Macroeconomics Final Exam
Demand-pull inflation occurs when
prices rise because of an increase in aggregate spending not fully matched by an increase in aggregate output. Demand-pull inflation occurs when prices rise because of an increase in aggregate spending not fully matched by an increase in aggregate output. It is sometimes expressed as "too much spending (or money) chasing too few goods."
Compare a hypothetical DVC with a hypothetical IAC. In the DVC, average per capita income is $500 per year. In the IAC, average per capita income is $40,000 per year. If both countries have a saving rate of 10 percent per year, the amount of saving per capita in the DVC will be _______ per person per year, while in the IAC it will be _______ per person per year.
$50; $4,000 The correct answer is that the amount of saving per capita in the DVC will be $50 per person per year (= 10 percent saving rate × $500 per person per year of income), while in the IAC it will be $4,000 per person per year (= 10 percent saving rate × $40,000 per person per year of income). The key point to take away from these computations is just how bad poverty is for getting out of poverty. The poorer a country is, the harder it becomes for it to substantially increase its capital stock and, by extension, the amount of output per worker that it will be able to generate for its population.
Suppose the CPI was 110 last year and is 121 this year. In contrast, suppose that the CPI was 110 last year and is 108 this year. What is this year's inflation rate?
-1.8 percent If the CPI was 110 last year and is 108 this year, the inflation rate is approximately -1.8 percent = [(108 - 110)/110) × 100].
In year 1, Adam earns $1,000 and saves $100. In year 2, Adam gets a $500 raise so that he earns a total of $1,500. Out of that $1,500, he saves $200. What is Adam's MPC out of his $500 raise?
0.80 Adam's MPC out of his $500 raise is 0.80. That is true because when Adam's income goes up by a marginal (extra) $500, his consumption goes up by a marginal (extra) $400. Those numbers allow us to calculate the MPC as: MPC=change in consumptionchange in income Substituting Adam's values into the formula tells us that MPC = 0.80 (= $400/$500). If you are confused about Adam's marginal consumption going up by exactly $400, think about how much he was consuming in each year. To do so, remember that any money that is not saved is by definition consumed. So when Adam saves $100 in year 1 out of an income of $1,000, he must be consuming $900 (= $1,000 − $100) that year. In the same way, when he is saving $200 out of an income of $1,500 in year 2, he must be consuming $1,300 (= $1,500 − $200). Looking at those two consumption numbers, we see that Adam's consumption rises from $900 in year 1 to $1,300 in year 2, which is a $400 increase. And because that $400 increase came in response to a $500 increase in pay, we know that his MPC out of that $500 increase in pay is 0.80.
Suppose the price level and value of the U.S. dollar in year 1 are 1 and $1, respectively. If the price level rises to 1.15 in year 2, what is the new value of the dollar?
0.87 The amount a dollar will buy varies inversely with the price level; that is, a reciprocal relationship exists between the general price level and the purchasing power of the dollar. That is, to find the value of the dollar $V, divide 1 by the price level P expressed as an index number (in hundredths). In equation form, the relationship looks like this: $V = 1/P. This implies that when the price level rises to 1.15 in year 2, the new value of the dollar is $V = 1/1.15 = $0.87.
Suppose the price level and value of the U.S. dollar in year 1 are 1 and $1, respectively. If, instead, the price level falls to 0.60, what is the value of the dollar?
1.67 The amount a dollar will buy varies inversely with the price level; that is, a reciprocal relationship exists between the general price level and the purchasing power of the dollar. That is, to find the value of the dollar $V, divide 1 by the price level P expressed as an index number (in hundredths). In equation form, the relationship looks like this: $V = 1/P. b. This also implies that when the price level falls to 0.60, the new value of the dollar is $V = 1/0.60 = $1.67.
If real GDP grows at 7 percent per year, then real GDP will double in approximately __________ years.
