1. Over the past two decades, the United States has

a.  generally had, or been very near to a trade balance.

b.  had trade deficits in about as many years as it has trade surpluses.

c.  persistently had a trade deficit.

d.  persistently had a trade surplus.



2. In the open-economy macroeconomic model, the market for loanable funds identity can be written as

a.  S = I

b.  S = NCO

c.  S = I + NCO

d.  S + I = NCO


Figure 1.






3. Refer to Figure 1 above. Which of the following shifts show the effects of an import quota?

a.  shifting the middle supply curve in panel c to the one to its left.

b.  shifting the demand curve from the right to the left in panel c.

c.  shifting the demand curve from the left to the right in panel c.

d.  None of the above is correct.



4. Refer to Figure 1 above. If the interest rate were initially at r2 and an import quota were imposed, the interest rate would

a.  stay at r2.

b.  decrease because supply would shift right.

c.  increase because supply would shift left.

d.  decrease because demand would shift left.



5. Refer to Figure 1 abvove.  If the economy were initially in equilibrium at r2 and E3 and the government removed import quotas, the exchange rate would

a.  appreciate to E4.

b.  appreciate to E2.

c.  depreciate to E1.

d.  depreciate to E2.


6. Suppose that U.S. citizens start saving more. What does this imply about the supply of loanable funds and the equilibrium real interest rate? What happens to the real exchange rate?



If the US starts saving more, the supply of loanable funds will increase, and the equilibrium real interest rate will fall. Due to the lower interest rate, U.S. net capital outflow rises. This increase makes the supply of dollars shift to the right, and the real exchange rate of the dollar depreciates.





7. Aggregate demand shifts to the left if the money supply decreases. (True or False)


8. Which of the following adjusts to bring aggregate supply and demand into balance?

a.  the price level and real output

b.  the real rate of interest and the money supply

c.  government expenditures and taxes

d.  the saving rate and net exports


9. Other things the same, the aggregate quantity of goods demanded decreases if

a.  real wealth falls.

b.  the interest rate rises.

c.  the dollar appreciates.

d.  All of the above are correct.


10. State at least 4 variables besides real GDP tend to decline during recessions? Given the definition of real GDP, argue that declines in these variables are to be expected.


The variables include employment, sales, income, home purchases.

GDP can be measured either as the production or expenditure of final goods and services. This implies that any variable that can be used to measure production or expenditure for example sales or employment will move in the same direction as the real GDP






11.  Make a list of at least 5 things that would shift the aggregate demand curve to the right.


Examples include:

A stock market boom that increases consumption spending,

A tax cut that increases consumption,

An increase in government expenditure,

Improvements in the capital goods like computers that increase investment,

An increase in economic expansion.

Investment tax credit

An increase in money supply





Figure 2.






12. Refer to Figure 2 above. An increase in the money supply would move the economy from C to

a.  B in the short run and the long run.

b.  D in the short run and the long run.

c.  B in the short run and A in the long run.

d.  D in the short run and C in the long run.

13.  Refer to Figure 2 above. If the economy is at A and there is a fall in aggregate demand, in the short run the economy

a.  stays at A.

b.  moves to B.

c.  moves to C.

d.  moves to D.


14. During recessions which type of spending falls?

a. consumption and investment
b. investment but not consumption
c. consumption but not investment
d. neither consumption nor investment





15. According to the theory of liquidity preference, the money supply

a.         and money demand are positively related to the interest rate.

b.         and money demand are negatively related to the interest rate.

c.         is negatively related to the interest rate while money demand is positively related to the interest rate.

d.         is independent of the interest rate, while money demand is negatively related to the interest rate.



16. The multiplier is computed as MPC/(1 – MPC). (True or False)

Should be 1/(1-MPC)


Figure 3



17.  In Figure 3 above, which of the following sequences shows the logic of the interest rate effect?

a.  1, 2, 3, 4

b.  1, 4, 3, 2

c.  3, 4, 2, 1

d.  3, 2, 1, 4



18. Other things the same, which of the following responses would we expect to result from an decrease in U.S. interest rates?

a.  U.S. citizens decide to hold more foreign bonds.

b.  people choose to hold more currency.

c.  You decide to purchase a new oven for your cookie factory.

d.  All of the above are correct.


