Macroeconomics, 8th Edition by Olivier Blanchard All Chapters 1-24 With Appendix (1 2 3) TEST BANK

TEST BANK Macroeconomics, 8th Edition by Olivier Blanchard | Chapters TestAll Bank For 1-24 With Appendix (1 2 3) Macroeconomics, 8th Edition Olivier Blanchard Chapter 1-24 With Appendix (1 2 3) Chapter 1: A Tour of the World 1.1 The Crisis 1) The most recent financial crisis started in A) stock market.

B) bond market.

C) foreign exchange market.

D) housing market.

Answer: D Diff: 2 2) Briefly explain why the decline in housing prices led to a major financial crisis.

Answer: Many of the mortgage loans that had been given out during earlier expansion were of poor quality. Many of the borrowers had taken too large a loan and were increasingly unable to make mortgage payments. mortgage backed securities were so complex that their value was nearly impossible to assess. Not knowing the quality of the assets that other banks had on their balance sheet, banks became very reluctant to lend to each other for fear that the bank to which they lent might not be able to repay. The credit market froze up. Unable to borrow, and with assets if uncertain value, many banks found them in trouble. The bankruptcy of Lehman Brothers put other banks at risk of going bankrupt as well. The whole financial system was in trouble.

Diff: 2 3) Explain how the financial crisis turned into a major economic crisis.

Answer: Hit by the decrease in housing prices and the collapse in stock prices, and worried that this might be the beginning of another Great Depression, people sharply cut back consumption.

Worried about sales and uncertain about the future, firms sharply cut back investment. Decreases in consumption and investment led to decrease in demand, which in turn, led to decrease in output.

Diff: 2 4) Explain why the U.S. crisis became a world crisis.

Answer: Other countries were affected through two channels. The first channel was trade. As U.S. consumers and firms cut spending, part of the decrease fell on imports of foreign goods. The second channel was financial. U.S. banks, badly needing funds in the United States, repatriated from other countries, creating problems for banks in those countries. The result was not just a U.S., but a world recession.

Diff: 2 5) What problems remain in advanced countries after the crisis?

Answer: Both in the United States and the Euro area, unemployment remains very high. What is behind this persistently high unemployment is low output growth, and behind this low growth are many factors like declining housing prices and low housing investment. Banks are still not in good shape, and bank lending is still tight. Consumers are cutting consumption. And the crisis has led to a large increase in budget deficits, which have in turn led to a large increase in public debt over 1 Copyright © 2021 Pearson Education, Inc.

time. Countries must now reduce their deficits, and this is proving difficult. In some European countries, governments may not be able to adjust and may default on their debt.

Diff: 2 1.2

The United States

1) In 2018, output per capita in the United States was approximately equal to A) $15,500.

B) $25,800.

C) $43,800.

D) $62,500.

Answer: D Diff: 2 2) The standard of living typically refers to A) the rate of unemployment.

B) output per capita.

C) wealth per capita.

D) all of these Answer: B Diff: 1 3) In 2018 , the U.S. GDP accounts for ________ of world output.

A) 20% B) 24% C) 45% D) 50% Answer: B Diff: 1 4) In 2018, the unemployment in the U.S. was A) 5%.

B) 11%.

C) 3.7%.

D) 4.6%.

Answer: C Diff: 2 5) Inflation represents A) an increase in output.

B) an increase in the aggregate price level.

C) an increase in the unemployment rate.

D) a recession.

Answer: B Diff: 1 1.3

The Euro area 2 Copyright © 2021 Pearson Education, Inc.

1) Economists have suggested that the relatively higher unemployment in Europe has been caused by which of the following?

A) relatively high unemployment benefits B) relatively high level of worker protection C) inadequate macroeconomic policies D) increased labor costs E) all of these Answer: E Diff: 2 2) Which of the following countries had the lowest level of output per capita in 2018?

A) Spain B) France C) Italy D) German Answer: A Diff: 2 3) How many countries are in the European Union?

A) 27 B) 6 C) 21 D) 17 Answer: A Diff: 2 4) How many countries are in the Euro area?

A) 19 B) 27 C) 21 D) 11 Answer: A Diff: 2 5) Some economists believe that the source of European high unemployment in the past two decades is A) labor market rigidities.

B) tight monetary policy.

C) tight fiscal policy.

D) financial crisis.

Answer: A Diff: 2 6) Discuss the types of policies that could be implemented to reduce European unemployment.

Answer: There are basically two sets of policies. First, policy makers could reduce labor market rigidities that some economists believe have contributed to the high unemployment. Some examples of labor market rigidities are high unemployment benefits, high minimum wages, and excessive job protection regulations. The second set of policies includes bad labor relations and 3 Copyright © 2021 Pearson Education, Inc.

inadequate macroeconomic policies.

Diff: 2 7) Discuss what is meant by labor market rigidities and explain how they might cause the relatively high unemployment in Europe.

Answer: Examples of labor market rigidities are: relatively high minimum wage, relatively high unemployment benefits, and relatively high level of worker protection. All three of these are hypothesized to cause a reduction in employment and, therefore, an increase in the unemployment rate.

Diff: 2 8) Discuss some of the potential benefits and costs of the adoption of the Euro.

Answer: One of the benefits of the Euro is largely symbolic. Countries that have in the past century been in wars against each other are now using the same currency. There are economic benefits as well. The use of the same currency will eliminate the need to convert currencies when, for example, buying foreign goods from a country that has also adopted the Euro. One of the possible costs of the Euro is that it will force countries to pursue the same monetary policy. No longer will policy makers in these countries pursue independent monetary policy.

Diff: 2 1.4

China

1) In 2018, output per capita in China was approximately equal to A) $2,100.

B) $9,700.

C) $22,100.

D) $32,100.

Answer: B Diff: 2 2) Between 2010 and 2017 the annual rate of output growth in China was approximately equal to A) 2%.

B) 5%.

C) 8%.

D) 20%.

Answer: C Diff: 2 3) Which of the following explains the relatively high growth rate of output in China since 1980?

A) accumulation of capital B) technological progress C) a transition from central planning to a market economy D) all of these Answer: C Diff: 2 4) What are the two primary sources of economic growth in China since 1980?

Answer: The relatively high output growth in China has occurred as a result of capital 4 Copyright © 2021 Pearson Education, Inc.

accumulation and technological progress.

Diff: 1 5) In addition to capital accumulation and technological progress, what are some of the other possible explanations for recent output growth in China?

Answer: There are several additional potential causes of economic growth in China. These are: (1) the transition from central planning to a market economy; (2) the encouragement of joint ventures with foreign firms; and (3) protection of property rights.

Diff: 2 1.5

Looking Ahead

1) Which of the following countries has a population of 1,330 million?

A) India B) Japan C) China D) Brazil Answer: A Diff: 1

5 Copyright © 2021 Pearson Education, Inc.

Macroeconomics, 8e (Blanchard) Chapter 2: A Tour of the Book 2.1

Aggregate Output

1) Fill in the blank for the following: GDP is the value of all ________ produced in a given period.

A) final and intermediate goods and services produced by the private sector only B) final goods and services C) final and intermediate goods and services, plus raw materials D) all of these E) none of these Answer: B Diff: 1 2) When using the income approach to measure GDP, the largest share of GDP generally consists of A) interest income.

B) labor income.

C) indirect taxes.

D) profits.

E) capital income.

Answer: B Diff: 1 3) For this question, assume that 1980 is the base year. Given macroeconomic conditions in the United States over the past three decades, we know that A) nominal GDP is always smaller than real GDP since 1980.

B) real GDP and nominal GDP would be equal for the entire period.

C) real GDP is larger than nominal GDP from 2002 to 2008.

D) real GDP and nominal GDP were equal in 1980.

E) none of these Answer: D Diff: 2 4) Suppose nominal GDP increased in a given year. Based on this information, we know with certainty that A) real output has increased.

B) the price level (GDP deflator) has increased.

C) real output and the price level (GDP deflator) have both increased.

D) either real output or the price level (GDP deflator) have increased.

E) real output has increased and the price level has decreased.

Answer: D Diff: 2

6 Copyright © 2021 Pearson Education, Inc.

5) Use the following information to answer this question. If nominal GDP rises from $100 trillion to $120 trillion, while the GDP deflator rises from 2.0 to 2.2, the percentage change in real GDP is approximately equal to A) -10%.

B) 10%.

C) 20%.

D) 9.1%.

E) 0%.

Answer: D Diff: 2 6) Hedonic pricing is A) the way that luxury goods are priced in a market economy.

B) the tendency for the inflation rate to rise by greater and greater amounts.

C) the tendency for nominal GDP to rise when the price level rises.

D) the process of translating nominal GDP into real GDP. E) the process of pricing individual characteristics of a good or service.

Answer: E Diff: 1 7) In a given year, suppose a company spends $100 million on intermediate goods and $200 million on wages, with no other expenses. Also assume that its total sales are $800 million. The value added by this company equals A) $200 million.

B) $300 million.

C) $500 million.

D) $700 million.

E) $800 million.

Answer: D Diff: 2 8) A firm's value added equals A) its revenue minus all of its costs.

B) its revenue minus its wages.

C) its revenue minus its wages and profit.

D) its revenue minus its cost of intermediate goods.

E) none of these Answer: D Diff: 2 9) Deflation generally occurs when which of the following occurs?

A) the consumer price index is greater than the GDP deflator B) the consumer price index decreases C) the rate of inflation falls, for example, from 4% to 2% D) nominal GDP does not change Answer: B Diff: 1 7 Copyright © 2021 Pearson Education, Inc.

10) During the mid-1980s, we observed a significant reduction in oil prices. In the United States, we would expect that this reduction in oil prices would cause A) a larger reduction in the CPI compared to the GDP deflator.

B) an equal reduction in the CPI and GDP deflator.

C) a larger reduction in the GDP deflator compared to the CPI. D) no change in the CPI and a reduction in the GDP deflator.

Answer: A Diff: 2 11) Suppose nominal GDP in 2009 does not change (compared its previous level in 2008). Given this information, we know with certainty that A) real GDP increased during 2009.

B) the GDP deflator increased during 2009.

C) both the GDP deflator and real GDP fell during 2009.

D) more information is needed to answer this question.

Answer: D Diff: 2 12) During the late 1990s, Japan experienced reductions in the GDP deflator. Given this information, we know with certainty that A) real GDP fell during these periods.

B) real GDP did not change during these periods.

C) the overall price level in Japan decreased during these periods.

D) both real GDP and the overall price level decreased during these periods.

Answer: C Diff: 2 13) Hedonic pricing is used to A) convert nominal values to real values.

B) calculate the difference between nominal GDP and real GDP. C) measure the rate of change in real GDP. D) obtain chain-weight indexes.

E) none of these Answer: E Diff: 1 14) GDP in current dollars is equivalent to which of the following?

A) real GDP B) GDP in terms of goods C) GDP in 2000 dollars D) GDP in constant dollars E) none of these Answer: E Diff: 1

8 Copyright © 2021 Pearson Education, Inc.

15) Which of the following does not represent real GDP? A) GDP in current dollars B) GDP in terms of goods C) GDP in base year dollars D) GDP in constant dollars Answer: A Diff: 1 16) Which of the following represents real GDP? A) GDP in constant dollars B) GDP in terms of goods C) GDP in base year dollars D) all of these Answer: A Diff: 1 17) According to convention, a recession is referred to if an economy goes through A) at least two consecutive quarters of negative growth.

B) at least three consecutive quarters of negative growth.

C) at least four quarters of negative growth.

D) at least two consecutive months of negative growth.

Answer: A Diff: 1 18) Based on the notation presented in Chapter 2, which of the following expressions represents real GDP? A) Yt B) PtYt C) Yt/Pt D) $Yt/Pt Answer: A Diff: 1 19) Measures of aggregate output have been published on a regular basis in the United States since A) 1947.

B) 1933.

C) 1917.

D) 1946.

Answer: A Diff: 1

9 Copyright © 2021 Pearson Education, Inc.

20) Which of the following about capital income is not correct?

A) It refers to a firm's revenue.

B) It is also called profit income.

C) It goes to the firms.

D) It accounts for less than 35% of income in advanced countries.

Answer: A Diff: 1 21) Explain the three ways GDP can be measured.

Answer: GDP can be measured three ways. First, GDP represents the market value of the final goods and services produced in the economy during a given period. This would be obtained by adding C, I, G, and NX. Second, GDP is the sum of the value added by firms. The value added for a firm equals the value of the production (at that stage of the production process) minus the value of the intermediate goods (excluding labor services). The final value of aggregate output can be calculated by either summing the value of all final goods and services OR by summing the value added of all goods and services at each stage of production. And finally, GDP is also the sum of all incomes earned in a given period.

Diff: 1 22) First, define nominal GDP and real GDP. Second, is it possible for nominal GDP in a year to be less than real GDP in the same year? Explain.

Answer: Nominal GDP represents the value of goods and services produced using current prices.

Real GDP measures the value of the same goods and services using some base year prices. It is possible for nominal GDP to be less than real GDP in a given year. Given the definitions of the two variables, this will occur if prices in that year are simply less than prices in the base year. If, for example, the base year is 2002, it will generally be the case that nominal GDP will be less than real GDP for those years prior to 2002 given that prices have generally risen in all years.

Diff: 2 23) Explain whether it is possible for nominal GDP to increase and real GDP to decrease in the same period.

Answer: Nominal GDP can rise because either the price level is rising or the real quantity of goods and services produced has increased. Nominal GDP can increase while real GDP falls if the increase in the aggregate price level is larger (in a proportionate sense) than the drop in real economic activity.

Diff: 2

10 Copyright © 2021 Pearson Education, Inc.

2.2

The Unemployment Rate

1) Suppose you are provided with the following data for your country for a particular month: 200 million people are working, 20 million are not working but are looking for work, and 40 million are not working and have given up looking for work. The official unemployment rate for that month is A) 7.7%.

B) 9.1%.

C) 10%.

D) 23%.

E) 30%.

Answer: B Diff: 1 2) In the United States, someone is classified as unemployed if he or she A) does not have a job.

B) does not have a job, or else has a job but is looking for a different one while continuing to work.

C) does not have a job, has recently looked for work, and is collecting unemployment insurance.

D) does not have a job, and is collecting unemployment insurance.

E) none of these Answer: E Diff: 1 3) An individual is said to be a discouraged worker if he or she A) is working, but prefers not to work.

B) is working part time, but would prefer a full time job.

C) is working in jobs she/he is not suited for.

D) wants to work, and is actively searching for a job.

E) wants to work, but has given up searching for a job.

Answer: E Diff: 1 4) Which of the following tends to occur when the unemployment rate increases?

A) a reduction in the labor force participation rate B) a reduction in the number of discouraged workers C) an increase in the number of employed workers D) all of these E) none of these Answer: A Diff: 1

11 Copyright © 2021 Pearson Education, Inc.

5) Labor income's share in an advanced country is likely to be A) 70%.

B) 45%.

C) 29%.

D) 10%.

E) none of these Answer: A Diff: 2 6) The labor force in the United States is defined as A) the total number of individuals who are employed.

B) the sum of the total number of individuals who are employed and the officially unemployed.

C) the sum of the total number of individuals who are employed, the officially unemployed, and discouraged workers.

D) the total number of individuals who are 16 years old and older, but not retired.

E) none of these Answer: B Diff: 1 Use the information provided below to answer the following question(s).

Suppose a country using the United States' system of calculating official unemployment statistics has 100 million people, of whom 50 million are working age. Of these 50 million, 20 million have jobs. Of the remainder: 10 million are actively searching for jobs; 10 million would like jobs but are not searching; and 10 million do not want jobs at all.

7) Refer to the information above. The labor force is A) 20 million.

B) 40 million.

C) 60 million.

D) 80 million.

E) 100 million.

Answer: C Diff: 2 8) Refer to the information above. The labor force participation rate is A) .2.

B) .3.

C) .4.

D) .6.

E) .8.

Answer: D Diff: 2

12 Copyright © 2021 Pearson Education, Inc.

9) Refer to the information above. The official unemployment rate is A) .1.

B) .2.

C) .33.

D) .4.

E) .66.

Answer: C Diff: 2 10) Macroeconomists are concerned about changes in the unemployment rate because changes in the unemployment rate provide information about A) the state of the economy.

B) the welfare of those who are unemployed.

C) none of these D) the state of the economy and the welfare of those who are unemployed.

Answer: D Diff: 1 11) Explain the difference between the unemployment rate and the participation rate.

Answer: The unemployment rate is the percentage of the labor force (those employed and unemployed) that is unemployed. The participation rate is the percentage of the working age population that is in the labor force.

Diff: 2 12) Explain how the existence of discouraged workers alters the extent to which the official unemployment provides an accurate measure of the use of labor resources.

Answer: Discouraged workers are those individuals who have decided to stop searching for employment because they have become "discouraged" about employment opportunities. At some point, these individuals will no longer be considered as part of the labor force. The existence of discouraged workers will cause the official unemployment rate to provide an under-estimate of the underutilization of labor.

Diff: 2 13) Briefly explain why the reported official unemployment rate in Spain in 1994 may have provided an over-estimate of unemployment in Spain.

Answer: The relatively high unemployment rate in Spain is partly the result of a relatively large underground economy. The underground economy is that part of the economy which is not measured in official statistics. After taking into account those individuals who are "employed" in the underground economy, the unemployment rate in Spain would have been lower (but still relatively high).

Diff: 2 14) What are the social and economic implications of unemployment? Explain.

Answer: Economic implications: signal of economic activity and measure of the utilization of labor. Social implications: the emotional and psychological suffering that occurs as a result of being unemployed.

Diff: 2 13 Copyright © 2021 Pearson Education, Inc.

15) Explain why economists care about unemployment.

Answer: First, they care about unemployment because of its direct effect on the welfare of the unemployed. Unemployment is often associated with financial and psychological suffering.

Second, they care about unemployment because it provides a signal that the economy may not be using some of its resources efficiently.

Diff: 2 2.3

The Inflation Rate

1) The GDP deflator provides a measure of which of the following?

A) the ratio of GDP to the size of the population B) the ratio of GDP to the number of workers employed C) the ratio of nominal GDP to real GDP D) the price of a typical consumer's basket of goods E) real GDP divided by the aggregate price level Answer: C Diff: 1 2) Which of the following calculations will yield the correct measure of real GDP? A) divide nominal GDP by the consumer price index B) divide the GDP deflator by the consumer price index C) multiply nominal GDP by the consumer price index D) multiply nominal GDP by the GDP deflator E) none of these Answer: E Diff: 2 3) The prices for which of the following goods are included in both the GDP deflator and the consumer price index?

