selling Q units of the product
is PQ = 2000P – 0.1P2.
a. If the marginal cost of producing each unit of the product is $10,000, calculate the price of
the product, the quantity produced, and the firm's revenues, costs, and profits.
b. Now suppose the marginal cost rises to $11,000. The firm can keep the price of the product
unchanged, or it can change the product's price at a total cost of $700,000. Calculate the price,
quantity, revenues, costs, and profits as in part (a) both for changing the price and leaving the
price unchanged. Should the firm change the price of its product?
Answer:
a. P = $12,500, Q = 750, revenues = $9.375 million, costs = $7.5 million, profit = $1.875
million.
b. If price is unchanged, quantity and revenues remain the same, while costs rise to $8.25
million and profits fall to $1.125 million. If the firm raises its price, P = $13,750, Q = 625,
revenues = $8.59375 million, costs = $6.875 million + $.7 million = $7.575 million, and
profit = $1.01875 million. So the firm should leave the price unchanged.
Diff: 2 Type: ES
Page Ref: Sec. 12.4
3) a. Draw a figure, using the Keynesian IS-LM framework, of an economy in recession.
b. Now suppose the IS curve shifts to the right far enough that if the real interest rate is
unchanged, output will increase beyond full employment. If the Central Bank's goal is to move
output to its full-employment level, what must happen to the real interest rate? What is the effect
on the price level?
c. Suppose, before the Bank can act, that the government announces a restrictive fiscal policy,
shifting the IS curve to the left relative to its position in part (b). What is the Bank likely to do
(relative to what it would do if fiscal policy wasn't restrictive) if its goal is to target fullemployment output? What happens to the real interest rate relative to what it is in part (b)?
Answer:
a. The figure should be drawn such that the IS and LM curves intersect to the left of the FE line.
b. The Bank would shift the LM curve to restore general equilibrium. The real interest rate
would rise but the price level wouldn't change.
c. Tighter fiscal policy means the Bank shifts the LM curve down relative to what it would do in
part (b). As a result, the real interest rate doesn't rise as much.
Diff: 2 Type: ES
Page Ref: Sec. 12.2
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4) According to the Keynesian IS-LM model, what is the effect of each of the following on
output, the real interest rate, employment, and the price level? Distinguish between the short run
and the long run.
a. expected inflation declines
b. wealth declines
c. labour supply increases due to a change in demographics
d. the future marginal product of capital increases
Answer:
a. Short run: Y and N decline, r rises, P is unchanged.
Long run: P declines; Y, r, and N are unchanged.
b. Short run: Y, r, and N decline; P is unchanged.
Long run: r and P decline; Y and N are unchanged.
c. Nothing happens to any of the variables.
d. Short run: Y, r, and N rise; P is unchanged.
Long run: r and P rise; Y and N are unchanged.
Diff: 2 Type: ES
Page Ref: Sec. 12.2
5) A Keynesian economy is described by the following equations:
Cd = 250 + 0.5(Y - T) - 250r
Id = 250 - 250r
G = 300
T = 300
L = 0.5Y - 500r + πe
M = 3000
Y = 1250
πe = 0
a. Calculate the values of the real interest rate, the price level, consumption, and investment for
the economy in general equilibrium.
b. Now suppose government purchases increase to 350 with no change in taxes. What will be
the real interest rate, the price level, output, consumption, and investment in the short run?
c. What will be the real interest rate, the price level, output, consumption, and investment in the
long run?
Answer:
a. r = .05, P = 5, C = 712.5, I = 237.5
b. r = .10, P = 5, Y = 1300, C = 725, I = 225
c. r = .15, P = 5.4545, Y = 1250, C = 687.5, I = 212.5
Diff: 3 Type: ES
Page Ref: Sec. 12.2
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6) The following equations describe a Keynesian model of the economy:
Cd = 500 - 0.5(Y - T) - 100r
Id = 350 - 100r
L = 0.5Y - 200i
πe = 0.05, G = T = 200, Y = 1850
M = 3560
a. Find the full-employment equilibrium values of the real interest rate, consumption,
investment, and the price level.
b. Suppose government purchases decline to 175, with no change in taxes. What happens to the
real interest rate, output, consumption, and investment in the short run (in which the price level is
fixed)? What happens in the long run to the real interest rate, consumption, investment, and the
price level?
c. Suppose instead that government purchases rise to 225, with no change in taxes, starting
from the equilibrium in part (a). What happens to the real interest rate, output, consumption, and
investment in the short run (in which the price level is fixed)? What happens in the long run to
the real interest rate, consumption, investment, and the price level?
Answer:
a. Sd = Y - Cd - G = 0.5Y - 400 + 100r - G. Set Sd = Id: 0.5Y - 400 + 100r - G = 350 - 100r,
so
.
With G = 200 and Y = 1850, r = 125. Then C = 1312.5 and I = 337.5. 3560/P
= (0.5 × 1850) , so P = 4.
b. With P = 4, the LM curve is 3560/4 = 0.5Y - 200r - (200 × .05), or 0.5Y = 900 + 200r.
Combining this with the IS curve gives Y = 1650 + G.
For G = 175, Y = 1825, so r = .0625, C = 1306.25, I = 343.75 in the short run.
In the long run,
, so r = 0, C = 1325, I = 350, P = 3.891.
c. For G = 225, Y = 1875, so r = .1875, C = 1318.75, I = 331.25 in the short run.
In the long run,
, so r = 0.25, C = 1300, I = 325, P = 4.116.
Diff: 2 Type: ES
Page Ref: Sec. 12.2
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7) You are the liaison between the Bank of Canada and the Department of Finance. Your goal is
to coordinate policy efforts to achieve full-employment output in the economy while keeping a
fixed real interest rate. You must recommend tightening or easing both monetary and fiscal
policies to do this. What would your recommendation be in each of the following situations?
a. People decide to increase saving.
b. Expected inflation declines.
c. The future marginal productivity of capital declines.
d. There's an adverse oil price shock in which the LM curve moves farther to the left than does
the FE line
Answer:
a. Loosen fiscal policy, no change in monetary policy
b. Ease monetary policy, no change in fiscal policy
c. Ease fiscal policy, no change in monetary policy
d. Tighten fiscal policy, ease monetary policy
Diff: 3 Type: ES
Page Ref: Sec. 12.5
8) You are the governor of the Central Bank of Atlantis. You believe in a Keynesian model of the
economy, and your goal is to keep the economy at the full-employment level of output. How
would you respond (tightening or easing policy) in each of the following cases?
a. Government purchases increase.
b. Corporate tax rates increase.
c. Expected inflation increases.
d. There's a beneficial oil price shock (and the LM curve shifts more to the right than the FE
line).
Answer:
a. tighten
b. ease
c. tighten
d. tighten
Diff: 2 Type: ES
Page Ref: Sec. 12.5
9) Discuss the major problems that arise in practice in attempting to use aggregate demand
management to stabilize the economy.
Answer: There are problems in gauging how far the economy is from full-employment, knowing
how much output responds to a change in monetary or fiscal policy, and forecasting the economy
reasonably well.
Diff: 1 Type: ES
Page Ref: Sec. 12.5
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10) Describe the effects of an oil price shock in a Keynesian model; why are such supply shocks
difficult to handle using macroeconomic stabilization policies?
Answer: The FE line shifts left, the LM curve even more so, so the economy enters a recession.
The price level rises immediately, the real interest rate rises, and output declines.
Macroeconomic stabilization policy can't restore output to its previous level, for the attempt to
do so will cause inflation. Even restoring the economy to its (lower) full-employment level of
output is difficult without risking even higher inflation.
Diff: 1 Type: ES
Page Ref: Sec. 12.5
11) Japan experienced a near zero, even negative, economic growth for most of the 1990s. One
of the solutions suggested by the Keynesian economists to the deep Japanese recession was to
use an expansionary monetary policy. Japanese government followed this advice by announcing
increasing money supply and lowering the interest rates to a near zero. Unfortunately, the
economy did not recover. Using the IS-LM model, explain why the expansionary monetary
policy did not work in Japan? What are the alternative Keynesian solutions to the Japanese
recession?
Answer: The situation in Japan is called "liquidity trap." A liquidity trap occurs when the
nominal interest rate reaches zero and cannot decrease further (there is no such a thing as a
negative interest rate.) In this situation, an easy monetary policy cannot be effective anymore,
since there is no room for lowering the interest rate and increasing investment and consumption
spending. The liquidity trap can be shown by an LM curve, which is flat at zero interest rate. If
the IS curve intersects the LM curve at a point on the flat side of the LM curve and below the
potential output, then an expansionary monetary policy, which would shift the LM curve to the
right, will have no effect on the interest rate. The alternative solution is to use an expansionary
fiscal policy, which would shift the IS curve rightward increasing output without a need to
decrease the interest rate below zero.
Diff: 3 Type: ES
Page Ref: Sec. 12.4
12) Explain how the Keynesian model of business cycles is consistent with the business cycles
facts.
Answer: The Keynesian theory of cycles can account for several of the business cycle facts. For
example, the model can explain the recurrent fluctuations in output caused by aggregate demand
shocks. It can also correctly predict that employment will fluctuate in the same direction as
output and that money and inflation are procyclical. However, the Keynesian model of business
cycles faces a challenge in explaining the fact that labour productivity is procyclical.
Diff: 2 Type: ES
Page Ref: Sec. 12.5
13) Explain the effects of an anticipated fiscal policy on the long-run output and price level.
Discuss how Keynesian and the Classical models differ in analyzing the effect.
Answer: In anticipation of the effects of the expected fiscal policy, employees and firms
negotiate a nominal-wage contract that leaves the real wage unaffected by the anticipated price
change. Employees and firms make efforts to correctly anticipate the price level effects of
government policy because their goal is to negotiate a nominal wage that produces the marketclearing real wage and, hence, the full-employment level of output. Anticipated fiscal policies,
then, have no impact on real variables. In the classical model, the effect of fiscal policy on output
is due to its effect on wealth and labour supply.
Diff: 2 Type: ES
Page Ref: 400
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14) What type of expectations hypothesis do the Keynesian and the classical models use to
explain the impact of the fiscal and monetary policy on the full-employment output? Discuss.
Answer: Classical economists believe agents have rational expectations on economic variables.
Keynesians also believe that the public's forecast of economic variables is based on a reasoned
and intelligent examination of available information. That is, Keynesians accept the theory of
rational expectations as a model of how expectations are formed. Keynesians, however, are less
optimistic about the ability of free-market economies to respond quickly and efficiently to
nominal price shocks.
Diff: 2 Type: ES
Page Ref: 404
15) Keynesian models rely on the sticky-wage assumption. Explain the rationale for this
assumption.
Answer: Wage contracts typically last for years, during which economic conditions and policies
change. Even if firms and employees recognize that the price level has changed relative to what
they anticipated when they signed the labour contract, the contract would prevent adjustment of
the nominal wage until the contract expires.
Diff: 2 Type: ES
Page Ref: 407
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 13 Unemployment and Inflation
13.1 Multiple-Choice Questions
1) The origin of the idea of a trade-off between inflation and unemployment was a 1958 article
by
A) A.W. Phillips.
B) Edmund Phelps.
C) Milton Friedman.
D) Robert Gordon.
Answer: A
Diff: 1
Type: MC
Page Ref: 441
2) Phillips's research looked at British data on
A) unemployment and inflation.
B) unemployment and nominal wage growth.
C) inflation and nominal wage growth.
D) unemployment and output.
Answer: B
Diff: 1
Type: MC
Page Ref: 441
3) The negative relationship between unemployment and inflation is known as the
A) aggregate supply curve.
B) aggregate demand curve.
C) Phillips curve.
D) efficiency wage line.
Answer: C
Diff: 1
Type: MC
Page Ref: 441
4) The Phillips curve appeared to fit the data well for Canada in the
A) 1960s.
B) 1970s.
C) 1980s.
D) 1990s.
Answer: A
Diff: 1
Type: MC
Page Ref: 441
5) Which of the following best describes the original Phillips curve?
A) In the original Phillips curve, the inflation expectation is constant.
B) In the original Phillips curve, the inflation expectation is not constant.
C) In the original Phillips curve, the natural rate of unemployment is constant.
D) Both A and C are correct.
Answer: D
Diff: 1
Type: MC
Page Ref: 442
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6) Friedman and Phelps suggested that there should not be a stable relationship between inflation
and unemployment, but there should be a stable relationship between
A) anticipated inflation and frictional unemployment.
B) anticipated inflation and cyclical unemployment.
C) unanticipated inflation and frictional unemployment.
D) unanticipated inflation and cyclical unemployment.
Answer: D
Diff: 1
Type: MC
Page Ref: 442
7) Friedman and Phelps argued that the Phillips curve could not be stable because
A) it was not consistent with economic theory.
B) it was not supported by the data.
C) they thought the relationship was between the unanticipated inflation and unemployment.
D) they thought the relationship was between the inflation and cyclical unemployment.
Answer: A
Diff: 2
Type: MC
Page Ref: 442
8) Which of the following best explains economic theory behind the Phillips curve?
A) If inflation rate is lower than expected inflation rate, real money balance will increase leading
to a lower interest rate and a higher aggregate demand and output.
B) If inflation rate is lower than expected inflation rate, real money balance will decrease leading
to a higher interest rate and a lower aggregate demand and output.
C) If there is an unanticipated inflation rate, real wage will increase leading to a lower output and
employment.
D) If there is an unanticipated inflation rate, real wage will decrease leading to a lower output
and employment.
Answer: A
Diff: 2
Type: MC
Page Ref: 442
9) Which of the following represents the expectations-augmented Phillips curve?
A) Anticipated inflation rate is proportional to the cyclical unemployment rate.
B) Unanticipated inflation rate is proportional to the cyclical unemployment rate.
C) Unanticipated inflation rate is proportional to unemployment rate.
D) Anticipated inflation rate is proportional to unemployment rate.
Answer: B
Diff: 2
Type: MC
Page Ref: 443
10) According to the expectations-augmented Phillips curve,
A) If inflation rate is zero, unemployment rate will be zero.
B) If unanticipated inflation rate is zero, unemployment rate will be zero.
