Ch 10
Question 1
Assuming that both the price level and the interest rate are constant, if output were equal to Y´...
Correct answer:
b) ...desired demand (Y´C) is lower than output (Y´B) and inventories of unsold goods will
accumulate.
Feedback:
See Figure 10.3 in the text. Remember the 44° line happens to be the equilibrium condition of the
goods market, 0Y´=Y´D. Note: Actually without knowing the exact specification of taxation and
spending, there could be either a government surplus or deficit at Y´, we only know that the
government surplus increases (or the deficit decreases) as we move to the right
Page reference: 237
Question 2
Assuming both the price level and the interest rate are constant and government spending increases
from G to G´, the government spending multiplier is equal to...
Correct answer:
c) ...the difference (Y-Y´) divided by the difference (G´- G)
Feedback:
See Figures 10.4 and 10.6 in the text. Note that the difference, DD´- DD, is not equal to the
difference, G´-G; the distance BA has no natural interpretation (only horizontal distances have an
economic interpretation, € of spending or output); slope of the IS curve also depends upon the
interest sensitivity of investment.
Page reference: 241,245
Question 3
The LM curve has a positive slope because...
Correct answer:
c) The demand for money increases with the level of real GDP but decreases with nominal interest
rates.
Feedback:
See Figure 10.8 in the text. Holding the real money supply constant, we need an increase in interest
to choke off the additional demand for money induced by an increase in Y. Note also that the fixed
money supply has become more scarce relative to the transactions demand which increases with
output.
Page reference: 248
Question 4
When only such disturbances as changes in technology/tastes or in public spending and taxes can
affect economic growth and employment, whereas changes in the money supply would have no
effect upon economic growth and employment, we have...
Correct answer:
b) ...the classical dichotomy.
Feedback:
The Keynesian assumption that prices are sticky means that there will be an interaction between the
monetary and real sides of the macroeconomy, i.e. that there will not be the classical dichotomy.
Page reference: 233
Question 5
Instead of relying on the price mechanism to match the supply and demand for goods, the Keynesian
approach assumes...
Correct answer:
b) ...output adjusts to demand.
Feedback:
The real money supply changes when the price level adjusts under the neoclassical assumption.
Quantities, i.e. output, do the adjusting under the Keynesian assumption.
Page reference: 244
Question 6
Monetary policy set according to a Taylor rule under the Keynesian assumption of sticky prices could
be characterized as a compromise between the polar cases of (A)________ and (B)____________.
Correct answer:
d) (A) a constant interest rate policy rule; (B) a rule for the money supply to grow at the underlying
trend growth rate of output.
Feedback:
See the discussion of Figure 10.13. The Taylor rule is a compromise between two fixed rules so
there is an automatic adjustment of the quantity of money as economic conditions change.
Remember the demand for money remains a constraint on the possible outcomes achievable by the
central bank.
Page reference: 244
Ch 12
Question 1
The negative relationship between the gap between actual GDP and its trend value and the
difference between actual unemployment rate and its equilibrium value is called:
Correct answer:
d) Okun's Law
Feedback:
The aggregate supply curve combines Okun's Law and the augmented Phillips Curve together, the
Phillips Curve is a relationship between the unemployment gap and the difference between actual
and underlying inflation. The Battle of the Markups is the story that combines underlying inflation,
prices being marked up over costs and supply shocks.
Page reference: 236-237
Question 2
The reason for the long-run stability of the labour share is:
Correct answer:
d) Technical progress has continuously generated higher incomes
Feedback:
Productivity gains reduce real labour costs for given real wages and real wages increase with labour
productivity.
Page reference: 294
Question 3
Dividing nominal wages (W) by labour productivity (Y/L) yields:
Correct answer:
b) Nominal unit labour costs.
Feedback:
Same as dividing total labour costs (WL) by total output (Y).
Page reference: 292
Question 4
At point A, inflation is equal to the underlying rate of inflation and output is at the level of output
consistent with the equilibrium unemployment rate. If the economy were at point B, you would
expect...
Correct answer:
a) ...the underlying rate of inflation to accelerate because the actual inflation rate exceeds the
underlying rate of inflation.
Feedback:
Implicit in the discussion of Figure 12.11 is that when we are not at the equilibrium rate of
unemployment, the rate of underlying inflation changes! Since we don't know what aggregate
demand is doing, we can't meaningfully speak of excess supply or demand. Our presumption will be
that aggregate demand and short-run aggregate supply are equal.
Page reference: 299
Question 5
The critical macroeconomic policy implication of a vertical long-run Phillips Curve is that...
Correct answer:
d) ...demand policies cannot move the actual unemployment rate permanently away from its
equilibrium level.
Feedback:
On the one hand the message tells us that aggregate demand policies will not succeed in a
permanent reduction of the unemployment rate below its equilibrium level but it also gives us a ray of
hope in combating high inflation-if expectations of inflation can be reduced, a deep recession will not
be required to bring down the rate of inflation. There is more than one way to reduce the underlying
rate of inflation (though it is not as easy as a political leader giving us a speech, promising future
price stability…the promise has to be believed!).
