Macro Practice
Multiple Choice
Identify the choice that best completes the statement or answers the question.
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1. The demand-for-money curve illustrates the __________ relationship between the quantity demanded of
money and __________.
a. inverse; the interest rate
b. direct; GDP.
c. direct; the interest rate
d. inverse; GDP
2. As the interest rate __________, the opportunity cost of holding money __________ and individuals choose
to hold __________ money.
a. increases; increases; more
b. increases; decreases; more
c. increases; decreases; less
d. decreases; increases; more
e. decreases; decreases; more
Exhibit 14-3
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3. Refer to Exhibit 14-3. The economy is initially at point 1. Ideally, __________ monetary policy will move the
economy to point __________.
a. expansionary; 9
b. contractionary; 4
c. expansionary; 8
d. expansionary; 7
e. contractionary; 2
4. A.W. Phillips collected data on the rate of change in money wages and plotted it against unemployment rates
in the United Kingdom. The curve he fit to the data showed that
a. the rate of change of money wage rates and unemployment rates were inversely related.
b. the rate of change of money wage rates and unemployment rates were directly related.
c. the rate of change of money wage rates and unemployment rates were independent.
d. as money wage rates increased, the unemployment rate was cut in more than half.
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5. The short-run Phillips curve holds that
a. high inflation and high unemployment can occur together.
b. low inflation and low unemployment can occur together.
c. high inflation and low unemployment can occur together.
d. b and c
6. Stagflation is the simultaneous occurrence of
a. low inflation and high unemployment.
b. high inflation and low unemployment.
c. low inflation and low unemployment.
d. high inflation and high unemployment.
Exhibit 15-1
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7. Refer to Exhibit 15-1. Suppose the economy is currently at point A on the short-run Phillips curve, SRPC1.
What could get the economy to move to point B?
a. an increase in aggregate demand combined with an unchanged expected inflation rate
b. an increase in aggregate demand combined with a rise in the expected inflation rate
c. a rise in the expected inflation rate
d. a decrease in aggregate demand combined with an unchanged expected inflation rate
e. none of the above
8. According to the new classical theory, if the public correctly anticipates a government policy to increase
aggregate demand, then
a. there will be a short-run tradeoff between inflation and unemployment, but there will not
be a long-run tradeoff.
b. there will be a long-run tradeoff between inflation and unemployment, but there will not
be a short-run tradeoff.
c. there will be both a long-run and a short-run tradeoff between inflation and
unemployment.
d. there will be neither a long-run nor a short-run tradeoff between inflation and
unemployment.
e. there may be a short-run tradeoff between inflation and unemployment, but one cannot say
for certain whether there will be a long-run tradeoff.
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9. According to a new Keynesian theorist, a correctly anticipated increase in aggregate demand will
a. cause the price level to increase by a greater amount in the short run than what a new
classical rational expectations theorist would predict.
b. cause the price level to increase by a smaller amount in the short run than what a new
classical rational expectations theorist would predict.
c. cause the price level to increase by the same amount in the short run that a new classical
rational expectations theorist would predict.
d. leave the price level unchanged in the short run, but Real GDP will increase more than
what a new classical theorist would predict.
e. leave the price level unchanged in the short run, but Real GDP will increase less than what
a new classical theorist would predict.
10. The difference between the new classical theory and the new Keynesian theory is the assumption of
a. rational expectations.
b. adaptive expectations.
c. complete flexibility of wages and prices in the short run.
d. a and c
e. b and c
11. If expectations are formed rationally, wages and prices are completely flexible in both the short run and the
long run, and policy is unanticipated, there is a tradeoff between inflation and unemployment in
a. neither the short run nor the long run.
b. both the short run and the long run.
c. the short run, but not in the long run.
d. the long run, but not in the short run.
12. Under new classical assumptions, starting from long-run equilibrium, expansionary monetary policy that is
anticipated to be more expansionary than it actually is would lead to a __________ price level and
__________ unemployment rate.
a. lower; higher
b. lower; lower
c. higher; higher
d. higher; lower
13. The "balance of payments" is a periodic statement of the
a. assets and liabilities of a firm.
b. money value of all transactions between producers and consumers.
c. money value of all transactions between residents of one country and residents of another
country.
d. price of one currency-for example, the U.S. dollar-in terms of all other currencies.
14. When exports of American goods increase, this __________ the demand for U.S. dollars and at the same time
__________ foreign currencies.
a. increases; increases the supply of
b. decreases; increases the supply of
c. increases; decreases the supply of
d. increases; increases the demand for
e. none of the above
15. An international transaction that supplies the nation's currency also creates a __________ foreign currency
and is recorded as a __________ in the balance of payments.
a. demand for; debit
b. demand for; credit
c. supply of; credit
d. none of the above
____ 16. The Mexican demand for American goods leads to
a. the demand for Mexican pesos and the supply of U.S. dollars on the foreign exchange
market.
b. the demand for U.S. dollars and the demand for Mexican pesos on the foreign exchange
market.
c. the demand for U.S. dollars and the supply of Mexican pesos on the foreign exchange
market.
d. the demand for U.S. dollars and the supply of U.S. dollars on the foreign exchange market.
____ 17. In the balance of payment accounts, a transaction that supplies the nation's currency is recorded as a
a. debit.
b. cost.
c. surplus.
d. shortage.
____ 18. Which of the following would not be recorded as a credit in the U.S. balance of payments?
a. Russia purchases grain from U.S. farmers.
b. Florida citrus producers, after a particularly severe winter, buy oranges from Mexico to fill
their customers' orders.
c. The Czech Republic closes a deal with Caterpillar Inc. in Illinois for earth moving
machines.
d. Wealthy individuals in Iceland buy Alaskan furs.
____ 19. Americans buying Japanese cars
a. demand U.S. dollars and supply Japanese yen.
b. demand U.S. dollars and demand Japanese yen.
c. supply U.S. dollars and demand Japanese yen.
d. supply both U.S. dollars and Japanese yen.
____ 20. If a Swiss citizen purchases a U.S. bond, in the U.S. balance of payments capital
a. inflow will be credited.
b. inflow will be debited.
c. outflow will be credited.
d. outflow will be debited.
____ 21. If real interest rates are significantly lower in Japan than in the United States, the yen will likely __________
in terms of the dollar and the dollar will likely __________ in terms of the yen.
a. appreciate; depreciate
b. depreciate; appreciate
c. remain unaffected; remain unaffected
d. remain unaffected; appreciate
e. remain unaffected; depreciate
____ 22. Components of the current account include
a. exports of goods and services.
b. imports of goods and services.
c. outflow of U.S. capital.
d. a and c
e. a and b
____ 23. The purchasing power parity theory states that
a. exchange rates between any two currencies will adjust to reflect changes in the relative
price level of the two countries.
b. exchange rates between any two currencies will adjust to reflect change in the relative
income growth rates of the two countries.
c. the larger the economic growth rate in a country, the less likely its currency will depreciate
in value.
d. exchange rates cannot be compared over time.
e. currencies appreciate as often as they depreciate.