C) If unanticipated inflation rate is zero, cyclical unemployment rate will be zero
D) If unanticipated inflation rate is zero, cyclical unemployment rate will be negative.
Answer: C
Diff: 2
Type: MC
Page Ref: 443
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11) The Bank of Canada announces that it will increase the money supply by 5 percent for the
next five years. This will cause
A) the expected inflation to increase and the Phillips curve to shift right.
B) the expected inflation to decrease and the Phillips curve to shift right.
C) the natural rate of unemployment to decrease and the Phillips curve to shift left.
D) the natural rate of unemployment to increase and the Phillips curve to shift left.
Answer: A
Diff: 1
Type: MC
Page Ref: 444
12) The employment insurance has increased the size of the benefit to unemployed. This will
cause
A) the natural rate of unemployment to increase and the Phillips curve to shift left.
B) the expected inflation to increase and the Phillips curve to shift left.
C) the natural rate of unemployment to increase and the Phillips curve to shift right.
D) the expected inflation to decrease and the Phillips curve to shift left.
Answer: C
Diff: 1
Type: MC
Page Ref: 445
13) Milton Friedman and Edmund Phelps questioned
A) the use of expectations in the Phillips curve.
B) the stability of the relationship between inflation and unemployment.
C) the existence of a natural rate of unemployment.
D) the existence of a full-employment level of output.
Answer: B
Diff: 1
Type: MC
Page Ref: 446
14) In the extended classical model, an anticipated increase in the money supply would cause
output to ________ and the price level to ________ in the short run.
A) increase; increase
B) increase; not change
C) not change; increase
D) decrease; increase
Answer: C
Diff: 1
Type: MC
Page Ref: 449
15) In the extended classical model, an unanticipated increase in the money supply would cause
output to ________ and the price level to ________ in the short run.
A) increase; increase
B) increase; not change
C) not change; increase
D) decrease; increase
Answer: A
Diff: 1
Type: MC
Page Ref: 449
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16) In the extended classical model, an unexpected decrease in aggregate demand would cause
unanticipated inflation to be ________ and cyclical unemployment to be ________.
A) positive; negative
B) positive; positive
C) negative; negative
D) negative; positive
Answer: D
Diff: 2
Type: MC
Page Ref: 449
17) In the expectations-augmented Phillips curve π = πe - 3(u - .06), the natural rate of
unemployment is
A) .02.
B) .03.
C) .06.
D) 18.
Answer: C
Diff: 2
Type: MC
Page Ref: 446
18) In the expectations-augmented Phillips curve π = πe - 3(u - .06), when π = .06 and πe = .03,
the unemployment rate is
A) .03.
B) .05.
C) .07.
D) .09.
Answer: B
Diff: 2
Type: MC
Page Ref: 446
19) The Phillips curve is the relation between inflation and unemployment that holds for a given
natural rate of unemployment and a
A) given rate of inflation.
B) given expected rate of inflation.
C) given level of unemployment.
D) given expected level of unemployment.
Answer: B
Diff: 1
Type: MC
Page Ref: 447
20) Suppose most people had anticipated that inflation would increase by 10% in the coming
year because the Central Bank would increase the money supply by 10%. Instead, the Central
Bank increases the money supply by only 5%. In the short run, this would cause actual output to
be ________ full-employment output and prices to increase by ________ 5%.
A) above; more than
B) above; less than
C) below; more than
D) below; less than
Answer: C
Diff: 1
Type: MC
Page Ref: 446
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21) An increase in the expected rate of inflation would
A) shift the Phillips curve upward.
B) shift the Phillips curve downward.
C) shift the long-run Phillips curve to the right.
D) shift the long-run Phillips curve to the left.
Answer: A
Diff: 1
Type: MC
Page Ref: 447
22) If the expected inflation rate is unchanged, a rise in the natural rate of unemployment would
A) shift the Phillips curve to the right.
B) not shift the Phillips curve.
C) shift the Phillips curve to the left.
D) shift the Phillips curve to the left and shift the long-run Phillips curve to the right.
Answer: A
Diff: 1
Type: MC
Page Ref: 447
23) If the expected rate of inflation rose at the same time the natural rate of unemployment rose,
the Phillips curve
A) would shift down.
B) would shift up.
C) would not move.
D) might shift up or down or not move, depending on which effect was larger.
Answer: B
Diff: 1
Type: MC
Page Ref: 447
24) An adverse supply shock would cause
A) a movement up the short-run Phillips curve.
B) a movement down the short-run Phillips curve.
C) the short-run Phillips curve to shift upward and to the right.
D) the short-run Phillips curve to shift downward and to the left.
Answer: C
Diff: 1
Type: MC
Page Ref: 449
25) Classicals argue that an adverse supply shock would
A) raise neither the natural rate of unemployment nor the actual rate of unemployment.
B) raise the actual rate of unemployment, but not the natural rate of unemployment.
C) raise the natural rate of unemployment, but not the actual rate of unemployment.
D) raise both the natural rate of unemployment and the actual rate of unemployment.
Answer: D
Diff: 2
Type: MC
Page Ref: 449
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26) The Friedman-Phelps analysis shows that a negative relationship between inflation and
unemployment holds
A) even when expected inflation changes.
B) even when the natural rate of unemployment changes.
C) even if both the expected inflation rate and the natural rate of unemployment change.
D) as long as the expected inflation rate and the natural rate of unemployment are approximately
constant.
Answer: D
Diff: 1
Type: MC
Page Ref: 450
27) The Phillips curve shifted during the 1970s primarily because of
A) the two large oil price shocks.
B) the changing demographics of the population.
C) tight monetary policy.
D) easy fiscal policy.
Answer: A
Diff: 1
Type: MC
Page Ref: 450
28) Examining data on cyclical unemployment plotted against unanticipated inflation shows
A) a positive relationship.
B) a negative relationship.
C) no significant relationship.
D) a relationship only during the 1960s.
Answer: B
Diff: 1
Type: MC
Page Ref: 450
29) The Friedman-Phelps analysis suggests that there is a long-term relationship between
A) inflation and unemployment.
B) cyclical inflation and structural unemployment.
C) unanticipated inflation and cyclical unemployment.
D) anticipated inflation and structural unemployment.
Answer: C
Diff: 1
Type: MC
Page Ref: 450
30) Both classicals and Keynesians agree that policymakers
A) can exploit the Phillips curve in the short run.
B) cannot exploit the Phillips curve in the short run.
C) can keep the unemployment rate permanently below the natural rate by permanently running a
high rate of inflation.
D) cannot keep the unemployment rate permanently below the natural rate by permanently
running a high rate of inflation.
Answer: D
Diff: 1
Type: MC
Page Ref: 451
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31) The Lucas critique is an objection to the assumption that
A) inflation is always and everywhere a monetary phenomenon.
B) there is a negative relationship between inflation and unemployment.
C) historical relationships between macroeconomic variables will continue to hold after new
policies are in place.
D) people form expectations rationally.
Answer: C
Diff: 1
Type: MC
Page Ref: 453
32) The argument that when policy changes, people's behaviour changes so that historical
relationships between macroeconomic variables will no longer hold is known as
A) the Phillips curve.
B) the policy irrelevance hypothesis.
C) hysteresis.
D) the Lucas critique.
Answer: D
Diff: 1
Type: MC
Page Ref: 453
33) The long-run Phillips curve is
A) vertical.
B) horizontal.
C) upward sloping.
D) downward sloping.
Answer: A
Diff: 1
Type: MC
Page Ref: 453
34) If the expected inflation rate is equal to the actual inflation rate
A) the unemployment rate should be equal to the natural level of unemployment.
B) the unemployment rate should be greater than the natural level of unemployment.
C) the unemployment rate should be less than the natural level of unemployment.
D) the Phillips curve will be unstable.
Answer: A
Diff: 1
Type: MC
Page Ref: 453
35) The fact that the long-run Phillips curve is vertical implies that
A) monetary policy can't affect unemployment.
B) money is neutral in the long run.
C) there is a natural rate of inflation.
D) money can't affect inflation in the long run.
Answer: B
Diff: 1
Type: MC
Page Ref: 453
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36) Which of the following forms of unemployment probably imposes the greatest personal
costs?
A) frictional unemployment
B) structural unemployment
C) cyclical unemployment
D) voluntary unemployment
Answer: B
Diff: 1
Type: MC
Page Ref: 454
37) Some economists argue that Okun's Law overstates the cost of cyclical unemployment
because
A) the cost of retraining workers must be offset against the loss in output that occurs when
workers are unemployed.
B) if efficiency wages prevail, and workers are paid their real wage, already employed workers
will reduce their effort, reducing output.
C) it ignores the fact that leisure increases during a recession.
D) it ignores the loss of government revenue and additional government expenditures that occur
when unemployment rises.
Answer: C
Diff: 2
Type: MC
Page Ref: 454
38) One reason for the rise in the natural rate of unemployment is
A) changes in the demographic composition of the work force.
B) the rise in inflation.
C) increased competition from foreign workers.
D) the depreciation of the dollar relative to foreign currencies.
Answer: A
Diff: 1
Type: MC
Page Ref: 456
39) Hysteresis in unemployment means
A) many people counted as employed are really underemployed.
B) the natural rate of unemployment changes in response to the actual rate of unemployment.
C) there is no natural rate of unemployment; there is a natural rate of inflation instead.
D) the actual unemployment rises when the natural rate of unemployment rises.
Answer: B
Diff: 1
Type: MC
Page Ref: 457
40) The idea that the natural rate of unemployment rises when the actual rate of unemployment
rises is known as
A) stabilization.
B) insider-outsider theory.
C) hysteresis.
D) an efficiency wage model.
Answer: C
Diff: 1
Type: MC
Page Ref: 457
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41) The insider-outsider theory suggests that
A) insiders get lower wages but higher benefits than outsiders.
B) unemployment insurance leads to higher rates of unemployment.
C) unions seek high wages without causing firms to cut employment.
D) the minimum wage forces low-skilled workers to become unemployed.
Answer: C
Diff: 1
Type: MC
Page Ref: 457
42) Which of the following would probably be the most effective at reducing structural
unemployment?
A) reduce unemployment benefits
B) provide more information about the availability and location of jobs
C) retrain workers who are unemployed
D) increase union strength in the economy
Answer: C
Diff: 1
Type: MC
Page Ref: 460
43) Which of the following policies will NOT reduce the natural unemployment rate?
A) policies to increase labour market flexibility
B) job training and worker relocation
C) increasing unemployment benefits
D) expansionary policies to reduce actual unemployment rate
Answer: C
Diff: 2
Type: MC
Page Ref: 460
44) A high-pressure economy is one in which
A) monetary and fiscal policy are used to keep unemployment as low as possible.
B) there is no unemployment insurance, putting pressure on workers to keep their jobs and stay
off welfare.
C) wage and price controls prevent firms from raising prices by more than the general price
level.
D) the Central Bank tightens monetary policy to force all inflation out of the economy.
Answer: A
Diff: 1
Type: MC
Page Ref: 460
45) One cost of a perfectly anticipated inflation is that it
A) transfers wealth from lenders to borrowers.
B) transfers wealth from borrowers to lenders.
C) erodes the value of currency.
D) damages the role of prices as signals in the economy.
Answer: C
Diff: 1
Type: MC
Page Ref: 461
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46) Shoe leather costs refer to
A) the costs of changing prices during inflation.
B) income redistribution cost of inflation.
C) resources used by people to reduce their holdings of currency.
D) resources used by people to reduce their risk.
Answer: C
Diff: 1
Type: MC
Page Ref: 461
47) One cost of a perfectly anticipated inflation is that it
A) transfers wealth from lenders to borrowers.
B) transfers wealth from borrowers to lenders.
C) increases menu costs.
D) damages the role of prices as signals in the economy.
Answer: C
Diff: 1
Type: MC
Page Ref: 461
48) When actual inflation is greater than expected inflation,
A) unemployment rises, according to Phillips-curve analysis.
B) cyclical unemployment rises, according to Phillips-curve analysis.
C) there are transfers from borrowers to lenders.
D) there are transfers from lenders to borrowers.
Answer: D
Diff: 1
Type: MC
Page Ref: 462
49) One cost of an unanticipated inflation is that it
A) transfers wealth from lenders to borrowers.
B) transfers wealth from borrowers to lenders.
C) decreases menu costs.
D) increases the purchasing power of money.
Answer: A
Diff: 1
Type: MC
Page Ref: 462
50) Which of the following statements about inflation is true?
A) Both anticipated and unanticipated inflation are costly.
B) Anticipated inflation is not costly, but unanticipated inflation is costly.
C) Anticipated inflation is costly, but unanticipated inflation is not costly.
D) The cost of anticipated inflation is much higher than that of unanticipated inflation.
Answer: A
Diff: 1
Type: MC
Page Ref: 462
51) One cost of an unanticipated inflation is that it
A) damages the role of prices as signals in the economy.
B) transfers wealth from borrowers to lenders.
C) decreases menu costs.
D) increases the purchasing power of money.
Answer: A
Diff: 1
Type: MC
Page Ref: 462
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52) A COLA is
A) a centre of labour activity.
B) a cost of living adjustment.
C) a contract on long-term assets.
D) a crisis of labour analysis.
Answer: B
Diff: 1
Type: MC
Page Ref: 463
53) Hyperinflation occurs when the inflation rate
A) rises.
B) declines.
C) is extremely high.
D) is extremely low.
Answer: C
Diff: 1
Type: MC
Page Ref: 463
54) When there is a hyperinflation, all of the following occur except
A) people spend a lot of time and energy getting rid of currency as fast as possible.
B) the government finds it difficult to collect taxes.
C) markets become inefficient because prices are no longer reliable signals.
D) people make fixed rate loans to protect themselves against inflation.
Answer: D
Diff: 1
Type: MC
Page Ref: 464
55) The reduction of the inflation rate is called
A) deflation.
B) disinflation.
C) unflation.
D) reflation.
Answer: B
Diff: 1
Type: MC
Page Ref: 464
56) The costs of disinflation would be low if
A) expected inflation falls as inflation falls.
B) wage and price controls were used.
C) the Phillips curve were nearly horizontal.
D) the Phillips curve adjusted slowly to changes in inflation.