10 If real GDP grows at 7 percent per year, then real GDP will double in approximately 10 years. We can derive this fact by using the rule of 70, which tells us that the approximate number of years required to double real GDP is equal to the number 70 divided by real GDP's annual percentage rate of growth. Applying the rule of 70 to this problem, we see that it will take approximately 10 years (= 70/7) to double real GDP.
Suppose the CPI was 110 last year and is 121 this year. What is this year's inflation rate?
10 percent If the CPI was 110 last year and is 121 this year, the inflation rate is 10 percent = [(121 - 110)/110) × 100].
A country's current unemployment rate is 11 percent. Economists estimate that its natural rate of unemployment is 6 percent. About how large is this economy's negative GDP gap?
10 percent This economy's negative GDP gap should be about 10 percent. This estimate is based on Okun's law, which indicates that for every 1 percentage point by which the actual unemployment rate exceeds the natural rate, a negative GDP gap of about 2 percentage points occurs. To apply Okun's law to the current situation, we first note that actual unemployment exceeds the natural rate by 5 percentage points (= 11 percent actual rate of unemployment - 6 percent natural rate of unemployment). It then follows that the negative GDP gap must be 10 percent (= 5 percentage points × 2).
A commercial bank has $100 million in checkable-deposit liabilities and $12 million in actual reserves. The required reserve ratio is 10 percent. How big are the bank's excess reserves?
2 million This bank has $2 million of excess reserves. The bank's excess reserves can be calculated by subtracting the bank's required reserves from the bank's actual reserves of $12 million. The bank's required reserves are $10 million (= 0.10 (reserve ratio of 10 percent) × $100 million in checkable-deposit liabilities). Thus, the bank's excess reserves are equal to $2 million (= $12 million in actual reserves − $10 million in required reserves).
Suppose that the Fed has set the reserve ratio at 10 percent and that banks collectively have $2 billion in excess reserves. What is the maximum amount of new checkable-deposit money that can be created by the banking system?
20 billion The correct answer is that the banking system can create a maximum of $20 billion in new checkable-deposit money. To see why this is true, begin with the fact that the monetary multiplier m is the reciprocal of the reserve ratio. That is, m = (1/R). Given that the Fed in this problem has set the reserve ratio at 10 percent, this formula implies that the monetary multiplier will be equal to 10 (= 1/0.10). Next, remember that the banking system's maximum checkable-deposit money creation D is equal to the banking system's excess reserves E times the monetary multiplier, or D = E × m. Given that we know that the excess reserves are $2 billion and m = 10, this formula implies that the maximum checkable-deposit money creation will be D = $20 billion (= $2 billion in excess reserves × monetary multiplier of 10). The initial $2 billion in excess reserves can be multiplied into up to $20 billion in new checkable-deposit money because when bank A extends a loan and creates new money, that money will eventually be deposited in another bank B, where any part of that amount except the required reserve amount can be lent out again. With this process repeating itself from bank B to bank C to bank D, a single dollar in initial excess reserves at bank A can initiate a much larger total volume of loans.
Suppose that this year a small country has a GDP of $100 billion. Also assume that Ig = $30 billion, C = $60 billion, and Xn = − $10 billion. What is the value of G?
20 billion G equals $20 billion. To see why this is true, we can rearrange the GDP equation, which is normally presented as GDP = C + Ig + G + Xn. Rearranging the equation to solve for G reveals that G = GDP − C − Ig − Xn. With that version of the equation in hand, we can plug in our values for GDP, consumption, gross investment, and net exports. Doing so, we see that G = $100 billion − $60 billion − $30 billion − (− $10 billion). Taking into account the fact that a "negative times a negative is a positive," we see that G = $20 billion.
Suppose that you are given a $100 budget at work that can be spent only on two items: staplers and pens. If stapler cost $10 each and pens cost $2.50 each, then the opportunity cost of purchasing one stapler is:
4 pens (4x$2.50=$10) (therefore: $10/2.5= 4 pens)
If the slope of the aggregate expenditures schedule is 0.8, the multiplier will be
5. If the slope of the aggregate expenditures schedule is 0.8, then the MPC will equal 0.8 and the MPS will equal 0.2. Therefore, the multiplier will be 5 (= 1/0.2).