____ 24. There is a flexible exchange rate system and only two countries in the world, the United States and Mexico.
The real interest rate in the United States rises relative to the real interest rate in Mexico. It follows that
a. the dollar will depreciate and the peso will appreciate.
b. the peso will depreciate and the dollar will appreciate.
c. both the peso and the dollar are likely to appreciate.
d. both the peso and the dollar are likely to depreciate.
____ 25. There is demand for and supply of dollars and a demand for and supply of pesos. Under a flexible exchange
rate system, if income growth in the United States is greater than income growth in Mexico, then
a. the demand for dollars will shift to the right and the demand for pesos will shift to the left.
b. the demand for pesos will shift to the right and the supply of dollars will shift to the left.
c. the demand for pesos will shift to the left and the supply of pesos will shift to the right.
d. the supply of pesos will shift to the right and the supply of dollars will shift to the right.
e. none of the above
Essay
26. When making historical comparison’s of one’s income, is it better to use real income or nominal income for
the basis of your comparison? Explain why one makes a better comparison than the other.
27. Describe the terms frictional unemployment, structural unemployment, and cyclical unemployment. Give a
hypothetical example of each to help support your answer.
28. Explain the substitution-bias inherent in a fixed-weighted price index and the impact this bias has on the
reported cost of living.
29. Describe what the term "full employment" means to an economist.
30. Describe what the unemployment rate and the employment rate measure. If we were to sum the
unemployment rate and the employment rate, would that sum be equal to one hundred percent? Explain why
or why not.
31. Describe what the difference is between the employment rate and the labor force participation rate (LFPR).
Under what circumstance would the two be equal to one another?
32. List and explain the three different approaches used to measure GDP.
33. Draw an appropriate diagram to represent the business cycle and label each of the five phases. Provide a brief
description of each phase.
34. With respect to the business cycle, describe the difference between the expansion phase and the recovery
phase.
35. Explain why GDP figures do not necessarily measure happiness or well-being.
36. Given that GDP is a measure of what is produced in a country, explain how the expenditure approach can
measure GDP. How are items produced, but not yet sold, accounted for in the expenditure approach?
37. List and describe four of the six categories of economic exchanges that are omitted from GDP calculations.
Explain why these transactions are not included in GDP and give an example of each to help support your
answer.
38. Assume that the economy is currently in short-run equilibrium, then the U.S. dollar appreciates. Describe the
correct sequence of events that happens as the economy adjusts to a new short-run equilibrium.
39. List and describe the three reasons that help to explain why the aggregate demand (AD) curve slopes
downward.
40. Explain how aggregate demand and aggregate supply may affect your job prospects after leaving college.
Support your answer with an appropriate example.
41. What type of relationship do Real GDP and the unemployment rate have, ceteris paribus? Under what
circumstance might Real GDP rise at the same time the unemployment rate rises?
42. Explain why the short-run aggregate supply curve (SRAS) is upward sloping, while the long-run aggregate
supply (LRAS) curve is a vertical line.
43. Assume that the economy is currently in short-run equilibrium, then personal income taxes decline. Describe
the correct sequence of events that happens as the economy adjusts to a new short-run equilibrium.
44. Define the term subprime loan. Give a brief history of how the incidence of subprime mortgage loans
changed between 1995 and 2003, and explain the factors that contributed to a number of subprime borrowers
being unable to repay their loans in recent years.
45. Using the aggregate demand and aggregate supply (AD-SRAS) framework, describe how the U.S.
involvement in the Vietnam War, coupled with the actions of the Federal Reserve, influenced U.S. Real GDP
and the price level during the period 1965-1969.
46. If the economy is self-regulating, explain the correct sequence of events that occurs once the economy is in a
recessionary gap to move the economy to long-run equilibrium.
47. Explain how it is possible for the economy to produce at a point beyond its institutional production
possibilities frontier (PPF), but not beyond its physical PPF.
48. Describe how Say's law can hold in a money economy, according to the classical economists.
49. Explain the policy implications of the classical economists' beliefs.
50. Using the aggregate demand and aggregate supply (AD-SRAS) framework, explain how a large-scale natural
disaster would be expected to impact the economy. Discuss how an economist who believes the economy is
self-regulating would view the longer term impact of such a disaster, and whether they would advocate the
need for government intervention.
51. Explain the sequence of events that occurs in the economy once total production (TP) is less than total
expenditure (TE).
52. Discuss how the Great Depression contributed to the development of Keynesian economics.
53. Explain the process by which a change in autonomous spending can lead to an even greater change in Real
GDP.
54. What is the general format of the consumption function? Explain what each term means and use the
consumption function to explain the three different ways that consumption can increase.
55. Describe Keynes' criticism of Say's law in a money economy.
56. Explain how the Keynesian view differs from the classical view with respect to saving. Explain further how
the two views differ with respect to investment.
57. What type of relationship exists between the marginal propensity to consume (MPC) and the multiplier?
Explain why this relationship exists.
58. Using the concept of the multiplier, explain in detail how college students flocking to beach towns for spring
break can positively impact the beach towns’ economies.
59. List and describe three of the five different lags that can occur which may impede the effectiveness of the use
of fiscal policy.
60. Explain how tax cuts can impact both aggregate demand and aggregate supply. Give an example of each.
61. Describe the fiscal policy remedies that a Keynesian economist might prescribe to close a recessionary gap.
How might the issue of crowding out impact the effectiveness of these policies?
62. Define crowding out. Give a hypothetical numerical example to show the difference between complete
crowding out and incomplete crowding out. Explain how complete and incomplete crowding out could
impact the effectiveness of fiscal policy.
63. Explain the difference between a progressive income tax, a proportional income tax and a regressive income
tax. Under which type of system is the federal income tax?
64. Define the term budget deficit (as it applies to the federal government) and describe the difference between a
cyclical deficit and a structural deficit. Provide a hypothetical numerical example to help support your
answer.
65. Describe the process by which banks create money.
66. Describe the circumstances under which the M1 money supply could fall while the M2 money supply remains
constant at the same time.
67. List and describe the three functions of money.
68. Describe the differences between M1 and M2.
69. Explain why it is not necessary for paper money to be backed by some commodity (e.g. gold) before it can
have value.
70. Discuss some of the economic symbolism thought by many to be contained in L. Frank Baum’s book The
Wonderful Wizard of Oz.
71. List and describe the three major monetary policy tools the Federal Reserve can use to increase the money
supply. Be specific in your response regarding which direction the tool would need to change in order for the
money supply to grow.
72. Summarize the history of how the Federal Reserve came to have twelve districts.
73. List and describe five of the eight major functions or responsibilities of the Fed.
74. What is the name and make-up of the policymaking group that has the authority to conduct open market
operations? Describe how the use of open market operations helps to increase or decrease the money supply.
75. Explain the major differences between the Federal Reserve and the U.S. Treasury.
76. Explain the difference between the discount rate and the federal funds rate. If the Fed wants to lower one of
these rates, which one can the Fed change by issuing an order? Describe in detail how the Fed helps to lower
the other rate.
77. Describe the difference between the simple quantity theory of money and the equation of exchange.
78. Explain how a change in the money supply can affect the following in the short run:
a. The supply of loanable funds
b. Real GDP
c. The price level
d. The expected inflation rate
79. Describe the expectations (or Fisher) effect.
80. List and describe the four positions held by monetarists that help to explain the monetarists view of the
economy.
