FACULTY OF COMMERCE
SPRING SESSION SECOND MID-TERM 2005
ANSWERS
ECO120 MACROECONOMICS
LECTURERS: Rod Duncan
DAY & DATE: 1th November 2005
TIME: 1:00pm - 2:00 pm
WRITING TIME: 50 Minutes
READING TIME: 10 Minutes
MATERIALS SUPPLIED BY UNIVERSITY:
General Purpose Answer Sheet
MATERIALS PERMITTED IN EXAMINATION: 2B Pencil/Eraser
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NUMBER OF QUESTIONS:
ECO120 Macroeconomics
Part A: 20;
Part B: 2
Page 1 of 10
PART A
Multiple Choice Questions
(60 marks – 3 marks each)
Answer all twenty (20) questions.
1. An increase in personal income taxes will lead to what outcome according to the
AD-AS model?
A)
B)
C)
D)
Prices rise, and output rises.
Prices rise, and output falls.
Prices fall, and output rises.
Prices fall, and output falls.
Answer: D
2. An increase in government spending will lead to what outcome according to the
AD-AS model?
A)
B)
C)
D)
Prices rise, and output rises.
Prices rise, and output falls.
Prices fall, and output rises.
Prices fall, and output falls.
Answer: A
3. If the Reserve Bank of Australia wishes to pursue a contractionary monetary
policy, it could:
A)
B)
C)
D)
Increase the supply of ESAs and raise the cash rate.
Increase the supply of ESAs and lower the cash rate.
Reduce the supply of ESAs and raise the cash rate.
Reduce the supply of ESAs and lower the cash rate.
Answer: C
4. Bank loan rates:
A)
B)
C)
D)
Stay the same when the cash rate rises.
Fall when the cash rate rises.
Rise when the cash rate rises.
Have nothing to do with the cash rate.
Answer: C
ECO120 Macroeconomics
Page 2 of 10
5. If a bank has $2m in deposits, $100,000 in reserves and if the reserve ratio is 5%,
then the bank has excess reserves of:
A)
B)
C)
D)
-$50,000
$0
$50,000
$100,000
Answer: B
6. If the banking systems reserve ratio is 5%, the simple money multiplier is:
A)
B)
C)
D)
1
5
20
25
Answer: C
7. Which of the following is true along the investment demand curve?
A) When interest rates rise, it becomes more expensive to borrow and more
investment is made.
B) When interest rates rise, it becomes more expensive to borrow and less
investment is made
C) When interest rates fall, it becomes more expensive to borrow and more
investment is made.
D) When interest rates fall, it becomes more expensive to borrow and less
investment is made
Answer: B
8. If the Reserve Bank of Australia increases the reserve ratio, the simple money
multiplier:
A)
B)
C)
D)
Is not affected.
Falls.
Rises.
Stays the same.
Answer: B
ECO120 Macroeconomics
Page 3 of 10
9. When we state all prices in terms of the Australian dollar, we are using the
Australian dollar as:
A)
B)
C)
D)
A medium of exchange.
A store of value.
A unit of account.
None of the above.
Answer: C
10. In the Quantity Theory of Money, if all else stays the same but the velocity of
money rises:
A)
B)
C)
D)
We should see a fall in prices.
We should see a rise in prices.
Real output should rise.
Real output should fall.
Answer: B
11. In the Quantity Theory of Money, if velocity is constant, real output is rising at
3% per year and the money supply is rising at 5% per year:
A)
B)
C)
D)
Then we will have 0% inflation.
Then we will have 2% inflation.
Then we will have 5% inflation.
Then we will have 8% inflation.
Answer: B
12. Assume the economy is in a recession, what actions by the Reserve Bank of
Australia would be the best way of moving the economy back to its natural rate?
A)
B)
C)
D)
Cut interest rates and shift the AD curve right.
Cut interest rates and shift the AD curve left.
Raise interest rates and shift the AD curve right.
Raise interest rates and shift the AD curve left.
Answer: A
13. A rise in producer costs causes cost-push inflation, so if producer costs rise, we
should see:
A)
B)
C)
D)
High inflation and low unemployment.
High inflation and high unemployment.
Low inflation and low unemployment.
Low inflation and high unemployment.
Answer: B
ECO120 Macroeconomics
Page 4 of 10
14. An increase in aggregate demand causes demand-pull inflation, so if we have a
large increase in aggregate demand, we should see:
A)
B)
C)
D)
High inflation and low unemployment.
High inflation and high unemployment.
Low inflation and low unemployment.
Low inflation and high unemployment.
Answer: A
15. The economy is hit by a rise in oil prices, how should the Reserve Bank of
Australia react if the Reserve Bank wants to avoid inflation?
A)
B)
C)
D)
Cut interest rates and shift the AD curve right.
Cut interest rates and shift the AD curve left.
Raise interest rates and shift the AD curve right.
Raise interest rates and shift the AD curve left.
Answer: D
16. If the Reserve Bank of Australia is worried about low demand and deflation
(falling prices) in the future, what might the RBA do now?