Answer: A
Diff: 2
Type: MC
Page Ref: 464
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57) According to the expectations-augmented Phillips curve, if macroeconomic policy succeeds
in reducing inflation below its expected rate, unemployment will
A) fall below the natural rate.
B) rise above the natural rate.
C) remain unchanged.
D) be equal to the natural rate.
Answer: B
Diff: 2
Type: MC
Page Ref: 464
58) The cost of disinflation is unemployment. To reduce this cost,
A) money supply should growth faster.
B) government should increase its spending.
C) money supply growth should be rapidly reduced to bring down the expected inflation.
D) government should announce its commitment to the future contractionary fiscal policy, but
change it when it is not needed anymore.
Answer: C
Diff: 2
Type: MC
Page Ref: 464
59) A rapid and decisive reduction in the rate of growth of the money supply for the purpose of
disinflation is called
A) a salt water policy.
B) a cold shower policy.
C) gradualism.
D) a cold turkey policy.
Answer: D
Diff: 1
Type: MC
Page Ref: 465
60) Keynesians prefer a disinflation policy of
A) cold turkey.
B) stabilization.
C) gradualism.
D) aggregate demand management.
Answer: C
Diff: 1
Type: MC
Page Ref: 465
61) The sacrifice ratio is
A) the amount of output lost when the inflation rate is reduced by one percentage point.
B) the percentage reduction in inflation when output falls one percentage point below potential.
C) the percentage change in employment when output declines by one percentage point.
D) the number of percentage points that the unemployment rate rises when output declines by
one percentage point.
Answer: A
Diff: 1
Type: MC
Page Ref: 466
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62) The amount of output lost when the inflation rate is reduced by one percentage point is called
A) Okun's law.
B) the sacrifice ratio.
C) the Solow residual.
D) Planck's constant.
Answer: B
Diff: 1
Type: MC
Page Ref: 466
63) Ball found that the disinflation in Canada had a sacrifice ratio of about
A) 0.5
B) 1.0
C) 1.5
D) 2.0
Answer: C
Diff: 1
Type: MC
Page Ref: 466
64) Ball's research showed that the sacrifice ratio
A) was the same for all countries.
B) was nearly zero for most countries.
C) was about 10 for all countries except Canada, where it was about 1.5.
D) varied considerably across countries.
Answer: D
Diff: 1
Type: MC
Page Ref: 466
65) Ball found that an important factor affecting the sacrifice ratio is
A) the flexibility of the labour market.
B) the shape of the yield curve.
C) the real interest rate.
D) the tightness of fiscal policy.
Answer: A
Diff: 1
Type: MC
Page Ref: 466
66) Countries in which wages adjust slowly to changes in the supply of and demand for labour
are likely to have ________ sacrifice ratio.
A) an infinite
B) a high
C) a low
D) a zero
Answer: B
Diff: 1
Type: MC
Page Ref: 466
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67) Countries in which wages adjust rapidly to changes in the supply and demand for labour are
likely to have ________ sacrifice ratio.
A) an infinite
B) a high
C) a low
D) a negative
Answer: C
Diff: 1
Type: MC
Page Ref: 466
68) Countries in which the government heavily regulates the labour market are likely to have
________ sacrifice ratio.
A) an infinite
B) a high
C) a low
D) a negative
Answer: B
Diff: 1
Type: MC
Page Ref: 466
69) Ball's research on disinflation across different countries found that
A) costs of disinflation were smaller for rapid disinflation than for gradual disinflation.
B) costs of disinflation were larger for rapid disinflation than for gradual disinflation.
C) costs of disinflation were about the same for both rapid and gradual disinflation.
D) costs of disinflation were smaller when the Central Bank had a strong inflation-fighting
reputation.
Answer: A
Diff: 1
Type: MC
Page Ref: 466
70) If a rapid disinflation has a lower sacrifice ratio than a slow disinflation, then reducing
inflation is best accomplished by
A) gradualism.
B) increasing money growth.
C) reducing interest rates.
D) a cold-turkey approach.
Answer: D
Diff: 1
Type: MC
Page Ref: 466
71) The main determinant of how quickly expected inflation adjusts to changes in monetary
policy is
A) the slope of the Phillips curve.
B) the slope of the short-run aggregate supply curve.
C) the credibility of the Central Bank.
D) the degree of indexation in the economy.
Answer: C
Diff: 1
Type: MC
Page Ref: 467
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72) The most important factor determining how quickly expected inflation adjusts when the
government attempts to reduce inflation is
A) the slope of the Phillips curve.
B) the credibility of the government's disinflationary policy.
C) the degree of gradualism in the government's disinflationary policy.
D) the slope of the IS curve.
Answer: B
Diff: 2
Type: MC
Page Ref: 467
73) Keynesians contend that stabilization policy can offset the output and unemployment effect
of unanticipated inflation because
A) nominal wage and price stickiness prevent prices and inflation from adjusting quickly and as
a result unemployment sustains.
B) price and inflation expectations do not adjust quickly as claimed by classical economists.
C) nominal wage and price adjust quickly and as a result cyclical unemployment remains zero.
D) price and inflation expectations adjust quickly and employment rises.
Answer: A
Diff: 2
Type: MC
Page Ref: 468
74) Which one of the following statements is true about the Phillips curve?
A) The short-run Phillips curve is positively sloped while the long-run Phillips curve is vertical.
B) There is no empirical evidence to support the Phillips curve.
C) The short-run Phillips curve is negatively sloped while the long-run Phillips curve is vertical.
D) The Phillips curve is consistent with the Keynesian model but not the Classical model.
Answer: C
Diff: 2
Type: MC
Page Ref: 441
75) According to the expectations-augmented Phillips curve, if the cyclical unemployment rate is
zero,
A) the inflation rate will be equal to the anticipated inflation rate.
B) the anticipated inflation rate will be negative.
C) the anticipated inflation rate will be positive.
D) the unanticipated inflation rate will be zero.
Answer: D
Diff: 2
Type: MC
Page Ref: 446
76) The expectations-augmented Phillips curve implies that lower inflation is associated with
A) a higher natural rate of unemployment.
B) a lower cyclical unemployment rate.
C) higher inflation expectations.
D) a lower natural rate of unemployment.
Answer: D
Diff: 2
Type: MC
Page Ref: 447
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77) Which of the following policies does NOT decrease the natural rate of unemployment?
A) tax credits or subsidies for training and relocating unemployed workers
B) lowering consumption taxes
C) lowering payroll taxes
D) using aggressive policy to keep the actual unemployment rate low
Answer: B
Diff: 2
Type: MC
Page Ref: 452
78) Reducing inflation without incurring serious unemployment costs is possible if
A) policymakers are able to reduce the expected inflation rate.
B) people form their expectations based on rational expectations theory.
C) monetary authorities rapidly decrease the money supply.
D) the government makes a significant budget cut.
Answer: A
Diff: 2
Type: MC
Page Ref: 464
79) In the expectations-augmented Phillips curve, when the expected inflation rate is equal to the
actual inflation rate, the economy will be in
A) a recession.
B) a boom.
C) full-employment.
D) a zero natural unemployment rate.
Answer: C
Diff: 2
Type: MC
Page Ref: 443
80) In what period, did the negative relationship between unemployment and inflation
discontinue?
A) 1960s.
B) 1970s.
C) 2000s
D) 2010s.
Answer: B
Diff: 2
Type: MC
Page Ref: 442
81) Which of the following was NOT a question raised about the original Phillips curve in the
1960s?
A) Why was the original Phillips curve frequently observed in the 1960s?
B) Why did the Phillips curve fail to hold after 1970?
C) Can policymakers guarantee a permanently low unemployment rate while maintaining a high
inflation rate?
D) Are people's expectations rational?
Answer: D
Diff: 2
Type: MC
Page Ref: 444
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82) The failure of the Phillips curve
A) was predicted during the 1960s, before the Phillips curve actually proved to be unstable.
B) was discussed only after the data became available in the 1970s.
C) was shown when the rational expectations were included in the macroeconomic models.
D) was evident by the data during the 1960s.
Answer: A
Diff: 2
Type: MC
Page Ref: 443
83) The Phillips curve fails to hold when
A) policymakers do not honour their promises.
B) the expectations about the inflation is not taken into account.
C) unemployment is high and inflation low.
D) the inflation expectations are included in the model.
Answer: D
Diff: 2
Type: MC
Page Ref: 445
84) Which of the following is true when the economy is in full-employment condition?
A) The public correctly predicts aggregate demand growth and inflation.
B) Actual unemployment exceeds the natural rate.
C) Cyclical unemployment rate is positive.
D) Unanticipated inflation is not zero.
Answer: A
Diff: 2
Type: MC
Page Ref: 446
85) Which of the following shifts the Phillips curve?
A) a change in the natural rate of unemployment
B) a change in unemployment rate
C) a change in inflation rate
D) a change in GDP
Answer: A
Diff: 2
Type: MC
Page Ref: 447
86) Which of the following is NOT a shift factor for the Phillips curve?
A) a change in the natural rate of unemployment
B) a change in the expected inflation rate
C) a change in GDP
D) an adverse supply shock
Answer: C
Diff: 2
Type: MC
Page Ref: 448
87) A beneficial supply shock
A) shifts the Phillips curve up and to the right.
B) shifts the Phillips curve down and to the left.
C) increases the natural unemployment rate.
D) increases the expected inflation rate.
Answer: B
Diff: 2
Type: MC
Page Ref: 451
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88) Which of the following events caused the original Phillips curve to fail?
A) World War II.
B) the first oil price shock in 1973
C) the stock market crash in 1987
D) the 1982 recession
Answer: B
Diff: 2
Type: MC
Page Ref: 452
13.2 Essay Questions
1) The relationship between inflation and unemployment is given by π = πe - 3(u - .06).
a. Graph the short-run and long-run Phillips curves.
b. What is the value of the natural rate of unemployment?
c. If actual inflation is .02 and expected inflation is .05, what is the unemployment rate?
d. If actual inflation is .08 and expected inflation is .05, what is the unemployment rate?
Answer:
a. Long run: vertical line at u = = 0.06. Short-run: downward sloping line (curve) crossing the
long-run curve at π = πe.
b. .06
c. .07
d. .05
Diff: 2
Type: ES
Page Ref: Sec. 13.1
2) Starting on a Phillips curve with expected inflation equal to 5% and unemployment at its
natural rate, show what happens to unemployment if the Central Bank tries to reduce inflation,
but has no credibility. As time passes and people realize that the inflation rate is now lower, what
happens to the short-run Phillips curve?
Answer: The unemployment rate rises as the economy moves along the Phillips curve and as
inflation declines. As time passes, inflation expectations begin to decline, shifting the Phillips
curve down and to the left until the unemployment rate returns to its natural rate, and inflation
and expected inflation are equal at a lower level.
Diff: 2
Type: ES
Page Ref: Sec. 13.1
3) What is the Lucas critique, and why was it so important to macroeconomists in the 1970s?
Answer: The Lucas critique suggests that historical relationships between economic variables
will be changed significantly when there are significant changes in the economy such as new
policies. In the 1970s this was important as it explains the movement of the Phillips curve.
Diff: 1 Type: ES
Page Ref: Sec. 13.1
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4) Describe the principal costs of unemployment. Are there any benefits to unemployment?
Answer: The costs of unemployment are the loss of output because of idle resources and the
personal or psychological cost faced by unemployed workers and their families. There are
benefits from unemployment: (1) unemployed workers engage in useful activities, such as
searching for a better job match or acquiring new skills; and (2) increased leisure time. But the
benefits are likely to be small compared to the costs.
Diff: 1
Type: ES
Page Ref: Sec. 13.2
5) If you were prime minister, what would you do to reduce the natural rate of unemployment?
Propose at least three different methods.
Answer: Provide support for job training and worker relocation; increase labour-market
flexibility by reducing the minimum wage; reform the unemployment insurance system; run a
high-pressure economy (if there is hysteresis)
Diff: 1
Type: ES
Page Ref: Sec. 13.2
6) Describe the major costs of inflation, being sure to distinguish between anticipated and
unanticipated inflation.
Answer: Costs of anticipated inflation include an erosion of the value of currency, which leads
to shoe-leather costs, and the costs of changing prices. Costs of unanticipated inflation arise
because unanticipated inflation transfers wealth between people and because it disturbs the role
of prices as signals in the economy.
Diff: 1
Type: ES
Page Ref: Sec. 13.3
7) What are the pros and cons of using cold turkey disinflation compared to a policy of
gradualism?
Answer: Cold turkey disinflation reduces inflation quickly and could be successful if expected
inflation fell at the same time; that requires that policy be credible, however. But Keynesians
suggest that menu costs and nominal wage contracts will prevent prices and wages from
adjusting quickly, so a cold turkey strategy will cause a recession. Further, if a cold turkey
strategy is begun, but people think the costs will be so large that the strategy will be abandoned,
then expected inflation will not decline. For this reason, Keynesians prefer a gradualist approach
to allow wages and prices more time to adjust to policy changes. Such a policy is more likely to
be sustainable politically.
Diff: 1 Type: ES
Page Ref: Sec. 13.3
8) How is the sacrifice ratio measured? How big is the sacrifice ratio in Canada? In other
countries? What problems are there in measuring the sacrifice ratio?
Answer: The sacrifice ratio is measured as the percentage by which output falls below potential
for every percentage point decline in inflation. In Canada, the sacrifice ratio is about 1.5, while
other countries have sacrifice ratios ranging from 3/4 to 3. The sacrifice ratio is difficult to
measure because it's hard to calculate what output would have been in the absence of disinflation
and because supply shocks may distort the calculation.
Diff: 1
Type: ES
Page Ref: Sec. 13.3
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9) How would each of the following changes likely affect the natural unemployment rate?
a. Government increases the subsidies for training workers.
b. According to a new law, the laid off employees will receive a higher lump sum payment.
c. In a new law, the number of months an unemployed worker can receive benefit is reduced by
half.
d. An aggressive easy monetary policy introduced to keep unemployment rate low.