81. Explain in detail how the California gold rush contributed to rising prices in the early 1850’s.
82. What is the only factor that can continually increase in such a way as to bring about continued increases in
aggregate demand, and thus bring about continued inflation? Give two reasons why government purchases
cannot continually increase, and so cannot be the cause of continued inflation.
83. Describe the Keynesian transmission mechanism for a decrease in the money supply, assuming that no
liquidity trap exists and that investment is not interest insensitive. How can you tell if this is a direct
transmission mechanism or an indirect one?
84. Describe the workings of the transmission mechanism that links monetary policy and the exchange rate.
85. What are the two assumptions made in the nonactivist constant-money-growth-rate rule? Describe the
alternative rule known as the predetermined-money-growth-rate rule and explain why some nonactivists
prefer this rule.
86. Describe the monetary policy known as inflation targeting. What are the three major issues that surround this
practice?
87. What type of relationship exists between bond prices and interest rates? What must be true about interest
rates when the time is best to buy bonds? Using the framework of the bond market, explain in detail why it is
so difficult to predict changes in interest rates.
88. Describe the policy ineffectiveness proposition (PIP). Be sure to state which economic theory the PIP is
associated with and the assumptions that are necessary for this argument to hold.
89. Explain the difference between how adaptive expectations are formed and how rational expectations are
formed. How does this difference affect the speed at which economic variables are expected to change?
90. In what ways does the original Phillips curve differ from the Phillips curve created by economists Samuelson
and Solow? What conclusions did economists draw based on the findings of Phillips, Samuelson and Solow?
91. Explain why there is an inverse relationship between wage inflation and unemployment as aggregate demand
changes.
92. Describe the sequence of events that real business cycle theorists would use to explain how an adverse supply
shock would impact the economy. Use your answer to explain why it is easy to confuse cause and effect
between changes originating on the supply side and those that begin on the demand side.
93. What is the primary objective of the World Trade Organization (WTO)? How do they accomplish this
objective? Why do some people criticize the role that this organization has played in world affairs?
94. Explain how increased immigration will affect the supply and demand for labor. What will be the effect on
wages?
95. List and describe three arguments that help to support the imposition of trade restrictions. Does everyone
agree with these arguments?
96. Why does the government impose quotas, despite the fact that trade restrictions raise prices for U.S.
consumers?
97. Describe the type of international monetary system that is currently in use. What advantages do proponents of
this type of system cite in support of its use? What disadvantages do its opponents cite?
98. Assume that there are only two countries in the world, the United States and Japan. What creates the demand
for and supply of Japanese yen on the foreign exchange market? Name three different things that could cause
the yen to appreciate in value.
99. List the three things that countries must agree to do in order to have an international gold standard.
100. Suppose the governments of Mexico and the United States agree to a fixed exchange rate. Describe some of
the options available to the Mexican government if the peso was persistently overvalued, creating a surplus of
pesos on the foreign exchange market. Be sure to explain how each of these options would be expected to
impact the supply and/or demand for Mexican pesos.
Macro Practice
Answer Section
MULTIPLE CHOICE
1. ANS:
LOC:
2. ANS:
LOC:
3. ANS:
LOC:
4. ANS:
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5. ANS:
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6. ANS:
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7. ANS:
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8. ANS:
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9. ANS:
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10. ANS:
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11. ANS:
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12. ANS:
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13. ANS:
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14. ANS:
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15. ANS:
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16. ANS:
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17. ANS:
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18. ANS:
LOC:
19. ANS:
LOC:
20. ANS:
LOC:
21. ANS:
LOC:
A
PTS: 1
DIF: Easy
Monetary and fiscal policy
E
PTS: 1
DIF: Moderate
Monetary and fiscal policy
A
PTS: 1
DIF: Difficult
Monetary and fiscal policy
A
PTS: 1
DIF: Easy
Understanding and Applying Economic Models
C
PTS: 1
DIF: Easy
Understanding and Applying Economic Models
D
PTS: 1
DIF: Moderate
Understanding and Applying Economic Models
A
PTS: 1
DIF: Moderate
Understanding and Applying Economic Models
D
PTS: 1
DIF: Difficult
Understanding and Applying Economic Models
B
PTS: 1
DIF: Moderate
Understanding and Applying Economic Models
C
PTS: 1
DIF: Moderate
Understanding and Applying Economic Models
C
PTS: 1
DIF: Moderate
Understanding and Applying Economic Models
C
PTS: 1
DIF: Moderate
Understanding and Applying Economic Models
C
PTS: 1
DIF: Moderate
International trade and finance
A
PTS: 1
DIF: Moderate
International trade and finance
A
PTS: 1
DIF: Moderate
International trade and finance
C
PTS: 1
DIF: Moderate
International trade and finance
A
PTS: 1
DIF: Moderate
International trade and finance
B
PTS: 1
DIF: Moderate
International trade and finance
C
PTS: 1
DIF: Moderate
International trade and finance
A
PTS: 1
DIF: Moderate
International trade and finance
B
PTS: 1
DIF: Moderate
International trade and finance
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
NAT: Analytic
22. ANS:
LOC:
23. ANS:
LOC:
24. ANS:
LOC:
25. ANS:
LOC:
E
PTS: 1
International trade and finance
A
PTS: 1
International trade and finance
B
PTS: 1
International trade and finance
E
PTS: 1
International trade and finance
DIF: Easy
NAT: Analytic
DIF: Moderate
NAT: Analytic
DIF: Moderate
NAT: Analytic
DIF: Moderate
NAT: Analytic
ESSAY
26. ANS:
Real income should be used when making historical comparisons. This is because nominal income can
change as a result of changes in the price level, while a change in real income reflects a change in purchasing
power.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Unemployment and inflation
27. ANS:
Frictional unemployment is created when individuals with transferable skills leave their jobs to move to
others. It is caused by normal changes in market conditions and a lack of complete information available to
both employers and employees. Structural unemployment occurs when the unemployed person's skills do not
match the available job openings. It is caused largely by automation and long-lasting shifts in demand.
Cyclical unemployment occurs when the actual unemployment rate is different from the natural
unemployment rate. Examples will vary.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Unemployment and inflation
NOT: NEW
28. ANS:
Any price index that uses fixed quantities of goods does not reflect the way that people actually make
purchases. When the price of an item rises, people often shift to a substitute good in response to the change in
relative prices. As a result of this substitution-bias, a fixed-weighted price index can overstate the cost of
living.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Unemployment and inflation
29. ANS:
Full employment exists when the economy is operating at its natural unemployment rate. Full employment
does not mean that the unemployment rate is zero percent because some unemployment is natural in a
dynamic, changing economy.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Unemployment and inflation
30. ANS:
The unemployment rate measures the percentage of the civilian labor force that is unemployed and is
computed by taking the number of persons unemployed and dividing by the civilian labor force. The
employment rate is a measure of the percentage of the civilian noninstitutional population that is employed
and is calculated by taking the number of people employed and dividing by the civilian noninstitutional
population. Since these two calculations have different denominators (the civilian labor force for the
unemployment rate and the civilian noninstitutional population for the employment rate) their sum would not
be equal to one hundred percent.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Unemployment and inflation
NOT: NEW
31. ANS:
The employment rate is a measure of the percentage of the civilian noninstitutional population that is
employed and is calculated by taking the number of people employed and dividing by the civilian
noninstitutional population. The LFPR is a measure of the percentage of the civilian noninstitutional
population that is in the civilian labor force and is calculated by taking the number of people in the labor
force (which includes both the employed and the unemployed) and dividing by the civilian noninstitutional
population. Therefore, the difference between the two is that the LFPR includes both the employed and the
unemployed, while the employment rate only includes the people who are employed. The only way that the
employment rate and the LFPR would be equal to one another would be for there to be no unemployed
workers.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Unemployment and inflation
NOT: NEW
32. ANS:
The three different approaches are: expenditure approach, income approach and value-added approach. When
using the expenditure approach the amount of money spent by buyers on final goods and services is summed.