A) goods bought by households B) goods bought by firms C) good bought by governments D) goods bought by foreign households (i.e., exports) E) all of these Answer: A Diff: 2 4) Suppose we switch the base year from 2000 to 2008. This change in the base year will cause A) nominal GDP in every year to increase.

B) nominal GDP in every year to decrease.

C) both nominal and real GDP in every year to decrease.

D) real GDP in every year to decrease.

E) none of these Answer: E Diff: 2 14 Copyright © 2021 Pearson Education, Inc.

5) Pure inflation occurs when A) nominal wages rise faster than all prices.

B) all prices rise faster than nominal wages.

C) all prices and nominal wages rise by the same percentage.

D) the GDP deflator and Consumer Price Index rise by the same percentage.

E) none of these Answer: C Diff: 2 6) One of the reasons macroeconomists have concerns about inflation is that inflation causes A) real GDP to rise.

B) nominal GDP to fall.

C) wages to rise as fast as prices.

D) real GDP to exceed nominal GDP. E) none of these Answer: E Diff: 1 7) Which of the following prices will be used when calculating the rate of growth of real GDP between the year's 2005 and 2006 using the chain method?

A) prices in the base year (2002) B) prices in 2005 C) prices in 2006 D) the average of prices in 2005 and 2006 E) prices in 2005, 2006, and in 2002 (the base year) Answer: D Diff: 2 8) Which of the following factors is not believed to affect output in the long run?

A) technology B) monetary policy C) the size of the labor force D) the capital stock Answer: B Diff: 1 9) Prices for which of the following are included in the GDP deflator, but not included in the Consumer Price Index?

A) firms' purchases of new equipment B) intermediate goods and services C) consumption of goods D) consumption of services Answer: A Diff: 1

15 Copyright © 2021 Pearson Education, Inc.

10) Based on the notation presented in Chapter 2, which of the following expressions represents nominal GDP? A) Yt B) PtYt C) Yt/Pt D) $Yt/Pt Answer: B Diff: 1 11) Will the CPI and GDP deflator always move together? Explain.

Answer: No they will not. Some of the goods included in the GDP deflator (some investment goods) are not included in the CPI. Some of the goods included in the CPI (foreign goods) are not included in the GDP deflator.

Diff: 2 12) Explain how inflation can lead to distortions.

Answer: First, not all prices and wages adjust automatically when inflation occurs. Second, variations in relative prices (which occur when there is not pure inflation) can lead to uncertainty.

Inflation can also lead to distortions if the tax system is not adjusted when inflation occurs (e.g. nominal income tax brackets).

Diff: 2 13) Explain why economists care about inflation.

Answer: Inflation will cause relative prices to change. It will also cause changes in the distribution of income. Inflation will lead to other distortions such as tax distortions and uncertainty.

Diff: 2 2.4

Output, Unemployment, and the Inflation Rate: Okun's Law and the Phillips Curve

1) The Okun's law shows the relationship between A) inflation and unemployment rate.

B) output growth and unemployment.

C) inflation and output growth.

D) output growth and money supply.

Answer: B Diff: 2 2) The Phillips curve describes the relationship between A) output growth and unemployment.

B) inflation and output growth.

C) output growth and money supply.

D) inflation and unemployment .

Answer: D Diff: 2

16 Copyright © 2021 Pearson Education, Inc.

3) Which of the following about the Phillips curve is not correct?

A) It shows the relation between GDP growth and unemployment.

B) It has been redefined as a relation between the change in the rate of inflation and the unemployment rate.

C) It was first explored by A. W. Phillips.

D) The curve is downward sloping.

Answer: A Diff: 1 4) Explain Okun's Law. Answer: It shows the relationship between GDP growth and unemployment rate. If output growth is high, unemployment will decrease.

Diff: 1 5) Explain the Phillips curve.

Answer: It shows the negative relationship between inflation rate and unemployment rate. After 1970s, it was redefined as the relationship between the change in the rate of inflation and the unemployment rate.

Diff: 1 6) Explain why the Phillips curve on average is downward sloping.

Answer: When unemployment becomes very low, the economy is likely to overheat and this will lead to upward pressure on inflation.

Diff: 2 7) Can an economy maintain high output growth, low unemployment, and low inflation at the the same time? Explain.

Answer: It would be very hard to achieve the three objectives at the same time. High output growth leads to low unemployment, which is likely to put pressure on inflation.

Diff: 2 2.5

The Short Run, the Medium Run, and the Long Run

1) Changes in GDP in the short run are caused primarily by A) demand factors.

B) supply factors.

C) technology.

D) capital accumulation.

E) all of these Answer: A Diff: 2

17 Copyright © 2021 Pearson Education, Inc.

2) Changes in GDP in the medium run are determined primarily by A) demand factors.

B) supply factors.

C) monetary policy.

D) all of these Answer: B Diff: 2 3) Changes in GDP in the long run are determined primarily by A) monetary policy.

B) fiscal policy.

C) demand.

D) all of these E) none of these Answer: E Diff: 2 4) Explain what factors cause changes in output in: (1) the short run; (2) medium run; and (3) long run.

Answer: In the short run, demand factors primarily cause changes in output. In the medium run, factors such as the technology, amount of capital, and the skill and size of the labor force (supply factors) affect output. And in the long run, the education system, saving rate, and role of government affect economic activity.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 3: The Goods Market 3.1

The Composition of GDP

1) For the U.S. economy, which of the following represents the largest component of GDP? A) imports B) investment C) government spending D) exports E) none of these Answer: E Diff: 1 2) Which of the following types of government spending is included when calculating GDP? A) spending at the federal level B) spending at the state level C) spending at the municipal level D) all of these E) spending at the federal and sate level Answer: D Diff: 1 18 Copyright © 2021 Pearson Education, Inc.

3) Which of the following would not be considered part of fixed investment spending (I)?

A) Toyota buys a new robot for its automobile assembly line.

B) Apple computer builds a new factory.

C) Exxon increases its inventories of unsold gasoline.

D) An accountant buys a newly built home for herself and her family.

E) all of these Answer: C Diff: 1 4) Which of the following is true for a "closed economy"?

A) government spending equals taxes B) there are no imports or exports C) exports equal imports D) there is no saving E) there is no government spending or taxes Answer: B Diff: 1

19 Copyright © 2021 Pearson Education, Inc.

5) Which of the following is an exogenous variable in our model of the goods market in Chapter 3?

A) consumption (C) B) saving (S) C) disposable income (YD) D) government spending (G) E) none of these Answer: D Diff: 2 6) Which of the following is an endogenous variable in our model of the goods market in Chapter 3?

A) consumption (C) B) disposable income (YD) C) saving (S) D) total income (Y) E) all of these Answer: E Diff: 2 7) Discuss the two components of fixed investment.

Answer: Nonresidential investment represents the purchase of new equipment and structures.

Residential investment represents the purchase by people of new homes, condos, and apartments.

Diff: 1 3.2

The Demand for Goods

1) Disposable income equals A) income minus saving.

B) income minus both saving and taxes.

C) consumption minus taxes.

D) the sum of consumption and saving.

E) none of these Answer: D Diff: 1 2) The marginal propensity to consume represents A) the level of consumption that occurs if disposable income is zero.

B) the ratio of total consumption to disposable income.

C) total income minus total taxes.

D) the change in output caused by a one-unit change in autonomous demand.

E) the change in consumption caused by a one-unit change in disposable income.

Answer: E Diff: 1

20 Copyright © 2021 Pearson Education, Inc.

3) Let the consumption function be represented by the following equation: C = c0 + c1YD. For this equation, we assume that c1 is A) negative.

B) larger than c0.

C) different at different levels of income.

D) equal to one.

E) none of these Answer: E Diff: 1 4) Suppose the consumption equation is represented by the following: C = 250 + .75YD. The multiplier in this economy is A) .25.

B) .75.

C) 1.

D) 4.

E) 5.

Answer: D Diff: 2 5) Suppose the consumption equation is represented by the following: C = 250 + .75YD. Given this information, the marginal propensity to save is A) .25.

B) .7.

C) 1.

D) 4.

E) none of these Answer: A Diff: 2 6) Which of the following occurs when disposable income is zero?

A) consumption must be zero B) saving must be zero C) saving must be positive D) consumption is negative E) none of these Answer: E Diff: 2

21 Copyright © 2021 Pearson Education, Inc.

3.3

The Determination of Equilibrium Output

1) Equilibrium in the goods market requires that A) production equals income.

B) production equals demand.

C) consumption equals saving.

D) consumption equals income.

E) government spending equals taxes minus transfers.

Answer: B Diff: 1 2) An economy is in equilibrium when which of the following conditions is satisfied?

A) consumption equals saving B) output equals consumption C) total saving equals zero D) total saving equals investment E) all of these Answer: D Diff: 1 3) Which of the following is included in G? A) medicare B) social security payments C) interest payments on the government debt D) government purchases E) all of these Answer: D Diff: 2 4) Suppose the consumption equation is represented by the following: C = 250 + .8YD. The multiplier for the above economy equals A) 2.

B) 3.

C) 4.

D) 5.

E) none of these Answer: D Diff: 2

22 Copyright © 2021 Pearson Education, Inc.

5) Suppose the consumption equation is represented by the following: C = 250 + .75YD. Now assume government spending increases by 100 for the above economy. Given the above information, we know that equilibrium output will increase by A) 200.

B) 400.

C) 800.

D) 1000.

E) none of these Answer: B Diff: 2 6) Which of the following will not increase equilibrium output in the short run?

A) increases in R&D B) increases in consumer confidence C) increases in investment demand D) increases in government spending E) decreases in taxes Answer: A Diff: 2 7) Which of the following would tend to make the multiplier smaller?

A) an increase in the marginal propensity to consume B) an increase in the marginal propensity to save C) a reduction in taxes D) a reduction in government spending E) none of these Answer: B Diff: 2 8) Which of the following represents total saving for an economy?

A) the sum of private saving and fixed investment B) the sum of private saving and consumption C) the sum of taxes and government spending D) the excess of taxes over government spending E) none of these Answer: E Diff: 1 9) Which of the following events will cause a reduction in equilibrium output?

A) an increase in the marginal propensity to save B) an increase in taxes C) a reduction in the marginal propensity to consume D) all of these E) none of these Answer: D Diff: 2 23 Copyright © 2021 Pearson Education, Inc.

10) Based on our understanding of consumption and saving, we know that the marginal propensity to consume and the marginal propensity to save must A) be equal to each other.

B) sum to exactly one.

C) sum to less than one.

D) sum to more than one.

E) be equal to the multiplier.

Answer: B Diff: 1 11) Suppose there is an increase in autonomous consumption. Specifically, suppose c0 increases where C = c0 + c1YD. This increase in autonomous consumption will cause which of the following to increase?

A) equilibrium income B) equilibrium disposable income C) demand D) all of these E) none of these Answer: D Diff: 2 12) If C = 2000 + .9YD, what increase in government spending must occur for equilibrium output to increase by 1000?

A) 100 B) 200 C) 250 D) 500 E) 1000 Answer: A Diff: 2 13) Which of the following equals demand in an open economy?

A) C + I + G + X B) C + I + G + X - IM C) C + I + G + IM - X D) C + I + G Answer: B Diff: 1 14) Which of the following equals demand in a closed economy?

A) C + I + G + X B) C + I + G + X - IM C) C + I + G + IM - X D) none of these Answer: D Diff: 1 24 Copyright © 2021 Pearson Education, Inc.

15) Suppose an open economy is in equilibrium. Given this information, we know with certainty that A) G = T. B) X = IM. C) S = I. D) Y = Z. Answer: D Diff: 1 16) For a closed economy, which of the following conditions must be satisfied for equilibrium to be maintained?

A) G = T B) X = IM = 0 C) C = S D) none of these Answer: D Diff: 2 17) Autonomous spending in a closed economy equals which of the following?

A) c0 + I + G - c1T B) C + I + G C) Z D) c0 + I + G + c1T Answer: A Diff: 2 18) Based on our understanding of the model presented in Chapter 3, we know that an increase in c1 (where C = c0 + c1YD) will cause A) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a smaller effect on output.

B) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a larger effect on output.

C) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a smaller effect on output.

D) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a larger effect on output.

Answer: B Diff: 2

25 Copyright © 2021 Pearson Education, Inc.

19) Based on our understanding of the model presented in Chapter 3, we know that a reduction in c1 (where C = c0 + c1YD) will cause A) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a smaller effect on output.

B) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a larger effect on output.

C) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a smaller effect on output.

D) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a larger effect on output.

Answer: C Diff: 2 20) An increase in the marginal propensity to save from .3 to .4 will cause A) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a smaller effect on output.

B) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a larger effect on output.

C) the ZZ line to become flatter and a given change in autonomous consumption (c0)) to have a smaller effect on output.

D) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a larger effect on output.

Answer: B Diff: 2 21) A reduction in the marginal propensity to save from .4 to .3 will cause A) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a smaller effect on output.

B) the ZZ line to become steeper and a given change in autonomous consumption (c0) to have a larger effect on output.

C) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a smaller effect on output.

D) the ZZ line to become flatter and a given change in autonomous consumption (c0) to have a larger effect on output.

Answer: C Diff: 2

26 Copyright © 2021 Pearson Education, Inc.

22) An increase in the marginal propensity to save from .1 to .2 will cause A) an increase in the multiplier and a given change in autonomous consumption (c0) to have a smaller effect on output.

B) an increase in the multiplier and a given change in autonomous consumption (c0) to have a larger effect on output.

C) a reduction in the multiplier and a given change in autonomous consumption (c0) to have a smaller effect on output.

D) a reduction in the multiplier and a given change in autonomous consumption (c0) to have a larger effect on output.

Answer: C Diff: 2 23) When the economy is in equilibrium, we know with certainty that A) public saving equals investment.

B) private saving equals investment.

C) G = T. D) none of these Answer: D Diff: 1 24) When a closed economy is in equilibrium, we know with certainty that A) I = S + (T - G).

B) I = S. C) I = S + (G - T).

D) G = T and S = I. Answer: A Diff: 1 25) An increase in the desire to save by households will cause A) a reduction in output.

B) a reduction in investment.

C) an increase in output.

D) no change in investment and no change in output.

Answer: A Diff: 2 26) An increase in taxes will cause A) a reduction in investment.

B) an increase in investment.

C) no change in investment.

D) no change in autonomous spending.

Answer: C Diff: 2

27 Copyright © 2021 Pearson Education, Inc.

27) A tax cut will cause A) a reduction in investment.

B) an increase in investment.

C) no change in investment.

D) no change in autonomous spending.

Answer: C Diff: 2 28) Based on our understanding of the model presented in Chapter 3, we know with certainty that an equal and simultaneous increase in G and T will cause A) an increase in output.

B) no change in output.

C) a reduction in output.

D) an increase in investment.

Answer: A Diff: 3 29) Based on our understanding of the model presented in Chapter 3, we know with certainty that an equal and simultaneous reduction in G and T will cause A) an increase in output.

B) no change in output.

C) a reduction in output.

D) an increase in investment.

Answer: C Diff: 3 30) Based on our understanding of the model presented in Chapter 3, a reduction in investment will cause A) an increase in the multiplier.

B) a reduction in the multiplier.

C) a reduction in the marginal propensity to save.

D) a reduction in output.

E) a reduction in the multiplier and output.

Answer: D Diff: 2 31) Suppose business confidence decreases causing a reduction in investment. Based on our understanding of the model presented in Chapter 3, we know with certainty that a reduction in investment will cause A) an increase in the multiplier.

B) a reduction in the multiplier.

C) a reduction in the marginal propensity to save.

D) a reduction in consumption as the economy adjusts to this decrease in investment.

Answer: D Diff: 2

28 Copyright © 2021 Pearson Education, Inc.

32) Suppose the marginal propensity to consume equals .8 (i.e., c1 = .8). Given this information, which of the following events will cause the largest increase in output?

A) G increases by 200 B) T decreases by 200 C) I increases by 150 D) G increases by 200 and T decreases by 200 Answer: A Diff: 3 33) Inventory investment refers to A) the difference between production and sales in a given year.

B) fixed investment.

C) nonresidential investment.

D) the purchase by firms of new machines.

Answer: A Diff: 3 34) Suppose the consumption equation is represented by the following: C = 250 + .75YD, then private savings is A) -250+0.25YD. B) -250+0.75YD. C) -1000+0.25YD. D) -1000+0.75YD. Answer: A Diff: 3 35) If C = 2000 + .9YD, what decrease in taxes must occur for equilibrium output to increase by 1000?

A) 111 B) 100 C) 1000 D) 500 Answer: A Diff: 3

29 Copyright © 2021 Pearson Education, Inc.

36) Suppose the United States economy is represented by the following equations: Z=C+I+G YD = Y - T G = 2000

C = 500 + .5YD

T = 600

I = 300

a. Given the above variables, calculate the equilibrium level of output. Hint: First specify (using the above numbers) the demand equation (Z) for this economy. Second, using the equilibrium condition, equate this expression with Y. Once you have done this, solve for the equilibrium level of output. Using the ZZ-Y graph (i.e., a graph that includes the ZZ line and 45-degree line with Z on the vertical axis, and Y on the horizontal axis), illustrate the equilibrium level of output for this economy. b. Now, assume that consumer confidence decreases causing a reduction in autonomous consumption (c0) from 500 to 400. What is the new equilibrium level of output? How much does income change as a result of this event? What is the multiplier for this economy? c. Graphically illustrate the effects of this change in autonomous consumption on the demand line (ZZ) and Y. Clearly indicate in your graph the initial and final equilibrium levels of output. d. Briefly explain why this reduction in output is greater than (in absolute terms) the initial reduction in autonomous consumption.

Answer: a. Y = 5000. The graph is easy to show. b. Y = 4800; the multiplier is 2. c. Graph. d. When demand falls by 100, firms cut production by 100. As production falls by 100, income falls which causes a subsequent reduction in consumption and demand.

This Y-induced fall in demand causes another reduction in production. This continues and we observe a final change in Y that exceeds the initial change in autonomous demand.

Diff: 2 37) Explain what the multiplier represents.

Answer: The multiplier illustrates the extent to which equilibrium output will change as a result of a given change in autonomous demand.

Diff: 2 38) Discuss and explain what effect a reduction in the marginal propensity to consume has on the size of the multiplier.

Answer: A reduction in the marginal propensity to consume will cause a reduction in the multiplier. When firms increase production in response to some initial change in demand, households will increase their consumption by a smaller amount when the mpc falls. So, the income-induced change in demand will be that much smaller causing a smaller multiplier effect.

Diff: 2 39) Use the ZZ-Y model presented in chapter 3 to illustrate the effects of a reduction in consumer confidence on the economy. Also, explain what effect this reduction in consumer confidence has on the economy.