Answer:
a. Higher subsidies for training workers will likely reduce the natural unemployment rate since
they encourage firms to hire workers and increase the possibility of finding jobs.
b. The natural unemployment rate is expected to increase since the unemployed workers will
have less incentive to search for new jobs.
c. The natural unemployment rate is expected to decrease since the unemployed workers will
have more incentive to search for a new job.
d. The expansionary monetary policy will decrease unemployment rate. If the policy continues
aggressively, a "high pressure economy," it will likely increase on-the-job training and reduce
mismatch, which would lower natural unemployment rate.
Diff: 2
Type: ES
Page Ref: Sec. 13.2
10) Consider an economy in which the inflation and unemployment rates are 6 and 4 percent,
respectively. If the expected inflation rate is 5 percent and the natural unemployment rate is 3
percent, what is the slope of the expectations-augmented Phillips curve?
Answer: 5 - 6 = -h (4 - 3), h = 1
Diff: 2
Type: ES
Page Ref: Sec. 13.1
11) Using a graph and an equation, explain the short-run and the long-run Phillips curve. What
makes these two curves different?
Answer: See equation 13.1.
Equation (13.1) describes the expectations-augmented Phillips curve. According to the
expectations-augmented Phillips curve, actual inflation exceeds expected inflation, if the actual
unemployment rate is less than the natural rate, and actual inflation is less than expected inflation
if the unemployment rate exceeds the natural rate. In the long run, the Phillips curve shifts as
expectations change and the unemployment rate is equal to the natural unemployment rate.
Therefore, the long-run Phillips curve is vertical (Figure 13.8).
Diff: 2
Type: ES
Page Ref: 454
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12) Discuss different costs imposed on an economy by high unemployment rates. What are the
offsetting factors?
Answer: There are two principal costs of unemployment. The first is the loss of output that
occurs because fewer people are productively employed. This cost is borne disproportionately by
unemployed workers themselves, in terms of the income they lose because they are out of work.
However, because the unemployed may stop paying taxes and instead receive unemployment
insurance benefits or other government payments, society (in this case, taxpayers) also bears
some of the output cost of unemployment. The other substantial cost of unemployment is the
personal or psychological cost faced by unemployed workers and their families.
There are two offsetting factors. First, to the extent that unemployed workers engage in
economically productive activities, such as searching for a job or acquiring new skills, the loss of
output arising from current unemployment may be compensated for by increased output in the
future. In particular, frictional unemployment, the result of workers and firms seeking
appropriate matches, raises future productivity and output and, thus, may impose little net
economic cost, or even lead to an economic gain.
A second offsetting factor is that unemployed people have more leisure time to spend with
family and friends, work around the house, and so on. However, the benefits of extra leisure time
decrease as the amount of leisure increases, and most unemployed workers would not feel that
increased leisure was adequate compensation for their lost income.
Diff: 2
Type: ES
Page Ref: 455
13) How do changes in the natural rate of unemployment affect the Phillips curve? What are the
explanations for changes in the natural rate of unemployment?
Answer: Changes in the natural rate of unemployment shifts the Phillips curve. Factors that
contribute to changes in the natural rate of unemployment are demographic changes,
technological change, hysteresis, and employment insurance.
Diff: 2
Type: ES
Page Ref: 458
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 14 Monetary Policy and the Bank of Canada
14.1 Multiple-Choice Questions
1) The monetary base is equal to
A) banks' reserves plus their holdings of Treasury securities.
B) banks' reserves plus Bank of Canada funds.
C) banks' reserves plus currency in circulation.
D) M2 minus M1.
Answer: C
Diff: 1
Type: MC
Page Ref: 474
2) The monetary base is defined as
A) bank reserves plus currency in circulation.
B) bank reserves minus vault cash.
C) all deposits at the Bank of Canada.
D) deposits at the Bank of Canada plus vault cash.
Answer: A
Diff: 1
Type: MC
Page Ref: 474
3) Vault cash is equal to $2 million, deposits by depository institutions at the Central Bank are $3
million, the monetary base is $10 million, and bank deposits are $25 million. Bank reserves are
equal to
A) $2 million.
B) $3 million.
C) $5 million.
D) $10 million.
Answer: C
Diff: 2
Type: MC
Page Ref: 475
4) Fractional reserve banking is the system that
A) allows banks not to insure their deposits.
B) allows banks not to join the Canadian Payments Association.
C) limits banks' activities from crossing provincial lines.
D) allows banks to keep smaller reserves than their deposits.
Answer: D
Diff: 1
Type: MC
Page Ref: 475
5) Under the 100% reserve banking, banks
A) do not lend and pay negative interest rates.
B) do not lend and pay positive interest rates.
C) lend and pay positive interest rate.
D) lend and pay negative interest rate.
Answer: A
Diff: 2
Type: MC
Page Ref: 475
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6) Magog banks currently have 1 million dinars and a system of 100% reserve banking. The
government passes a law allowing fractional reserve banking and a minimum reserve-deposit
ratio of 10%. Assuming people hold no currency, after the full process of multiple expansion of
loans and deposits had worked itself out, the nation's money supply would equal
A) 1,000,000 dinars.
B) 9,000,000 dinars.
C) 10,000,000 dinars.
D) 11,000,000 dinars.
Answer: C
Diff: 2
Type: MC
Page Ref: 475
7) The currency-deposit ratio is determined by
A) banks.
B) the public.
C) the Central Bank.
D) Parliament.
Answer: B
Diff: 1
Type: MC
Page Ref: 477
8) Assume that the currency-deposit ratio is 0.5 and the reserve-deposit ratio is 0.2. The Bank of
Canada carries out open-market operations, purchasing $1,000,000 worth of bonds from banks.
This action will increase the money supply by
A) $1,428,571.
B) $1,714,285.
C) $2,142,857.
D) $2,400,000.
Answer: C
Diff: 2
Type: MC
Page Ref: 477
9) Assume that the reserve-deposit ratio is 0.2. The Bank of Canada carries out open-market
operations, purchasing $1,000,000 worth of bonds from banks. This action increased the money
supply by $2,600,000. What is the currency-deposit ratio?
A) 0.2
B) 0.3
C) 0.4
D) 0.5
Answer: B
Diff: 3
Type: MC
Page Ref: 477
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10) Assume that the currency-deposit ratio is 0.4. The Bank of Canada carries out open-market
operations, purchasing $1,000,000 worth of bonds from banks. This action increased the money
supply by $1,750,000. What is the reserve-deposit ratio?
A) 0.2
B) 0.3
C) 0.4
D) 0.45
Answer: C
Diff: 3
Type: MC
Page Ref: 477
11) Assume that the currency-deposit ratio is 0.3 and the reserve-deposit ratio is 0.2. What is the
money multiplier?
A) 1.5
B) 2.0
C) 2.6
D) 5.0
Answer: C
Diff: 2
Type: MC
Page Ref: 476
12) If people hold more currency, other things remaining constant
A) the money multiplier will decrease.
B) the money multiplier will increase.
C) the money multiplier will remain unchanged.
D) the monetary base will decrease.
Answer: A
Diff: 2
Type: MC
Page Ref: 478
13) Which one of the following statement is true?
A) The money supply created in a multiple expansion of loans and deposits are less than the
monetary base.
B) The money supply created in a multiple expansion of loans and deposits are much larger than
the monetary base.
C) The money supply created in a multiple expansion of loans and deposits are equal to the
monetary base.
D) The money supply created in a multiple expansion of loans and deposits are equal to the total
currency.
Answer: B
Diff: 2
Type: MC
Page Ref: 478
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14) Money multiplier is
A) the number of dollars of money supply that can be created from each dollar of monetary base.
B) the number of dollars of monetary base that can be created from each dollar of currency held
by public.
C) the ratio of number of dollars of money demand that can be created from each dollar of
monetary base.
D) the number of dollars of money supply that can be created from each dollar of reserves.
Answer: A
Diff: 1
Type: MC
Page Ref: 478
15) Suppose the Bank of Canada decides to increase the money supply by $10 billion. In Canada,
the currency-deposit ratio is 0.1485, and the reserve-deposit ratio is 0.0079. How much should
the Bank of Canada change the monetary base?
A) $1.4 billion
B) $14.85 billion
C) $10 billion
D) $14.85 million
Answer: A
Diff: 2 Type: MC
Page Ref: 478
16) Currently, the currency-deposit ratio is 0.3 and the reserve-deposit ratio is 0.2. The Bank of
Canada raises the reserve-deposit ratio to 0.25, as a response to a change in the public's currencydeposit ratio, to maintain the old money multiplier. What is the public's approximate new
currency-deposit ratio?
A) 0.22
B) 0.25
C) 0.33
D) 0.35
Answer: A
Diff: 3
Type: MC
Page Ref: 478
17) Suppose there was a banking crisis. The money supply would shrink by the greatest amount
if the public ________ their currency-deposit ratio and the banks ________ their reserve-deposit
ratio.
A) decreased; decreased
B) decreased; increased
C) increased; decreased
D) increased; increased
Answer: D
Diff: 2
Type: MC
Page Ref: 479
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18) Suppose the Bank of Canada wanted to increase the money supply without using openmarket operations. It could try to get the public to ________ their currency-deposit ratio and
________ banks' reserve requirements, which would in turn change the banks' reserve-deposit
ratio.
A) decrease; lower
B) decrease; raise
C) increase; lower
D) increase; raise
Answer: A
Diff: 2
Type: MC
Page Ref: 479
19) The money supply is $10 million, currency held by the public is $2 million, and the reservedeposit ratio is 0.2. Deposits are equal to
A) $1.6 million.
B) $2 million.
C) $4 million.
D) $8 million.
Answer: D
Diff: 1
Type: MC
Page Ref: 479
20) The money supply is $10 million, currency held by the public is $2 million, and the reservedeposit ratio is 0.2. Bank reserves are equal to
A) $1.6 million.
B) $2 million.
C) $4 million.
D) $8 million.
Answer: A
Diff: 2
Type: MC
Page Ref: 479
21) The money supply is $6 million, currency held by the public is $2 million, and the reservedeposit ratio is 0.1. The monetary base is equal to
A) $2 million.
B) $2.4 million.
C) $2.6 million.
D) $4 million.
Answer: B
Diff: 2
Type: MC
Page Ref: 479
22) Vault cash is equal to $2 million, deposits by depository institutions at the Central Bank are
$4 million, the monetary base is $10 million, and bank deposits are $25 million. The money
multiplier is equal to
A) 2.5.
B) 3.0.
C) 4.0.
D) 5.0.
Answer: B
Diff: 2
Type: MC
Page Ref: 479
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23) Suppose that in Mysore, the reserve-deposit ratio is res = 0.5 - 2i, where i is the nominal
interest rate. The currency-deposit ratio is 0.2 and the monetary base equals 100. The real
quantity of money demanded is given by the money demand function L(Y, i) = 0.5Y - 10i, where
Y is real output. Currently, the real interest rate is 5% and the economy expects an inflation rate
of 5%. The money multiplier equals
A) 2.00.
B) 2.40.
C) 3.00.
D) 4.00.
Answer: B
Diff: 2
Type: MC
Page Ref: 479
24) Suppose that in Mysore, the reserve-deposit ratio is res = 0.5 - 2i, where i is the nominal
interest rate. The currency-deposit ratio is 0.2 and the monetary base equals 100. The real
quantity of money demanded is given by the money demand function L(Y, i) = 0.5Y - 10i, where
Y is real output. Currently, the real interest rate is 5% and the economy expects an inflation rate
of 5%. The reserve-deposit ratio equals
A) 0.1.
B) 0.2.
C) 0.3.
D) 0.4.
Answer: C
Diff: 2
Type: MC
Page Ref: 479
25) Suppose that in Mysore, the reserve-deposit ratio is res = 0.5 - 2i, where i is the nominal
interest rate. The current-deposit ratio is 0.2 and the monetary base equals 100. The real quantity
of money demanded is given by the money demand function L(Y, i) = 0.5Y - 10i, where Y is real
output. Currently, the real interest rate is 5% and the economy expects an inflation rate of 5%.
The money supply equals
A) 200.
B) 240.
C) 300.
D) 400.
Answer: D
Diff: 3
Type: MC
Page Ref: 479
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26) Suppose that in Mysore, the reserve-deposit ratio is res = 0.5 - 2i, where i is the nominal
interest rate. The currency-deposit ratio is 0.2 and the monetary base equals 100. The real
quantity of money demanded is given by the money demand function L(Y, i) = 0.5Y - 10i, where
Y is real output. Currently, the real interest rate is 5% and the economy expects an inflation rate
of 5%. Assume that the price level P is equal to 1. The value of output Y that clears the asset
market is
A) 240.
B) 460.
C) 480.
D) 482.
Answer: D
Diff: 3
Type: MC
Page Ref: 479
27) If the Bank of Canada increases the monetary base by $5 million and the money multiplier is
5, M1 will
A) rise by $25 million.
B) fall by $25 million.
C) rise by $1 million.
D) fall by $1 million.
Answer: A
Diff: 1
Type: MC
Page Ref: 479
28) If the money multiplier is 10, the sale of $1 billion of securities by the Bank on the open
market causes
A) a $10 billion decrease in the money supply.
B) a $1 billion decrease in the money supply.
C) a $1 billion increase in the money supply.
D) a $10 billion increase in the money supply.
Answer: A
Diff: 2
Type: MC
Page Ref: 479
29) Which of the following will increase the money supply?
A) open-market purchases
B) higher reserve requirements
C) less discount lending
D) tighter credit controls
Answer: A
Diff: 1
Type: MC
Page Ref: 480
30) The Central Bank can increase the money supply by
A) increasing the currency-deposit ratio.
B) increasing the monetary base.
C) increasing reserve requirements.
D) increasing the discount rate.
Answer: B
Diff: 2
Type: MC
Page Ref: 481
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31) Suppose the Bank of Canada decides to reduce the interest rate. Which of the following
actions will produce the desired outcome?
A) The Bank sells treasury bills in the open-market operations.
B) The Bank reduces the Bank rate.
C) The Bank buys treasury bills in the open-market operations.
D) The Bank increases the desired reserve ratio.
Answer: C
Diff: 2
Type: MC
Page Ref: 481
32) When was the Bank of Canada created?