A)
B)
C)
D)
Cut interest rates and shift the AD curve right.
Cut interest rates and shift the AD curve left.
Raise interest rates and shift the AD curve right.
Raise interest rates and shift the AD curve left.
Answer: A
17. The economy suffers a recession because of a drop in investment demand. What
process will lead to a return to the natural rate of output in the long-run if the
government does not act?
A)
B)
C)
D)
A drop in wages and a shift right of the AS curve.
A rise in wages and a shift right of the AS curve
A drop in wages and a shift left of the AS curve
A rise in wages and a shift left of the AS curve.
Answer: A
ECO120 Macroeconomics
Page 5 of 10
18. The economy enters a boom because of a sharp increase in demand for Australian
exports. What process will lead to a return to the natural rate of output in the long-run
if the government does not act?
A)
B)
C)
D)
A drop in wages and a shift right of the AS curve.
A rise in wages and a shift right of the AS curve
A drop in wages and a shift left of the AS curve
A rise in wages and a shift left of the AS curve.
Answer: D
19. There are two different types of inflation in an AD-AS model. What reaction by
the Federal government would be appropriate if the government is interested in
keeping the economy at the natural rate of output?
A) Cut spending with demand-pull inflation and cut spending with cost-push
inflation.
B) Cut spending with demand-pull inflation and raise spending with cost-push
inflation.
C) Raise spending with demand-pull inflation and raise spending with cost-push
inflation.
D) Raise spending with demand-pull inflation and cut spending with cost-push
inflation.
Answer: B
20. The Phillips Curve shows the relationship between:
A)
B)
C)
D)
The price level and unemployment.
Unemployment and output.
Output and inflation.
Inflation and unemployment.
Answer: D
ECO120 Macroeconomics
Page 6 of 10
PART B
(40 marks – 20 marks each)
Answer both questions in the space provided on this sheet.
QUESTION: B.1
Often the government uses monetary and fiscal policy together. When policies are
working together, they are called “complementary”. The government cuts personal
income taxes.
(a) What impact will the cut in personal income taxes have on the economy? Show
in an AD-AS diagram and explain in words. Remember to show both the initial
equilibrium and the equilibrium after the tax cuts.
Answer: A cut in personal income taxes will increase C so AD0 shifts right to AD1.
Prices rise to P1, output rises to Y1. We have increased prices (inflation) and lower
unemployment.
P
AS0
P1
P0
AD1
AD0
Y0 Y1
ECO120 Macroeconomics
Y
Page 7 of 10
(b) If the RBA is concerned about the consequences of the income tax cuts on
inflation in Australia, what policy should the RBA pursue? Show the
consequences of this monetary policy on an AD-AS diagram and explain in
words.
Answer: In order to prevent inflation, the RBA has to stop prices from rising. The
RBA can do this by pursuing a contractionary monetary policy. The RBA raises to
cash rate which raises interest rates and reduces investment demand. This shifts the
AD curve left back to AD , and, if timed just right, prevents any inflationary
consequences of the income tax cut.
P
AS0
P1
P0
AD1
AD2
Y0 Y1
Y
Output stays at Y0, and prices stay at P0. There is no inflation due to the tax cut.
ECO120 Macroeconomics
Page 8 of 10
QUESTION: B.2
Assume we start at an equilibrium with GDP equal to the natural rate of output. The
short-run AS curve shifts up by 10% as inflation expectations are 10% in the
economy, so all wages rise by 10%. [Hint: Set initial prices at 100.]
(a) Draw the initial equilibrium and show the shift up in the AS curve. Draw the
Phillips Curve for inflation expectations of 10%.
Answer:
P
AS1
Infl
AS0
110
10%
100
Phillips
Curve
AD0
Y*
Y
U*
Unemp
Where Y* is the natural rate of output and U* is the natural rate of unemployment.
The Phillips Curve at an expected 10% inflation rate goes through 10% inflation at
U*-the natural rate of unemployment.
(b) What happens if the AD curve does not shift? Show what point this is on the ADAS and the Phillips Curve for 10% inflation expectations?
Answer: If the AD curve does not shift, then our equilibrium next year will occur
where the original AD and the new AS1 intersect. Inflation will be less than
anticipated, say at 5%, while unemployment will be higher than the natural rate of
unemployment at U0. This point will be down and to the right on the Phillips Curve at
point B.
ECO120 Macroeconomics
Page 9 of 10
P
AS1
Infl
AS0
105
10%
100
B
5%
Phillips
Curve
AD0
Y0
Y
Y*
U*
U0
Unemp
(c) What happens if the AD curve shifts up by 10%? Show what point this is on the
AD-AS and the Phillips Curve for 10% inflation expectations.
Answer: The AD curve shifts to AD1. Inflation will be equal to expected inflation at
10%, while unemployment will be equal to the natural rate at U*. We will be at point
C.
P
AS1
Infl
AS0
110
C
10%
100
AD1
AD0
Y*
ECO120 Macroeconomics
Y
Phillips
Curve
U*
Unemp
Page 10 of 10