Suppose the CPI was 110 last year and is 121 this year. What term do economists use to describe this second outcome?
Deflation This outcome is referred to as deflation by economists.
The social science concerned with how individuals, institutions, and society make optimal (best) choices under conditions of scarcity:
Economics
Making choices based on comparing marginal benefits with marginal costs:
Marginal Analysis
In 2009, the inflation rate reached negative 0.4 percent while the unemployment rate hit 10 percent. If the target inflation rate was 2 percent and the full-employment rate of unemployment was 5 percent, what value does the Taylor Rule predict for the Fed's target interest rate back then? Would that rate have been possible given the zero lower bound problem?
Negative 4.6 percent; not possible. The mathematical expression of the Taylor Rule is: Fed target interest rate = real risk-free interest rate + current actual inflation rate + 0.5 × (inflation gap) − 1.0 × (unemployment gap) Plugging in the information given in the question into the Taylor Rule equation, we get: Fed target interest rate = 2 percent + (−0.4 percent) + 0.5 × (−2.4 percent) − 1.0 × (5 percent) = −4.6 percent A negative target interest rate is not possible because it would actually require a lender to pay a borrower to borrow money.
Suppose the central bank in the nation of Zook attempts to pay off its national debt by printing large amounts of currency. The large increase in the money supply causes the price level to rise by 500 percent. What do you expect will happen to the value of Zook's currency?
The value of Zook's currency will decrease by 80 percent. Using the relationship, $V = 1/P, we can determine how the value of money will change when the price level rises by 500 percent. Since we need to calculate the percentage change, we can assume that the price level and the value of money both start at a value of 1. An increase in the price level by 500 percent means that the price level will increase by a factor of 5. If we start at a price level of 1, our new price level will be 5. Therefore, we expect the new value of money to be 1/5 = 0.2. We can find the percentage change using the formula, [(new value − old value)/(old value)] × 100 (to convert to a percentage). In our example, the new value of money is 0.2 and the old value is 1, so the percentage change = [(0.2 − 1)/1] × 100 = −80 percent. The negative value indicates a decrease, but since we have stated that it is a decrease, we drop the negative sign from our answer.
In January, the interest rate is 5 percent and firms borrow $50 billion per month for investment projects. In February, the federal government doubles its monthly borrowing from $25 billion to $50 billion, driving the interest rate up to 7 percent. As a result, firms cut back their borrowing to only $30 billion per month. Which of the following is true? There is a crowding-out effect of $20 billion. There is a crowding-out effect of $25 billion. There is no crowding-out effect because the government's increase in borrowing exceeds firms' decrease in borrowing. There is no crowding-out effect because both the government and firms are still borrowing a lot.
There is a crowding-out effect of $20 billion. There is a crowding-out effect of $20 billion. A crowding-out effect occurs when increased government borrowing drives up interest rates and thereby reduces investment by firms. That is precisely what happens in this scenario, where the government's decision to double its monthly borrowing drives up the interest rate from 5 percent to 7 percent, causing firms to cut back on their investment spending by $20 billion per month (= $50 billion per month at the old 5 percent interest rate − $30 billion per month at the new 7 percent interest rate). Please note that crowding-out effects can offset efforts at deficit-finance stimulus spending. To see why, suppose that the government's intention was to double its borrowing in order to spend money on stimulus projects. Under our current scenario, the strength of the crowding-out effect will mean that much of the government's increase in spending will be offset by a decrease in private-sector spending. In particular, the government's $25 billion increase in spending will be mostly offset by the $20 billion fall in private investment. As a result, there will be only a net $5 billion increase in aggregate expenditures. Knowing that this sort of thing is possible, many economists argue that politicians should be cautious about the potential benefits of debt-financed stimulus programs. Due to the crowding-out effect, government "borrowing and spending" may not be as effective as desired.