A) 1914
B) 1934
C) 1946
D) 1990
Answer: B
Diff: 1
Type: MC
Page Ref: 481
33) The Bank of Canada is
A) on the north shore of the Ottawa river.
B) a Toronto fast-food outlet.
C) a money laundering service.
D) the Central Bank of Canada.
Answer: D
Diff: 1
Type: MC
Page Ref: 481
34) The leadership of the Bank of Canada is provided by
A) the Board of Directors.
B) the department of finance.
C) the federal government.
D) the directors of the main private banks.
Answer: A
Diff: 1
Type: MC
Page Ref: 481
35) The governor of the Bank of Canada
A) is elected by the government.
B) is appointed by the government.
C) is appointed by the senate.
D) is chosen by the Bank itself.
Answer: B
Diff: 1
Type: MC
Page Ref: 481
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36) Which of the following are included in the Bank of Canada's Board of Directors?
A) the governor, the senior deputy governor, the deputy minister of finance, and 12 private
citizens
B) the governor, minister of finance, and 12 part-time CEOs of private firms
C) the governor, prime minister, and 12 part-time citizens
D) the governor, the senior deputy governor, and 12 member of parliament
Answer: A
Diff: 1
Type: MC
Page Ref: 481
37) Which of the following tasks does NOT represent the Bank of Canada's responsibility?
A) implementing monetary policy
B) serving as a lender of last resort
C) implementing fiscal policy
D) acting as fiscal agent for the federal government
Answer: C
Diff: 1
Type: MC
Page Ref: 481
38) The Bank of Canada's largest asset is
A) foreign currency deposits.
B) advances to members of the CPA.
C) notes in circulation.
D) Treasury bills.
Answer: D
Diff: 1
Type: MC
Page Ref: 482
39) Which of the following is NOT listed in the assets of the Bank of Canada's balance sheet?
A) Treasury bills
B) Government of Canada's deposits
C) Other government securities
D) Foreign reserves
Answer: B
Diff: 1
Type: MC
Page Ref: 482
40) The Bank of Canada's largest liability is
A) notes in circulation at banks.
B) notes in circulation outside banks.
C) deposits at members of the CPA.
D) Treasury bills.
Answer: B
Diff: 1
Type: MC
Page Ref: 482
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41) Open-market operations directly and immediately affect
A) the monetary base.
B) banks' holdings of securities.
C) the Bank's holdings of foreign exchange.
D) the money multiplier.
Answer: A
Diff: 1
Type: MC
Page Ref: 484
42) The primary purpose of the lender of last resort is to
A) influence the nation's money supply.
B) prevent financial crises.
C) control banks' excess reserves.
D) influence the amount of loans that banks provide to the public.
Answer: B
Diff: 1
Type: MC
Page Ref: 484
43) When Canadian banks borrow from one another, they must pay the
A) bank rate.
B) prime rate.
C) overnight rate.
D) Interbank Offer Rate.
Answer: C
Diff: 1
Type: MC
Page Ref: 484
44) The Bank of Canada influences the movement of the Canadian dollar exchange rates through
A) open-market operations.
B) overnight rates.
C) intervention using the exchange fund account.
D) SPRAs.
Answer: C
Diff: 1
Type: MC
Page Ref: 488
45) Suppose the Bank of Canada reduces the Bank rate. This will cause
A) the interest rate to fall, the exchange rate to depreciate, and lending by banks to increase.
B) the interest rate to fall, the exchange rate to appreciate, and lending by banks to increase.
C) the interest rate to rise, the exchange rate to appreciate, and lending by banks to decrease.
D) the interest rate to rise, the exchange rate to depreciate, and lending by banks to decrease.
Answer: A
Diff: 2
Type: MC
Page Ref: 490
46) If a bank borrows from the Bank of Canada, the interest rate is called
A) the prime rate.
B) the bank rate.
C) the overnight rate.
D) the reserve availability rate.
Answer: B
Diff: 1
Type: MC
Page Ref: 490
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47) Which of the following is NOT a policy instrument of the Bank?
A) open-market operations
B) overnight rates operating board
C) changes in reserve requirements
D) changes in the government deficit
Answer: D
Diff: 1
Type: MC
Page Ref: 490
48) Which of the following statements would Milton Friedman disagree with?
A) Monetary policy has few short-run effects on the real economy.
B) In the long run, changes in the money supply primarily affect the price level.
C) In practice, there is little scope for using monetary policy actively to smooth out business
cycles.
D) The Central Bank cannot be relied on to effectively smooth out business cycles.
Answer: A
Diff: 1
Type: MC
Page Ref: 492
49) Suppose the Bank of Canada's target for inflation is 2 percent. If deviation of output from
full-employment output is 1 percent, and the rate of inflation over the previous four quarters is 4
percent, what overnight interest rate the Bank should choose if it follows the Taylor rule?
A) 5.7 percent
B) 4 percent
C) 7.5 percent
D) 3 percent
Answer: C
Diff: 2
Type: MC
Page Ref: 496
50) Which of the following statements would Milton Friedman agree with concerning the
conduct of monetary policy?
A) Information lags are short, enabling the Central Bank to respond quickly to changes in the
economy.
B) There is little uncertainty over the effect of a change in the money supply on the economy.
C) There are long and variable lags between monetary policy actions and their economic results.
D) Wage and price adjustments are relatively slow, so changing the money supply will have a
minimal impact on the real economy.
Answer: C
Diff: 2
Type: MC
Page Ref: 493
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51) Milton Friedman would eliminate the destabilizing effect of the Central Bank's monetary
policy by
A) eliminating the Central Bank.
B) removing the Central Bank's political independence.
C) requiring that the Central Bank choose a monetary aggregate and increase it at a fixed
percentage rate each year.
D) eliminating the Central Bank's right to carry out open-market operations.
Answer: C
Diff: 1
Type: MC
Page Ref: 493
52) Monetarists suggest doing which of the following?
A) maintain a steady growth rate of the money supply
B) use fiscal policy to combat unemployment in the short run
C) use monetary policy to combat unemployment in the long run
D) use fiscal policy to combat inflation in the long run
Answer: A
Diff: 1
Type: MC
Page Ref: 492
53) Members of the Central Bank and Canadabank are both vying for promotions. Central Bank
members receive promotions if they keep interest rates and unemployment low. Canadabank
officers receive promotions if they make loans with few defaults. In case A, the Bank keeps
money growth low, minimizing inflation, but hurting growth; and in Case B, they allow money
growth, which reduces interest rates, but increases inflation in the long run. In case C,
Canadabank officers make few loans, minimizing the variability of profits; and in case D, they
make many loans, increasing the variability of profits. The possible outcomes and promotions
are listed below:
Assume members of the Bank and Canadabank don't care whether other people receive
promotions. If the Bank makes their policy move first, what action will each bank take?
A) (A, C)
B) (A, D)
C) (B, C)
D) (B, D)
Answer: A
Diff: 2
Type: MC
Page Ref: 491
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54) There is an election coming up. Conservatives are currently in government, and will be able
to raise more money for the next election campaign if they keep inflation and unemployment
low. Conservatives can persuade firms whether or not to raise prices; Liberals can persuade the
Bank whether or not to increase the money supply. The amount of money raised by each party
and the resulting inflation and unemployment rates are given below. If the Conservatives can
move first, what will be the outcome of this game?
A) Outcome A
B) Outcome B
C) Outcome C
D) Outcome D
Answer: D
Diff: 3
Type: MC
Page Ref: 491
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55) There is an election coming up. Conservatives are currently in government, and will be able
to raise more money for the next federal election if they keep inflation and unemployment low.
Conservatives can persuade firms whether or not to raise prices; Liberals can persuade the Bank
whether or not to increase the money supply. The amount of money raised by each party and the
resulting inflation and unemployment rates are given below. If the Liberals can move first, what
will be the outcome of this game?
A) Outcome A
B) Outcome B
C) Outcome C
D) Outcome D
Answer: D
Diff: 3
Type: MC
Page Ref: 491
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56) There is an election coming up. Liberals can persuade firms whether or not to raise prices;
Conservatives can persuade the Bank whether or not to increase the money supply. The Liberals
move first. The amount of money raised by each party and the resulting inflation and
unemployment rates are given below. What will be the outcome of this game?
A) Outcome A
B) Outcome B
C) Outcome C
D) Outcome D
Answer: A
Diff: 3
Type: MC
Page Ref: 491
57) The problem with the strategy of achieving credibility through reputation is that
A) reputations are rarely credible.
B) reputations lack any commitment.
C) serious costs may be incurred during the period in which reputation is established.
D) rules always have a lower cost than reputations in maintaining credibility.
Answer: C
Diff: 2
Type: MC
Page Ref: 495
58) The primary criticism by Keynesians of the credibility argument for rules is that
A) reputations are a less costly method of gaining credibility.
B) reputations are a less costly method of maintaining credibility.
C) the cost of losing flexibility over policy choices may exceed the cost of gaining credibility.
D) rules that reduce government influence over monetary policy could ultimately be harmful to
the economy.
Answer: C
Diff: 2
Type: MC
Page Ref: 495
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59) Mobin finds a $50 bill under his couch and deposits it in his bank account. How much can
the money supply increase if the deposit ratio is 10 percent?
A) $500
B) $450
C) $50
D) $10
Answer: B
Diff: 2
Type: MC
Page Ref: 475
60) In Winterland, the monetary base is $20 billion, total desired bank reserves are $1 billion,
and total bank deposits are $5 billion. What is the money supply in Winterland?
A) $5 billion
B) $20 billion
C) $50 billion
D) $100 billion
Answer: D
Diff: 3
Type: MC
Page Ref: 475
61) In Summerland, the reserve deposit ratio is 4% and the currency-deposit ratio is 10%. What
is the money multiplier?
A) 4.7
B) 14
C) 7.86
D) 6
Answer: C
Diff: 2
Type: MC
Page Ref: 477
62) In Winterland, currency outside banks is $65 billion, bank reserves are $25 billion, and
deposits are $603 billion. What is the monetary base in Winterland?
A) $90 billion
B) $40 billion
C) $693 billion
D) $628 billion
Answer: A
Diff: 3
Type: MC
Page Ref: 477
63) Which of the following is true about the Bank of Canada?
A) The Bank of Canada is a private corporation established in 1938.
B) The Bank of Canada's governor is appointed by Parliament.
C) The Bank of Canada sets the Canadian interest rate.
D) The Bank of Canada seems to be an arm of the government but is, rather, an independent
institution.
Answer: D
Diff: 1
Type: MC
Page Ref: 482
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64) The liabilities of the Central Bank that are usable as money are called
A) the demand deposits.
B) M2.
C) high-power money.
D) M1.
Answer: C
Diff: 1
Type: MC
Page Ref: 482
65) The monetary base
A) is the liabilities of the Central Bank that are usable as money.
B) is also called high-power money.
C) is equal to the money supply in an all-currency economy.
D) All of the above.
Answer: D
Diff: 1
Type: MC
Page Ref: 474
66) In a fractional reserve banking,
A) the reserve-deposit ratio is 1.
B) the reserve-deposit ratio is greater than 1.
C) the reserve-deposit ratio is less than 1.
D) the reserve-deposit ratio is zero.
Answer: C
Diff: 2
Type: MC
Page Ref: 475
67) Consider an economy with a fractional reserve banking and no currency held by public. If
the monetary base is $1,000,000 and the reserve-deposit ratio 0.1, the money supply is
A) $ 5,000,000
B) $100,000
C) $900,000
D) $10,000,000
Answer: D
Diff: 3
Type: MC
Page Ref: 477
68) Consider an economy with a fractional reserve banking and no currency held by public. If
the money supply is $50 billion and the reserve-deposit ratio 0.1, the monetary base is
A) $500 billion
B) $5 billion
C) $10 billion
D) $5 million
Answer: B
Diff: 3
Type: MC
Page Ref: 477
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69) A bank run happens when
A) depositors attempt to withdraw currency simultaneously.
B) banking system is a 100 percent reserve banking.
C) the Central Bank does not lend money to the banks.
D) banks offer a high interest rate.
Answer: A
Diff: 2
Type: MC
Page Ref: 478
70) Which of the following is true (M = Money supply, CU = currency held by public, DEP =
bank deposits, BASE = monetary base)?
A) BASE = M + DEP
B) M = CU + BASE
C) CU = BASE - M
D) M = CU + DEP
Answer: D
Diff: 2
Type: MC
Page Ref: 478
71) Which of the following is true (M = Money supply, CU = currency held by public, DEP =
bank deposits, BASE = monetary base, RES = monetary base held as reserves by banks)?
A) BASE = M + DEP
B) M + CU + BASE
C) BASE = CU + RES
D) DEP = BASE - DEP
Answer: C
Diff: 2
Type: MC
Page Ref: 478
72) Which of the following is true (M = Money supply, cu = currency - deposit ratio, res =
reserve - deposit ratio, BASE = monetary base)?
A) M = [(cu + 1)/(cu + res)] BASE
B) M = [(cu + res)/(cu + 1)] BASE
C) BASE = [(cu + 1)/(cu + res)] M
D) BASE = [cu/(cu + 1)] M
Answer: A
Diff: 2
Type: MC
Page Ref: 479
73) In an economy with a fractional system banking, cu=0.6, res=0.2, and M=1,000,000. What is
the monetary base?
A) $10,000,000
B) $2,000,000
C) $5,000,000
D) $500,000
Answer: D
Diff: 3
Type: MC
Page Ref: 479
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74) If currency-deposit ratio 0.6 and money multiplier is 2, what is the reserve-deposit ratio?
A) 3
B) 1
C) 2
D) 1.2
Answer: C
Diff: 3
Type: MC
Page Ref: 479
75) The open-market sale by the central bank
A) reduces the monetary base.
B) increases the money supply.
C) increases the monetary base.
D) increases the reserve-deposit ratio.
Answer: A
Diff: 2
Type: MC
Page Ref: 481
14.2 Essay Questions
1) Suppose the reserve-deposit ratio is res = 0.5 - 2i, where i is the nominal interest rate. The
currency-deposit ratio is 0.2 and the monetary base equals 100. The real quantity of money
demanded is given by the more demand function L(Y, i) = 0.5Y - 10i, where Y is real output.