The spending by the four sectors of the economy (households, businesses, government and foreign sector) is
combined to yield the GDP. The income approach is computed by summing the income earned by the
different resources that were used to produce a country's goods and services (national income) and then
making some adjustments to arrive at GDP. In the value-added approach, the dollar value contributed to a
final good at each stage of production is summed to compute GDP.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Measuring the Economy
33. ANS:
The five phases of the business cycle are: peak, contraction, trough, recovery and expansion. At the peak of a
business cycle Real GDP is at a temporary high. In the contraction phase Real GDP is declining. A trough
represents the low point in Real GDP, just before it begins to turn up. The recovery phase is the period when
GDP is rising, up until it reaches the initial peak. The expansion phase represents an increase in GDP, beyond
the initial peak and until the next peak.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Measuring the Economy
34. ANS:
The recovery phase is the period when GDP is rising, up until it reaches the level of the initial peak. The
expansion phase represents an increase in GDP, beyond the initial peak and continues until the next peak.
PTS: 1
DIF: Easy
NAT: Analytic
LOC: Measuring the Economy
NOT: NEW
35. ANS:
Well-being and happiness are subjective. Just because a country is able to produce relatively more goods does
not mean that the people in that country are relatively happier. Perhaps their increased production results in
more pollution, more stress and less leisure. These people may actually be less happy than the people living in
a country with lower production, but a calmer way of life.
PTS: 1
36. ANS:
DIF: Moderate
NAT: Analytic
LOC: Measuring the Economy
The expenditure approach measures GDP by summing the purchases of final goods and services by the four
sectors of the economy. This is a reflection of production because an item can not be purchased unless it has
been produced. Even items that have been produced, but not yet sold, are accounted for in the expenditure
approach because national income accountants assume that anything that is produced but not sold to
consumers is bought by the firm that produced it. These items would show up as part of the firms' inventory,
and therefore would be counted as part of investment.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Measuring the Economy
37. ANS:
Certain nonmarket goods and services are not counted in GDP. For example, if a family hires a babysitter to
care for their children the service would be counted in GDP, but if a mother cares for her own children there
is no market transaction which would allow for the service to be counted in GDP calculations. Underground
activities consist of unreported exchanges. Most underground activities occur because the activity is either
illegal or the participants in the exchange are trying to avoid paying taxes on the transaction. Since there is no
official records of these transactions, it is impossible for them to be included in GDP. Sales of used goods are
excluded from GDP because GDP measures current production and the value of the good was already
captured in the year in which it was produced. Financial transactions, such as the value of stocks and bonds
traded, are not included in GDP since they represent a transfer of ownership of an asset, as opposed to current
production. Government transfer payments, such as social security and veterans’ benefits, are not included in
GDP because they do not represent a payment made for current production. Leisure is too difficult for
national income accountants to quantify. If the residents of a country are able to consume more leisure time
as a result of a decrease in the average work week, this is a benefit to those residents, but the GDP statistics
do not reflect this improved situation.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Measuring the Economy
NOT: NEW
38. ANS:
As the dollar appreciates, foreign goods become less expensive, so Americans buy more imported goods. An
appreciated dollar means that the foreign currency has depreciated, so American goods become more
expensive for foreigners to purchase and U.S. exports decline. When imports rise and exports fall, net exports
fall and aggregate demand (AD) decreases. This would push the AD curve leftward, resulting in a decrease in
the price level and a decline in Real GDP.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Aggregate demand and aggregate supply
39. ANS:
If the AD curve slopes downward, it means that there is an inverse relationship between the price level and
the quantity demanded of Real GDP. The three effects that explain this are the real balance effect, the interest
rate effect and the international trade effect:
Real balance effect - A decrease in the price level causes purchasing power to rise, which increases monetary
wealth. As people become wealthier, they buy more goods and the quantity demanded of Real GDP rises.
Interest rate effect - As the price level falls, a person needs less money to buy the same bundle of goods. As
they spend less, people save more and the supply of credit increases. The increased supply of credit leads to
falling interest rates, so businesses and households borrow more and buy more goods, resulting in an increase
in the quantity demanded of Real GDP.
International trade effect - As the U.S. price level falls, U.S. goods become relatively less expensive and both
Americans and foreigners buy more U.S. goods. The quantity demanded of U.S. Real GDP rises.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Aggregate demand and aggregate supply
40. ANS:
The ability to find a job depends, in part, on where the aggregate demand curve and the short-run aggregate
supply curve in the economy intersect. Supporting examples will vary.
PTS: 1
DIF: Easy
NAT: Analytic
LOC: Aggregate demand and aggregate supply
41. ANS:
Real GDP and the unemployment rate have an inverse relationship, ceteris paribus. In order for Real GDP
and the unemployment rate to have a direct relationship, the ceteris paribus assumption must be relaxed, so
that some other economic variable is changing. For example, as Real GDP rises, if the civilian labor force
declines by a larger percentage than the percentage decline in the number of unemployed persons, the
unemployment rate will rise.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Aggregate demand and aggregate supply
42. ANS:
The SRAS curve slopes upward because of sticky wages and workers' misperceptions. However, these are all
temporary phenomena that will be resolved over time. In the long run, wages will become unstuck and
misperceptions will be replaced by accurate perceptions, making the LRAS a vertical line at Natural Real
GDP.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Aggregate demand and aggregate supply
43. ANS:
As personal income taxes decline, households will have more after-tax income so they will be able to
purchase more goods and services. The resulting increase in consumption will raise aggregate demand (AD).
This would push the AD curve rightward, resulting in an increase in the price level and an increase in Real
GDP.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Aggregate demand and aggregate supply
44. ANS:
The term subprime loan refers to a loan with an elevated credit risk. Between 1995 and 2003 the percentage
of all mortgage loans that were subprime loans rose substantially. There are several related factors that have
led to problems in the subprime market. One such factor is that subprime loans typically have a higher loanto-value ratio, which lessens the margin for error should housing prices fall. In addition, subprime loans were
frequently made with low initial interest rates that could adjust as the loan aged. As interest rates rose a large
number of subprime borrowers found themselves unable to pay their new (higher) mortgage payment. Unable
to make their payments, many borrowers defaulted on their loans. To make matters worse, home values
began falling which resulted in many loan balances being in excess of the current market value of the home
secured by the loan which made it impossible to borrowers to sell their home to pay off the balance of their
loan.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Aggregate demand and aggregate supply
NOT: NEW
45. ANS:
MSC: Economics 24/7
As U.S. involvement in the Vietnam War escalated, the U.S. government spent more and more on the
military. Increased military spending resulted in an increase in overall government spending which shifted
the AD curve rightward. At the same time, the Federal Reserve increased the money supply which also
shifted the AD curve rightward. The result of these rightward shifts of the AD curve was an increase in Real
GDP and an increase in the price level (inflation).