the pleasure, happiness, or satisfaction obtained from consuming a good or service:
Utility
The economy's current level of equilibrium GDP is $780 billion. The full-employment level of GDP is $800 billion. The multiplier is 4. Given those facts, we know that the economy faces __________ expenditure gap of __________.
a recessionary; $5 billion The correct answer is that the economy faces a recessionary expenditure gap of $5 billion. This is true because aggregate expenditures would have to be increased (and the aggregate expenditures curve shifted up vertically) by $5 billion in order to get the economy back to the full-employment level of GDP. We know this to be true because with a multiplier of 4 we would need to increase aggregate expenditures by $5 billion in order to close the $20 billion gap between the full-employment level of GDP ($800 billion) and the current equilibrium level of GDP ($780 billion). If the government could increase aggregate expenditures by $5 billion, the multiplier of 4 would increase that $5 billion initial increase in aggregate expenditures into a $20 billion total change in equilibrium GDP.
The graph below is an illustration of the aggregate demand-aggregate supply model. Between 1990 and 2009, the U.S. price level rose by about 64 percent while real output increased by about 62 percent. Use the aggregate demand-aggregate supply model above to describe these outcomes graphically.
a. Aggregate demand would have shifted outward Correct. b. Aggregate supply (short run) would have shifted outward Correct. c. Aggregate demand must have shifted more than Correctthe shift in short-run aggregate supply. Explanation a, b. Both AD and AS expanded over the 1990-2009 period. Increased productivity would cause AS to shift outward. However, since the price level also increased, AD must have shifted outward as well (since an increase in only AS would cause the price level to fall). c. Since both real GDP and the price level increased, the effect of the shift in aggregate demand must have dominated the effect of the shift in short-run aggregate supply. Therefore, aggregate demand must have shifted more than the shift in short-run aggregate supply.
Use the figure to answer the following questions. Assume that the economy initially is operating at price level 120 and real output level $870. This output level is the economy's potential (full-employment) level of output. Next, suppose that the price level rises from 120 to 130.
a. By how much will real output increase in the short run? $ 20 Numeric Response 1.Edit Unavailable. 20 In the long run? $ 0 b. Instead, now assume that the price level drops from 120 to 110. Assuming flexible product and resource prices, by how much will real output fall in the short run? $ 20 In the long run? $ 0 c. What is the long-run level of output at each of the three price levels shown? $ 870 a. In the short run, aggregate supply will increase to $890, which is an increase of $20. The short run is represented by the movement along AS2. In the long run, the aggregate supply schedule will shift upward from AS2 to AS3 as wages adjust. This moves the economy back to the potential (full-employment) level of output $870 at the price level 130. b. In the short run, aggregate supply will fall to $850, which is a decrease of $20. The short run is represented by the movement along AS2. In the long run, the aggregate supply schedule will shift downward from AS2 to AS1 as wages adjust. This moves the economy back to the potential (full-employment) level of output $870 at the price level 110. c. Given the answers above, the long-run level of output is $870 at each of the three price levels.
The two market diagrams below show the market for public and private colleges. How will an increase in state subsidies to public colleges affect the market for public and private colleges?
a. In the market for public colleges: supply will shift to the right b. In the market for private colleges: demand will shift to the left Consider the case of state subsidies to public colleges. The state subsidies to public colleges shift the supply curve for public colleges to the right, thus reducing tuition and increasing enrollments in these institutions. The decreased cost of public college education leads to some substitution away from private colleges, where the enrollment demand curve shifts to the left. The final result is a lower cost of tuition in both public and private colleges.
Because investment and capital goods are paid for with savings, higher savings rates reflect a decision to consume fewer goods in the present and more goods in the future. Households in China save 40 percent of their annual incomes each year, whereas U.S. households save less than 5 percent. At the same time, production possibilities are growing at roughly 7 percent per year in China but only about 3.0 percent in the United States. Use the graphical analysis of "present goods" versus "future goods" to explain the difference between China's growth rate and the U.S. growth rate.
a. Which point, A or B, best represents the combination of present and future goods in the United States? Point A b. Which production possibilities curve best represents future growth in the United States? PPC2 Instructions: For the following questions, use the diagram of the production possibilities for China. c. Which point, A or B, best represents the combination of present and future goods in China? Point B d. Which production possibilities curve best represents future growth in China? PPC3 Since the United States is consuming more today rather than saving, its production possibilities curve will shift out slower (less) over time because households are accumulating less capital. China's production possibilities curve will shift out faster (more) over time because households are accumulating more capital.