Currently the real interest rate is 5% and the economy expects an inflation rate of 5%. Assume
the price level P is equal to 1.
a. Calculate the money multiplier.
b. Calculate the reserve-deposit ratio.
c. Calculate the money supply.
d. Calculate the value of output Y that clears the asset market.
Answer:
a. 2.4
b. 0.3
c. 240
d. 482
Diff: 2
Type: ES
Page Ref: Sec. 14.1
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2) The money supply is $12 million, currency held by the public is $2 million, and the reservedeposit ratio is 0.2.
a. What is the quantity of bank deposits?
b. What is the quantity of bank reserves?
c. What is the quantity of the monetary base?
d. What is the money multiplier (give a number)?
Answer:
a. $10 million
b. $2 million
c. $4 million
d. 3
Diff: 2
Type: ES
Page Ref: Sec. 14.1
3) Describe, in general terms, the strategy of monetary-policy, explaining how monetary-policy
tools are used to achieve the goals of monetary policy. What intermediate stages are important in
going from tools to goals? What are the links between the different stages? How does the Bank
of Canada use this strategy today?
Answer: The Bank uses its tools to influence intermediate targets that in turn affect the goal
variables. The link between tools and intermediate targets is an economic relationship such as the
money multiplier, which relates changes in the monetary base to changes in the money supply.
The link between intermediate targets and the goal variables is an economic model. Today the
Bank targets the bank rate fairly directly, but watches many indicators to figure out the correct
funds rate.
Diff: 2
Type: ES
Page Ref: Sec. 14.2
4) Suppose the Bank of Canada has just learned that some foreign economies are headed for
recession, which will reduce Canadian exports. This is an economic shock that shifts the IS curve
down. What would you do in response to the shock if you want to keep the economy at fullemployment equilibrium under each of the following cases?
a. You use the classical (RBC) model.
b. You use the Keynesian (efficiency wage) model.
c. You use the extended classical model with misperceptions.
In each case, show the IS-LM-FE diagram associated with your answer.
Answer:
a. Do nothing, let P adjust.
b. Increase the money supply, shifting LM to the right.
c. Do nothing if the IS shift was anticipated; could increase money supply if the IS shift was
unanticipated and the money supply change would be unanticipated, or you could inform people
about the IS shock, so they would build it into their expectations.
Diff: 2
Type: ES
Page Ref: Sec. 14.2
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5) Suppose the Bank of Canada cares only about keeping the economy close to full-employment
output. The Bank can target the real money supply (thus keeping the LM curve fixed) or it can
target the real interest rate—changing the money supply and shifting the LM curve, however, is
necessary to prevent a change in the real interest rate.
a. Which is the best policy if the main shocks to the economy are shocks to the IS curve?
Explain why.
b. Which is the best policy if the main shocks to the economy are shocks to real money
demand? Explain why.
Answer:
a. Target the real money supply, since targeting r would lead to larger fluctuations in output.
b. Target the real interest rate to offset shocks to money demand and stabilize output.
Diff: 3
Type: ES
Page Ref: Sec. 14.2
6) If you could determine the goals of the Bank of Canada, what goals would you choose?
Should the Bank's policy be activist? Discuss the pros and cons.
Answer: Goals: Maintain low inflation and unemployment in a stable economic environment
with steady interest rates and exchange rates. If you are a Keynesian, you believe that activist
policy is desirable, as the Bank can offset shocks to the economy. Monetarists see activist policy
as destabilizing, partly because of the long and variable lags associated with monetary policy.
Classical (RBC) economists see no need for activist policy, since the economy is self-correcting.
Diff: 2
Type: ES
Page Ref: Sec. 14.2
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7) There is an election coming up. Conservatives are currently in government, and will be able to
raise more money for the next election campaign if they keep interest rates and unemployment
low. Conservatives can persuade firms whether or not to raise prices; Liberals can persuade the
Bank whether or not to increase interest rates. The amount of money raised by each party and the
resulting inflation and unemployment rates are given below.
a. If the Conservatives can move first, what will be the outcome of this game?
b. Now suppose the Liberals move first. What will be the outcome?
c. Suppose the roles are reversed and Liberals can influence prices, while Conservatives
influence the money supply. What is the outcome if Liberals move first? If Conservatives move
first?
Answer:
a. Outcome D
b. Outcome D
c. Outcome A; Outcome A
Diff: 3
Type: ES
Page Ref: Sec. 14.3
8) What types of rules for monetary policy may be sensible for policymakers to consider? What
is the advantage of using rules over discretion? What problems might there be with rules?
Answer: One possible rule is a constant money growth rule, as proposed by Milton Friedman
and the monetarists. It has the advantage of being based on economic theory and using
observable data. Following such a rule might be preferable to discretion, because people would
understand the Bank's rule and form expectations accordingly, which would in turn reduce the
costs of disinflation. The problem with such a rule could come if there were structural change in
the economy, such as a change in money demand. In such a case, the rule's lack of flexibility
could cause the Bank to follow inappropriate policies.
Diff: 2
Type: ES
Page Ref: Sec. 14.3
9) Why is it important to policymakers that people believe them when they say they are going to
reduce inflation? How can they increase their credibility?
Answer: If policymakers are credible, inflation expectations will fall quickly, reducing the costs
of disinflation. Credibility can be enhanced by building a reputation, following a rule, appointing
a tough central banker, or increasing Central Bank independence.
Diff: 2
Type: ES
Page Ref: Sec. 14.3
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10) Should the Central Bank be independent? Or should the Central Bank be required to confer
with Parliament to coordinate fiscal and monetary policies? Explain the pros and cons.
Answer: The value of Bank independence is that it prevents political pressure from influencing
the money supply process. On the other hand, if fiscal and monetary policy aren't coordinated,
there may be large swings in the real interest rate and/or output if the policies move in opposite
directions.
Diff: 2
Type: ES
Page Ref: Sec. 14.3
11) Suppose the Bank of Canada strictly followed a rule of keeping money supply at $900
billion. This level of money is consistent with the economy's initial general equilibrium.
a. Assume that GDP has increased. How will the interest rate change?
b. Assume that banks have introduced chequing accounts that pay interest. How will the interest
rate change?
c. What are the effects of the Bank's money targeting policy on the economy?
Answer:
a. Higher GDP will cause demand for money to rise. Since the Bank's policy is to keep money
supply constant, the interest rate will increase.
b. Introducing the new chequing accounts that pay interest will decrease demand for money.
Since the Bank's policy is to keep money supply constant, the interest rate will decrease.
c. The money targeting policy will lead to interest rate fluctuations and therefore changes in
aggregate demand. The money targeting policy will not allow the Bank to accommodate the
money demand shocks and therefore aggregate demand will fluctuate.
Diff: 2
Type: ES
Page Ref: Sec. 14.3
12) Consider an economy with the following data on its banking system: currency outside banks
(CU) = $56 billion, bank reserves (RES) = $42 billion, and total deposits (DEP) = $600 billion.
a. How much is the monetary base?
b. How much is the money supply?
c. What is the reserve-deposit ratio?
d. What is the currency-deposit ratio?
e. What is the money multiplier?
f. If the monetary base rises by $2 billion, by how much will the money supply increase?
Answer:
a. $98 billion
b. $656 billion
c. 0.07
d. 0.09
e. 6.7
f. $13.4 billion
Diff: 3
Type: ES
Page Ref: Sec. 14.1
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13) What is inflation targeting policy? Discuss its advantages and disadvantages.
Answer: Inflation targeting policy is a monetary policy to control inflation. In this policy, the
central bank targets one of its ultimate goals, the rate of inflation, rather than targeting an
intermediate variable (such as money growth).
One advantage of the inflation targeting policy is that it is simple to understand. The more
clearly the Bank of Canada explains its intentions, the better Canadian households and firms are
able to plan their own choices and maximize their own well-being. A major disadvantage of
inflation targeting is that inflation responds to policy actions only with a long lag.
Diff: 3
Type: ES
Page Ref: 497
14) What is quantitative easing and how does it work? Give an example of a case when it was
used and how effective was.
Answer: Open-market operations that involve the purchase and sale of government or
nongovernment securities with long terms to maturity have become known as exercises in
quantitative easing. During the financial crisis of 2007-2009, many central banks (most notably
the U.S. Federal Reserve) used quantitative easing as a way of directly influencing the rates of
return on the sorts of securities that private firms rely upon to raise funds for investment. Thus,
the U.S. Federal Reserve purchased risky assets with government-issued Treasury bills and in
this way took those assets off the books of private banks.
Diff: 2
Type: ES
Page Ref: 486
15) Discuss how the Bank of Canada responded to the 2008 financial crisis and compare it with
Federal Reserve's policy in the U.S.
Answer: As well as relying on tighter regulations already in place, the Bank of Canada added
liquidity to the financial sector to keep it running smoothly during the uncertain times of the
financial crisis. The Bank was also careful to design interventions in a way that mitigated the
"moral hazard" that is said to arise when someone protected from risk behaves differently from
how they would otherwise.
The U.S. Federal Reserve used quantitative easing as a way of directly influencing the rates of
return on the sorts of securities that private firms rely upon to raise funds for investment. The use
of quantitative easing was also encouraged as a way of ensuring the viability of private banks
thought to be at risk of collapse. Thus, the U.S. Federal Reserve purchased risky assets with
government-issued Treasury bills and in this way took those assets off the books of private
banks.
Diff: 2
Type: ES
Page Ref: 486
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Macroeconomics, Cdn. 9e (Abel et al.)
Chapter 15 Government Spending and Its Financing
15.1 Multiple-Choice Questions
1) Since the 1950s, the share of GDP devoted to government purchases on average in the OECD
countries has
A) steadily increased.
B) steadily decreased.
C) remained fairly steady.
D) increased, but only after recessions.
Answer: C
Diff: 1
Type: MC
Page Ref: 506
2) Since the 1950s, transfer payments' share of GDP has
A) steadily increased.
B) steadily decreased.
C) remained fairly steady.
D) increased during Liberal governments and decreased during Conservative governments.
Answer: A
Diff: 1
Type: MC
Page Ref: 506
3) Interest payments by the government as a share of GNP have
A) steadily increased.
B) remained fairly steady.
C) increased, but only to reflect changes in nominal interest rates.
D) increased sharply in the early 1930s, the 1940s and in the 1980s-1990s.
Answer: D
Diff: 1
Type: MC
Page Ref: 507
4) The largest source of tax receipts for the government is
A) direct taxes from persons.
B) investment income.
C) indirect taxes.
D) direct taxes from enterprises.
Answer: A
Diff: 1
Type: MC
Page Ref: 508
5) The type of tax receipts that has shown the largest growth since the end of World War II has
been
A) direct taxes from persons.
B) investment income.
C) indirect taxes.
D) direct taxes from enterprises.
Answer: A
Diff: 1
Type: MC
Page Ref: 508
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6) The type of tax receipts that has shown the slowest growth since World War II has been
A) direct taxes from persons.
B) investment income.
C) indirect taxes.
D) direct taxes from enterprises.
Answer: D
Diff: 2
Type: MC
Page Ref: 508
7) The total spending by government during a period of time includes
A) government purchases of goods and services.
B) transfer payments.
C) interest payments.
D) all of the above.
Answer: D
Diff: 1
Type: MC
Page Ref: 505
8) The main sources of the Canadian government income are
A) direct and indirect taxes.
B) foreign investment.
C) investment income.
D) both A and C.
Answer: D
Diff: 1
Type: MC
Page Ref: 507
9) Which of the following is NOT included in the government transfer payments?
A) Old age security payments
B) Foreign aids
C) Employment insurance benefits
D) Intergovernmental payments
Answer: D
Diff: 1
Type: MC
Page Ref: 509
10) What portion of government purchases of goods and services is carried out by provincial and
local governments?
A) one-third
B) one-half
C) two-thirds
D) four-fifths
Answer: C
Diff: 1
Type: MC
Page Ref: 509
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11) Provincial and local governments rely on ________ as their primary source of tax receipts.
A) direct taxes from persons
B) investment income
C) indirect taxes
D) direct taxes from enterprises
Answer: C
Diff: 1
Type: MC
Page Ref: 509
12) The primary surplus is equal to
A) tax revenues - expenditures.
B) tax revenues - transfers - net interest - government purchases.
C) revenues - expenditures + net interest.
D) tax revenues - transfers - government purchases.
Answer: D
Diff: 1
Type: MC
Page Ref: 510
13) The deficit is
A) the amount by which government purchases, transfers, and net interest exceed tax revenues.
B) the amount by which government purchases and transfers exceed tax revenues.
C) the primary deficit minus net interest payments.
D) total tax revenues minus net interest minus government expenditures.
Answer: A
Diff: 1
Type: MC
Page Ref: 512
14) The primary deficit is
A) the amount by which government purchases, transfers, and net interest exceed tax revenues.
B) the amount by which government purchases and transfers exceed tax revenues.
C) the deficit plus net interest payments.
D) total tax revenues minus net interest minus government expenditures.
Answer: B
Diff: 1
Type: MC
Page Ref: 512
15) Classical economists think that lump-sum tax changes
A) should be used to smooth business cycles.
B) have a powerful effect on the economy.
C) affect aggregate demand after a lag.
D) have no effect because of Ricardian equivalence.
Answer: D
Diff: 1
Type: MC
Page Ref: 527
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16) The political process by which fiscal policy is made
A) is relatively rapid, contributing to the effectiveness of fiscal policy.
B) requires only that the prime minister approve changes to the budget, a decision that takes
several months.
C) is efficient in reaching a decision within a year.
D) is slow and results in a long time lag for fiscal policy.
Answer: D
Diff: 1
Type: MC
Page Ref: 512
17) Assume the marginal tax rate for income above $25000 has risen to 30 percent. If the tax rate
for the income less than $25000 is 10 percent, how much tax a person with an income of $40,000
will pay?
A) $600
B) $6500
C) $7000
D) $8000
Answer: C
Diff: 3
Type: MC
Page Ref: 516
18) Assume the marginal tax rate for income above $25000 has risen to 30 percent. If the tax rate
for the income less than $25000 is 10 percent, what is the average tax rate for a person with an
income of $40,000?
