Study Guide Practice Problem Answers:
1. What is the current economic situation in the U.S.? How bad was the Great Recession
compared to the Great Depression and previous recessions? What economic indicators have
rebounded since the Great Recession ended and what has not?
Review the presentation titled “Today’s Economic Situation” which we went through in class
(and which is posted on the class website).
2. Explain the basic difference between Keynes’ argument and Classical Economists’ argument
about the role of government during the Great Depression.
Classical economists (most economists at the time) believed that eventually, in the long-run, the
macroeconomy would return to full employment without government intervention, through
prices adjusting. Keynes argued that the long-run might be too long (hence his quote, “In the
long-run, we’re all dead.”). So government intervention (increased spending and reduced taxes)
is needed to allow the economy to return to full employment.
3. The larger the mpc, the larger the multiplier and the larger the effect of a change in initial
spending on short-run equilibrium output.
4. Suppose the marginal propensity to consume is 0.67, and the change in initial spending is $50 million.
What is the estimated change to GDP?
If the MPC is 0.67, the multiplier is 3, so the change to GDP would be $50 million*3=$150
million.
5. If aggregate expenditure in an economy equals 1,000 + .9Y, initial spending equals 1000, the MPC
equals 0.9, and the multiplier equals 10.
6. If aggregate expenditure in an economy equals 1,000 + .9Y and potential output (Y*) equals
9,000, then this economy has a(n) expansionary output gap equal to 1,000.
7. If short-run equilibrium output equals 9,000, the MPC equals .8, and potential output (Y*)
equals 10,000, then spending must be increased by $200 to eliminate any output gap.
8. Suppose the potential output in an economy is $8 trillion, actual output is $7 trillion, and the multiplier
is 4. To remove this output gap, what must the change in initial expenditures equal?
There must be an increase in output equal to $1 trillion. With a multiplier of 4, the change in initial
expenditures must equal $250 billion.
9. Refer to the figure above. Based on the figure and starting from an initial short-run
equilibrium where output equals 20,000, if initial spending decreases by 1,000, then the new
short-run equilibrium is at an output equal to 16,000.
10. Based on the figure, if the economy is in short-run equilibrium with output equal to 16,000,
then there is a(n) recessionary gap and a $1,000 increase in government spending would return
the economy to potential output (Y*).
11. Based on the figure, suppose output is currently at 16,000. According to Okun’s Law, what is the
level of cyclical unemployment?
According to Okun’s Law, the level of cyclical unemployment equals ½ the output gap in percentage
terms. If output is 16,000, the output gap equal (4,000/20,000)*100=20%, so cyclical unemployment is
equal to 10%.
12. Based on the figure above, if the economy is in short-run equilibrium with output equal to
24,000, then there is a(n) expansionary gap and a $1,000 decrease in government spending
would return the economy to potential output (Y*).
13. Based on the figure above, the multiplier in the economy equals 4.
14a.) Suppose Aggregate Expenditures (AE) in an economy are given by: 400 + 0.6Y. Calculate the
short run equilibrium output for this economy.
AE = Y
400 + 0.6Y = Y
400 = 0.4Y
Y*=1,000
b.) If AE are reduced to 300 + 0.6Y, what is the new short run equilibrium? If your answer for a.) is the
potential output, what is the output gap in this economy?
300 + 0.6Y = Y
300 = 0.4Y
Y* = 750
The recessionary gap = potential output – actual output = 1,000 – 750 = 250
c.) According to Okun’s Law, what is the change to cyclical unemployment as a result of this change in
output?
Output decreased by 25% (-250/1000)*100, so according to Okun’s Law, cyclical unemployment would
increase by 12.5% (one half whatever the percentage change in output is).
d.) What could the government do to government expenditures and/or taxes to address this output gap?
By how much should they try to change AE to address this output gap?
The government could increase government expenditures and/or decrease taxes.
They should base the change in AE on the change in initial spending, which in this case is 100
(they should increase G or decrease taxes enough to increase spending by 100)
e.) Depict this situation on the following set of axes. Graph both AE lines and show the equilibrium
output levels associated with each AE.
AE
Y=AE
AE=400+0.6Y
AE=300+0.6Y
400
300
750
1000
Y (output)
15. An increase in inflation causes a(n) decrease in aggregate quantity demanded and a(n) increase in
aggregate quantity supplied, other things constant.
16. Suppose there is a boom in the stock market that increases wealth in the economy. How would this
affect the AD and/or AS curve? How would this affect inflation in the short-run
An increase in wealth will increase aggregate demand (shift the AD curve to the right).
It will not affect the AS curve.
This will increase inflation and output in the short run.
17. Consider a situation where the economy is initially in a long-run equilibrium and a decrease in
housing prices induces a large decrease in consumer spending. How would this affect inflation and
output in the short-run?
The decrease in consumer spending causes a leftward shift of the AD curve and causes a recessionary
gap. Inflation will be lower and output will be below potential.
Consider the following graph:
LRAS
AS1
Inflation π
π2
π1
D
C
A
π3
B
AD1
Y1
Y*
Output Y
18. At point A there is a _____________ gap equal to _____________.
At point A there is a recessionary gap equal to (Y*-Y1).
19. Suppose the economy starts at point A. What is the appropriate fiscal policy to bring the economy
back to potential?
Because there is a recessionary gap the appropriate fiscal policy is to increase government spending
and/or decrease taxes in order to increase aggregate demand.