The type of inflation that is more likely to be associated with a negative GDP gap is
cost-push inflation Cost-push inflation describes prices rising because of increases in per-unit costs of production. Cost-push inflation is most likely to be associated with a negative GDP gap, as the rising costs of production reduce spending and output.
The type of inflation that is more likely to be associated with a positive GDP gap is
demand-pull inflation. Demand-pull inflation is more likely to occur with a positive GDP gap, because actual GDP will exceed its potential only when aggregate spending is strong and rising. As the economy produces above its potential, bottlenecks and more severe resource scarcity occur, driving up prices.
Because economic resources are used to produce goods and services, they are called
factors of production or inputs
If the slope of the aggregate expenditures schedule is 0.8, and aggregate expenditures decline by $4 billion, real GDP will
fall by $20 billion The ratio of decline in real GDP to the initial drop of expenditures would be a ratio of 5:1. That is, if expenditures decline by $4 billion, GDP should decline by $20 billion.
Suppose that you are a member of the Board of Governors of the Federal Reserve System and the economy is experiencing an 8 percent inflation rate. Unemployment is at the full-employment level and the target interest rate is currently 4 percent. a. If the economy is experiencing a sharp rise in inflation, as a member of the Board of Governors, you would recommend
increasing the federal funds rate To reduce inflation, the federal funds rate should be raised.
To lower the inflation rate to 4 percent, you recommend contracting the money supply,
increasing the reserve ratio, the IOER rate, or the discount rate, or selling bonds. A sharp rise in the inflation rate can be reduced through a contraction of the money supply. This would be accomplished typically through open-market operations (selling bonds), but could also be achieved with an increase in the reserve ratio, IOER rate, or discount rate.
Real GDP equals _________ times _________.
labor input; labor productivity Real GDP equals labor input times labor productivity. As a formula, this relationship is typically expressed as: Real GDP = hours of work × labor productivity. Looking at the formula, we see that the economy's output of goods and services is dependent on two things: how much work is done and how efficient workers are for each hour of work. There are consequently only two ways to increase the economy's overall output of goods and services: increasing the amount of labor input or making workers more efficient. Increasing the amount of labor input is difficult, as it involves things like trying to convince retirees to come out of retirement or attempting to convince existing workers to work longer hours. None of those things are easy. As a result, efforts to increase real GDP tend to focus on making workers more efficient. This is done by giving workers more and better machines to work with and by improving production methods and technologies to increase productivity.
economists classify resources as
labor, land, real capital, and entrepreneurs.
In the two months following the September 11, 2001, attacks on the United States, consumption also declined. This caused a In the two months following the September 11, 2001, attacks on the United States, consumption also declined. This caused a
leftward shift in aggregate demand, and lower investment would have caused a leftward shift in aggregate supply. This event caused a leftward shift in aggregate demand, and lower investment would have caused a leftward shift in aggregate supply.
Use AD-AS analysis to explain the impacts of the following events on real GDP. In early 2001 investment spending sharply declined in the United States. This caused a
leftward shift in aggregate demand, and lower investment would have caused a leftward shift in aggregate supply. This event caused a leftward shift in aggregate demand, and lower investment would have caused a leftward shift in aggregate supply.
economic resources are the
natural, human, and manufactured inputs used to produce goods and services.