Answer: The graph is easy. The reduction in consumer confidence will cause a reduction in consumption and demand. As demand falls, firms will cut production. So, this event will cause a lower level of equilibrium output.

Diff: 2 30 Copyright © 2021 Pearson Education, Inc.

40) Explain the difference between endogenous and exogenous variables.

Answer: Endogenous variables are determined by the model. Exogenous variables are taken as given and, for example in this model, do not change as income changes.

Diff: 2 3.4 Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium 1) Which of the following about IS relation is not correct?

A) It is the the relation between interest rate and savings.

B) It is the equilibrium condition for the goods market.

C) It stands for "Investment equals saving."

D) It shows what firms want to invest must be equal to what people and the government want to save.

Answer: A Diff: 3 2) Based on our understanding of the paradox of saving, we know that a reduction in the desire to save will cause A) an increase in equilibrium GDP. B) a reduction in GDP. C) an increase in the desire to invest.

D) no change in equilibrium GDP. E) a permanent reduction in the level of saving.

Answer: A Diff: 2 3) Discuss what is meant by the paradox of saving.

Answer: The paradox of saving refers to the effects of an increased desire to save on output and on the final level of saving. The increased desire to save is equivalent to a reduction in consumption. This drop in demand will cause a drop in output. Furthermore, in this simple economy, the final level of saving will equal the initial level of saving. So, an increased desire to save has a negative effect on the economy and has no permanent effect on the level of saving (because S = I in the simple model).

Diff: 1 4) Suppose that, at a given level of disposable income, consumers decide to save more. Explain what effect this decision will have on equilibrium income. Also, explain what effect this decision will have on the level of saving once the economy has reached the new equilibrium.

Answer: This is the paradox of saving. Here, consumption will fall causing a reduction in demand and a reduction in output. Despite the initial increase in saving at the initial level of income, saving will return to the initial level as income falls in order to maintain the alternative equilibrium condition: S = I. So, the initial increase in the desire to save will have no permanent effect on the level of saving.

Diff: 2 31 Copyright © 2021 Pearson Education, Inc.

3.5

Is the Government Omnipotent? A Warning

1) Which of the following is correct?

A) Governments can not achieve the level of output they want.

B) Changing government spending or taxes is easy.

C) Investment will remain constant.

D) Expectations do not matter for government to change spending or taxes.

Answer: A Diff: 1 3.6

Essay Questions

1) For this question, assume that taxes are independent of income (i.e., the income tax rate is zero).

Now suppose that fiscal policy makers wish to decrease equilibrium output by $500 billion.

Further suppose that policy makers can choose one of the following two options: (1) change in government spending; or (2) change in taxes. Compare and explain the relative size of the changes in government spending and taxes needed to obtain this desired change in output.

Answer: The change in taxes will have to be larger because part of any tax increase will cause saving to fall. So, to cause the same reduction in demand, the size of the tax cut will have to be larger than the size of any reduction in government spending.

Diff: 2 2) Explain what factors cause shifts and changes in the slope of the ZZ curve presented in chapter 3.

Answer: The ZZ curve is upward sloping. The ZZ curve illustrates the level of demand at each level of income. As Y increases, households consume more causing an increase in demand. So, as Y rises, so does demand. The marginal propensity to consume will determine the size of the slope.

The ZZ curve will shift when any autonomous component of demand changes. This will include changes in T, G, I and c0.

Diff: 2 3) Why would consumer decrease consumption even if their disposable income has not changed?

Answer: If consumers start worrying about the future and decide to save more, they will decrease c0 and hence consumption. This is what happened at the start of the most recent financial crisis.

Diff: 2 4) In the model discussed in Chapter 3, why do we assume G and T are exogenous?

Answer: It is based on two arguments: First, government do not behave with the same regularity as consumers or firms, so there is no reliable rule we could write for G or T. Second, treating G and T as exogenous help explore the implications of alternative spending and tax decisions.

Diff: 2

32 Copyright © 2021 Pearson Education, Inc.

5) Suppose the United States economy is represented by the following equations: Z=C+I+G YD = Y - T G = 2000

C = 500 + .5YD

T = 600

I = 300

a. Given the above variables, calculate the equilibrium level of output. b. Now, assume that government spending decreases from 2000 to 1900. What is the new equilibrium level of output? How much does income change as a result of this event? What is the multiplier for this economy?

Answer: a. Y = 5000 b. Y = 4800, multiplier = 2.

Diff: 2 6) Suppose the United States economy is represented by the following equations: Z=C+I+G YD = Y - T G = 2000

C = 500 + .5YD

T = 600

I = 300

a. Given the above variables, calculate the equilibrium level of output. b. Now, assume that taxes increase from 600 to 700. What is the new equilibrium level of output?

How much does income change as a result of this event? What is the multiplier for this economy?

Answer: a. Y = 5000. b. Y = 4900, multiplier = 2.

Diff: 2 7) Graphically illustrate the effects of an increase in autonomous consumption on the demand line (ZZ) and Y. Clearly indicate in your graph the initial and final equilibrium levels of output. Briefly explain why this increase in output is greater than (in absolute terms) the initial change in autonomous consumption.

Answer: ZZ line will shift upward and Y will increase. The increase in output is greater than the initial change in autonomous consumption is due to the multiplier effect.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 4: Financial Markets I 4.1

The Demand for Money

1) Which of the following is a characteristic of bonds?

A) pay zero nominal interest B) can be used for transactions C) are sold for a price that varies inversely with the interest rate D) all of these E) none of these Answer: C Diff: 1 33 Copyright © 2021 Pearson Education, Inc.

2) Which of the following is a flow variable?

A) income B) money C) financial wealth D) all of these E) none of these Answer: A Diff: 1 3) Which of the following is a component of money?

A) bonds B) saving C) income D) stocks E) none of these Answer: E Diff: 1 4) Which of the following is a component of money?

A) coins held by the nonbank public B) bills held by banks C) checkable deposits D) all of these Answer: D Diff: 1

34 Copyright © 2021 Pearson Education, Inc.

5) Which of the following will cause an increase in the amount of money that one wishes to hold?

A) an increase in the interest rate increase B) a reduction in the interest rate increase C) a reduction in income D) none of these Answer: B Diff: 2 6) The money demand curve will shift to the right when which of the following occurs?

A) an increase in income B) a reduction in the interest rate C) an increase in the money supply D) all of these E) none of these Answer: A Diff: 2 7) The money demand curve will shift to the left when which of the following occurs?

A) a reduction in the interest rate B) an increase in the interest rate C) an open market sale of bonds by the central bank D) an increase in income E) none of these Answer: E Diff: 2 8) Which of the following is not included as a component of the M1 definition of money?

A) bonds B) checkable deposits C) coins and bills held by the nonbank public D) all of these E) none of these Answer: A Diff: 1 9) In 2006, the average U.S. household held approximately how much currency (dollar bills and coins)?

A) $50 B) $100 C) $600 D) $1600 E) none of these Answer: D Diff: 2

35 Copyright © 2021 Pearson Education, Inc.

10) Which of the following countries has adopted the U.S. dollar as its own currency?

A) Ecuador B) Mexico C) Canada D) France E) Australia Answer: A Diff: 2 11) Which of the following affects demand for money?

A) prices B) nominal income C) interest rate D) all of these E) none of these Answer: D Diff: 2 12) First, explain why the money demand curve is downward sloping. Second, explain what factor(s) will cause shifts in the money demand curve.

Answer: The money demand curve is downward sloping (with the interest rate on the vertical axis). It is assumed that money pays no interest. At the same time, individuals earn interest when they hold bonds. So, as the interest rate increases, individuals are more willing to incur the costs associated with converting bonds to money when they wish to buy goods. So, an increase in the interest rate causes a reduction in money demand. Money demand depends on the level of transactions and on the interest rate. As the level of transactions increases, individuals will increase money demand. Assuming that nominal income is correlated with nominal transactions, an increase in nominal income will cause an increase in money demand and shifts in the curve.

Diff: 2 4.2

Determining the Interest Rate: I

1) At the current interest rate, suppose the supply of money is less than the demand for money.

Given this information, we know that A) the price of bonds will tend increase.

B) the price of bonds will tend to fall.

C) production equals demand.

D) the goods market is also in equilibrium.

E) the supply of bonds also equals the demand for bonds.

Answer: B Diff: 2

36 Copyright © 2021 Pearson Education, Inc.

2) The interest rate will increase as a result of which of the following events?

A) an increase in income B) an open market purchase of bonds by the central bank C) a reduction in income D) all of these E) none of these Answer: A Diff: 2 3) Which of the following is not an asset on a bank's balance sheet?

A) reserves B) loans C) checkable deposits D) all of these E) none of these Answer: C Diff: 1 4) Which of the following is a liability on a bank's balance sheet?

A) checkable deposits B) reserves C) loans D) all of these E) none of these Answer: A Diff: 1 5) Which of the following is a liability for the central bank?

A) currency B) bonds C) savings accounts D) loans E) checkable deposits Answer: A Diff: 1 6) Suppose a one-year discount bond offers to pay $1000 in one year and currently sells for $950.

Given this information, we know that the interest rate on the bond is A) 5.3%.

B) 9.5%.

C) 10%.

D) 90%.

E) 110%.

Answer: A Diff: 2

37 Copyright © 2021 Pearson Education, Inc.

7) Suppose a one-year discount bond offers to pay $1000 in one year and currently has a 15% interest rate.

Given this information, we know that the bond's price must be A) $869.56.

B) $1150.

C) $850.

D) $950.

E) none of these Answer: A Diff: 2 8) Banks are different from other financial intermediaries because A) banks receive funds and make loans.

B) some of a bank's deposits are money.

C) banks can conduct open market operations on their own.

D) banks do not need to hold reserves against their deposits.

E) banks are open longer hours.

Answer: B Diff: 1 9) Which of the following generally occurs when a central bank pursues expansionary monetary policy?

A) the central bank purchases bonds and the interest rate increases.

B) the central bank purchases bonds and the interest rate decreases.

C) the central bank sells bonds and the interest rate increases.

D) the central bank sells bonds and the interest rate decreases.

Answer: B Diff: 2 10) Which of the following generally occurs when a central bank pursues contractionary monetary policy?

A) the central bank purchases bonds and the interest rate increases.

B) the central bank purchases bonds and the interest rate decreases.

C) the central bank sells bonds and the interest rate increases.

D) the central bank sells bonds and the interest rate decreases.

Answer: C Diff: 2 11) Which of the following will occur when the central bank pursues expansionary monetary policy?

A) a leftward shift in the money demand curve and a leftward shift in the money supply curve B) a rightward shift in the money demand curve and a leftward shift in the money supply curve.

C) a leftward shift in the money demand curve and a rightward shift in the money supply curve.

D) a rightward shift in the money demand curve and a rightward shift in the money supply curve.

E) none of these Answer: E Diff: 2 38 Copyright © 2021 Pearson Education, Inc.

12) Suppose a one-year discount bond offers to pay $100 in one year and currently sells for $99.

Given this information, we know that the interest rate on the bond is A) 11.1%.

B) 10%.

C) 5.3%.

D) 9.9%.

Answer: A Diff: 2 13) Which of the following is an asset of a central bank?

A) currency B) bonds C) reserves D) none of these Answer: B Diff: 2 14) Which of the following is an asset for both a bank and a central bank?

A) currency B) deposits C) bonds D) all of these E) none of these Answer: C Diff: 2 15) Explain what types of policies a central bank can implement to reduce the interest rate.

Answer: Central banks have two options to reduce the interest rate: a central bank purchase of bonds or a reduction in the required reserve ratio. Both policies result in an increase in the money supply and a reduction in the interest rate.

Diff: 1 16) Graphically illustrate and explain what effect an increase in real income will have on the money market.

Answer: An increase in income will cause an increase in transactions and an increase in money demand. The money demand curve will shift to the right causing an excess demand for money and excess demand for bonds. The interest rate will rise to restore money market equilibrium. There is no change in money supply as a result of this.

Diff: 2

39 Copyright © 2021 Pearson Education, Inc.

17) Graphically illustrate and explain what effect a purchase of bonds by the Federal Reserve will have on the money market.

Answer: A Fed purchase of bonds will cause an increase in H and an increase in the money supply. At the initial interest rate, there will be an excess supply of money. The interest rate will fall to restore money market equilibrium. All else fixed, there will be no change in money demand.

Diff: 2 18) Use the market for central bank money to answer this question. Graphically illustrate and explain what effect a Federal Reserve purchase of bonds will have on this market and on the equilibrium interest rate.

Answer: A Fed purchase of bonds will cause an increase in the supply of central bank money. To restore equilibrium in this market, the interest rate will have to fall. As it does, the quantity demanded for central bank money will rise and, therefore, restore equilibrium.

Diff: 2 4.3

Determining the Interest Rate: II

1) Which of the following is a component of high powered money?

A) bonds held by banks, loans, and bank reserves B) currency in circulation plus bank reserves C) currency in circulation plus checkable deposits D) bonds held by banks plus checkable deposits E) the sum of currency in circulation, bank reserves, and checkable deposits Answer: B Diff: 2 2) For this question, assume that individuals do not hold currency (i.e., c = 0). If the ratio of reserves to deposits is .10, the money multiplier is A) .1.

B) .9.

C) 4.

D) 5.

E) 10.

Answer: E Diff: 2 3) Which of the following will cause the money multiplier to become smaller?

A) an increase in high powered money B) a decrease in the ratio of reserves to checkable deposits C) an increase in the public's preference for checking deposits as opposed to holding currency D) a reduction in high powered money E) none of these Answer: E Diff: 3

40 Copyright © 2021 Pearson Education, Inc.

4) The money supply will tend to fall when which of the following occurs?

A) a central bank sale of bonds B) a decrease in the ratio of reserves to deposits C) a shift in public preferences away from currency to checkable deposits D) all of these E) none of these Answer: B Diff: 3 5) Which of the following events will cause the interest rate to increase?

A) an open market sale of bonds B) an increase in the reserve deposit ratio (i.e., θ) C) an increase in income D) all of these Answer: D Diff: 2 6) The federal funds rate is determined in which of the following markets?

A) the market for U.S. treasury securities B) the money market C) the bond market D) the market for central bank money E) none of these Answer: E Diff: 1 7) For this question, assume that individuals do not hold currency (i.e., c = 0). The money multiplier is equal to A) 1.

B) 1/(1 - c).

C) θ.

D) 1/(1- θ).

E) none of these Answer: E Diff: 2 8) For this question, assume that individuals do not hold currency (i.e., c = 0). The money multiplier is equal to A) 1/(1-c).

B) 1/[c + θ(1 - c)].

C) [c + θ(1 - c)].

D) 1/θ.

E) none of these Answer: D Diff: 2

41 Copyright © 2021 Pearson Education, Inc.

9) For this question, assume that individuals hold both currency and checkable deposits. The money multiplier is equal to A) 1/c.

B) 1/[c + θ(1 - c)].

C) [c + θ(1 - c)].

D) 1/θ.

E) 1/(1-c) Answer: B Diff: 3 10) We would expect which of the following to occur when the central bank pursues expansionary monetary policy?

A) an increase in bond prices and an increase in the interest rate (i) B) a reduction in bond prices and an increase in i C) an increase in bond prices and a reduction in i D) a reduction in bond prices and a reduction in i E) none of these Answer: C Diff: 2 11) We would expect which of the following to occur when the central bank pursues contractionary monetary policy?

A) an increase in bond prices and an increase in the interest rate (i) B) a reduction in bond prices and an increase in i C) an increase in bond prices and a reduction in i D) a reduction in bond prices and a reduction in i E) none of these Answer: B Diff: 2 12) Based on our understanding of the determinants of the interest rate and bond prices, we know that a reduction in income will cause A) an increase in bond prices and an increase in the interest rate (i).

B) a reduction in bond prices and an increase in i.

C) an increase in bond prices and a reduction in i.

D) a reduction in bond prices and a reduction in i.

E) none of these Answer: C Diff: 2

42 Copyright © 2021 Pearson Education, Inc.

13) We would expect which of the following to occur when the central bank conducts an open market sale of bonds?

A) a reduction in the monetary base (H) B) a reduction in the money multiplier C) an increase in H D) an increase in the money multiplier E) an increase in H and the money multiplier Answer: A Diff: 2 14) We would expect which of the following to occur when the central bank conducts an open market purchase of bonds?

A) a reduction in the monetary base (H) B) a reduction in the money multiplier C) an increase in the money multiplier D) an increase in the money supply Answer: D Diff: 2 15) The FDIC currently insures each bank account up to what level?

A) $10,000 B) $50,000 C) $250,000 D) $150,000 Answer: C Diff: 1 16) An increase in the reserve ratio, θ, will cause A) an increase in the monetary base (H).

B) a reduction in H. C) an increase in the money multiplier.

D) a reduction in the money multiplier.

E) none of these Answer: D Diff: 2 17) A reduction in the reserve ratio, θ, will cause A) an increase in the monetary base (H).

B) a reduction in H and a reduction in the money multiplier.

C) an increase in the money multiplier.

D) a reduction in the money multiplier.

Answer: C Diff: 2

43 Copyright © 2021 Pearson Education, Inc.

18) An increase in the parameter c, the proportion of money individuals wish to hold as currency, will tend to cause which of the following?

A) an increase in the monetary base (H) B) a reduction in H C) an increase in the money multiplier D) a reduction in the money multiplier Answer: D Diff: 2 19) A reduction in the parameter c, the proportion of money individuals wish to hold as currency, will tend to cause which of the following?

A) an increase in the monetary base (H) B) a reduction in H C) an increase in the money multiplier D) a reduction in the money multiplier Answer: C Diff: 2 20) An increase in income will tend to cause which of the following?

A) an increase in the monetary base (H) B) a reduction in H C) an increase in the interest rate D) a reduction in the money multiplier E) none of these Answer: C Diff: 2 21) If individuals do not hold currency, we know that A) M = D. B) H = R. C) the money multiplier is 1/θ.

D) all of these Answer: D Diff: 2 22) If individuals do not hold checkable deposits, we know that A) M = CU. B) H = CU. C) the money multiplier is 1.

D) all of these Answer: D Diff: 2

44 Copyright © 2021 Pearson Education, Inc.

23) An increase in the interest rate will cause A) a reduction in the supply of central bank money.

B) a reduction in the demand for currency.

C) a reduction in the demand for reserves.

D) all of these E) a reduction in the demand for currency and for reserves Answer: E Diff: 2 24) An increase in income will cause A) a reduction in the supply of central bank money.

B) a reduction in the demand for currency.

C) a reduction in the demand for reserves.