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Aggregate demand and aggregate supply
MSC: Economics 24/7
NOT: NEW
46. ANS:
The actual unemployment rate is greater than the natural unemployment rate and actual Real GDP is less than
Natural Real GDP. Labor market surpluses will push wages down and the SRAS curve will shift to the right.
This shift will cause the price level to fall, so the real balance, interest rate and international trade effects will
make the quantity demanded of Real GDP increase and the economy will move down the AD curve.
Ultimately, the economy will move to long-run equilibrium and produce its Natural Real GDP.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Understanding and applying economic models
47. ANS:
The physical PPF represents the maximum combinations of goods that can be produced with a fixed amount
of resources and technology, so it is currently impossible for production to occur beyond this level. The
institutional PPF represents the maximum combinations of goods that can be produced with fixed resources
and technology, plus the institutional constraints of that society. When forces within the economy cause
people to relax their customary social constraints, it is possible for that economy to produce beyond its
institutional PPF.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Understanding and applying economic models
48. ANS:
In order for Say's law to hold in a money economy, any money that is saved must be spent through
investment. Interest rate flexibility is the key to the classical economists' argument. If households save more
and spend less, the increased dollars saved push down market interest rates. Lower interest rates will stimulate
investment and make up for the lack of spending by households so that no overproduction will occur.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Understanding and applying economic models
49. ANS:
The classical economists believed that the economy was self-regulating. Their view was that any recessionary
or inflationary gaps would be eliminated through changes in the markets. They believed that wages, prices,
and interest rates would adjust to clear any overproduction, or underproduction, of goods and services. Given
that they believed that the economy could heal itself, they saw no need for government intervention in the
economy. These beliefs caused the classical economists to advocate a macroeconomic policy of laissez faire.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Understanding and applying economic models
50. ANS:
A large-scale natural disaster represents an adverse supply shock, and thus the SRAS curve would shift
leftward as a result. A leftward shift in the SRAS curve causes a rise in the price level and a decline in Real
GDP, possibly pushing the economy into a recessionary gap. Economists who believe the economy is selfregulating would contend that even if the economy were in a recessionary gap that it would be a temporary
situation. If Real GDP fell below its natural level, over time wages would fall, the SRAS curve would shift
rightward, and the recessionary gap would be eliminated without the need for government intervention to
resolve the problem.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Understanding and applying economic models
MSC: Economics 24/7
NOT: NEW
51. ANS:
If TP is less than TE, it indicates that businesses have produced too little relative to what the three sectors of
the economy want to buy. The difference between TP and TE would result in an unexpected fall in
inventories. Falling inventories send a signal to firms that they have underproduced, so they will increase the
quantity of goods they produce. The rise in production causes Real GDP to increase and the levels of TP and
TE will move closer together. This cycle will continue until TE and TP are equal.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Understanding and applying economic models
52. ANS:
During the Great Depression, high levels of unemployment and contracting Real GDP plagued many
countries around the world. The classical assertion in a self-regulating economy, one that could heal itself of
its economic ills, was not working out. This led Keynes and his followers to conclude that laissez-faire was
not a viable policy stance, and that the economy was inherently unstable.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Understanding and applying economic models
53. ANS:
When autonomous spending increases, the multiplier process causes Real GDP to grow by some multiple of
the initial increase in spending. This occurs because an increase in spending generates an equal increase in
income. As income increases, another round of spending will be generated (MPC  increase in spending),
which will lead to yet another increase in income. This spending-income cycle will continue until the dollar
amount left to spend becomes very tiny. Theoretically, the resulting change in Real GDP is equal to [1/(1MPC)] times the initial change in spending.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Understanding and applying economic models
54. ANS:
The general consumption formula is: C = Co + MPC(Yd). Co is autonomous consumption, which is the part of
consumption that is independent of the level of income. It does not change as disposable income changes.
MPC is the marginal propensity to consume and it represents the portion of a change in income that is spent.
Yd is the symbol for disposable income. This equation shows that consumption can change as a result of a
change in autonomous consumption, a change in the marginal propensity to consume, or a change in
disposable income. Consumption will rise when any one of these three variables rises.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Understanding and applying economic models
55. ANS:
In order for Say's law to hold in a money economy, any decrease in saving would have to be offset by an
equal increase in investment. According to the Classical economists, this would happen through changes in
interest rates. Keynes disagreed with this view and pointed out that added saving would not necessarily lead
to an equal amount of added investment. Keynes asserted that people save and invest for a variety of reasons,
and not on one single variable such as interest rates. According to Keynes, saving is more responsive to
changes in income than to changes in the interest rate, and investment is more responsive to change in
technology and business expectations than to changes in interest rate.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Understanding and applying economic models
56. ANS:
Classical economists believed that the amount of money saved and interest rates are directly related.
Therefore, savers would save more at higher interest rates than they would at lower interest rates. The
Keynesian view of saving is that savers may not necessarily save more at higher interest rates or save less at
lower interest rates. If savers have a given targeted amount that they are saving towards, a higher interest rate
will mean that they can actually save a smaller portion of their income to achieve that goal. Keynes held that
saving is more responsive to income than it is to the interest rate.
The classical view of investment is that the amount invested is inversely related to interest rates. Therefore,
businesses invest more at lower interest rates than they would at lower interest rates. The Keynesian view of
investment is that the interest rate is not the only factor important in determining investment. Keynes held
that other variables, such as business expectations, are also important determining factors in determining
investment. If businesses are pessimistic about the future then they are unlikely to increase their level of
investment, even if interest rates are relatively low.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Understanding and applying economic models
NOT: NEW
57. ANS:
The MPC and the multiplier have a direct relationship. This occurs because the MPC measures the portion of
a change in income that is spent, and as more of each additional dollar of income is spent a greater change in
Real GDP occurs as a result. If people are reluctant to spend a change in their income (indicating a relatively
low MPC), less overall spending would occur and fewer new goods and services would need to be produced.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Understanding and applying economic models
NOT: NEW
58. ANS:
College students on spring break will spend money on lodging, food and drink, souvenirs, and so on. From
the perspective of the beach town, this money represents autonomous spending and an increase in income. In
turn, the beach town residents will spend a portion of this increase in income, which generates additional
income for others, and so on and so on. Ultimately, the beach town economy can grow by some multiple of
the additional spending done by the college students.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Understanding and applying economic models
MSC: Economics 24/7
NOT: NEW
59. ANS:
Data lag - The time it takes for policymakers to be aware of changes in the economy.
Wait-and-see lag - Rather than act upon a change in the economy immediately, policymakers will generally
wait some time period to determine if this is more than just a short-run phenomenon.
Legislative lag - The time it takes for the President and Congress to build political support for a fiscal policy
measure and the time it takes to pass this legislation.
Transmission lag - After a fiscal policy measure is enacted, it takes some time for the tax change or spending
change to actually take effect.