Some politicians have suggested that the United States enact a constitutional amendment requiring that the federal government balance its budget annually. Such an amendment, if strictly enforced, would force the government to enact a contractionary fiscal policy whenever the economy experienced a severe recession because
net tax revenue falls and transfer payments rise during a recession, so balancing the budget would require lowering transfer payments and raising taxes. When the economy enters a recession, net tax revenue falls. Specifically, revenues from income and excise taxes decline as unemployment rises and consumer spending falls. At the same time, transfer payments to help the poor and/or unemployed rise. If tax revenue falls and the government is required to balance the budget, it will be forced to either cut spending or increase taxes—both of which are contractionary policies likely to worsen the recession.
The next-best thing that must be forgone in order to produce one more unit of a given product:
opportunity cost
The recommendations you provided above would
reduce the lending ability of the banking system, increase the real interest rate, and reduce investment spending, aggregate demand, and inflation. The restrictive monetary policy would reduce the lending ability of the banking system, increase the real interest rate, reduce investment spending, reduce aggregate demand, and reduce inflation.
If an economy has fully flexible prices, and demand unexpectedly increases, you would expect the economy's real GDP to:
remain the same If an economy has fully flexible prices and demand unexpectedly increases, you would expect the economy's real GDP to remain the same. This is true because with fully flexible prices, the increase in demand will tend to bid up prices for the amount of output that is already being supplied. That amount of output was based on the expectations that firms had before demand unexpectedly increased. In particular, firms chose how many factories to build, how many workers to hire, and how much to produce based on their expectations about what demand would be. So when demand ends up being unexpectedly strong, firms are at least for a while stuck producing what has turned out to be an insufficiently low level of output. In addition, it is often hard for firms to make rapid adjustments to their output levels when demand ends up unexpectedly high. So what is likely to happen in this situation where prices are fully flexible is that prices will rise as the unexpectedly high demand interacts with a level of supply that is fixed in the short run (by the fact that increasing output takes time).
A decrease in the aggregate expenditures schedule will cause a decline in real GDP that is greater than the decline in the aggregate expenditures schedule because
the decrease in the aggregate expenditures schedule is multiplied into a larger change in real GDP. Through the multiplier effect, an initial change in investment spending can cause a magnified change in domestic output and income (because the initial change causes multiple rounds of spending).
which of the following represents a normative economic statement
the government ought to lower taxes so people have more money
The magnitude of the drop in real GDP that occurs when aggregate expenditures fall depends on
the size of the marginal propensity to consume. The size of the multiplier depends on the size of the MPS in the economy: Multiplier = 1/MPS, or 1/(1 − MPC).
which of the following represents a positive economic statement
the unemployment rate is 4.8 percent
A bank currently has $100,000 in checkable deposits and $15,000 in actual reserves. If the reserve ratio is 20 percent, the bank has ________ in money-creating potential. If the reserve ratio is 14 percent, the bank has ________ in money-creating potential.
−$5,000; $1,000 If the reserve ratio is 20 percent, the bank has −$5,000 in money-creating potential. If the reserve ratio is 14 percent, the bank has $1,000 in money-creating potential. To see why this is true, first consider the case where the bank has a reserve ratio of 20 percent. Given that it has $100,000 in checkable deposits, the reserve ratio of 20 percent implies that the bank must keep $20,000 (= 0.20 × $100,000) worth of reserves. But given that it has only $15,000 of actual reserves on hand, the bank is short $5,000 worth of reserves. In order to get that money, the bank will have to reduce the volume of its outstanding loans by $5,000. As it does so, the money supply will be reduced by $5,000 as there will be $5,000 less of checkable-deposit money circulating in the economy. Thus, the bank's current situation of being short $5,000 of reserves implies that its money-creating potential is −$5,000. Next, consider the case where the required reserve ratio is 14 percent. Given that the bank has $100,000 in checkable deposits, this reserve ratio implies that the bank must keep $14,000 (= 0.14 × $100,000) worth of reserves. But the bank's actual reserves of $15,000 exceed that amount by $1,000. Thus, the bank has $1,000 of excess reserves that could be lent out and thereby used to create $1,000 of new checkable-deposit money. Consequently, the bank's money-creating potential in this scenario is $1,000.