19.  What is the difference between monetary policy and fiscal policy?


The difference between monetary policy and fiscal policy is that monetary policy relates to raising or lowering of tax rates and is naturally implemented by a central bank, while fiscal policy are usually the decisions that are set by the national government and relate to taxes and the spending thereof. Nevertheless, both policies may be used to influence the performance of the economy in the short run.





20. Suppose that there are no crowding-out effects and the MPC is .9. By how much must the government increase expenditures to shift the aggregate demand curve to the right by $10 billion?


From the Multiplier formula, we know that 1/(1-MPC). This implies that an MPC of .9 means the multiplier = 1/(1 – .9) = 10. The increase in aggregate demand equals the multiplier times the change in government expenditures. Therefore, the increase in aggregate demand by $10 billion implies that the government would have to increase expenditures by $1 billion.







21. When the Fed increases the money supply, the interest rate decreases. This decrease in the interest rate increases consumption and investment demand so the aggregate demand curve shifts to the right. (True or False)




22.    The misery index is calculated as the

a.  inflation rate plus the unemployment rate.

b.  unemployment rate minus the inflation rate.

c.  actual inflation rate minus the expected inflation rate.

d.  natural unemployment rate plus the long-run inflation rate.


23.    In the long run,

a.  the natural rate of unemployment depends primarily on the level of aggregate demand.

b.  inflation depends primarily upon the money supply growth rate.

c.  there is a tradeoff between the inflation rate and the natural rate of unemployment.

d.  All of the above are correct.


24.    In the short run, policy that changes aggregate demand changes

a.  both unemployment and the price level.

b.  neither unemployment nor the price level.

c.  only unemployment.

d.  only the price level.





Figure 4.



25. Refer to Figure 4 above. If the economy starts at c (left graph) and 1(right graph), then in the short run, an increase in government expenditures moves the economy to

a.  b and 2.

b.  b and 3.

c.  d and 3.

d.  None of the above is correct.


26 . Refer to Figure 4 above. If the economy starts at c (left graph) and 1(right graph), then in the short run, a decrease in aggregate demand moves the economy to

a.  a and 2.

b.  d and 3.

c.  e and 3.

d.  None of the above is correct.



27.  If macroeconomic policy expands aggregate demand, unemployment will fall and inflation will rise in the short run. (True or False)


28. Suppose that the Fed unexpectedly pursues contractionary monetary policy. What will happen to unemployment in the short run? What will happen to unemployment in the long run?


If the Fed unexpectedly pursues contractionary monetary policy, then in the short run, unemployment will increase as the policy reduces actual inflation thus moving the economy down the Philips curve. However, in the long run, the economy will have returned to its normal rate of unemployment and thus the Philips curve will shift to the left as inflation expectations fall.








29. President George W. Bush and congress cut taxes and raised government expenditures in 2003. According to the aggregate supply and aggregate demand model

a.  both the tax cut and the increase in government expenditures would tend to increase output.

b.  only the tax cut would tend to increase output.

c.  only the increase in government expenditures would tend to increase output.

d.  neither the tax cut nor the increase in government expenditures would tend to increase output.


30.  If the unemployment rate rises, which policies would be appropriate to reduce it?

a.  increase the money supply, increase taxes

b.  increase the money supply, cut taxes

c.  decrease the money supply, increase taxes

d.  decrease the money supply, cut taxes


31. Explain the main arguments in favor of economic stabilization.



Fluctuations in the economy during recessions and booms are very costly. Especially during recession, a lot of resources are wasted since people and machines are inoperative instead of producing goods and/or services. This means that stabilization policies can help in eliminating these wastes.







32. Which of the programs below would transfer wealth from the young to the old?

a.  Taxes are raised to provide better education.

b.  Taxes are raised to improve government infrastructure such as roads and bridges.

c.  Taxes are raised to provide more generous Social Security benefits.

d.  None of the above transfer wealth form the young to the old.


33. Some countries have had high inflation for a long time. Others have had low or moderate inflation for a long time. Which of the following, at least in theory, could explain why some countries would continue to have high inflation?

a.  High inflation countries have relatively small sacrifice ratios and so see no need to reduce inflation.

b.  Inflation reduction works best when it is unexpected, and people in high inflation countries would quickly anticipate any change in monetary policy.

c.  In a country where inflation has been high for a long time, people are likely to have found ways to limit the costs.

d.  All of the above are correct.