D) none of these E) a reduction in the demand for currency and for reserves.

Answer: D Diff: 2 25) An increase in income will cause A) a reduction in the supply of central bank money.

B) a reduction in the demand for currency.

C) an increase in the demand for reserves.

D) none of these Answer: C Diff: 2 26) An open market sale of securities will tend to cause A) a reduction in the supply of central bank money.

B) a reduction in the demand for currency.

C) a reduction in the demand for reserves.

D) none of these Answer: A Diff: 2 27) Use the market for central bank money to answer this question. Graphically illustrate and explain what effect an increase in the reserve deposit ratio (θ) will have on this market and on the equilibrium interest rate.

Answer: An increase in the parameter θ will cause an increase in banks' demand for reserves and, therefore, an increase in the demand for central bank money. This will cause an excess demand for central bank money at the initial interest rate. In this case, the interest rate will rise to restore equilibrium.

Diff: 2

45 Copyright © 2021 Pearson Education, Inc.

28) Explain what effect changes in each of the following variables has on the demand for central bank money: (1) the interest rate, i; and (b) real income, Y. Answer: Interest rate. A reduction in the interest rate will cause an increase in money demand (movement along the demand curve). This will cause an increase in the demand for currency that will cause an increase in the demand for central bank money. The increase in the demand for money will also cause an increase in the demand for deposits and, therefore, an increase in banks' demand for reserves. This will also cause an increase in the demand for central bank money. In this case, we only move along the demand curve.

Real income. An increase in Y will cause an increase in money demand and, as described above, an indirect increase in the demand for currency and reserves. So, this increase in Y will cause an increase in the demand for central bank money and a shift in the curve.

Diff: 2 29) Discuss the tools of the Federal Reserve and explain how each can be used to change the money supply and equilibrium interest rate.

Answer: The Fed has three tools: discount rate, open market operations, and the reserve ratio. An open market sale or purchase will cause a change in H and M. This will in turn cause a change in the money supply. A change in the required reserve ratio will cause a change in the money multiplier and, therefore, the money supply. When the money supply changes, the interest rate will change. Changes in the discount rate do not directly cause changes in the money supply.

Diff: 2 30) What is the money multiplier and what factors determine its size?

Answer: The money multiplier represents the effect of a given change in high powered money on the money supply. The money multiplier will be affected by changes in two parameters: c and θ.

An increase in either parameter will cause a reduction in the money multiplier.

Diff: 2 31) Use the money market to answer this question. Suppose there is a reduction in income. First, briefly explain what effect this will have on the interest rate. Second, explain all types of policies the central bank could implement to prevent this reduction in income from affecting the interest rate.

Answer: The reduction in income will cause a reduction in money demand, a leftward shift in the money demand curve, and a reduction in the interest rate. To prevent the drop in the interest rate, the central bank could pursue an open market sale of securities (to reduce the money supply) or it could increase the required reserve ratio (which would also reduce the money supply).

Diff: 2 32) Graphically illustrate and explain what effect a sale of bonds by the Federal Reserve will have on the money market.

Answer: A Fed purchase of bonds will cause a decrease in H and an decrease in the money supply. At the initial interest rate, there will be an excess demand for money. The interest rate will increase to restore money market equilibrium. All else fixed, there will be no change in money demand.

Diff: 2 46 Copyright © 2021 Pearson Education, Inc.

33) What is the difference between saving and savings?

Answer: Saving is the part of after-tax income that one does not spend. It is a flow variable.

Savings is used as a synonym for wealth. It is a stock variable.

Diff: 2 34) Explain what types of policies a central bank can implement to raise the interest rate.

Answer: Central banks have two options to raise the interest rate: a central bank sale of bonds or a n increase in the required reserve ratio. Both policies result in a decrease in the money supply and an increase in the interest rate.

Diff: 2 35) The demand for money is given by Md = $Y (0.3 - i), where $Y = 120 and the supply of money is $30. a. What is the equilibrium interest rate? b. If the central bank wants to decrease i by 2%, at what level should it set the supply of money?

Answer: a. i = 5%. b. Ms = 32.4.

Diff: 2 36) The demand for money is given by Md = $Y (0.3 - i), where $Y = 100 and the supply of money is $20. a. What is the equilibrium interest rate? b. What is the impact on the interest rate if central bank money is increased to $25?

Answer: a. i = 10% b. Interest rate will decrease to 5%.

Diff: 2 4.4

The Liquidity Trap

1) Which of the following conditions will most likely coincide with the existence of a liquidity trap?

A) inflation is rising B) inflation is constant C) inflation is zero D) individuals prefer to hold only money and not bonds E) the real interest rate is negative Answer: D Diff: 1

47 Copyright © 2021 Pearson Education, Inc.

2) When a liquidity trap situation exists, we know that A) an open market operation will have no effect on the supply of money.

B) an open market operation will have no effect on the monetary base.

C) fiscal policy will have no effect on the demand for goods.

D) expansionary monetary policy will be deflationary.

E) none of these Answer: E Diff: 1 3) Suppose a liquidity trap situation exists. Which of the following is most likely to occur if taxes are cut?

A) no change in output and no change in the interest rate B) an increase in output and an increase in the interest rate C) an increase in output and little change in the interest rate D) an increase in output and a reduction in the interest rate E) none of these Answer: C Diff: 1 4) An open market purchase of bonds by the central bank will cause which of the following when a liquidity trap situation exists?

A) The interest rate will decrease.

B) The interest rate will not change.

C) Output will increase.

D) The money supply, M, will not change.

E) none of these Answer: B Diff: 1 5) An open market sale of bonds by the central bank will cause which of the following when a liquidity trap situation exists?

A) The interest rate will increase.

B) The interest rate will not change.

C) Output will decrease.

D) The money supply, M, will not change.

E) none of these Answer: E Diff: 1 6) Which of the following will occur when an economy is faced with a liquidity trap situation?

A) A reduction in the price level will cause a rightward shift in the aggregate demand curve.

B) A reduction in the price level will cause a leftward shift in the aggregate demand curve.

C) The aggregate demand curve is now vertical.

D) The aggregate demand curve is now upward sloping.

Answer: C Diff: 1 48 Copyright © 2021 Pearson Education, Inc.

7) When a liquidity trap situation exists, the most appropriate policy to increase output would be A) a central bank sale of bonds.

B) an increase in government spending.

C) a central bank purchase of bonds.

D) none of these Answer: B Diff: 1 Macroeconomics, 8e (Blanchard) Chapter 5: Goods and Financial Markets: The IS-LM Model 5.1

The Goods Market and the IS Relation

1) The IS curve represents A) the single level of output where the goods market is in equilibrium.

B) the single level of output where financial markets are in equilibrium.

C) the combinations of output and the interest rate where the money market is in equilibrium.

D) the combinations of output and the interest rate where the goods market is in equilibrium.

E) none of these Answer: D Diff: 1 2) The IS curve will shift to the right when which of the following occurs?

A) an increase in the money supply B) an increase in government spending C) a reduction in the interest rate D) all of these E) none of these Answer: B Diff: 2 3) Which of the following occurs as the economy moves leftward along a given IS curve?

A) An increase in the interest rate causes investment spending to decrease.

B) An increase in the interest rate causes money demand to increase.

C) An increase in the interest rate causes a reduction in the money supply.

D) A reduction in government spending causes a reduction in demand for goods.

E) An increase in taxes causes a reduction in demand for goods.

Answer: A Diff: 2 4) During 2008 in the United States, consumer confidence fell significantly. Which of the following will occur as a result of this reduction in consumer confidence?

A) The LM curve will shift up.

B) The LM curve will shift down.

C) The IS curve will shift rightward.

D) The IS curve will shift leftward.

E) The IS curve will shift rightward, and the LM curve will shift up.

Answer: D 49 Copyright © 2021 Pearson Education, Inc.

Diff: 2

50 Copyright © 2021 Pearson Education, Inc.

5) Suppose policy makers decide to reduce taxes. This fiscal policy action will cause which of the following to occur?

A) The LM curve shifts and the economy moves along the IS curve.

B) The IS curve shifts and the economy moves along the LM curve.

C) Both the IS and LM curves shift.

D) Neither the IS nor the LM curve shifts.

E) Output will change causing a change in money demand and a shift of the LM curve.

Answer: B Diff: 2 6) Suppose fiscal policy makers implement a policy to reduce the size of a budget deficit. Based on the IS-LM model, we know with certainty that the following will occur as a result of this fiscal policy action.

A) Investment spending will decrease.

B) Investment spending will increase.

C) There will be no change in investment spending.

D) Investment spending may increase, decrease, or not change.

E) none of these Answer: D Diff: 3 7) For this question, assume that investment spending depends only on the interest rate and no longer depends on output. Given this information, a reduction in government spending A) will cause investment to decrease.

B) will cause investment to increase.

C) may cause investment to increase or to decrease.

D) will have no effect on output.

E) will cause a reduction in output and have no effect on the interest rate.

Answer: B Diff: 3 8) Suppose investment spending is not very sensitive to the interest rate. Given this information, we know that A) the IS curve should be relatively flat.

B) the IS curve should be relatively steep.

C) the LM curve should be relatively flat.

D) the LM curve should be relatively steep.

E) neither the IS nor the LM curve will be affected.

Answer: B Diff: 2

51 Copyright © 2021 Pearson Education, Inc.

9) Explain the determinants of investment. Include in your answer an explanation of how a change in each determinant affects investment.

Answer: Investment depends on the level of sales/output and on the interest rate. As output changes, the demand for goods will change and firms will change investment so that their capacity changes with the level of economic activity (and demand). I also depends on the interest rate. As the interest rate rises, the cost of borrowing rises. Firms will cut back on investment as borrowing costs rise.

Diff: 2 10) What is the IS relation? Explain why IS curve is downward sloping.

Answer: The IS relation shows the combinations of the interest rate and the level of output that are consistent with equilibrium in the goods market. An increase in the interest rate leads to a decline in output. Consequently, the IS curve is downward sloping.

Diff: 2 11) Graphically derive the IS curve from the goods market equilibrium.

Answer: Suppose the initial equilibrium in the goods market is at point A with interest rate i.

Suppose now that the interest rate increases from its initial value i to a higher value i'. The increase in the interest rate decreases investment. The decrease in investment leads to a decrease in output.

Now the new equilibrium point is at A', with a higher value of i and lower value of Y. After we plot the combinations of i and Y when the goods market is in equilibrium, we can connect these two points (A and A') to get a downward sloping IS curve.

Diff: 2 5.2

Financial Markets and the LM Relation

1) For each interest rate, the LM curve illustrates the level of output where A) the goods market is in equilibrium.

B) inventory investment equals zero.

C) money supply equals money demand.

D) all of these E) none of these Answer: C Diff: 2 2) The LM curve shifts down (or, equivalently, to the right) when which of the following occurs?

A) an increase in taxes B) an increase in output C) an open market sale of bonds by the central bank D) an increase in consumer confidence E) none of these Answer: E Diff: 2

52 Copyright © 2021 Pearson Education, Inc.

3) Which of the following statements is consistent with a given (i.e., fixed) LM curve?

A) A reduction in the interest rate causes investment spending to increase.

B) A reduction in the interest rate causes money demand to decrease.

C) A reduction in the interest rate causes an increase in the money supply.

D) An increase in output causes an increase in demand for goods.

E) An increase in output causes an increase in money demand.

Answer: E Diff: 2 4) In late 2007 and early 2008, the U.S. Federal Reserve pursued expansionary monetary policy.

Which of the following will occur as a result of this monetary policy action?

A) The LM curve shifts down.

B) The LM curve shifts up.

C) The IS curve shifts rightward as the interest rate falls.

D) The IS curve shifts leftward as the interest rate increases.

E) none of these Answer: A Diff: 2 5) Suppose the demand for money is not very sensitive to the interest rate. Given this information, we know that A) the IS curve should be relatively flat.

B) the IS curve should be relatively steep.

C) the LM curve should be relatively flat.

D) the LM curve should be relatively steep.

E) neither the IS nor the LM curve will be affected.

Answer: D Diff: 3 6) Which of the following is the definition for the real supply of money?

A) The stock of money measured in terms of goods, not dollars.

B) The stock of high powered money only.

C) The real value of currency in circulation only.

D) The actual quantity of money, rather than the officially reported quantity.

E) The ratio of the real GDP to the nominal money supply.

Answer: A Diff: 1 7) First, define the LM curve. Second, explain why it has its particular shape.

Answer: The LM curve illustrates the combinations of the interest rate and level of output that maintain financial market equilibrium. The curve is upward sloping because as income increases, money demand will rise. This increase in money demand will cause an excess demand for money and an excess supply of bonds. Bond prices will fall and the interest rate will increase until equilibrium is restored.

Diff: 2

53 Copyright © 2021 Pearson Education, Inc.

5.3

Putting the IS and the LM Relations Together

1) Suppose the economy is currently operating on both the LM curve and the IS curve. Which of the following is true for this economy?

A) Production equals demand.

B) The quantity supplied of bonds equals the quantity demanded of bonds.

C) The money supply equals money demand.

D) Financial markets are in equilibrium.

E) all of these Answer: E Diff: 1 2) Suppose the economy is operating on the LM curve but not on the IS curve. Given this information, we know that A) the goods market is in equilibrium and the money market is not in equilibrium.

B) the money market and bond markets are in equilibrium and the goods market is not in equilibrium.

C) the money market and goods market are in equilibrium and the bond market is not in equilibrium.

D) the money, bond and goods markets are all in equilibrium.

E) neither the money, bond, nor goods markets are in equilibrium.

Answer: B Diff: 2 3) Suppose the current level of output and the interest rate are such that the economy is operating on neither the IS nor LM curve. Which of the following is true for this economy?

A) Production does not equal demand.

B) The money supply does not equal money demand.

C) The quantity supplied of bonds does not equal the quantity demanded of bonds.

D) Financial markets are not in equilibrium.

E) all of these Answer: E Diff: 2 4) An increase in the money supply will cause an increase in which of the following variables?

A) output B) investment C) consumption D) all of these E) none of these Answer: D Diff: 2

54 Copyright © 2021 Pearson Education, Inc.

5) Suppose there is an increase in consumer confidence. Which of the following represents the complete list of variables that must increase in response to this increase in consumer confidence?

A) consumption B) consumption and investment C) consumption, investment and output D) consumption and output E) consumption, output and the interest rate Answer: E Diff: 2 6) Suppose there is a fiscal contraction. Which of the following is a complete list of the variables that must decrease?

A) consumption B) consumption and investment C) consumption and output D) consumption, output and the interest rate E) consumption, output and investment Answer: C Diff: 2 7) We know with certainty that a tax increase must cause which of the following?

A) an increase in investment B) a reduction in investment C) no change in investment D) none of these Answer: D Diff: 2 8) A fiscal contraction will tend to cause which of the following to occur?

A) a reduction in the interest rate and a reduction in investment B) a reduction in the interest rate and an upward shift in the LM curve C) a reduction in the interest rate and an ambiguous effect on investment D) no change in output if the Fed simultaneously pursues contractionary monetary policy Answer: C Diff: 2 9) An increase in the money supply must cause which of the following?

A) a leftward shift in the IS curve B) a reduction in the interest rate and ambiguous effects on investment C) an increase in investment and a rightward shift in the IS curve D) no change in the interest rate if investment is independent of the interest rate E) no change in output if investment is independent of the interest rate Answer: E Diff: 1

55 Copyright © 2021 Pearson Education, Inc.

10) An increase in consumer confidence will tend to cause which of the following to occur?

A) a rightward shift in the IS curve B) a leftward shift in the IS curve C) an upward shift in the LM curve D) a downward shift in the LM curve Answer: A Diff: 1 11) Assume that investment does not depend on the interest rate. A reduction in government spending will cause which of the following for this economy?

A) no change in the interest rate B) no change in output C) no change in investment D) an increase in investment E) none of these Answer: E Diff: 3 12) Assume that investment does not depend on the interest rate. A reduction in the money supply will cause which of the following for this economy?

A) no change in the interest rate B) no change in output C) a reduction in investment D) an increase in investment Answer: B Diff: 3 13) For this question, assume that investment spending depends only on output and no longer depends on the interest rate. Given this information, an increase in the money supply A) will cause investment to decrease.

B) will cause investment to increase.

C) will cause a reduction in the interest rate.

D) will have no effect on output or the interest rate.

E) will cause an increase in output and have no effect on the interest rate.

Answer: C Diff: 3 14) A reduction in consumer confidence will likely have which of the following effects?

A) a rightward shift in the IS curve B) a leftward shift in the IS curve C) an upward shift in the LM curve D) a downward shift in the LM curve Answer: B Diff: 2

56 Copyright © 2021 Pearson Education, Inc.

15) An increase in the reserve deposit ratio, θ, will most likely have which of the following effects?

A) a rightward shift in the IS curve B) a leftward shift in the IS curve C) an upward shift in the LM curve D) a downward shift in the LM curve Answer: C Diff: 2 16) A Fed purchase of securities will most likely have which of the following effects?

A) a rightward shift in the IS curve B) a leftward shift in the IS curve C) an upward shift in the LM curve D) a downward shift in the LM curve Answer: D Diff: 2 17) A reduction in the aggregate price level, P, will most likely have which of the following effects?

A) a rightward shift in the IS curve B) a leftward shift in the IS curve C) an upward shift in the LM curve D) a downward shift in the LM curve Answer: D Diff: 2 18) An increase in the aggregate price level, P, will most likely have which of the following effects?

A) a rightward shift in the IS curve B) a leftward shift in the IS curve C) an upward shift in the LM curve D) a downward shift in the LM curve Answer: C Diff: 2 19) The IS curve will not shift when which of the following occurs?

A) a reduction in government spending B) a reduction in the interest rate C) a reduction in consumer confidence D) all of these E) none of these Answer: B Diff: 1

57 Copyright © 2021 Pearson Education, Inc.

20) Which of the following best defines the IS curve?

A) the combinations of i and Y that maintain equilibrium in the goods market B) illustrates the effects of changes in i on investment C) illustrates the effects of changes in i on desired money holdings by individuals D) the combinations of i and Y that maintain equilibrium in financial markets Answer: A Diff: 1 21) Which of the following best defines the LM curve?

A) the combinations of i and Y that maintain equilibrium in the goods market B) illustrates the effects of changes in i on investment C) illustrates the effects of changes in i on desired money holdings by individuals D) the combinations of i and Y that maintain equilibrium in financial markets Answer: D Diff: 1 22) Based on our understanding of the IS-LM model that takes into account dynamics, we know that a reduction in the money supply will cause A) an immediate drop in Y and immediate increase in i.