Page reference: 300
Question 6
"It is better for an economy to have a 5% rate of inflation over a 5% rate of unemployment."
Without getting into a debate on the relative costs of unemployment and inflation yet, why do we
know this statement is not helpful for policy makers, even if the prime minister says this explicitly?
Correct answer:
c) Even if we could reduce unemployment to 0% today at a cost of an increase in inflation of 5%,
there is no guarantee that underlying inflation in the economy would remain unchanged.
Feedback:
Depending upon what the equilibrium rate of unemployment is, presumably different from 5%, there
would not be a sustainable, constant rate of inflation.
Page reference: 302
Question 7
Which of the following events would not involve a supply shock that would shift the aggregate supply
curve?
Correct answer:
b) Financial crisis results in a freezing of interbank lending.
Feedback:
The key to a supply shock is that unit costs of production would be affected, as opposed to aggregate
spending decisions of households, businesses and governments.
Page reference: 297-298
Chapter 13
Results
Question 1
The above figure represents a short-run equilibrium of a small economy in a fixed
exchange rate regime.
The reason that the long-run aggregate demand curve is horizontal at the rate of
inflation of the rest of the world π* is...
Correct answer:
d) ...the principle of long-run PPP.
Feedback:
The real exchange rate is constant in the long run (the principle of purchasing power
parity (PPP)). With fixed nominal exchange rate, the prices at home and abroad
must change at the same rate for the real exchange rate to remain constant.
Page reference: 309
Question 2
The AD curve is downward sloping for a small economy in a fixed exchange rate
system because (A) __________ weakens the country's external competitiveness,
which (B) ____________ for domestic goods.
Correct answer:
c) (A) rising domestic inflation; (B) reduces domestic and foreign demand
Feedback:
Domestic demand will decrease with rising domestic inflation as folks at home will
begin buying more of the relatively cheaper foreign goods.
The point is whether domestic inflation is greater or less than foreign inflation, not
whether it is positive or zero.
Page reference: 310-311
Question 3
For a small economy in a fixed exchange rate system in the long run, the domestic
underlying rate of inflation must equal the foreign rate of inflation because:
Correct answer:
d) Each must equal the domestic rate of inflation so that AS does not shift and the
relative competitiveness of domestic goods does not change.
Feedback:
Note that the real exchange rate and the Principle of PPP depend upon the actual
domestic rate of inflation and not the underlying rate of domestic inflation. For a
long-run equilibrium to occur, both the AS and AD curves must not shift.
Page reference: 311, 314
Question 4
For a small economy in a fixed exchange rate system that begins in period 0 at the
long-run equilibrium point A, the government cuts net taxes moving the aggregate
demand curve from its initial position AD to AD´ so that the economy is in short-run
equilibrium in period 1 at point B. Assume the backward looking component of coreinflation dominates the forward looking component.
Which of the following observations will not be true of the ultimate long-run that this
economy will attain after the policy change of period 1?
Correct answer:
d) The new long-run equilibrium will have higher inflation and higher unemployment
(i.e. stagflation).
Feedback:
The long-run anchors for the system are the foreign rate of inflation and the zerooutput gap. Neither have changed because of the change in fiscal policy, so we will
return to the starting point. In the end the rate of inflation will be the same and the
equilibrium unemployment rate will be the same.
Page reference: 315-316
Question 5
For a small economy in a flexible exchange rate system that begins in long-run
equilibrium point, a higher rate of inflation in the short run will be followed by:
The central bank responding with (A)________ which will result in a
(B)______________.
Correct answer:
c) (A) contractionary monetary policy ; (B) real exchange rate appreciation.
Feedback:
According to the Taylor rule, the central bank will respond to a rise in inflation by
tightening monetary policy (an upward shift in the TR curve in the interest-rateoutput-gap drawing).
Page reference: 322-323
Question 6
Consider a small economy in a flexible exchange rate system that begins in long-run
equilibrium at point A.
After a permanent increase in the central bank's inflation target, the line TR goes
down because an increase in the permanent inflation target of the central bank is (A)
_____________ monetary policy. The IFM line shifts up because the higher rate of
inflation implies (B)___________ of the exchange rate.
Correct answer:
c) (A) an expansionary; (B) depreciation
Feedback:
Short-run equilibrium occurs at point B, where actual inflation exceeds underlying
inflation so we see that the monetary policy has been expansionary. The foreign rate
of return constraint on the domestic interest rate has increased to compensate for
the higher inflation rate at home.
Page reference: 324
Question 7
In the period that it occurs, an adverse supply shock simultaneously
(A)____________ and increases (B) ______________.
Correct answer:
c) (A) lowers output ; (B) actual inflation
Feedback:
Underlying inflation only adjusts to the supply shock in later periods. The Taylor rule
describes how the central bank reacts to changes in the rate of inflation and the
output gap in setting interest rates and is independent of demand and supply
shocks.
Page reference: 326-327