34.  A consumption tax is a tax strictly on spending, while an income tax is a tax on salary paid for work. You are contemplating a run for the presidency in 2012 and some of your economic advisors have argued that you should campaign to replace the income tax with a consumption tax.  What argument for a consumption tax might they put forward to you?


  • We have to compare the two types of taxes.
  • In comparing the income tax, a consumption tax would place a levy on money spent on goods and services.
  • By levying a consumption tax, the Fed government will expand its tax base by capturing the money spent by all segments of the society including corporations, individuals especially the rich who seem to spend more.
  • A consumption tax will also reduce the number of tax evaders by placing a tax on transactions as opposed to income.
  • This type of tax will also simplify the current cumbersome system meaning that it will accomplish the much needed tax reform as well as enable the elimination of tax shelters and eliminate tax evasion.
  • Under the consumption tax, we will see that personal savings being excluded from the taxable base while the savings would encourage economic growth and help stabilize the economy


























EC1. Suppose that the government increases expenditures by $150 billion while increasing taxes by $150 billion. Suppose that the MPC is .80 and that there are no crowding out or accelerator effects.


  1. What is the combined effects of these changes? Why is the combined change not equal to zero?  Hint: Calculate the Multiplier and apply it to obtain a multiplier effect




We will use the multiplier formula, 1/(1-MPC).

Therefore, 1/(1-MPC) = 1/(1-.8) = 1/.2 = 5.

This means that an increase of $150 billion in the government expenditures will result to a shift of $750 billion ($150b * 5) in aggregate demand.  The increase in taxes will decrease income by $150 billion and so the initial decrease consumption of $150 billion * MPC will be: $150 billion * 0.8 = $120 billion and the multiplier effect created will be $120 billion * 5 = $600 billion. This basically means that the net change will be $750 billion –  $600 billion = $150 billion.

This implies that the changes do not cancel each other out because a tax increase will decrease consumption by less than the increase in tax.






  1. Using the IS-LM framework, sketch a graph that would indicate the fiscal policy initiative’s impact on equilibrium interest (r)  and income (Y) and suggest what, if any, monetary policy could the Federal Reserve implement to accommodate the government expenditure increase.


Figure 1









The IS-LM model determines the equilibrium interest rate as well.

The IS curve shifts right if there is: an increase in Co + Io + G, or a decrease in T

V The LM curve shifts right if: M/P or Eπ increases, or Lo decreases









EC2.          Fill in the table below with the direction of the variables that change in response to the events in the first column.


Event (1st Column)


U.S. real

interest rate


U.S. domestic



U.S. net



U.S. real

exchange rate

of domestic



U.S. trade


U.S. government

budget deficit


Rises Falls Falls Appreciates Falls
U.S. imposes

import quotas


No change No change No change Appreciates No change
capital flight

from the United


Rises Falls Rises Depreciates Rises




EC3. Economist John Taylor has suggested that the Fed use the following rule for chosing its target for the federal funds interest rate (r):




Where π  is the average of the inflation rate over the past year, y is real GDP as recently measured, y* is an estimate of the natural rate of output, and π* is the Fed’s goal for inflation.


  1. a.  Explain the logic that might lie behind this rule for setting interest rates. Would you support the Fed’s use of this rule?



The John Taylor rule is to basically help the Fed government to adjust its interest rates accordingly to adjust and balance out inflation. The above rule is an interest rate forecasting model that Taylor suggested should be used to determine interest rates by the Fed based on the country’s rational expectations theory. The equation basically says that the nominal and real interest rate is inflation and as such real interest rates should be factored in inflation.
b. Some economists advocate such a rule for monetary policy but believe p  and y should be the forecasts of future values of inflation and output. What are the advantages of using forecasts instead of actual values?  What are the disadvantages?


Since the federal funds rate is determined in a market, manipulation of that rate by the authorities presents a problem in that they will have difficulty determining whether a particular movement in the rate was a result of their actions or a consequence of market forces. This implies that they cannot be sure precisely how much of an observed change was policy-induced.

Moreover, quite aside from this problem, high nominal interest rates do not necessarily imply that money is tight but may be an indication that the expected future inflation rate is high.

According to this model, the advantage is that the nominal interest rate should respond to divergences of actual inflation rates from target inflation rates.

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