B) an immediate increase in i and no initial change in Y. C) a gradual increase in i and gradual reduction in Y. D) none of these Answer: B Diff: 2 23) Based on our understanding of the IS-LM model that takes into account dynamics, we know that a reduction in government spending will cause A) an immediate drop in Y and immediate increase in i.

B) an immediate reduction in i and no initial change in Y. C) a gradual reduction in i and gradual reduction in Y. D) a gradual reduction in i and an immediate reduction in Y. Answer: C Diff: 2 24) Based on our understanding of the IS-LM model that takes into account dynamics, we know that an increase in the money supply will cause A) an immediate increase in i and no initial change in Y. B) an immediate decrease in i and no initial change in Y. C) a gradual decrease in i and gradual increase in Y. D) none of these Answer: B Diff: 2

58 Copyright © 2021 Pearson Education, Inc.

25) Based on our understanding of the IS-LM model that takes into account dynamics, we know that an increase in government spending will cause A) a gradual increase in i and gradual increase in Y. B) an immediate increase in Y and immediate drop in i.

C) an immediate increase in i and no initial change in Y. D) a gradual increase in i and an immediate increase in Y. Answer: A Diff: 2 26) An increase in government spending will likely have which of the following effects?

A) a rightward shift in the IS curve B) a leftward shift in the IS curve C) an upward shift in the LM curve D) a downward shift in the LM curve Answer: A Diff: 2 27) A reduction in the reserve deposit ratio, θ, will most likely have which of the following effects?

A) a rightward shift in the IS curve B) a leftward shift in the IS curve C) an upward shift in the LM curve D) a downward shift in the LM curve Answer: D Diff: 2 28) If government spending and taxes increase by the same amount, A) the IS curve does not shift B) the IS curve shift leftward C) the IS curve shifts rightward D) the LM curve shifts downward Answer: C Diff: 2 29) If government spending and taxes decrease by the same amount, A) the IS curve does not shift.

B) the IS curve shift leftward.

C) the IS curve shifts rightward.

D) the LM curve shifts downward.

Answer: B Diff: 2

59 Copyright © 2021 Pearson Education, Inc.

30) Which of the following triggered the U.S. recession of 2001?

A) decline in investment demand B) decline in consumption demand C) increase in budget deficit D) increase in trade deficit Answer: A Diff: 2 31) The IS curve will shift to the left when which of the following occurs?

A) a reduction in the money supply B) a reduction in government spending C) an increase in the interest rate D) all of these E) none of these Answer: B Diff: 2 32) Which of the following occurs as the economy moves rightward along a given IS curve?

A) A reduction in the interest rate causes investment spending to decrease.

B) A reduction in the interest rate causes money demand to increase.

C) A reduction in the interest rate causes a reduction in the money supply.

D) An increase in government spending causes a reduction in demand for goods.

E) A reduction in taxes causes a reduction in demand for goods.

Answer: A Diff: 2 33) When the central bank pursues contractionary monetary policy, we that this policy will result in an increase in the interest rate, a reduction in investment, a reduction in demand, and a lower level of equilibrium output. Explain what happens to the position of the IS curve as the central bank pursues contractionary monetary policy.

Answer: Changes in the interest rate do cause changes in investment, demand, and output.

However, they do not cause shifts of the IS curve. Changes in the interest rate cause movements along the IS curve.

Diff: 2 34) A fiscal expansion (e.g. a tax cut) will result in an increase in income, an increase in money demand, and an increase in the equilibrium interest rate in financial markets. Explain what happens to the position of the LM curve as policy makers pursue expansionary fiscal policy.

Answer: The fiscal expansion will cause an increase in output. However, changes in Y only cause movements along the LM curve. The effects of changes in Y on the interest rate are embedded in the shape of the LM curve.

Diff: 2

60 Copyright © 2021 Pearson Education, Inc.

35) Explain in detail what effect a Fed sale of bonds will have on: (1) the LM curve; and (2) the IS curve.

Answer: A Fed sale of bonds will cause a reduction in H and a reduction in the money supply.

This will cause an excess demand for money and the interest rate must increase to restore money market equilibrium. The LM curve will shift up as a result of this to reflect the now higher interest rate. The IS curve does not shift as a result of this. We would simply observe a movement along the IS curve.

Diff: 2 36) Explain in detail what effect a reduction in government spending will have on: (1) the LM curve; and (2) the IS curve.

Answer: A reduction in taxes will cause an increase in disposable income and an increase in consumption. The rise in C will cause an increase in demand and the equilibrium level of output in the goods market will be higher. This is reflected in a rightward shift in the IS curve. Goods market events such as this will not cause a shift in the LM curve (only a movement along it).

Diff: 2 37) Based on your understanding of the IS-LM model, graphically illustrate and explain what effect a reduction in consumer confidence will have on output, the interest rate, and investment.

Answer: A reduction in consumer confidence will cause a reduction in consumption and, therefore, a reduction in demand and a leftward shift in the IS curve. As Y decreases, money demand will decrease causing the interest rate to fall. The effects on I are ambiguous. The lower Y will cause I to fall while the lower interest rate will cause I to increase.

Diff: 2 38) Based on your understanding of the IS-LM model, graphically illustrate and explain what effect a monetary expansion will have on output, the interest rate, and investment.

Answer: An increase in M will cause the LM curve to shift down and the interest rate to fall. As the interest rate falls, firms will increase investment causing an increase in demand and subsequent increase in output. So, the interest rate will fall and Y will rise. I will be higher due to the rise in Y and drop in the interest rate.

Diff: 2 39) Increases in the budget deficit are believed to cause reductions in investment. Based on your understanding of the IS-LM model, will a fiscal policy action that causes a reduction in the budget deficit cause an increase in investment? Explain.

Answer: A policy that causes a reduction in the budget deficit will have an ambiguous effect on investment. Output will fall which will tend to depress I. However, the interest rate will also fall which will tend to increase I. I could increase, decrease, or remain unchanged.

Diff: 2

61 Copyright © 2021 Pearson Education, Inc.

40) Explain in detail what effect a Fed purchase of bonds will have on: (1) the LM curve; and (2) the IS curve.

Answer: A Fed purchase of bonds will cause an increase in H and an increase in the money supply. This will cause an excess supply of money and the interest rate must decline to restore money market equilibrium. The LM curve will shift down as a result of this to reflect the now lower interest rate. The IS curve does not shift as a result of this. We would simply observe a movement along the IS curve.

Diff: 2 41) Explain in detail what effect an increase in government spending will have on: (1) the LM curve; and (2) the IS curve.

Answer: An increase in government spending will cause an increase in demand and the equilibrium level of output in the goods market will be higher. This is reflected in a rightward shift in the IS curve. Goods market events such as this will not cause a shift in the LM curve (only a movement along it).

Diff: 2 5.4

Using a Policy Mix

1) Suppose there is a simultaneous fiscal expansion and monetary expansion. We know with certainty that A) output will increase.

B) output will decrease.

C) the interest rate will increase.

D) the interest rate will decrease.

E) both output and the interest rate will increase.

Answer: A Diff: 2 2) Suppose there is a simultaneous fiscal expansion and monetary contraction. We know with certainty that A) output will increase.

B) output will decrease.

C) the interest rate will increase.

D) the interest rate will decrease.

E) both output and the interest rate will increase.

Answer: C Diff: 2

62 Copyright © 2021 Pearson Education, Inc.

3) For this question, assume that investment spending depends only on output and no longer depends on the interest rate. Given this information, an increase in government spending A) will cause investment to decrease.

B) will cause investment to increase.

C) may cause investment to increase or to decrease.

D) will have no effect on output.

E) will cause an increase in output and have no effect on the interest rate.

Answer: B Diff: 3 4) A reasonable dynamic assumption for the IS-LM model is that A) the economy is always on both the IS and LM curves.

B) the economy is always on the IS curve, but moves only slowly to the LM curve.

C) the economy is always on the LM curve, but moves only slowly to the IS curve.

D) the money market is quick to adjust, but the bond market adjusts more slowly.

E) adjustment to the new IS-LM equilibrium is instantaneous after an LM shift, but not after an IS shift.

Answer: C Diff: 2 5) Under the reasonable dynamic assumptions discussed in the text, a monetary contraction should result in A) an immediate rise in the interest rate, and no further interest rate changes.

B) an immediate rise in the interest rate, and then a fall in the interest rate over time.

C) an immediate rise in the interest rate, and then a further rise over time.

D) a very gradual but steady rise in the interest rate to its new equilibrium level.

E) no change in the interest rate initially, and then a sudden rise to its new equilibrium value.

Answer: B Diff: 2 6) For this question, assume that investment spending depends only on the interest rate and no longer depends on output. Given this information, a reduction in the money supply A) will cause investment to decrease.

B) will cause investment to increase.

C) may cause investment to increase or to decrease.

D) will have no effect on output.

E) will cause a reduction in output and have no effect on the interest rate.

Answer: A Diff: 3

63 Copyright © 2021 Pearson Education, Inc.

7) Suppose there is a Fed purchase of bonds and simultaneous tax cut. We know with certainty that this combination of policies must cause A) an increase in the interest rate (i).

B) a reduction in i.

C) an increase in output (Y).

D) a reduction in Y. Answer: C Diff: 2 8) Suppose there is a simultaneous Fed sale of bonds and increase in consumer confidence. We know with certainty that these two simultaneous events will cause A) an increase in the interest rate (i).

B) a reduction in i.

C) an increase in output (Y).

D) a reduction in Y. Answer: A Diff: 2 9) Suppose there is a simultaneous central bank purchase of bonds and increase in taxes. We know with certainty that this combination of policies must cause A) an increase in the interest rate (i).

B) a reduction in i.

C) an increase in output (Y).

D) a reduction in Y. Answer: B Diff: 2 10) Suppose there is a simultaneous central bank sale of bonds and tax increase. We know with certainty that this combination of policies must cause A) an increase in the interest rate (i).

B) a reduction in i.

C) an increase in output (Y).

D) a reduction in Y. Answer: D Diff: 2 11) First, briefly explain what is meant by the policy mix. Second, explain what effect different policy mixes might have on the level of output, investment, and the interest rate.

Answer: The policy mix refers to the possible combinations of monetary (exp. or contr.) and fiscal (exp. or contr.) that can be simultaneously implemented. There are a number of different answers that could be given to the latter part of the question. The effects on output, the interest rate, and investment will depend on the type of mix.

Diff: 2

64 Copyright © 2021 Pearson Education, Inc.

12) Use the IS-LM model to answer this question. Suppose there is a simultaneous increase in government spending and reduction in the money supply. Explain what effect this particular policy mix will have on output and the interest rate. Based on your analysis, do we know with certainty what effect this policy mix will have on investment? Explain.

Answer: In this case, the LM curve shifts up and the IS curve shifts to the right. The interest rate will clearly be higher. The effects on output depend on the relative magnitude of the two policies.

The effects on I are also ambiguous. If output falls, I will be lower. However, it is possible that output will rise here which creates the ambiguity.

Diff: 2 13) Use the IS-LM model to answer this question. Suppose there is a simultaneous increase in taxes and reduction in the money supply. Explain what effect this particular policy mix will have on output and the interest rate. Based on your analysis, do we know with certainty what effect this policy mix will have on investment? Explain.

Answer: In this case, the LM curve shifts up and the IS curve shifts to the left. In this case, output will clearly fall. What happens to the interest rate depends on the relative magnitude of the two policies. The effects on I are again ambiguous.

Diff: 2 14) Use the IS-LM model to answer this question. Suppose there is a simultaneous increase in government spending and increase in the money supply. Explain what effect this particular policy mix will have on output and the interest rate. Based on your analysis, do we know with certainty what effect this policy mix will have on investment? Explain.

Answer: In this case, the LM curve shifts down and the IS curve shifts to the right. The output will clearly be higher. The effects on interest rate depend on the relative magnitude of the two policies. The effects on I are also ambiguous. If interest rate falls, I will be higher. However, it is possible that interest rate will rise here which creates the ambiguity.

Diff: 2 5.5

How does the IS-LM Model Fit the Facts?

1) Empirically it takes nearly ________ years for monetary policy to have its full effect on output.

A) 2 B) 1 C) 3 D) 4 Answer: A Diff: 1

65 Copyright © 2021 Pearson Education, Inc.

2) The largest decrease in retail sales from an increase in federal funds rate occurs after ______quarters.

A) 5 B) 1 C) 2 D) 4 Answer: A Diff: 1 3) The largest decrease in output from an increase in federal funds rate occurs after ______quarters.

A) 8 B) 7 C) 5 D) 3 Answer: A Diff: 1 Macroeconomics, 8e (Blanchard) Chapter 6: Financial Markets II: The Extended IS-LM Model 6.1

Nominal versus Real Interest Rate

1) Which of the following best defines the real interest rate (r)?

A) the amount of goods we must give up next year in order to consume more goods today B) the amount of dollars we must give up next year in order to consume more goods today C) the amount of dollars we must give up next year in order to have more dollars today D) the amount of dollars we must give up today in order to have more dollars next year E) the amount of dollars we must give up today in order to consume more goods today Answer: A Diff: 1 2) The nominal interest rate is A) the interest rate measured in terms of goods.

B) always less than the real interest rate.

C) equal to the real interest rate minus the rate of inflation.

D) the type of interest rate typically reported in the financial pages of newspapers.

E) equal to the expected rate of inflation.

Answer: D Diff: 1 3) If the nominal interest rate 8% and expected inflation 3%, the expected real interest rate in year t is approximately A) 2%.

B) 3%.

C) 5%.

D) 8%.

E) 11%.

66 Copyright © 2021 Pearson Education, Inc.

Answer: C Diff: 1 4) Whenever the expected inflation rate is positive A) the real interest rate is greater than the nominal interest rate.

B) the real interest rate is negative.

C) the real interest rate is positive.

D) the nominal interest rate must be equal to the real interest rate.

E) none of these Answer: E Diff: 2

67 Copyright © 2021 Pearson Education, Inc.

5) Suppose that the nominal interest rate increases while the expected inflation rate rises. Given this information, we know with certainty that the real interest rate A) will not change.

B) will fall.

C) will fall, but only if the increase in the nominal rate is smaller than the increase in expected inflation.

D) will fall, but only if the increase in the nominal rate is greater than the increase in expected inflation.

E) none of these Answer: C Diff: 2 6) Under which of the following assumptions would the nominal interest rate be equal to the real interest rate?

A) Expected inflation is equal to the nominal interest rate.

B) Expected inflation is equal to the real interest rate.

C) Expected inflation is negative.

D) Expected inflation is equal to zero.

E) none of these Answer: D Diff: 2 7) If the nominal interest rate is less than the real interest rate, we know that A) both the nominal or real interest rate must be negative.

B) the nominal interest rate must be equal to expected inflation.

C) expected deflation must be occurring.

D) expected inflation must be positive.

E) expected inflation must be zero.

Answer: C Diff: 2 8) If the expected inflation rate is negative, the expected real interest rate must be A) negative.

B) less than the nominal interest rate.

C) equal to the nominal interest rate.

D) greater than the nominal interest rate.

E) none of these Answer: D Diff: 2

68 Copyright © 2021 Pearson Education, Inc.

9) Data on real and nominal interest rates of one-year U.S. T-Bills show that, over the past twenty years, A) the nominal rate has always been less than the real rate.

B) whenever the nominal rate rises, the real rate falls, and vice versa.

C) the nominal rate has varied, but the real rate has not.

D) the real rate has varied, but the nominal rate has not.

E) the real rate has always been less than the nominal rate.

Answer: E Diff: 1 10) With a nominal interest rate of 10%, the present discounted value of $200 to be received in one year is A) $90.91.

B) $165.29.

C) $181.82.

D) $190.00.

E) $220.00.

Answer: C Diff: 2 11) With a nominal interest rate of 10% per year, the present discounted value of $200 to be received in two years is A) $82.64.

B) $90.91.

C) $165.29.

D) $181.82.

E) $220.00.

Answer: C Diff: 2 12) If the nominal interest rate is 20% per year, how much money can an individual borrow today if she wants to repay $100 in one year?

A) $80.00 B) $83.33 C) $120.00 D) $78.00 E) $121.00 Answer: B Diff: 2

69 Copyright © 2021 Pearson Education, Inc.

13) With a nominal interest rate of 5% per year, the present discounted value of $100 to be received in 10 years is A) $50.00.

B) $61.39.

C) $95.24.

D) $150.00.

E) $163.89.

Answer: B Diff: 2 14) With a constant nominal interest rate equal to i, the present discounted value of $1.00 to be received 4 years from today is equal to A) 1 + i.

B) i4.

C) (1 + i)4.

D) 1/(1 + i) 4.

E) 4(1 + i).

Answer: D Diff: 2 15) An increase in the nominal interest rate, all else held constant, will always cause which of the following?

A) the real interest rate to decrease B) the expected inflation rate to decrease C) the demand for money to increase D) all of these E) none of these Answer: E Diff: 1 16) The present discounted value of a future payment becomes smaller when A) the nominal interest rate decreases.

B) the payment is made sooner rather than later.

C) the payment itself decreases.

D) all of these E) none of these Answer: C Diff: 1

70 Copyright © 2021 Pearson Education, Inc.

17) Suppose the nominal interest rate is zero. In this situation, the present discounted value of a finite sequence of future payments is equal to which of the following?

A) zero B) the sum of the all payments divided by the rate of inflation C) the average value of each payment D) the sum of all payments E) the square of the sum of all payments Answer: D Diff: 1 18) For this question, assume that the interest rate is greater than 0. Given this information and the information about the payments provided below, rank the following three sequences of payments according to their present value

2005 2006 2007

"A" $190 $200 $210

"B" $200 $200 $200

"C" $210 $200 $190

A) A > B > C B) A > C > B C) C > B > A D) C > A > B E) B > A > C Answer: C Diff: 2 19) For this question, assume that expected inflation is zero. In this situation, we know that A) the nominal and real interest rates are equal.

B) the nominal interest rate will exceed the real interest rate.

C) the real interest rate will exceed the nominal interest rate.

D) the real interest will be zero.

E) the real interest rate is negative.

Answer: A Diff: 1 20) When individuals make decisions about how much money and bonds to hold, which of the following variables affects those decisions?

A) the real interest rate only B) the nominal interest rate only C) the expected inflation rate only D) either the real interest rate or the expected inflation rate E) both the nominal and real interest rates Answer: B Diff: 1

71 Copyright © 2021 Pearson Education, Inc.

21) Because expected inflation is typically positive, we know that A) the nominal interest rate is generally less than the real interest rate.

B) the real interest rate is generally less than the nominal interest rate.

C) the nominal and real interest rates are generally equal.

D) the real interest rate is approximately equal to zero.