A) 15%
B) 16%
C) 17.5%
D) 18%
Answer: C
Diff: 3
Type: MC
Page Ref: 516
19) According to Keynesian economists, the primary problem with using fiscal policy as a
stabilization tool is that
A) fiscal policy does not have the effect on output in practice that it should have in theory.
B) fiscal policy will be effective only if it is funded through lump-sum tax changes.
C) fiscal policy will be effective only if it is funded through permanent changes in taxes.
D) fiscal policy is inflexible because a large portion of government spending is planned years in
advance and cannot easily be changed.
Answer: D
Diff: 2
Type: MC
Page Ref: 512
20) Which of the following would NOT act as an automatic stabilizer?
A) unemployment insurance
B) government purchases
C) personal income taxes
D) corporate income taxes
Answer: B
Diff: 1
Type: MC
Page Ref: 513
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21) Because of automatic stabilizers, in recessions the government budget deficit ________,
while in expansion the deficit ________.
A) falls; rises
B) falls; falls
C) rises; falls
D) rises; rises
Answer: C
Diff: 1
Type: MC
Page Ref: 513
22) The full-employment deficit is
A) the number of jobs needed to restore full employment.
B) what the government budget deficit would be if the economy were at full employment.
C) the increase in government spending that would be needed to return the economy to full
employment.
D) the extra amount paid to government workers in a recession.
Answer: B
Diff: 1
Type: MC
Page Ref: 514
23) Which of the following statements about the structural surplus or cyclically adjusted surplus
is true?
A) An expansionary fiscal policy lowers the structural surplus.
B) An increase in tax rates raises the structural surplus.
C) A contractionary fiscal policy raises the structural surplus.
D) A and C
Answer: D
Diff: 2
Type: MC
Page Ref: 514
24) Which of the following is true about the actual and structural budget surplus in Canada?
A) The actual budget surplus was significantly less than the structural budget surplus during the
last three recessions reflecting the importance of automatic stabilizers.
B) The actual budget surplus was significantly larger than the structural budget surplus during
the last three recessions reflecting the importance of automatic stabilizers.
C) The actual budget surplus was not significantly different than the structural budget surplus
during the last three recessions indicating that the automatic stabilizers were not important.
D) The actual budget surplus was not significantly different than the full-employment budget
surplus during the last three recessions indicating that the automatic stabilizers were not
important.
Answer: A
Diff: 2
Type: MC
Page Ref: 514
25) Government capital consists of
A) money owned by the government.
B) securities owned by the government.
C) the buildings owned by the government in Ottawa.
D) long-lived physical assets owned by the government.
Answer: D
Diff: 1
Type: MC
Page Ref: 515
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26) All of the following are government capital except
A) roads.
B) schools.
C) Treasury securities.
D) mass-transit systems.
Answer: C
Diff: 1
Type: MC
Page Ref: 515
27) Roads and education are examples of
A) government physical and human capital formation, respectively.
B) government human and physical capital formation, respectively.
C) government spending on current items.
D) government subsidies.
Answer: A
Diff: 1
Type: MC
Page Ref: 515
28) The average tax rate is
A) the fraction of an additional dollar of income that must be paid in taxes.
B) the total amount of taxes paid divided by after-tax income.
C) the total amount of taxes paid divided by before-tax income.
D) the average amount of government spending that is financed by taxes.
Answer: C
Diff: 1
Type: MC
Page Ref: 516
29) The marginal tax rate is
A) the fraction of an additional dollar of income that must be paid in taxes.
B) the total amount of taxes paid divided by after-tax income.
C) the total amount of taxes paid divided by before-tax income.
D) the average amount of government spending that is financed by taxes.
Answer: A
Diff: 1
Type: MC
Page Ref: 516
30) In general,
A) the higher the marginal tax rate already is, the greater are the additional distortions created by
raising the marginal tax rate still further.
B) the higher the marginal tax rate already is, the smaller are the additional distortions created by
raising the marginal tax rate still further.
C) the higher the average tax rate already is, the smaller are the additional distortions created by
raising the average tax rate still further.
D) the higher the average tax rate and the marginal tax rate, the smaller are the additional
distortions created by raising the marginal and average tax rates still further.
Answer: A
Diff: 2
Type: MC
Page Ref: 517
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31) A decrease in the marginal tax rate, with the average tax rate held constant, will
A) increase the amount of labour supplied at any real wage.
B) not affect the amount of labour supplied at any real wage.
C) decrease the amount of labour supplied at any real wage.
D) increase the amount of labour supplied at any real wage if the average tax rate is above the
marginal tax rate, but decrease the amount of labour supplied at any real wage if the average tax
rate is below the marginal tax rate.
Answer: A
Diff: 2
Type: MC
Page Ref: 517
32) A decrease in the average tax rate, with the marginal tax rate held constant, will
A) increase the amount of labour supplied at any real wage.
B) not affect the amount of labour supplied at any real wage.
C) decrease the amount of labour supplied at any real wage.
D) increase the amount of labour supplied at any real wage if the average tax rate is above the
marginal tax rate, but decrease the amount of labour supplied at any real wage if the average tax
rate is below the marginal tax rate.
Answer: C
Diff: 2
Type: MC
Page Ref: 517
33) What is the difference between the average and marginal tax rates' effects on the labour
supply?
A) An increase in the average tax rate will increase labour supply, but an increase in the marginal
tax rate will decrease labour supply.
B) An increase in the average tax rate will decrease labour supply, but a decrease in the marginal
tax rate will decrease labour supply.
C) There is no difference. An increase in the average tax rate and the marginal tax rate will
increase labour supply.
D) There is no difference. An increase in the average tax rate and the marginal tax rate will
decrease labour supply.
Answer: A
Diff: 2
Type: MC
Page Ref: 517
34) Suppose that all workers place a value on their leisure of 75 goods per day. The production
function relating output per day Y to the number of people working per day N is Y = 500N 0.4N2 and the marginal product of labour is MPN = 500 - 0.8 N. A 25% tax is levied on wages.
Output per day would be
A) 100,000.
B) 150,000.
C) 200,000.
D) 250,000.
Answer: B
Diff: 2
Type: MC
Page Ref: 517
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35) Suppose that all workers place a value on their leisure of 75 goods per day. The production
function relating output per day Y to the number of people working per day N is Y = 500N 0.4N2 and the marginal product of labour is MPN = 500 - 0.8 N. A 25% tax is levied on wages.
In terms of lost output, what is the cost of the distortion introduced by this tax?
A) 63
B) 531
C) 2734
D) 3751
Answer: C
Diff: 3
Type: MC
Page Ref: 517
36) Taxes distort economic behaviour because
A) they change the composition of income and spending.
B) they cause deviations in economic behaviour from the efficient, free-market outcome.
C) they change the balance between private and public expenditures.
D) they change the composition of consumption, investment, government spending, and net
exports.
Answer: B
Diff: 1
Type: MC
Page Ref: 518
37) Assume that the lost output due to tax distortions is proportional to the square of the tax rate.
If the government increased the tax rate from 25% to 40%, the lost output would increase by a
factor of
A) 1.56.
B) 1.60.
C) 1.96.
D) 2.56.
Answer: D
Diff: 2
Type: MC
Page Ref: 518
38) Assume that the lost output due to tax distortions is proportional to the square of the tax rate.
If the average cost of the distortion created by taxes is currently $100, and the tax rate is
increased from 20% to 50%, the average cost of the distortion created by taxes will increase to
A) $169.
B) $225.
C) $250.
D) $625.
Answer: D
Diff: 2
Type: MC
Page Ref: 518
39) The average cost of the distortion created by taxes
A) increases proportionately with the tax rate.
B) is lower when the tax rate is constant than when it fluctuates.
C) is higher when the tax rate is constant than when it fluctuates.
D) equals the square root of the tax rate.
Answer: B
Diff: 1
Type: MC
Page Ref: 518
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40) An example of tax smoothing is provided by evidence of
A) temporary changes in defense expenditures by the government.
B) reductions in tax rates prior to elections.
C) Keynesian tax cuts designed to help the economy recover from a recession.
D) reliance on debt financing rather than taxation during World War II.
Answer: D
Diff: 1
Type: MC
Page Ref: 519
41) Economists prefer tax rate smoothing because
A) it minimizes distortions.
B) it eliminates distortions.
C) it is beneficial to poor.
D) it maximizes government tax revenues.
Answer: A
Diff: 1
Type: MC
Page Ref: 519
42) The debt-GDP ratio in Canada
A) steadily fell after World War II.
B) steadily increased after World War II.
C) fell from the end of World War II until around 1976 and rose thereafter.
D) fell from the end of World War II until around 1976 and rose thereafter, until 1996.
Answer: D
Diff: 1
Type: MC
Page Ref: 523
43) Increases in the debt-GDP ratio are primarily caused by
A) a high growth rate of GDP.
B) a high primary government deficit.
C) increases in government.
D) increases in interest rates.
Answer: B
Diff: 2
Type: MC
Page Ref: 523
44) All else constant, if the interest rate paid on government debt falls short of the GDP growth
rate,
A) the debt-GDP ratio will rise from one year to the next.
B) the debt-GDP ratio will fall from one year to the next.
C) the debt-GDP ratio will remain unchanged from one year to the next.
D) the debt will rise more than the GDP growth rate from one year to the next.
Answer: B
Diff: 2
Type: MC
Page Ref: 523
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45) In 2004, The DEBTLAND's debt-GDP ratio was 0.7, and in 2005, the government primary
deficit to GDP ratio is -0.2. If the interest rate paid on debt is 4 percent and the economy grows
by 4 percent in 2005, the DEBTLAND's debt-DGP ratio in 2005 will
A) increase by 20 percent.
B) decrease by 20 percent.
C) increase by 4 percent.
D) not change.
Answer: B
Diff: 3
Type: MC
Page Ref: 523
46) The DEBTLAND's debt-GDP ratio in 2004 was 0.7, but it went down by 20 percent in 2005.
If the interest rate paid on debt is 4 percent and the economy grows by 4 percent in 2005, the
DEBTLAND's primary deficit to GDP ratio must
A) have increased by 20 percent.
B) have decreased by 20 percent.
C) have remained unchanged.
D) have decreased by 4 percent.
Answer: B
Diff: 3
Type: MC
Page Ref: 523
47) The DEBTLAND's economic growth is 5 percent and the interest rate paid on debt is also 5
percent. If the primary deficit to GDP ratio is 2 percent, the DEBTLAND's debt-GDP ratio will
change by
A) 3 percent.
B) 5 percent.
C) 7 percent.
D) 2 percent.
Answer: D
Diff: 3
Type: MC
Page Ref: 523
48) Which of the following can explain the Canada's unprecedented high debt-GDP ratio
between 1975 and 1995?
A) Canada experienced a combination of low interest rate payable on government debt and a
high economic growth.
B) Canada experienced a combination of high interest rate payable on government debt and a
slow economic growth.
C) Canada experienced a combination of low interest rate payable on government debt and a
slow economic growth.
D) Canada experienced a combination of high interest rate payable on government debt and a
high economic growth.
Answer: B
Diff: 2
Type: MC
Page Ref: 525
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49) Given a stable primary deficit to GDP ratio, Canada can reduce its dept-GDP ratio, if
A) the economic growth is higher than the interest rate paid on debt.
B) the economic growth is lower than the interest rate paid on debt.
C) the economic growth is the same as the interest rate paid on debt.
D) the economic growth is higher than the inflation rate.
Answer: A
Diff: 2
Type: MC
Page Ref: 527
50) Generational accounts show how much each generation
A) contributes to government capital.
B) saves.
C) earns relative to the income of other generations.
D) pays in taxes as a function of lifetime income.
Answer: D
Diff: 1
Type: MC
Page Ref: 526
51) Which of the following would NOT be an argument that government debt imposes a burden
on future generations?
A) Lump-sum taxes in the future may be raised to pay higher real interest costs.
B) Higher taxes in the future could increase the average cost of distortions to the economy
created by taxes.
C) Higher taxes in the future to repay government debt will transfer resources from the poor to
the rich.
D) Higher government deficits resulting from increased purchases may reduce savings, causing
investment to fall.
Answer: A
Diff: 2
Type: MC
Page Ref: 526
52) An increased government deficit created by a lump-sum tax cut will reduce national saving if
A) the value of government bonds outstanding grows faster than the public's wealth.
B) it causes consumption to rise.
C) the government runs a primary deficit as a result.
D) the real interest rate is greater than the growth rate of real GNP.
Answer: B
Diff: 2
Type: MC
Page Ref: 526
53) According to the Ricardian equivalence proposition, current deficits
A) will not affect consumption or national saving.
B) will affect consumption but not national saving.
C) will affect national saving but not consumption.
D) will affect both consumption and national saving.
Answer: A
Diff: 1
Type: MC
Page Ref: 527
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54) Deficits are a burden on future generations if
A) they cause higher rates of inflation to occur.
B) they are not used for government capital formation.
C) they cause national saving to fall.
D) they are always a primary government deficit.
Answer: C
Diff: 1
Type: MC
Page Ref: 526
55) A decrease in taxes on the current generation would have no effect on consumption or
national saving if
A) individuals face borrowing constraints.
B) individuals increase their consumption by less than the tax cut.
C) consumers bequeath all of the tax cut to the next generation.
D) consumers are not forward looking concerning their future tax burden.
Answer: C
Diff: 1
Type: MC
Page Ref: 526
56) Which of the following would be most likely to increase consumption in the economy?
A) a lump-sum tax cut
B) a tax break for saving account
C) a cut in sales taxes
D) a cut in the corporate tax rate
Answer: C
Diff: 1
Type: MC
Page Ref: 527
57) Seignorage is the revenue a government raises by
A) taxation.
B) printing money.
C) borrowing money.
D) charging fees for services.
Answer: B
Diff: 1
Type: MC
Page Ref: 532
58) An expansionary fiscal policy will NOT cause an increase in the price level if the
government
A) reduces the corporate income tax rate.
B) increases purchases in the classical model.
C) lowers taxes and Ricardian equivalence does not hold.
D) lowers taxes and Ricardian equivalence holds.
Answer: D
Diff: 1
Type: MC
Page Ref: 532
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59) In which case would you be most likely to expect inflation to occur?