Effectiveness lag - The time it takes after a policy is put into effect before this action has in impact on the
economy.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Monetary and fiscal policy
60. ANS:
A tax cut can increase consumption or investment or both and can thus increase aggregate demand. For
example, a cut in personal income taxes will give households more disposable income to spend.
In addition, when the marginal tax rates are cut, people will have an incentive to work more. As resources
shift away from leisure toward work, short-run aggregate supply increases. If the lower marginal tax rates are
permanent, most economists predict that both the short-run and the long-run AS curves will shift rightward.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Monetary and fiscal policy
61. ANS:
To close a recessionary gap, a Keynesian economist would suggest the use of expansionary fiscal policy --- a
tax cut or an increase in government spending. If crowding out is present, it can either partially or fully negate
the growth in Real GDP created by these fiscal policy solutions.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Monetary and fiscal policy
62. ANS:
Crowding out occurs when private expenditures (consumption, investment, net exports) fall as a consequence
of increased government spending or the financing needs of a budget deficit. Complete crowding out occurs
when the cutback in private expenditures is equal to the increase in government spending, and incomplete
crowding out occurs when the cutback in private expenditures is less than the increase in government
spending. For example, suppose that government spending increases by $1 billion. If private expenditures
then fall by $1 billion it would be termed complete crowding out and if private spending falls by $800 million
it would be termed incomplete crowding out. In the case of complete crowding out, there would be no
resulting impact on Real GDP from the increased government spending, fully negating the use of fiscal
policy. In the case of incomplete crowding out, Real GDP would grow somewhat, but not by as much as it
would have in the absence of crowding out.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Monetary and fiscal policy
NOT: NEW
63. ANS:
A progressive tax is an income tax system in which the taxpayer pays a higher tax rate as her taxable income
rises (up to some maximum rate), as with the current federal income tax system. A proportional income tax
(sometimes called a flat tax) is one in which the taxpayer pays a constant tax rate as her taxable income rises
or falls. A regressive income tax is an income tax system in which the taxpayer pays a lower tax rate as her
taxable income rises.
PTS: 1
64. ANS:
DIF: Moderate
NAT: Analytic
LOC: Monetary and fiscal policy
A federal budget deficit occurs when government expenditures exceed tax revenues. A cyclical deficit is the
part of the budget deficit that results from a downturn in economic activity. Any remaining deficit is termed a
structural deficit and is the part of the deficit that would exist if the economy were operating at full
employment. For example, assume that government expenditures are currently $500 billion and tax revenues
are currently $450 billion, resulting in a $50 billion budget deficit. Assume further that the government
estimates that if the economy were operating at full employment government expenditures would only be
$475 billion and tax revenues would be $460 billion. From this information we can conclude that the deficit
at full employment would be $15 billion (the structural deficit). Based on our previous calculation of the
budget deficit at $50 billion, we can conclude that the cyclical deficit is $35 billion.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Monetary and fiscal policy
NOT: NEW
65. ANS:
When a customer deposits money into her bank, the bank's reserves rise by an equal amount. In a fractional
reserve banking system, the bank is only required to set aside a small portion of this deposit and the bank is
free to loan the remainder. In the process of making these new loans, checkable deposits are created for the
people who received the loans. Given that checkable deposits are part of the money supply, by extending
loans the banking system has increased the money supply.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: The role of money
66. ANS:
In order for the M1 money supply to fall, one of the components of M1 (checkable deposits, currency held
outside banks, or traveler's checks) would have to decline. M2 would remain constant as long as the money
that was deducted from M1 was deposited into one of the additional components of M2 (savings deposits,
small-denomination time deposits, or retail money market mutual funds).
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: The role of money
67. ANS:
Money serves as a medium of exchange, a unit of account and a store of value. Medium of exchange - In a
money economy, money serves as the medium through which transactions are made. Unit of account - Money
is the common standard by which value is determined in a money economy (a "yardstick" of value). Store of
value - Money will retain value over time.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: The role of money
68. ANS:
M1 is the narrow definition of the money supply. It only includes money that can be directly used for
everyday transactions. M1 consists of traveler’s checks, checkable deposits, and currency held outside banks.
M2 is the broad definition of the money supply. M2 is made up of M1 plus savings deposits, smalldenomination time deposits, and retail money market mutual funds.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: The role of money
69. ANS:
The U.S. money supply is no longer backed by gold, but that does not mean that it does not have value. It is
the general acceptability of paper money that gives it value. As long as sellers continue to accept paper
money as payment in exchange for goods and services that are valuable, the paper money will continue to
have value.
PTS: 1
NOT: NEW
70. ANS:
DIF: Moderate
NAT: Analytic
LOC: The role of money
Many people believe that Baum’s well-known work is an allegory for the presidential election of 1896
between William McKinley and William Jennings Bryan. Young Dorothy is thought to represent Bryan (only
36 years old as the Democratic presidential candidate) and her voyage to the Emerald city represents Bryan’s
quest to win the presidency and move to the nation’s capital. During this era, the U.S. economy was going
through very difficult times which many people blamed on the gold standard. Those people --- including both
Bryan and Baum --- believed that a bimetallic monetary standard (using both gold and silver) would lead to
an increase in the money supply, thereby helping to pull the economy out of its depression. Other symbolism
in the book includes:
Cyclone: The 1896 Democratic convention
Yellow brick road: The gold standard
Scarecrow: Farmers
Tin man: Industrial workers
Cowardly lion: The Populist party
Toto: The Democratic party
Wicked Witch of the West: The gold standard
Dorothy’s silver shoes: Silver
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: The role of money
MSC: Economics 24/7
NOT: NEW
71. ANS:
Open market operations are when the Fed buys or sells U.S. government securities in financial markets. In
order to increase the money supply, the Fed buys government securities (called an open market purchase). As
the Fed makes open market purchases, the money paid by the Fed to the seller of the securities will result in
an increase in bank reserves and the money supply will ultimately increase. Another option the Fed uses to
increase the money supply is to lower the discount rate. The discount rate is the interest rate charged by the
Fed to banks that need to borrow reserves. The lower the discount rate is relative to the federal funds rate, the
more likely the banks are to borrow from the Fed. As a bank borrows from the Fed, the bank's reserves
increase while the reserves of no other bank decrease, creating an increase in reserves for the banking system.
The final monetary policy tool used by the Fed is changing the required reserve ratio. If the Fed wants to
increase the money supply, they will decrease the required reserve ratio, allowing banks to loan a larger
portion of checkable deposits.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Monetary and fiscal policy
72. ANS:
The prevailing popular opinion of the time was to have a small number of districts, as few as six to eight.
However, then Secretary of State William Jennings Bryan, called for fifty district banks. A compromise was
reached and the Federal Reserve Act stated that "not less than eight nor more than twelve cities" would be
designated as Federal Reserve district headquarters. A commission of three persons was set up to draw the
district boundaries and the locations of the district banks. The commission determined that there should be
twelve districts and they determined the boundaries based upon prevailing trade patterns. Some banks
protested this proposal and filed petitions for review of the plan with the Federal Reserve Board. When the
board members appeared to be about to vote in favor of reducing the number of districts, one of the supporters
of the original twelve banks turned to the attorney general of the U.S., protesting that the board did not have
the authority to override the commission's decisions. The attorney general gave that opinion and the board
ultimately accepted the attorney general's opinion.