Answer: B Diff: 1 22) For a given nominal interest rate, a reduction in expected inflation will cause A) a reduction in the real interest rate.

B) an increase in the real interest rate.

C) an increase in investment.

D) an increase in money demand.

Answer: B Diff: 2 23) Suppose that the nominal interest rate and expected inflation both decrease by 2%. Given this information, we would expect which of the following to occur?

A) an increase in the real interest rate B) a reduction in the real interest rate C) a reduction in investment D) an increase in money demand E) an increase in the real interest rate and a reduction in investment Answer: D Diff: 2 24) For this question, assume that expected inflation is equal to the nominal interest rate. In this situation, which of the following is correct?

A) The real interest rate is negative.

B) The real interest rate is positive.

C) The real interest rate is higher than the nominal interest rate.

D) The real interest rate is zero.

Answer: D Diff: 1 25) Because the nominal interest rate is always positive, the discount factor is always A) negative.

B) greater than one.

C) zero.

D) less than one.

Answer: D Diff: 1

72 Copyright © 2021 Pearson Education, Inc.

26) Which of the following will not cause an increase in the present value of a sequence of payments?

A) a reduction in the current interest rate B) a reduction in expected future interest rates C) an increase in a future expected payment D) none of these Answer: D Diff: 2 27) Let: (1) Pt be the price of one unit of a market basket of goods (i.e., a composite commodity) in year t; (2) Pet+1 be the expected price of one unit of a market basket of goods in year t + 1; (3) πet+1 be the expected rate of inflation between period t and t + 1; and (4) it be the one-year nominal interest rate. Suppose an individual borrows the equivalent of one unit of a composite commodity today. Given this information, which of the following expressions represents (i.e., is equal to) the amount of the composite commodity one must repay in one year?

A) (1 + it)(Pet+1)/(Pt) B) (1 + πet+1)/(1 + it) C) {(1 + πet+1)/(1 + it)} - 1 D) {(1 + it)(Pt)/(Pet+1)} - 1 E) none of these Answer: A Diff: 2 28) Let: (1) Pt be the price of one unit of a market basket of goods (i.e., a composite commodity) in year t; (2) Pet + 1 be the expected price of one unit of a market basket of goods in year t + 1; (3) πet + 1 be the expected rate of inflation between period t and t + 1; and (4) it be the one-year nominal interest rate. Suppose an individual borrows the equivalent of one unit of a composite commodity today. Given this information, which of the following expressions represents (i.e., is equal to) the real interest rate (rt)?

A) (1 + it)(Pet+1)/(Pt) B) (1 + πet+1)/(1 + it) C) {(1 + πet+1)/(1 + it)} - 1 D) {(1 + it)(Pt)/(Pet+1)} - 1 E) none of these Answer: D Diff: 2

73 Copyright © 2021 Pearson Education, Inc.

29) If the expected real interest rate 5% and expected inflation 3%, the nominal interest rate in year t is approximately A) 2%.

B) 3%.

C) 5%.

D) 8%.

E) 11%.

Answer: D Diff: 1 30) With a nominal interest rate of 5%, the present discounted value of $100 to be received in one year is A) $90.91.

B) $95.23.

C) $181.82.

D) $190.00.

E) $220.00.

Answer: B Diff: 2 31) With a nominal interest rate of 5%, the present discounted value of $100 to be received in two year is A) $90.00.

B) $90.70.

C) $95.23.

D) $110.00.

Answer: B Diff: 2 6.2

Risk and Risk Premia

1) The risk that interest payments will not be made, or that the face value of a bond is not repaid when a bond matures is A) interest rate risk.

B) inflation risk.

C) liquidity risk.

D) default risk.

Answer: D Diff: 1 2) Which of the following bonds are considered to be default-risk free?

A) municipal bonds B) investment-grade bonds C) U.S. Treasury bonds D) junk bonds Answer: C Diff: 1 74 Copyright © 2021 Pearson Education, Inc.

3) The spread between the interest rates on bonds with default risk and default-free bonds is called the A) risk premium.

B) junk margin.

C) bond margin.

D) default premium.

Answer: A Diff: 2 4) Which of the following long-term bonds has the highest interest rate?

A) corporate BBB bonds B) U.S. Treasury bonds C) corporate AAA bonds D) municipal bonds Answer: A Diff: 2 5) Which of the following long-term bonds has the lowest interest rate?

A) corporate BBB bonds B) U.S. Treasury bonds C) corporate AAA bonds D) municipal bonds Answer: B Diff: 2 6) Risk premiums on corporate bonds tend to ________ during business cycle expansions and ________ during recessions, everything else held constant.

A) increase; increase B) increase; decrease C) decrease; increase D) decrease; decrease Answer: C Diff: 2 6.3

The Role of Financial Intermediaries

1) The process of indirect finance using financial intermediaries is called A) direct lending.

B) financial intermediation.

C) resource allocation.

D) financial liquidation.

Answer: B Diff: 1

75 Copyright © 2021 Pearson Education, Inc.

2) Which of the following statements are true?

A) A bank's assets are its sources of funds.

B) A bank's liabilities are its uses of funds.

C) A bank's balance sheet shows that total assets equal total liabilities plus equity capital.

D) A bank's balance sheet indicates whether or not the bank is profitable.

Answer: C Diff: 2 3) Which of the following statements is false?

A) A bank's assets are its uses of funds.

B) A bank issues liabilities to acquire funds.

C) The bank's assets provide the bank with income.

D) Bank capital is recorded as an asset on the bank balance sheet.

Answer: D Diff: 2 4) Which of the following are reported as liabilities on a bank's balance sheet?

A) reserves B) checkable deposits C) consumer loans D) deposits with other banks Answer: B Diff: 1 5) The leverage ratio is the ratio of a bank's A) assets divided by its liabilities.

B) income divided by its assets.

C) assets divided by capital.

D) capital divided by its total liabilities.

Answer: C Diff: 1 6) The capital ratio is the ratio of a bank's A) assets divided by its liabilities.

B) income divided by its assets.

C) capital divided by its assets.

D) capital divided by its total liabilities.

Answer: C Diff: 1

76 Copyright © 2021 Pearson Education, Inc.

7) Channeling funds from individuals with surplus funds to those desiring funds when the saver does not purchase the borrower's security is known as A) barter.

B) redistribution.

C) financial intermediation.

D) taxation.

Answer: C Diff: 1 8) Securitization is a process of asset transformation that involves a number of different financial institutions working together. These financial institutions are known collectively as the A) transformers.

B) amalgamation.

C) movers and shakers.

D) shadow banking system.

Answer: D Diff: 1 9) Depositors lack of information about the quality of bank assets can lead to A) bank panics.

B) bank booms.

C) sequencing.

D) asset transformation.

Answer: A Diff: 1 10) Depositors have a strong incentive to show up first to withdraw their funds during a bank crisis because banks operate on a A) last-in, first-out constraint.

B) sequential service constraint.

C) double-coincidence of wants constraint.

D) everyone-shares-equally constraint.

Answer: B Diff: 1 11) A bank is insolvent when A) its liabilities exceed its assets.

B) its assets exceed its liabilities.

C) its capital exceeds its liabilities.

D) its assets increase in value.

Answer: A Diff: 1

77 Copyright © 2021 Pearson Education, Inc.

12) Holding large amounts of bank capital helps prevent bank failures because A) it means that the bank has a higher income.

B) it makes loans easier to sell.

C) it can be used to absorb the losses resulting from bad loans.

D) it makes it easier to call in loans.

Answer: C Diff: 1 6.4

Extending the IS-LM Model

1) How many interest rates were there in the IS-LM model in Chapter 5?

A) one B) two C) three D) zero Answer: A Diff: 1 2) The new term introduced in the extended IS-LM model is A) risk premium.

B) nominal interest rate.

C) taxes.

D) G. Answer: A Diff: 1 3) The policy rate is A) determined by monetary policy.

B) a real interest rate.

C) a risk premium.

D) entering the IS equation.

Answer: A Diff: 1 4) The borrowing rate is A) the rate at which consumers and firms can borrow.

B) a nominal interest rate.

C) determined by monetary policy.

D) a risk premium.

Answer: A Diff: 1

78 Copyright © 2021 Pearson Education, Inc.

5) When x increases A) IS curve shifts to the left.

B) IS curve shifts to the right.

C) LM curve shifts upward.

D) LM curve shifts downward.

Answer: A Diff: 1 6) When x decreases A) IS curve shifts to the left.

B) IS curve shifts to the right.

C) LM curve shifts upward.

D) LM curve shifts downward.

Answer: B Diff: 1 7) When x increases leading decrease in output, a better policy tool is A) decrease in policy rate.

B) increase in policy rate.

C) increase in government spending.

D) decrease in government spending.

Answer: A Diff: 1 8) Given the zero lower bound on the nominal rate, the lowest real interest rate the central bank can achieve is A) - .

B) .

C) 0.

D) i.

Answer: A Diff: 1 9) To prevent bank runs and the consequent bank failures, the United States established the ________ in 1934 to provide deposit insurance.

A) FDIC B) SEC C) Federal Reserve D) ATM Answer: A Diff: 1

79 Copyright © 2021 Pearson Education, Inc.

10) Although the FDIC was created to prevent bank failures, its existence encourages banks to A) take too much risk.

B) hold too much capital.

C) open too many branches.

D) buy too much stock.

Answer: A Diff: 1 6.5

From a Housing Problem to a Financial Crisis

1) The Case-Shiller index is normalized to equal 100 in January A) 1999.

B) 1990.

C) 2000.

D) 2001.

Answer: C Diff: 1 2) The Case-Shiller index reached its peak in A) 2006.

B) 2007.

C) 2005.

D) 2008.

Answer: A Diff: 1 3) By 2006, about ________ of all U.S mortgages were subprimes.

A) 10% B) 20% C) 30% D) 25% Answer: B Diff: 1 4) The mortgage is said to be underwater when A) the value of the house exceeds the value of the mortgage.

B) the house is flooded.

C) the value of the mortgage exceeds the value of the house.

D) none of these Answer: C Diff: 1

80 Copyright © 2021 Pearson Education, Inc.

5) In mid-2008, estimated losses on mortgages were estimated to be about ________ of U.S. GDP. A) 2% B) 5% C) 7% D) 9% Answer: A Diff: 1 6) Which of the followings is not a bank's assets?

A) reserves B) loans C) government bonds D) checkable deposits Answer: D Diff: 1 7) Suppose bank A has assets of 100, liabilities of 80, and capital of 20. Its capital ratio is A) 20%.

B) 25%.

C) 11%.

D) 10%.

Answer: A Diff: 1 8) Suppose bank A has assets of 100, liabilities of 80, and capital of 20. Its leverage ratio is A) 4.

B) 5.

C) 10.

D) 9.

Answer: B Diff: 1 9) Suppose bank A has assets of 100, liabilities of 60, and capital of 40. Its capital ratio is A) 40%.

B) 66%.

C) 25%.

D) 60%.

Answer: A Diff: 1

81 Copyright © 2021 Pearson Education, Inc.

10) Suppose bank A has assets of 100, liabilities of 60, and capital of 40. Its leverage ratio is A) 1.5.

B) 2.5.

C) 0.6.

D) 0.4.

Answer: B Diff: 1 11) The first structured investment vehicle (SIV) was set up by ________ in 1988.

A) J.P. Morgan B) Chase C) Citigroup D) Goldman Sachs Answer: C Diff: 1 12) AIG provide CDS against A) insolvency.

B) default risk.

C) illiquidity.

D) none of these Answer: B Diff: 1 13) Securitization can not help financial intermediaries A) diversify their portfolios.

B) avoid bankruptcy.

C) attract more investors to buy and hold their securities.

D) decrease the cost of borrowing.

Answer: B Diff: 1 14) Collateralized debt obligations (CDOs) were first issued in A) 1980s.

B) 1990s.

C) 2000.

D) 2001.

Answer: A Diff: 1

82 Copyright © 2021 Pearson Education, Inc.

15) Ted spread is A) the difference between the riskless rate and the rate at which banks are willing to lend to each other.

B) the difference between the riskless rate and the yield on corporate bonds.

C) the difference between the riskless rate and return on stocks.

D) none of these Answer: A Diff: 1 16) FDIC deposit insurance is ________ per account.

A) $100,000 B) $150,000 C) $200,000 D) $250,000 Answer: D Diff: 1 17) ________ was introduced in October 2008 to clean up banks.

A) Liquidity facilities B) Wholesale funding C) TARP D) Fire sale Answer: C Diff: 1 18) American Recovery and Reinvestment Act 2009 calls for A) both tax reductions and government spending reductions.

B) both tax reductions and government spending increases.

C) both tax increases and government spending increases.

D) both tax increases and government spending reductions.

Answer: B Diff: 1 19) Firms with ________ ratings are considered the safest.

A) AAA B) BBB C) CCC D) BB Answer: A Diff: 1

83 Copyright © 2021 Pearson Education, Inc.

20) LIBOR rate is A) interbank loan rate.

B) the riskless rate.

C) TED spread.

D) discount rate.

Answer: A Diff: 1 21) The primary cause of the reduction in the nominal money supply during the early years of the Great Depression was A) the Fed's sale of bonds.

B) the Fed's purchase of bonds.

C) a reduction in the money multiplier.

D) none of these Answer: C Diff: 1 22) The collapse of the subprime mortgage market A) did not affect the corporate bond market.

B) increased the perceived riskiness of Treasury securities.

C) reduced the BBB-AAA spread.

D) increased the BBB-AAA spread.

Answer: D Diff: 2 23) The collapse of the subprime mortgage market increased the spread between BBB and default-free U.S. Treasury bonds. This is due to A) a reduction in risk.

B) a reduction in maturity.

C) a flight to quality.

D) a flight to liquidity.

Answer: C Diff: 1 Macroeconomics, 8e (Blanchard) Chapter 7: The Labor Market 7.1

A Tour of the Labor Market

1) Which of the following is considered out of the labor force?

A) the unemployed B) those temporarily laid off who will soon be recalled C) those who worked full time, but in a family business D) those individuals who have started searching for employment for the first time E) none of these Answer: E Diff: 1 84 Copyright © 2021 Pearson Education, Inc.

Use the information provided below to answer the following question(s).

The non-institutional civilian population is 250 million, of which 100 million are employed and 10 million are unemployed.

2) Based on the information above, the unemployment rate is A) 4%.

B) 6.6%.

C) 9.1%.

D) 10%.

E) 11.1%.

Answer: C Diff: 2 3) Based on the information above, the labor force participation rate is A) 36%.

B) 40%.

C) 44%.

D) 90.1%.

E) 66%.

Answer: C Diff: 2 4) Based on the information above, the non-employment rate is A) 4%.

B) 9.1%.

C) 10%.

D) 60%.

E) 66%.

Answer: D Diff: 2

85 Copyright © 2021 Pearson Education, Inc.

5) Which of the following individuals would be considered unemployed?

A) an individual who works only part-time B) an individual who works full-time in a family business, but is not paid C) an individual who is not working and is not looking for work D) all of these E) none of these Answer: E Diff: 2 6) Based on the data provided in the chapter, which of the following represents the largest component of the labor force?

A) discouraged workers B) retired individuals C) employed D) unemployed Answer: C Diff: 1 7) The labor force is defined as A) the sum of the employed and unemployed.

B) the total number employed.

C) the total number of working age individuals in the population.

D) the sum of the number of employed, unemployed and discouraged individuals.

Answer: A Diff: 1 8) The participation rate in the United States in 2018 was approximately equal to A) 96%.

B) 90%.

C) 62%.

D) 26%.

E) 5%.

Answer: C Diff: 1 9) Which of the following represents the participation rate?

A) the ratio of the number employed to the size of the labor force B) the ratio of the number employed to the civilian noninstitutional population C) the ratio of the labor force to the civilian noninstitutional population D) the ratio of the labor force to the total number of employed and unemployed workers Answer: C Diff: 1

86 Copyright © 2021 Pearson Education, Inc.

10) The average amount of time people spend unemployed is approximately A) 1 month.

B) 6 months .

C) 12 months.

D) none of these Answer: D Diff: 2 11) The Current Population Survey interviews approximately how many households each month?

A) 5,000 B) 10,000 C) 60,000 D) 100,000 Answer: C Diff: 1 12) In the United States, how many workers become unemployed, on average, every day?

A) 5,000 B) 10,000 C) 50,000 D) 100,000 Answer: C Diff: 1 13) In the United States, the average length of time people spend unemployed is A) approximately one month.

B) between two and three months.

C) between ten and eleven months.

D) greater than twelve months.

Answer: B Diff: 2 14) A reduction in the unemployment rate will tend to cause which of the following?

A) an increase in the separation rate B) a reduction in the nominal wage C) a reduction in the duration that one is unemployed D) none of these Answer: C Diff: 2

87 Copyright © 2021 Pearson Education, Inc.

15) When the unemployment rate is low, we would expect that A) the probability of losing a job is high.

B) the probability of losing a job is low.

C) the probability an unemployed individual will find another job is low.

D) the separation rate will increase.

Answer: B Diff: 2 16) The participation rate in the U.S. has increased steadily over time. First, explain what the participation rate represents. Second, explain why the participation rate has increased.

Answer: The participation rate is the ratio of the labor force to the working age population. One of the reasons for the significant increase in the participation rate is the increasing participation of women in the labor force.

Diff: 2 17) What effect does the existence of discouraged workers have on the ability of the official unemployment rate to provide accurate information about the extent to which labor is employed?

Answer: Discouraged workers are individuals who have stopped searching for employment because, for example, they have become "discouraged" with the prospects of finding employment.

Once they stop searching (after 4 weeks), they are no longer counted as unemployed and, therefore, in the labor force. Such a dynamic would cause the official unemployment to fall.

Alternatively, the existence of discouraged workers implies that the official unemployment rate underestimates the extent to which labor is being is not being used. This explains why the existence of discouraged workers can cause the unemployment rate to be an imperfect measure of the utilization of labor.

Diff: 2 18) First, provide a brief explanation of what the unemployment rate measures. Second, explain how changes in each of the components of the unemployment rate can cause changes in the unemployment rate.

Answer: The unemployment rate measures the percentage of the labor force that is unemployed.

The unemployment rate is based on a monthly survey of households. Individuals are classified as employed, unemployed, or out of the labor force. Individuals employed or unemployed are in the labor force. Suppose individuals decide to enter the labor force for the first time. This increase in the size of the labor force, all else fixed, would cause an increase in the unemployment rate.

On the other hand, if there were an increase in the number of individuals unemployed (caused by, for example, firms laying off workers as demand for their products falls), we would observe no change in the labor force but an increase in the unemployment rate.