A) The government runs a sustained government deficit by lowering taxes.
B) The government runs a sustained government deficit by increasing purchases.
C) The government runs a sustained primary deficit by increasing purchases.
D) The government funds its sustained deficit by increasing the money supply.
Answer: D
Diff: 1
Type: MC
Page Ref: 532
60) The real seignorage collected by the government is the product of
A) the rate of inflation and the real supply of government bonds.
B) the rate of inflation and the real money supply.
C) the debt/GDP ratio and the real money supply.
D) the debt/GDP ratio and the rate of inflation.
Answer: B
Diff: 1
Type: MC
Page Ref: 532
61) Assume that the real interest rate is 4%, the expected rate of inflation is 8%, and the nominal
interest rate is 12%. The monetary base equals $50 billion. The real seignorage revenue collected
by the government would equal
A) $4 billion.
B) $6 billion.
C) $8 billion.
D) $12 billion.
Answer: A
Diff: 2
Type: MC
Page Ref: 532
62) Real money demand in the economy is given by L = 0.3Y - 600 i, where Y is real income and
i is the nominal interest rate. In equilibrium, real money demand L equals real money supply
M/P. Suppose that Y equals 2000 and the real interest rate is 5%. At what rate of inflation is
seignorage maximized?
A) 42.5%
B) 45.0%
C) 47.5%
D) 50.0%
Answer: C
Diff: 3
Type: MC
Page Ref: 532
63) Real money demand in the economy is given by L = 0.3Y - 600 i, where Y is real income and
i is the nominal interest rate. In equilibrium, real money demand L equals real money supply
M/P. Suppose that Y equals 2000 and the real interest rate is 5%. What is the maximum amount
of seignorage revenue?
A) 132,000
B) 135,375
C) 138,000
D) 141,125
Answer: B
Diff: 3
Type: MC
Page Ref: 532
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64) Consider an economy that has the following monetary data:
Currency in circulation
Bank reserves
Monetary base
Deposits
Money supply
= $300
=
$50
= $350
= $700
= $1000
The monetary base and the money supply are expected to grow at a constant rate of 20% per
year. Inflation and expected inflation are 20% per year. Suppose that bank reserves and currency
pay no interest, all currency is held by the public, and bank deposits pay no interest. What is the
cost to the public of the inflation tax?
A) $60
B) $140
C) $190
D) $200
Answer: D
Diff: 2
Type: MC
Page Ref: 532
65) Consider an economy that has the following monetary data:
Currency in circulation
Bank reserves
Monetary base
Deposits
Money supply
= $300
=
$50
= $350
= $700
= $1000
The monetary base and the money supply are expected to grow at a constant rate of 20% per
year. Inflation and expected inflation are 20% per year. Suppose that bank reserves and currency
pay no interest, all currency is held by the public, and bank deposits pay no interest. What is the
profit to the banks from the inflation?
A) $130
B) $140
C) $190
D) $200
Answer: A
Diff: 3
Type: MC
Page Ref: 532
66) Whether real seignorage revenue increases when the rate of money growth increases depends
on whether
A) the rise in real money holdings outweighs the decline in inflation.
B) the rise in inflation outweighs the decline in real money holdings.
C) the rise in inflation ratio outweighs the decline in the real supply of currency.
D) the rise in the real supply of currency outweighs the decline in inflation.
Answer: B
Diff: 1
Type: MC
Page Ref: 532
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67) An increase in the average tax rate and a decrease in the marginal tax rate will
A) decrease the labour supply.
B) increase the labour supply.
C) increase government debt.
D) increase government revenues.
Answer: B
Diff: 2
Type: MC
Page Ref: 516
68) One of the implications of the poverty trap is that
A) the effective marginal tax rate can be very high for low-skilled workers, leading to
discouraging the labour supply.
B) the average tax rate can be very high for low-skilled workers, leading to discouraging the
labour supply.
C) the effective marginal tax rate can be low for low-skilled workers, leading to discouraging the
labour supply.
D) the effective marginal tax rate can be very high for high-skilled workers, leading to
discouraging the labour supply.
Answer: A
Diff: 2
Type: MC
Page Ref: 518
69) The government debt-GDP ratio will increase with
A) a depreciation of the exchange rate.
B) a lower interest rate paid on government bonds.
C) higher tax revenues.
D) a lower rate of economic growth.
Answer: D
Diff: 2
Type: MC
Page Ref: 518
70) Which of the following is NOT an argument against the Ricardian equivalence theorem?
A) the lack of the central bank's independency
B) failure to leave bequests
C) non-lump-sum taxes
D) shortsightedness
Answer: A
Diff: 1
Type: MC
Page Ref: 528
71) In an economy with a 10 percent inflation rate and a $560 billion real money supply, the real
inflation tax revenue is equal to
A) $56 billion.
B) $17.857 million.
C) $5600 billion.
D) $5600 million.
Answer: A
Diff: 2
Type: MC
Page Ref: 533
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72) In Canada, the government spending as a percentage of GDP has
A) increased.
B) been stable.
C) decreased.
D) been less than that in the U.S.
Answer: C
Diff: 1
Type: MC
Page Ref: 506
73) In most of the OECD countries, the government spending as a percentage of GDP between
2000 and 2016 ha s
A) decreased.
B) been stable.
C) increased.
D) been higher relative to 1987.
Answer: A
Diff: 1
Type: MC
Page Ref: 506
74) The difference between the government revenue and government purchases and transfers is
called
A) total budget surplus.
B) primary budget surplus.
C) total budget deficit.
D) primary budget deficit.
Answer: A
Diff: 1
Type: MC
Page Ref: 509
75) The main difference between the Keynesian and classical economists in fiscal policy is
A) the effect of government purchases on GDP.
B) the effect of money supply on GDP.
C) the effect of taxes on income distribution.
D) the effect of taxes on aggregate demand.
Answer: D
Diff: 2
Type: MC
Page Ref: 512
76) Which one of the following is NOT considered as an automatic stabilizer?
A) employment insurance program
B) the income tax system
C) the transfer payments.
D) the stock market
Answer: D
Diff: 2
Type: MC
Page Ref: 513
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77) Last year, you paid $2000 income tax and the marginal tax rate was 25 percent for income
over $10,000. How much was your income?
A) $25000
B) $10,000
C) $18,000
D) $20,000
Answer: C
Diff: 3
Type: MC
Page Ref: 516
15.2 Essay Questions
1) You are given the following budget data for a country that has both a central government and
local governments:
Central purchases of goods
Local purchases of goods
Central transfer payments
Local transfer payments
Grants in aid (central to local)
Central tax receipts
Local tax receipts
Interest received from private sector by central government
Interest received from private sector by local governments
Total central government debt
Total local government debt
Central government debt held by local governments
Nominal interest rate
500
250
200
100
150
800
150
25
10
1500
0
300
10%
a. How much is the deficit for the central government, the local government, and the total of the
central and local governments?
b. How much is the primary deficit for the central government, the local government, and the
total of the central and local governments?
Answer:
a. 175, 10, 185
b. 50, 50, 100
Diff: 2
Type: ES
Page Ref: Sec. 15.1
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2) At the beginning of year one, there is no government debt outstanding. The government runs a
$100 billion deficit in year one. Interest at a nominal rate of 10% must be paid starting in year
two. Assume nominal GDP in year one is $2000 billion and the nominal growth rate of GDP is
4%. Assume the government balances its primary budget in the future and the interest rate and
growth rate do not change.
a. What will be the government deficit in years two, three, four, and five?
b. What will be the value of government bonds outstanding at the end of the fifth year?
c. What will be the debt-GDP ratio at the end of year five?
Answer:
a. $10, $11, $12.1, $13.31 (all in billions)
b. $146.41 billion
c. .0626
Diff: 2
Type: ES
Page Ref: Sec. 15.3
3) Suppose that for the economy of Chou
Tax revenues = 2000 + 0.1 GDP
Transfers = 1500 + 0.05 GDP
Government purchases = 3000
Interest payments = 200
Full employment GDP = 15,000
Actual GDP = 16,000
a. How much is the budget deficit?
b. How much is the primary budget deficit?
c. How much is the full-employment budget deficit?
Answer:
a. 300
b. 100
c. 450
Diff: 2
Type: ES
Page Ref: Sec. 15.1
4) Suppose that all workers place a value on their leisure of 75 goods per day. The production
function relating output per day Y to the number of people working per day N is Y = 500N 0.4N2, and the marginal product of labour is MPN = 500 - 0.8N. A 25% tax is levied on wages.
a. How much is output per day?
b. In terms of lost output, what is the cost of the distortion introduced by this tax?
Answer:
a. 150,000
b. 2734
Diff: 3
Type: ES
Page Ref: Sec. 15.2
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5) Why should government smooth tax rates? If they do so, what happens to deficits over the
business cycle?
Answer: Governments should smooth tax rates because the increase in distortions from
increasing the tax rate is larger than the decrease in distortions from reducing the tax rate by the
same amount. Because of that, it's better to keep tax rates constant over time and run periodic
deficits and surpluses rather than raise tax rates in times when the government needs extra
revenue. This means running deficits in recessions and surpluses in booms.
Diff: 2
Type: ES
Page Ref: Sec. 15.2
6) Who bears the burden of the government debt? Explain why. Under what circumstances is
there no burden to be borne?
Answer: If taxes must be raised in the future to pay off the debt, the distortions from higher tax
rates are a burden on future generations. Also, if bondholders are on average wealthier than
taxpayers, there will be a redistribution of wealth as the debt is repaid. Finally, if the debt
reduces national saving, then investment will be lower, which reduces the capital stock, which
means a lower standard of living for future generations. But if taxes are lump-sum and Ricardian
equivalence holds, there is no burden, since then private saving rises to prevent the debt from
having any effects on national saving.
Diff: 2
Type: ES
Page Ref: Sec. 15.3
7) The SPENDLAND's GDP and debt last year was $4000 billion and $2000 billion,
respectively. This year, the government revenue is $800 billion and the government expenditure
is $1000 billion. Suppose the interest rate payable on government debt is 10 percent.
a. What is the debt-GDP ratio for last year? This year?
b. How much did the debt-GDP ratio change?
c. Explain why the debt-GDP ratio changed?
Answer:
a. The debt-GDP ratio for last year = 50 % (2000/4000), for this year = 59%. Note that this
year's debt is equal to $2400, which includes last year's debt ($2000) plus $200 government
deficit as well as 10 percent interest on the last year's debt.
b. The debt-GDP ratio has increased by 9 percentage points.
c. There are two reasons for why the debt-GDP ratio increased. First, the new budget deficit,
and second, a combination of slow growth (1 percent) and a high interest rate (10 percent).
Diff: 3
Type: ES
Page Ref: Sec. 15.3
8) What are the main reasons (give at least three) that Ricardian equivalence might not hold?
Answer: People may face borrowing constraints, they may be shortsighted, they may fail to
leave bequests, or their economic behaviour may be affected because taxes aren't lump sum.
Diff: 2
Type: ES
Page Ref: Sec. 15.3
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9) How is real seignorage revenue related to inflation? How does the quantity of real seignorage
revenue change as inflation rises from zero to a positive level, to still higher levels?
Answer: Real seignorage revenue is the inflation rate times the level of real money balances. As
inflation rises, real money balances decline. Initially, as inflation rises from zero, real seignorage
revenue rises, because inflation rises more than the real money balances fall. Real seignorage
revenue continues to rise with higher inflation rates until it hits a point at which it begins to
decline, because real money balances begin to fall more than inflation rises.
Diff: 2
Type: ES
Page Ref: Sec. 15.4
10) Real money demand in the economy is given by L = 0.3Y - 600i, where Y is real income and
i is the nominal interest rate. In equilibrium, real money demand L equals real money supply
M/P. Suppose that Y equals 2000 and the real interest rate is 5%.
a. At what rate of inflation is seignorage maximized?
b. What is the maximum amount of seignorage revenue?
Answer:
a. 47.5%
b. 135.375
Diff: 3
Type: ES
Page Ref: Sec. 15.4
11) Consider an economy that has the following monetary data:
Currency in circulation
Bank reserves
Monetary base
Deposits
Money supply
= $300
= $50
= $350
= $700
=$1000
The monetary base and the money supply are expected to grow at a constant rate of 20% per
year. Inflation and expected inflation are 20% per year. Suppose that bank reserves and currency
pay no interest, all currency is held by the public, and bank deposits pay no interest.
a. What is the cost to the public of the inflation tax?
b. What is the nominal value of seignorage over the year?
c. What is the profit to the banks from the inflation?
Answer:
a. $200
b. $ 70
c. $130
Diff: 2
Type: ES
Page Ref: Sec. 15.4
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12) In 2013, the government of Debtland purchased $2 billion of goods and services, transferred
$20 billion to provinces and social accounts, and collected $18 billion in tax revenues. GDP is
$700 billion, and government bonds outstanding in the previous year were $100 billion. Given
the 2 percent economic growth and 1 percent interest on government bonds, how much of the
debt-GDP ratio is expected to change in 2014?
Answer: (20 + 2 - 18) / 700 + (0.02 - 0.01) × (100 / 700) = 0.71%
Diff: 3
Type: ES
Page Ref: Sec. 15.3
13) Suppose the marginal tax rate in BIGOV is 20 percent, which applies to income over
$10,000. Jade earns $50,000.
a. Calculate the income tax Jade needs to pay.
b. What is the average tax rate for Jade?
c. Now suppose government increases the marginal tax rate to 25 percent, but raises the income
level exempted from tax from $10,000 to $18,000. How much income tax does Jade need to pay?
What is the average tax rate?
d. Jade is offered to work extra hours for $50 per hour. How much would she pay as additional
tax on her hourly earnings under the original and new tax laws?
e. Discuss the implications of the new tax law on the labour supply. Will Jade work more or
fewer hours?
Answer:
a. $8,000.
b. 16 %.
c. $8,000 , 16%.
d. $10 at the original tax rate (20%), and $12.5 at the new tax rate (25%).
e. Jade will have less incentive to work extra hours, since her take-home pay for each extra hour
of work is less at the new tax rate.
Diff: 3
Type: ES
Page Ref: 516
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