PTS: 1
DIF: Difficult
MSC: Economics 24/7
NAT: Analytic
LOC: The role of government
73. ANS:
The eight major functions or responsibilities of the Fed are: controlling the money supply, supplying the
economy with paper money, providing check-clearing services, holding depository institutions' reserves,
supervising member banks, serving as the government's banker, and serving as the lender of last resort, and
serving as the fiscal agent for the Treasury.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: The role of government
74. ANS:
The group responsible for conducting open market operations is the Federal Open Market Committee
(FOMC). The FOMC is made up of twelve members. They are the seven board members, the president of the
New York Federal Reserve District Bank, and four other Federal Reserve District Bank presidents (who rotate
on and off the committee every year). In order to decrease the money supply, the Fed sells government
securities (called an open market sale). As the Fed makes an open market sale, the money paid to the Fed by
the buyer of the securities will result in a decrease in bank reserves and the money supply will ultimately
decrease.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: The role of government
75. ANS:
Although many people confuse the Treasury and the Fed, each has its own distinct role to play. The U.S.
Treasury is a budgetary agency, while the Federal Reserve is a monetary agency. The Treasury is responsible
for managing the financial affairs of the federal government. In this capacity they collect the taxes and
borrow the funds necessary to pay for government expenditures. The Fed is primarily concerned with the
availability of money and credit for the entire economy, in doing so they help to provide a stable monetary
framework for the economy. Unlike the Treasury, the Fed can create money “out of thin air”. The Treasury
mints the coins, and the Fed issues paper money. The Treasury issues Treasury securities, but the Fed does
not.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: The role of government
NOT: NEW
76. ANS:
The federal funds rate is the interest rate that banks charge one another for borrowing funds, while the
discount rate is the interest rate that the Fed charges banks that borrow funds from them. The discount rate is
the rate that the Fed can change by issuing an order. The federal funds rate is determined in the federal funds
market. The Fed changes the federal funds rate by changing the amount of reserves in the banking system.
More specifically, if the Fed wants to lower the federal funds rate they will need to exert downward pressure
on this rate in the federal funds market. They can do this by conducting an open market purchase. This
purchase would inject more reserves into the banking system, thereby increasing the supply of reserves in the
federal funds market. As in any other market, when the supply increases the “price” paid (in this case, the
federal funds rate) to get that item would decline.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Monetary and fiscal policy
NOT: NEW
77. ANS:
The equation of exchange is an identity which states that the money supply multiplied by velocity must equal
the price level times Real GDP. It is not a theory of the macroeconomy until assumptions are made about the
variables in the equation. In the simple quantity theory of money, velocity (V) and Real GDP (Q) are assumed
to be constant. With V and Q constant, it follows that changes in the money supply cause strictly proportional
changes in the price level.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Understanding and Applying Economic Models
78. ANS:
a.
a.
b.
c.
As the Fed increases the money supply (for example, with an open market purchase) reserves
in the banking system rise, giving banks the ability to extend more loans. Therefore, the supply
of loans rises.
As the money supply increases, the AD curve shifts rightward and Real GDP rises in the short
run.
As the money supply increases, the AD curve shifts rightward and the price level rises in the
short run.
Given that an increase in the money supply leads to a rising price level, it is reasonable to
assume that the expected inflation rate would rise, as well.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Understanding and Applying Economic Models
79. ANS:
The expectations effect (or Fisher effect, named for economist Irving Fisher) refers to the change in the
interest rate that is brought about by a change in the expected inflation rate. A change in the expected inflation
rate affects both the supply of and demand for loanable funds. As the expected inflation rate rises, borrowers
(demanders of loanable funds) will be willing to pay a higher interest rate in order to be able to make
purchases now, before prices rise. In addition, lenders (the suppliers of loanable funds) require a higher
interest rate to compensate them for the reduced purchasing power of the money they receive as the loan is
repaid. So the demand for loanable funds curve shifts rightward and the supply of loanable funds curve shifts
leftward, both of which will cause the interest rate to rise.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Understanding and Applying Economic Models
80. ANS:
Monetarists assume that velocity changes in a predictable way, that aggregate demand depends on the money
supply and on velocity, that the SRAS curve is upward sloping, and the economy is self-regulating (prices and
wages are flexible).
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Understanding and Applying Economic Models
81. ANS:
The discovery and mining of gold in California resulted in an increase in the amount of money in circulation.
More gold mined led to an increase in the supply of money, which led to higher and higher prices across the
country. The earliest and most dramatic inflation occurred near the gold mines. Prices of consumer goods
and real estate sky-rocketed in the vicinity of the mines as the gold rush continued.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Understanding and Applying Economic Models
NOT: NEW
82. ANS:
MSC: Economics 24/7
The only factor that can continually increase and bring about continued inflation is the money supply. One
reason that government purchases cannot increase continually is that there are real and political limits to
government spending. The real limit would be 100% of GDP (where all resources in the economy are
devoted to producing goods and services for the government). The political limit would likely be less than
100% of GDP, but it is a limit nonetheless. Either way, there is an upper limit to the amount of government
purchases, beyond which further such purchases cannot be made. The second reason for a limit to
government purchases has to do with crowding out. As the government spends more, many economists
believe that private sector spending falls as a result. This leads to little, or no, change in aggregate demand.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Understanding and Applying Economic Models
NOT: NEW
83. ANS:
When the money supply decreases, interest rates rise and the level of investment decreases. This causes the
AD curve to shift leftward, resulting in a decrease in both Real GDP and the price level. The Keynesian
transmission mechanism is an indirect transmission mechanism because changes in the money market must
affect the investment goods market before the goods and service market is affected, rather than immediately
impacting the goods and services market.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Monetary and fiscal policy
84. ANS:
An increase in the money supply pushes down interest rates. As domestic interest rates fall, the U.S. asset
markets become less attractive to foreign investors. A decrease in demand for U.S. investments by foreigners
will decrease the demand for the dollar, leading to a depreciation of the exchange rate value of the dollar. In
addition, a falling dollar means that foreign currencies are appreciating relative to the dollar. A cheaper dollar
will result in an increase in U.S. exports, while the appreciation of foreign currencies will lead to a decrease in
foreign imports, both of which cause an increase in net exports. The increase in net exports will shift the AD
curve rightward and Real GDP will rise (at least in the short run).
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Monetary and fiscal policy
85. ANS:
The two assumptions made in the constant-money-growth-rate rule are that velocity is constant and that the
money supply is defined correctly. Critics argue that it is not yet clear which definition of money (M1, M2,
etc) is the proper one to use and therefore which money supply growth rate ought to be fixed. They also state
that there have been periods when velocity has not been constant. Given these criticisms, some nonactivists
prefer the predetermined-money-growth-rate rule which states that the annual growth rate in the money
supply will be equal to the average annual growth rate in Real GDP minus the growth rate in velocity. With
this rule, the growth rate of the money supply is not fixed but it is predetermined based on the growth rates of
Real GDP and velocity.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Monetary and fiscal policy
86. ANS:
Inflation targeting requires that the Fed try to keep the inflation rate near some predetermined level. The first
issue surrounding this practice is whether the inflation rate target should be a specific rate or a narrow range
of rates. Second, whether the target is a specific inflation rate or a narrow range of rates, what should that
exact rate or range be? The final issue deals with whether the inflation rate target should be publicly
announced or not.