Diff: 2

88 Copyright © 2021 Pearson Education, Inc.

7.2

Movements in Unemployment

1) Data on labor-force flows show that A) almost all separations are due to death.

B) almost all separations are due to serious illness.

C) almost all separations are quits.

D) almost all separations are layoffs.

E) none of these Answer: E Diff: 2 2) Data on labor-force flows show that A) in any given month, almost none of the unemployed gets jobs.

B) in any given month, almost all of the unemployed gets jobs.

C) the average duration of unemployment is about 2 weeks.

D) the average duration of unemployment is about 2 years.

E) in any given month, about one-fourth of the unemployed get jobs.

Answer: E Diff: 2 3) Which of the following variables is most directly determined in the labor market?

A) stock prices B) nominal wages C) interest rates D) all of these E) none of these Answer: B Diff: 1 4) The two labor markets in the "dual labor market" are A) southern versus northern.

B) western versus eastern.

C) English speaking versus non-English speaking.

D) domestic versus foreign.

E) none of these Answer: E Diff: 1

89 Copyright © 2021 Pearson Education, Inc.

5) When the Current Population Survey (CPS) was introduced in 1940, it was based on a survey of approximately 8,000 households. The CPS survey is now based on a survey of how many households?

A) 8,000 B) 10,000 C) 12,000 D) 20,000 E) 60,000 Answer: E Diff: 2 6) As the unemployment rate falls, A) the proportion of the unemployed finding a job decreases.

B) the separation rate increases.

C) the young and unskilled experience larger-than-average decreases in unemployment.

D) the separation rate decreases.

Answer: C Diff: 2 7.3

Wage Determination

1) Which of the following statements about wage setting is true?

A) most workers in the U.S. have their wages set by formal contracts.

B) formal contracts play a more important role in Japan and Western Europe than in the United States.

C) the minimum wage in the U.S. is about 75% of the average wage.

D) all of these Answer: B Diff: 1 2) The reservation wage is A) the wage that an employer must pay workers to reduce turnover to a reasonable level.

B) the wage that ensures a laid-off individual will wait for re-hire, rather than find another job.

C) the lowest wage firms are allowed by law to pay workers.

D) the wage offer that will end a labor-strike.

E) none of these Answer: E Diff: 1 3) Efficiency wage theory suggests that A) workers will be paid less than their reservation wage.

B) productivity might drop if the wage rate is too low.

C) the government can only set tax rates so high before people will prefer not to work.

D) unskilled workers will have a lower turnover rate than skilled workers.

E) firms will be more resistant to wage increases as the labor market tightens.

Answer: B Diff: 2 90 Copyright © 2021 Pearson Education, Inc.

4) If efficiency wage theory is valid, we would expect a relatively low premium over the reservation wage when A) the unemployment rate is low.

B) the job requires very little training.

C) workers can be easily monitored.

D) workers have few other options for employment in the area.

E) all of these Answer: C Diff: 2 5) Henry Ford's experiment with efficiency wages resulted in A) a dramatic drop in productivity.

B) a dramatic increase in the turnover rate.

C) a reduction in the layoff rate.

D) new problems with the work force, like drunkenness and reckless driving.

E) no noticeable effects.

Answer: C Diff: 2 6) In the wage-setting relation, the nominal wage tends to decrease when A) the price level increases.

B) the unemployment rate decreases.

C) unemployment benefits decrease.

D) the minimum wage increases.

E) all of these Answer: C Diff: 1 7) In the wage setting relation W = PeF(u,z), the variable z does not include which of the following variables?

A) the minimum wage B) unemployment benefits C) the extent to which firms mark up prices over their marginal cost D) all of these E) none of these Answer: C Diff: 1 8) Labor productivity is represented by which of the following?

A) the ratio of output to employment B) workers per unit of capital C) capital per worker D) the ratio of output to population E) the ratio of output to the labor force Answer: A Diff: 1 91 Copyright © 2021 Pearson Education, Inc.

9) Today, about ________ of U.S. workers have their wages set by collective bargaining agreements.

A) 10% B) 15% C) 20% D) 25% Answer: A Diff: 2 10) Explain several implications and characteristics of efficiency wage theories.

Answer: The efficiency wage theory suggests that firms will pay workers a wage in excess of the workers' reservation wage to minimize quits and to increase productivity. The efficiency wage theory also suggests that nominal wages will be a function of labor market conditions. As the unemployment rate falls, the nominal wage will rise.

Diff: 2 11) Explain how an increase in the unemployment rate will affect bargaining power and nominal wages.

Answer: As the unemployment rate increases, it is more difficult for individuals to find employment at other firms. So, workers' bargaining power will fall. As bargaining power falls, the nominal wage will fall.

Diff: 2 12) First, explain what the WS relation represents. Second, explain why it has its particular shape.

Answer: The WS relation illustrates the effect of changes in the unemployment rate on the real wage implied by the wage-setting behavior of firms and workers. The WS curve (or relation) is downward sloping because as the unemployment rate increases, workers have less bargaining power so the nominal wage will decrease. This decrease in W, given P, implies that the real wage will also fall. Hence, the WS curve is downward sloping.

Diff: 2 7.4

Price Determination

1) The price setting equation is represented by the following: P = (1 + m)W. When there is perfect competition, we know that m will equal A) W. B) P. C) 1.

D) W/P. E) none of these Answer: C Diff: 2

92 Copyright © 2021 Pearson Education, Inc.

2) Explain why nominal wages are a function of the expected price level.

Answer: Workers and firms care about the real wage. Nominal wages are typically set for a period of time by contracts. Individuals will, therefore, be concerned about what the future price level will be when determining the nominal wage. When setting the nominal wage, individuals will form expectations of what the future price level will be. They will use this to help determine the nominal wage.

Diff: 2 7.5

The Natural Rate of Unemployment

1) The natural rate of unemployment is the rate of unemployment A) that occurs when the money market is in equilibrium.

B) that occurs when the markup of prices over costs is zero.

C) where the markup of prices over costs is equal to its historical value.

D) that occurs when both the goods and financial markets are in equilibrium.

E) none of these Answer: E Diff: 2 2) The natural level of output is the level of output that occurs when A) the goods market and financial markets are in equilibrium.

B) the economy is operating at the unemployment rate consistent with both the wage-setting and price-setting equations.

C) the markup (m) is zero.

D) the unemployment rate is zero.

E) there are no discouraged workers in the economy.

Answer: B Diff: 2 3) Suppose we wish to examine the determinants of the equilibrium real wage and equilibrium level of employment (N). In a graph with the real wage on the vertical axis, and the level of employment on the horizontal axis, the price-setting relation will now be A) a vertical line.

B) a horizontal line.

C) an upward sloping line.

D) a downward sloping line.

E) kinked at the natural rate of unemployment.

Answer: B Diff: 2

93 Copyright © 2021 Pearson Education, Inc.

4) Suppose we wish to examine the determinants of the equilibrium real wage and equilibrium level of employment (N). In a graph with the real wage on the vertical axis, and the level of employment on the horizontal axis, the wage-setting relation will now be A) a vertical line.

B) a horizontal line.

C) an upward sloping line.

D) a downward sloping line.

E) a curve that first slopes upward, then downward.

Answer: C Diff: 2 5) The natural level of employment (N) will increase when which of the following occurs?

A) an increase in the markup of prices over costs B) a reduction in unemployment benefits C) an increase in the actual unemployment rate D) all of these E) none of these Answer: B Diff: 2 6) Suppose workers and firms expect the overall price level to increase by 5%. Given this information, we would expect that A) the nominal wage will increase by less than 5%.

B) the nominal wage will increase by exactly 5%.

C) the nominal wage will increase by more than 5%.

D) the real wage will increase by 5%.

E) the real wage will increase by less than 5%.

Answer: B Diff: 2 7) Suppose the actual unemployment rate decreases. This will cause A) an upward shift in the WS curve.

B) a downward shift in the WS curve.

C) an upward shift in the PS curve.

D) a downward shift in the PS curve.

E) none of these Answer: E Diff: 2 8) Suppose the actual unemployment rate increases. This will cause A) an upward shift in the WS curve.

B) a downward shift in the WS curve.

C) an upward shift in the PS curve.

D) a movement along the WS and the PS curves.

E) none of these Answer: D Diff: 2 94 Copyright © 2021 Pearson Education, Inc.

9) With the real wage on the vertical axis and the unemployment rate on the horizontal axis, we know that A) the WS curve is upward sloping.

B) the WS curve is downward sloping.

C) the PS curve is upward sloping.

D) the PS curve is downward sloping.

Answer: B Diff: 2 10) Based on wage setting behavior, we know that a reduction in the unemployment rate will cause A) no change in the real wage.

B) a reduction in the real wage.

C) an increase in the real wage.

D) an upward shift of the WS curve.

Answer: C Diff: 2 11) Based on price setting behavior, we know that a reduction in the unemployment rate will cause A) no change in the real wage.

B) a reduction in the real wage.

C) an increase in the real wage.

D) an upward shift of the PS curve.

Answer: A Diff: 2 12) Suppose the aggregate production function is given by the following: Y = AN. Given this information, we know that labor productivity is represented by which of the following?

A) 1/A B) A C) 1/N D) N/Y Answer: B Diff: 2 13) Suppose the aggregate production function is given by the following: Y = N. Given this information, we know that labor productivity is represented by which of the following?

A) 1/N B) N C) N/Y D) 1 Answer: D Diff: 2

95 Copyright © 2021 Pearson Education, Inc.

14) A reduction in unemployment benefits will tend to cause which of the following?

A) an upward shift in the WS curve B) a downward shift in the WS curve C) an upward shift in the PS curve D) a downward shift in the PS curve E) none of these Answer: B Diff: 2 15) An increase in the minimum wage will tend to cause which of the following?

A) an upward shift in the WS curve B) a downward shift in the WS curve C) an upward shift in the PS curve D) a downward shift in the PS curve E) none of these Answer: A Diff: 2 16) Suppose that increased international trade makes product markets more competitive in the U.S. Given this information, we would expect to observe which of the following?

A) an upward shift in the WS curve B) a downward shift in the WS curve C) an upward shift in the PS curve D) a downward shift in the PS curve E) none of these Answer: C Diff: 2 17) With the real wage on the vertical axis and employment (N) on the horizontal axis, we know that A) the WS curve is upward sloping.

B) the WS curve is downward sloping.

C) the PS curve is upward sloping.

D) the PS curve is downward sloping.

Answer: A Diff: 2 18) Based on our understanding of the labor market model presented in Chapter 7, we know that an increase in the minimum wage will cause A) an increase in the equilibrium real wage.

B) a reduction in the equilibrium real wage.

C) a reduction in the natural rate of unemployment.

D) a reduction in the equilibrium real wage and natural rate of unemployment Answer: A Diff: 2

96 Copyright © 2021 Pearson Education, Inc.

19) Based on our understanding of the labor market model presented in Chapter 7, we know that an increase in the markup will cause A) an increase in the equilibrium real wage.

B) a reduction in the equilibrium real wage.

C) a reduction in the natural rate of unemployment.

D) a reduction in the equilibrium real wage and natural rate of unemployment Answer: B Diff: 2 20) Based on our understanding of the labor market model presented in Chapter 7, we know that a reduction in the markup will cause A) an increase in the equilibrium real wage.

B) a reduction in the equilibrium real wage.

C) an increase in the natural rate of unemployment.

D) a reduction in the natural rate of unemployment and no change in the real wage.

Answer: A Diff: 2 21) For this question, assume that Y = N. Based on our understanding of the labor market model presented in Chapter 7, we know that an increase in the minimum wage will cause A) an increase in the natural level of output.

B) a reduction in the natural level of output.

C) no change in the natural level of output.

D) an increase in the natural level of employment.

Answer: B Diff: 2 22) For this question, assume that Y = N. Based on our understanding of the labor market model presented in Chapter 7, we know that a reduction in the markup will cause A) an increase in the natural level of output.

B) a reduction in the natural level of output.

C) no change in the natural level of output.

D) a reduction in the natural level of employment.

Answer: A Diff: 2 23) Based on wage setting behavior, we know that an increase in the unemployment rate will cause A) no change in the real wage.

B) a reduction in the real wage.

C) an increase in the real wage.

D) an upward shift of the WS curve.

Answer: B Diff: 2

97 Copyright © 2021 Pearson Education, Inc.

24) Based on price setting behavior, we know that an increase in the unemployment rate will cause A) no change in the real wage.

B) a reduction in the real wage.

C) an increase in the real wage.

D) an upward shift of the PS curve.

Answer: A Diff: 2 25) An increase in unemployment benefits will tend to cause which of the following?

A) a downward shift in the WS curve B) an upward shift in the PS curve C) an upward shift in the WS curve D) a downward shift in the PS curve E) none of these Answer: C Diff: 2 26) A reduction in the minimum wage will tend to cause which of the following?

A) an upward shift in the WS curve B) a downward shift in the WS curve C) an upward shift in the PS curve D) a downward shift in the PS curve E) none of these Answer: B Diff: 2 27) Explain what effect a reduction in the unemployment rate will have on the real wage based on: (1) the WS relation; and (2) the PS relation.

Answer: A reduction in the unemployment rate will increase bargaining power, increase the nominal wage, and therefore increase the real wage based on wage setting behavior. Changes in the unemployment rate have no effect on the real wage based on price setting behavior.

Diff: 2 28) First, explain what the PS relation represents. Second, explain why it has its particular shape.

Answer: The PS relation illustrates the effect of changes in the unemployment rate on the real wage implied by the price-setting behavior of firms. Firms set prices as a markup over their marginal cost of producing goods. Given that the marginal cost is assumed to be independent of the level of employment (and, therefore, the unemployment rate), changes in u will have no effect on the price firms set and, therefore, on the real wage based on PS behavior.

Diff: 2

98 Copyright © 2021 Pearson Education, Inc.

29) Graphically illustrate (using the WS and PS relations) and explain the effects of an increase in the markup on the equilibrium real wage, the natural rate of unemployment, the natural level of employment, and the natural level of output.

Answer: An increase in the markup will cause firms to raise the price given the nominal wage.

This will cause the real wage based on price setting behavior to decrease; this is represented by a downward shift in the PS curve. This reduction in the real wage will also occur with an increase in the unemployment rate. So, the natural rate of unemployment will rise and the natural level of employment and, therefore, output will fall. The equilibrium real wage will also be lower.

Diff: 2 30) Graphically illustrate (using the WS and PS relations) and explain the effects of an increase in the minimum wage on the equilibrium real wage, the natural rate of unemployment, the natural level of employment, and the natural level of output.

Answer: An increase in the minimum wage will cause the nominal wage based on wage setting behavior to increase; this is represented as an upward shift in the WS relation. As the nominal wage increases, firms will respond by increasing the price level so we will observe no change in the equilibrium real wage. We will observe an increase in the natural rate of unemployment and a reduction in both the natural level of employment and output.

Diff: 2 31) Based on your understanding of the labor market model presented by Blanchard (i.e., the WS and PS relations), explain what types of policies could be implemented to cause a reduction in the natural rate of unemployment.

Answer: The natural rate of unemployment will change whenever either the PS or WS relations change. To reduce the natural rate, policy makers could implement polices that: (1) reduce unemployment benefits; (2) reduce the minimum wage; or (3) increase competition in product markets.

Diff: 2 32) Explain how a reduction in the unemployment rate will affect bargaining power and nominal wages.

Answer: As the unemployment rate decreases, it is easier for individuals to find employment at other firms. So, workers' bargaining power will increase. As bargaining power increases, the nominal wage will increase.

Diff: 2 33) Graphically illustrate (using the WS and PS relations) and explain the effects of a reduction in the markup on the equilibrium real wage, the natural rate of unemployment, the natural level of employment, and the natural level of output.

Answer: A reduction in the markup will cause firms to reduce the price given the nominal wage.

This will cause the real wage based on price setting behavior to increase; this is represented by a upward shift in the PS curve. This increase in the real wage will also occur with an decrease in the unemployment rate. So, the natural rate of unemployment will decrease and the natural level of employment and, therefore, output will increase. The equilibrium real wage will also be higher.

Diff: 2 34) Graphically illustrate (using the WS and PS relations) and explain the effects of a reduction in 99 Copyright © 2021 Pearson Education, Inc.

the minimum wage on the equilibrium real wage, the natural rate of unemployment, the natural level of employment, and the natural level of output.

Answer: A reduction in the minimum wage will cause the nominal wage based on wage setting behavior to decrease; this is represented as an downward shift in the WS relation. As the nominal wage deceases, firms will respond by reducing the price level so we will observe no change in the equilibrium real wage. We will observe a decrease in the natural rate of unemployment and an increase in both the natural level of employment and output.

Diff: 2 35) Explain what effect an increase in the unemployment rate will have on the real wage based on: (1) the WS relation; and (2) the PS relation.

Answer: An increase in the unemployment rate will decrease bargaining power, decrease the nominal wage, and therefore decrease the real wage based on wage setting behavior. Changes in the unemployment rate have no effect on the real wage based on price setting behavior.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 8: The Phillips Curve, the Natural Rate of Unemployment, and Inflation 8.1

Inflation, Expected Inflation, and Unemployment

1) In which of the following periods was the relationship between the U.S. unemployment rate and U.S. inflation rate unstable?

A) 1901 to 1909 B) 1911 to 1919 C) 1921 to 1929 D) 1931 to 1939 E) none of these Answer: D Diff: 2 2) In the Phillips curve equation, which of the following will cause an increase in the current inflation rate?

A) an increase in the expected inflation rate B) a reduction in the unemployment rate C) an increase in the markup, m D) all of these E) none of these Answer: D Diff: 2 3) Data for which country were first used to illustrate the relationship between unemployment and inflation (i.e., the original Phillips curve)?

A) France B) United States C) Canada D) Germany E) none of these 100 Copyright © 2021 Pearson Education, Inc.

Answer: E Diff: 1 4) Which of the following individuals first discovered the relationship between unemployment and inflation?

A) Solow B) Samuelson C) Friedman D) Phillips Answer: D Diff: 1

101 Copyright © 2021 Pearson Education, Inc.

5) Which of the following individuals first discovered the relationship between unemployment and inflation for the United States?

A) Solow and Friedman B) Samuelson and Solow C) Friedman and Phillips D) Friedman and Phelps Answer: B Diff: 1 6) Explain what is meant by the "wage-price" spiral.

Answer: The wage-price spiral refers to the effects of low unemployment on inflation.

Specifically, when the unemployment rate falls, the nominal wage will rise. As W rises, firms' costs increase causing them to increase prices. As prices rise, workers will later ask for increases in the nominal wage. This increase in W again causes firms' costs and prices to rise and the process repeats itself.