20. As the U.S. dollar appreciates in value compared to foreign currencies, what will happen to
the prices of U.S. exports and foreign imports, as well as net exports?
U.S. exports become more expensive and foreign imports become cheaper, causing net exports to fall.
21. Suppose the invention of a new computer system permanently increases worker productivity. What
will happen to output and inflation in the long-run?
Increasing productivity will shift the LRAS curve to the right. We would see output increase and
inflation decrease.
22. What is stagflation and what is it associated with in the AD/AS model?
Stagflation occurs when inflation is increasing at the same time output is falling below potential (so there
is high inflation and high unemployment).
It is associated with a decrease in AS.
23. Fill in the first two blanks with high or low. Then explain what was true of AD or AS to
explain that situation (AD was higher, AD was lower, AS was higher, AS was lower).
a. For most of the 1960s there was high inflation and low unemployment. This is because AD
was higher than normal.
b. For most of the 1970s there was high inflation and high unemployment. This is because AS
was lower than normal.
c. For most of the 1990s there was low inflation and low unemployment. This is because AS
was higher than normal.
d. Today there is low inflation and high unemployment. This is because AD is lower than
normal.
24. Suppose an economy’s aggregate demand function is given by: Y=13,000 – 20,000π
Where Y is output and π is inflation. Initially the inflation rate is 0.04 (4%). Potential output is 12,000.
a.) What is the output level in the short – run? What does the output gap equal? Is it expansionary or
recessionary?
In the short run, the equilibrium inflation rate and output level are given by the intersection of the
AD and AS curves. Algebraically, the short run equilibrium level of output is found by
substituting the current inflation rate into the AD equation. Doing this, we have:
Y  13,000  20,000
Y  13,000  20,000(0.04)
Y  12,200
The economy has an expansionary gap of 200 since potential output is 12,000 and actual output
is 12,200.
b.) What is the inflation rate in the long run equilibrium (when output is at its potential level)?
In the long run, the equilibrium inflation rate and output level are given by the intersection of the
LRAS and AD curves. Algebraically, the long-run equilibrium inflation rate is found by
substituting the level of potential output (in this case, 12,000) into the AD equation. Doing this,
we have:
12,000  13,000  20,000
 1,000  20,000
 1,000
   0.05  5%
 20,000
25. Suppose that a permanent increase in oil prices creates both an inflationary shock and reduces potential
output (LRAS). Use an AD-AS diagram to show the effects of the oil price increase on output and inflation
in the short run and the long run. Label everything.
26. What are automatic stabilizers?
Automatic stabilizers are anything that creates automatic increases in government spending or
decreases in taxes when output declines and vice versa.
27. The U.S. income tax system is progressive, which means that as GDP rises, average tax rates
rise.
28. The following table shows U.S. income tax brackets in the U.S. in 2013
Tax Bracket
10%
15%
25%
28%
33%
35%
39.6%
Taxable Income
$0–$8,925
$8,925– $36,250
$36,250 –$87,850
$87,850 –$183,250
$183,250 –$398,350
$398,350 - $400,000
$400,000 and above
Calculate the amount paid in taxes for an individual who earns $50,000 in taxable income. What
is their tax rate?
Taxes paid = .10 * $8925 + .15 ($36250 – $8925) + .25 ($50000 - $36250) = $892.5 + 4098.75
+3437.5 = $8428.75
Tax rate = (Taxes paid / Taxable income) *100 = ($8428.75/$50,000)*100 = 16.8%
29. Someone who earns $450,000 falls into a tax bracket of 39.6% in the U.S. The percent of
their income paid in federal taxes will be less than 39.6%.
30. Explain why most billionaires in the U.S. pay a tax rate on their income that is below 25%.
It’s because most billionaires pay taxes on capital gains (from stocks), and capital gains are taxed
at a lower rate than income (currently the capital gains tax rate is 20%).
31. The U.S. deficit currently equals approximately $650 billion, and the national debt currently
equals approximately $17.3 trillion.
32. What is the difference between gross and net public debt?
Gross public debt includes the total amount owed to all holders of government securities. Net
public debt is equal to gross public debt minus intragovernmental debt (the amount owed to
holders of public securities outside of the government).
33. What are the major problems associated with a large amount of government debt?
The opportunity cost of interest payments, the transfer of wealth to foreign governments, the
increase in income inequality, the reduction in national savings (and investment), and it limits the
government’s ability to respond to adverse events.
34. What are the future projections regarding the U.S. debt situation?
Future projections suggest it’s likely to get a lot worse before it gets better. The main reason is
Social Security, Medicare/Medicaid, and Interest Payments are expected to increase
dramatically.
35. Currently, approximately 33% of the federal U.S. budget is ‘discretionary’. If fiscal policy is
not changed, it is projected that 0% of the federal U.S. budget will be discretionary by 2030.
36. What could be done to address the growing burden of Social Security and Medicare?
Increase tax revenue (by increasing payroll tax rates (employer/employee rates are currently
equal to 6.2%) and/or increasing the current ceiling of $106,800).
AND/OR:
Decrease expenditures (by increasing the age of eligibility, decreasing benefits for all retirees,
and/or disqualifying wealthy individuals)
37. Laffer curve shows the relationship between tax rates and tax revenue.
38. Empirical studies suggest that the peak of the Laffer curve is equal to approximately 80%.