PTS: 1
87. ANS:
DIF: Moderate
NAT: Analytic
LOC: Monetary and fiscal policy
Bond prices and interest rates have an inverse relationship. The best time to buy bonds is when it is perceived
that interest rates are as high as they will go, since that would occur when bond prices are low. Interest rates
are determined based upon the supply and demand for bonds. When the demand for bonds increases, the
price of bonds will rise which will push down interest rates. Similarly, when the supply of bonds decreases,
the price of bonds will rise and interest rates will fall. There are a myriad of variables that influence the
supply and demand for bonds, and changes in these variables are very difficult to predict which makes interest
rate predictions very difficult.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Monetary and fiscal policy
MSC: Economics 24/7
NOT: NEW
88. ANS:
The PIP is associated with the new classical theory. The new classical theorists hold that under certain
assumptions, neither expansionary fiscal policy not expansionary monetary policy is effective at increasing
Real GDP and lowering the unemployment rate in the short run. The assumptions that are required to support
PIP are (1) the expansionary policy change is correctly anticipated, (2) individuals form their expectations
rationally, and (3) wages and prices are flexible.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Understanding and Applying Economic Models
89. ANS:
Adaptive expectations are based on observations of past experiences. Rational expectations are based not only
on what has occurred in the past, but also on predictions about the effects of present and future policy actions.
Expectations that are formed rationally change more quickly than expectations that are formed adaptively.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Understanding and Applying Economic Models
90. ANS:
The original Phillips curve showed the inverse relationship between money wage inflation and
unemployment. The information used to form this curve was based on an analysis of data from the United
Kingdom during the period 1861-1957. The Phillips curve developed by Samuelson and Solow depicted the
inverse relationship between price inflation and unemployment and it was based on data from the U.S. during
the period 1935-1959. The conclusions drawn from both Phillips curves was that stagflation is extremely
unlikely and that policymakers have a menu of choices between different combinations of inflation and
unemployment rates.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Understanding and Applying Economic Models
91. ANS:
In an economy with increasing aggregate demand, businesses will expand production and in so doing will
need to hire more workers. As the unemployment rate falls, businesses will find that they have to offer a
higher wage in order to attract new workers in this tighter labor market. Therefore, there is an inverse
relationship between the unemployment rate and wage rates (or wage inflation).
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: Understanding and Applying Economic Models
92. ANS:
NOT: NEW
An adverse supply shock would reduce the capacity of the economy to produce, leading to a leftward shift of
the LRAS curve (also an inward shift of the PPF). As the LRAS curve shifts leftward, Real GDP declines and
the price level rises. The reduction in Real GDP will lead to a cutback in employment and the demand for
labor will decrease, resulting in declining money wages. The combination of a higher price level and lower
money wages will lead to lower real wages, as well. Less work and lower real wages push down incomes, so
consumption and investment will decline. Deceased spending by households and businesses creates a decline
in the volume of outstanding loans and the money supply falls. The AD curve will shift leftward as a result of
the falling money supply. In this example, both the AD curve and the LRAS curve shifted, so some people
might believe that the events were caused by the falling money supply (which shifted AD), when the change
in money supply was really the effect of the shift in LRAS.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: Understanding and Applying Economic Models
93. ANS:
The primary objective of the WTO is to help trade flow "smoothly, freely, fairly, and predictably." They do
this by administering trade agreements, acting as a forum for trade negotiations, settling trade disputes,
reviewing national trade policies and assisting developing countries in trade policy issues. Some critics of the
WTO argue that in the pursuit of their goals they have sacrificed the sovereignty of some nations.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: International trade and finance
94. ANS:
Increased immigration will increase the supply of labor, shifting the supply of labor curve to the right. In
addition, an increase in immigration will create an increase in the demand for labor. This is because the
demand for labor is a derived demand, and the rising population will need more food, housing, clothes, and so
on. The result will be an increase in the demand for labor to produce those goods and services and the demand
for labor curve will shift to the right. The impact on wages is dependent upon whether the increase in the
demand is greater than, less than, or equal to the increase in supply. If demand increases by more than supply,
wages will rise; if supply increases by more than demand, wages will fall; if demand rises by the same
amount as supply rises, wages will not change.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: International trade and finance
95. ANS:
The arguments that have been given to support trade restrictions are the national-defense argument, the infantindustry argument, the antidumping argument, the foreign-export-subsidies argument and the savingdomestic-jobs argument. Everyone does not accept these arguments for trade restrictions as valid. Critics
maintain that the arguments can be (and are) abused and these arguments may be motivated by self-interest.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: International trade and finance
96. ANS:
Government is generally more responsive to producer interests than to consumer interests. This is because the
benefits of quotas are concentrated on relatively few producers and the costs of quotas are spread over
relatively many consumers. Therefore, the producers will lobby the government to obtain these gains from
quotas, while consumers will not lobby government to keep from paying the small additional (per person)
cost that results from the quotas. Hearing little, or no, opposition from the consumers, the politicians are
likely to respond to the interests of the producers.
PTS: 1
97. ANS:
DIF: Difficult
NAT: Analytic
LOC: International trade and finance
The international monetary system currently in use is described as a managed flexible exchange rate system,
or managed float. This is primarily a flexible system where the forces of supply and demand for the currencies
determine the exchange rates. However, nations do periodically intervene in the foreign exchange market to
adjust exchange rates. Proponents of the managed flexible exchange rate system believe that it allows nations
to pursue independent monetary policies, that it solves trade problems without trade restrictions, and that its
flexibility allows for easy adjustment to shocks. Opponents of this type of system believe that it promotes
exchange rate volatility and uncertainty, that it promotes inflation and that it corrects trade deficits a long time
after a depreciation in the currency.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: International trade and finance
98. ANS:
The demand for Japanese yen would come from people in the United States that want to buy Japanese goods,
services and financial assets. The supply of yen would come from people in Japan that want to buy American
goods, services and financial assets. The yen would appreciate in value if: 1) income growth rates were higher
in the U.S. than in Japan; 2) inflation was relatively higher in the U.S. than in Japan; 3) real interest rates were
relatively higher in Japan than in the United States.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: International trade and finance
99. ANS:
The countries must: 1) Define their currencies in terms of gold; 2) Be ready and willing to convert gold into
paper money, and vice versa, at the rate specified; 3) Link their money supplies to their holdings of gold.
PTS: 1
DIF: Moderate
NAT: Analytic
LOC: International trade and finance
100. ANS:
The Mexican government could buy pesos (and sell dollars) which would increase the demand for pesos. The
Mexican central bank could increase interest rates which would motivate some investors to purchase Mexican
bonds, thereby increasing the demand for pesos. The government could increase trade restrictions on goods
imported into Mexico from the United States, which would decrease the demand for dollars (and thus
decrease the supply of pesos). A final solution might be for the Mexican government to devalue the peso.
PTS: 1
DIF: Difficult
NAT: Analytic
LOC: International trade and finance