Diff: 1 7) Based on the "early incarnation" of the Phillips curve, explain what effect an increase in the unemployment rate will have on the inflation rate.

Answer: An increase in u will cause a reduction in W. As W falls, firms' costs fall. As firms' costs fall, they will reduce the price level. This reduction in the price level represents, in this case, deflation.

Diff: 2 8.2

The Philips Curve and Its Mutations

1) Since approximately 1970, the most stable Phillips-type relationship for the United States has been between which of the following?

A) the rate of inflation and the change in the unemployment rate B) the unemployment rate and the change in the rate of inflation C) the change in the unemployment rate and the change in the rate of inflation D) the inverse of the unemployment rate and the rate of inflation E) the unemployment rate and the rate of inflation Answer: B Diff: 2

102 Copyright © 2021 Pearson Education, Inc.

2) Which of the following assumptions best characterized the assumption about how individuals formed expectations of inflation by the early 1970s?

A) Expected inflation for the current year was smaller than the previous year's inflation rate.

B) Expected inflation for the current year was approximately equal to the previous year's inflation rate.

C) Expected inflation for the current year was less than the previous year's inflation rate.

D) Expected inflation for the current year equal to the average inflation rate over the past five years.

E) Expected inflation for the current year equal to the average inflation rate over the past ten years.

Answer: B Diff: 2 3) When inflation has not been very persistent, as was the case in the United States before the mid-1960s, we can expect that A) the expected price level for a given year will equal the previous year's actual price level.

B) the current inflation rate will not depend heavily on past years' inflation rates.

C) lower unemployment rates will be associated with higher inflation rates.

D) all of these E) none of these Answer: D Diff: 2 4) When inflation has been persistent, as was the case in the United States during the 1970s, low unemployment rates will likely be associated with A) low natural rates of unemployment.

B) high natural rates of unemployment.

C) low but stable rates of inflation.

D) high but stable rates of inflation.

E) increases in the inflation rate.

Answer: E Diff: 2 5) For this question, assume that individuals form expectations of inflation according to the following equation πet = θπt-1. From 1970 on, the value of θ for this equation A) increased over time and approached 1.

B) decreased over time and approached zero.

C) remained constant at zero.

D) remained constant at negative one.

E) none of these Answer: A Diff: 2

103 Copyright © 2021 Pearson Education, Inc.

6) For this question, assume that the Phillips curve equation is represented by the following equation: πt - πt-1 = (m + z) - αut. A reduction in the unemployment rate will cause A) a reduction in the markup over labor costs (i.e., a reduction in m).

B) an increase in the markup over labor costs.

C) an increase in the inflation rate over time.

D) a decrease in the inflation rate over time.

E) none of these Answer: D Diff: 2 7) For this question, assume that the expected rate of inflation is a function of past year's inflation.

Also assume that the unemployment rate has greater than the natural rate of unemployment for a number of years. Given this information, we know that A) the rate of inflation will approximately be equal to zero.

B) the rate of inflation should neither increase nor decrease.

C) the rate of inflation should steadily increase over time.

D) the rate of inflation should steadily decrease.

E) the inflation rate will be approximately equal to the natural rate of unemployment.

Answer: D Diff: 2 8) The original Phillips curve implied or assumed that A) the markup over labor costs was zero.

B) the expected rate of inflation would be zero.

C) the actual and expected rates of inflation would always be equal.

D) all of these E) none of these Answer: B Diff: 2 9) For this question, assume that the Phillips curve equation is represented by the following equation: πt - πt-1 = (m + z) - αut. Given this information, the natural rate of unemployment will be equal to A) m + z.

B) (m + z - α).

C) α(m + z).

D) 0.

E) none of these Answer: E Diff: 2

104 Copyright © 2021 Pearson Education, Inc.

10) For this question, assume that the Phillips curve equation is represented by the following: πt πt-1 = (m + z) - αut. Which of the following will cause a reduction in the natural rate of unemployment?

A) an increase in m B) an increase in z C) an increase in α D) an increase in actual inflation E) an increase in expected inflation Answer: C Diff: 2 11) For this question, assume that the Phillips curve equation is represented by the following: πt πt-1 = (m + z) - αut. Which of the following will not cause an increase in the natural rate of unemployment?

A) a reduction in m B) a reduction in z C) an increase in α D) an increase in the expected rate of inflation E) all of these Answer: D Diff: 2 12) Use the following Phillips curve equation to answer this question: πt - πt-1 = (m + z) - αut.

Which of the following will cause an increase in the natural rate of unemployment?

A) a reduction in m B) an increase in z C) an increase in α D) a reduction in expected inflation E) none of these Answer: B Diff: 2 13) In which of the following decades did the Phillips curve break down for the U.S.?

A) 1940s B) 1950s C) 1960s D) none of these Answer: D Diff: 1

105 Copyright © 2021 Pearson Education, Inc.

14) Assume that expected inflation is based on the following: πet = θπt-1. An increase in θ will cause A) an increase in the natural rate of unemployment.

B) a reduction in the natural rate of unemployment.

C) no change in the natural rate of unemployment.

D) inflation in period t to be more responsive to changes in unemployment in period t.

Answer: C Diff: 2 15) Assume that expected inflation is based on the following: πet = θπt-1. If θ = 0, we know that A) a reduction in the unemployment rate will have no effect on inflation.

B) low rates of unemployment will cause steadily increasing rates of inflation.

C) high rates of unemployment will cause steadily declining rates of inflation.

D) the Phillips curve illustrates the relationship between the level of inflation rate and the level of the unemployment rate.

Answer: D Diff: 2 16) Assume that expected inflation is based on the following: πet = θπt-1. If θ = 1, we know that A) a reduction in the unemployment rate will have no effect on inflation.

B) low rates of unemployment will cause steadily increasing rates of inflation.

C) the actual unemployment rate will not deviate from the natural rate of unemployment.

D) the Phillips curve illustrates the relationship between the level of inflation rate and the level of the unemployment rate.

Answer: B Diff: 2 17) Suppose policy makers underestimate the natural rate of unemployment. In a situation like this, policy makers might implement a policy that A) attempts to maintain output below the natural level of output.

B) results in deflation.

C) attempts to maintain output below the natural level of output and results in deflation D) results in steadily rising inflation.

Answer: D Diff: 2 18) During which decade did the original Phillips curve break down? Also, briefly explain why the original Phillips curve broke during this period.

Answer: The original Phillips curve broke down in the United States in the 1970s. First, the United States was affected by oil shocks that would cause an increase in both inflation and the unemployment rate. Second, individuals changed the way they formed expectations of prices.

Rather than assume that this year's price level would be equal to last year's price level (i.e., zero expected inflation), individuals started to assume that previous inflation would persist.

Diff: 2 19) Explain how the original Phillips curve differs from the expectations-augmented Phillips curve (or the modified, or accelerationist Phillips curve).

106 Copyright © 2021 Pearson Education, Inc.

Answer: The original Phillips curve did not take into account the effects of changes in expected inflation on inflation. The expectations-augmented Phillips curve did allow for changes in expected inflation to affect actual inflation.

Diff: 2 8.3

The Philips Curve and the Natural Rate of Unemployment

1) Which of the following will not cause an increase in the natural rate of unemployment?

A) an increase in m B) an increase in z C) an increase in the expected inflation rate D) a reduction in m E) none of these Answer: C Diff: 2 2) Since 1970, the evidence for the U.S. suggests that the average rate of unemployment required to keep inflation constant has been A) between 1% and 2%.

B) between 2% and 3%.

C) between 3% and 4%.

D) between 9% and 10%.

E) none of these Answer: E Diff: 2 3) The evidence for the U.S. suggests that the natural rate of unemployment has A) increased by more than 5% since the 1960s.

B) increased by 1 to 2% since the 1960s.

C) decreased from 2000-2007, lower than it had been in the 1980s.

D) decreased by more than 5% since the 1960s.

E) fluctuated over time since the 1960s.

Answer: C Diff: 1 4) When a worker's nominal wage is indexed, the nominal wage is usually automatically adjusted based on movements in which of the following variables?

A) productivity B) the price of the firm's product C) the average wage in the country D) the average wage in the industry E) none of these Answer: E Diff: 1 5) If a country experiences persistently low inflation, which of the following tends NOT to occur?

A) wage indexation will become less important 107 Copyright © 2021 Pearson Education, Inc.

B) nominal wages will be set for shorter periods of time C) the markup over labor costs will decrease D) all of these Answer: A Diff: 2 6) Which of the following will tend to occur as a result of a reduction in the proportion of a country's workers who have indexed wages?

A) the unemployment rate will be relatively low.

B) the unemployment rate will be relatively high.

C) the inflation rate will be relatively low.

D) a given change in the unemployment rate will cause a relatively smaller change in the inflation rate.

E) none of these Answer: D Diff: 2 7) Which of the following does not represent a "labor market rigidity" to which critics refer when discussing unemployment in Europe?

A) generous unemployment insurance B) restrictive monetary and fiscal policies C) a high degree of employment protection D) relatively high minimum wages E) none of these Answer: B Diff: 1 8) Suppose policy makers overestimate the natural rate of unemployment. In situations like these, policy makers will likely implement policies that result in A) less unemployment than necessary.

B) an unemployment rate that is "too low."

C) a lower inflation rate than necessary.

D) a steadily increasing inflation rate.

E) overly expansionary monetary and fiscal policy.

Answer: C Diff: 2

108 Copyright © 2021 Pearson Education, Inc.

9) Which of the following is one possible explanation for the change in the natural rate of unemployment in the United States during the 1970s?

A) contractionary fiscal policy B) an increase in the proportion of labor contracts that were indexed C) contractionary monetary policy D) all of these E) none of these Answer: E Diff: 2 10) Which of the following will most likely cause a change in the natural rate of unemployment?

A) changes in monetary policy B) changes in fiscal policy C) changes in expected inflation D) all of these E) none of these Answer: C Diff: 2 11) An increase in the price of oil will likely cause which of the following?

A) increase the markup in the Phillips curve equation B) increase the sum "m + z" in the Phillips curve equation C) increase the natural rate of unemployment D) all of these E) none of these Answer: D Diff: 2 12) As the proportion of labor contracts that index wages to prices declines, we would expect that A) a reduction in the unemployment rate will now have a smaller effect on inflation.

B) the natural rate of unemployment will increase.

C) the natural rate of unemployment will decrease.

D) nominal wages will become more sensitive to changes in unemployment.

Answer: A Diff: 2 13) Suppose the Phillips curve is represented by the following equation: πt - πt-1 = 20 - 2ut. Given this information, we know that the natural rate of unemployment in this economy is A) 10%.

B) 20%.

C) 6.5%.

D) 5%.

E) none of these Answer: A Diff: 2 14) Suppose the Phillips curve is represented by the following equation: πt - πt-1 = 20 - 2ut. Given 109 Copyright © 2021 Pearson Education, Inc.

this information, which of the following is most likely to occur if the actual unemployment in any period is equal to 6%?

A) the rate of inflation will tend to increase B) the rate of inflation will be constant C) the rate of inflation will tend to decrease D) none of these Answer: A Diff: 2 15) Based on your understanding of the Phillips curve, explain what happens to actual inflation (relative to expected inflation) when the actual unemployment rate is either above or below the natural rate of unemployment.

Answer: When the actual unemployment rate is equal to the natural rate of unemployment, we know that actual inflation and expected inflation must be equal. In such a case, all else fixed, inflation will not change. If the actual unemployment rate were to fall below the natural rate, inflation would increase. So, the natural rate of unemployment rate may also be referred to the non-accelerating-inflation rate of unemployment. If the opposite occurs, inflation will fall below expected.

Diff: 2 16) Briefly comment on the predictions of economists Milton Friedman and Edmund Phelps about the ability to exploit a trade-off between inflation and unemployment.

Answer: Both Friedman and Phelps (separately) argued that there might be a temporary trade-off between inflation and unemployment. However, both argued that this trade-off could not be exploited permanently. Eventually, expectations of inflation would adjust.

Diff: 2 17) A number of factors are believed to have caused changes in the natural rate of unemployment in the United States during the 1990s. Briefly comment on each of these factors.

Answer: There are a number of candidates here: decrease in monopoly power, decreasing role of unions, aging U.S. population, increased prison population, increased number of workers on disability, and unexpectedly high rate of productivity growth.

Diff: 2 18) Based on your understanding of the Phillips curve, is it possible for the unemployment rate to increase while inflation increases? Explain.

Answer: This can occur when negative supply shocks occur. That is, we would observe this when factors cause the natural rate of unemployment to rise (e.g. during the 1970s). This would cause an increase in u and an increase in inflation.

Diff: 2

110 Copyright © 2021 Pearson Education, Inc.

8.4

A Summary and Many Warnings

1) The data suggest that in the European Union countries, the natural rate of unemployment A) is now higher than in the U.S. B) is no longer a relevant concept.

C) has steadily declined over the past two decades.

D) will soon exceed the percentage of the labor force that is working.

E) has become less "natural," since it is now almost entirely determined by the policies of a few large corporations.

Answer: A Diff: 1 2) During the Great Depression, the actual unemployment rate in the U.S. ________, and the natural rate apparently ________.

A) increased; decreased B) increased; remain unchanged C) increased; increased as well D) decreased; increased E) decreased; remained unchanged Answer: C Diff: 2 3) Which of the following explains why the original Phillips curve relation disappeared or, as some economists have remarked, "broke down" in the 1970s?

A) Individuals assumed the expected price level for the current year would be equal to the actual price level from the previous year.

B) Individuals assumed that expected inflation would be zero C) Individuals changed the way they formed expectations of inflation.

D) Monetary policy became contractionary.

E) More labor contracts became indexed to changes in inflation.

Answer: C Diff: 2 4) Which of the following situations generally exists when deflation occurs?

A) Inflation and unemployment are both increasing.

B) Inflation and unemployment are both decreasing.

C) The price level is decreasing.

D) The rate of inflation is falling from, for example, 10% to 3%.

E) The natural rate of unemployment is zero.

Answer: C Diff: 1

111 Copyright © 2021 Pearson Education, Inc.

5) As of 2009, what was the last year that U.S. experienced deflation?

A) 1933 B) 1955 C) 1973 D) 1991 E) 2001 Answer: B Diff: 1 6) During the 1980s and early 1990s, it was believed that the natural rate of unemployment in the U.S. was equal to A) 4%.

B) 4.5%.

C) 5%.

D) 6.5%.

E) 7%.

Answer: D Diff: 1 7) Which of the following does not explain the relatively low price inflation compared to the higher wage inflation in the U.S. during the 1990s?

A) the appreciation of the dollar B) a reduction in benefits paid to workers C) an increase in the natural rate of unemployment D) a reduction in the price of oil Answer: C Diff: 2 8) In the Phillips curve equation, which of the following will cause a reduction in the current inflation rate?

A) a reduction in the expected inflation rate B) an increase in the unemployment rate C) a reduction in the markup, m D) all of these E) none of these Answer: D Diff: 2 9) Suppose policy makers underestimate the natural rate of unemployment. In situations like these, policy makers will likely implement policies that result in A) more unemployment than necessary.

B) an unemployment rate that is "too high."

C) a higher inflation rate than necessary.

D) a steadily decreasing inflation rate.

E) overly contractionary monetary and fiscal policy.

Answer: C Diff: 2 112 Copyright © 2021 Pearson Education, Inc.

10) Explain how a reduction in the proportion of contracts that are indexed affects the relationship between changes in the unemployment rate and inflation.

Answer: As the proportion of labor contracts that are indexed falls, the effects of changes in unemployment on inflation would fall. A reduction in u will cause an increase in inflation. When inflation rises in a period, some contracts (those that are indexed) will call for an immediate increase in wages further increasing inflation within that period. As indexation becomes less prevalent, that secondary effect (caused by the indexed contracts) on inflation will be reduced.

Diff: 2 11) Explain how the unexpectedly high rate of productivity growth at the end of the 1990s affected inflation and unemployment during this period.

Answer: The unexpectedly high rate of growth of productivity would cause firms' costs to drop.

This would cause (if unexpected) a reduction in unemployment. So, we would observe a simultaneous drop in u and drop in inflation.

Diff: 2 12) Explain how changes in the proportion of contracts that are indexed affect how a given change in monetary policy will affect economic activity.

Answer: An increase in nominal money growth will increase the real money supply causing an increase in economic activity. As the proportion of labor contracts that are indexed increases, the effects of changes in unemployment on inflation would increase. A reduction in u will cause an increase in inflation. When inflation rises in a period, some contracts (those that are indexed) will call for an immediate increase in wages further increasing inflation within that period. As indexation becomes more prevalent, that secondary effect on inflation will be magnified. This magnification of the inflation effect will cause the real money supply to increase by a smaller amount and, therefore, reduce the output effects of a given monetary expansion.

Diff: 2 13) Based on the "early incarnation" of the Phillips curve, explain what effect a decrease in the unemployment rate will have on the inflation rate.

Answer: An decrease in u will cause a rise in W. As W rises, firms' costs increase. As firms' costs increase, they will raise the price level. This increase in the price level represents, in this case, inflation.

Diff: 2 14) Why has the U.S. natural rate of unemployment fallen since the early 1990s?

Answer: Researchers have offer a number of explanations: Increased globalization and stronger competition between US and foreign firms may have led to a decrease in monopoly power and a decrease in the markup; The nature of the labor market has changed; the aging of the US population; an increase in the prison population and the increase in the number of workers on disability.

Diff: 2

113 Copyright © 2021 Pearson Education, Inc.

15) Explain the natural unemployment rate and its relationship to inflation rate.

Answer: The natural unemployment rate is the unemployment rate at which the inflation rate remains constant. When the actual unemployment rate exceeds the natural rate of unemployment, the inflation rate typically decreases; when the actual unemployment rate is less than the natural unemployment, the inflation rate typically increases.

Diff: 2 16) What is the difference between deflation and disinflation?

Answer: Deflation refers to a decrease in the price level, or equivalently, negative inflation.

Disinflation is a decrease in the inflation rate.

Diff: 1 17) How will the crisis affect the natural rate of unemployment?

Answer: There is an increasing worry that the increase in the actual unemployment rate may eventually translate into an increase in the natural unemployment rate. Workers who have been unemployed for a long time may lose their skills, or their morale, and become unemployable, leading to a higher natural rate.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 9: From the Short to the Medium Run: The IS-LM-PC Model 9.1

The IS-LM-PC Model

1) The Phillips curve shows that when the unemployment rate is lower than the natural rate, A) inflation is higher than expected.

B) inflation is lower than expected.

C) policy rate is higher than expected.

D) policy rate is lower than expected.

Answer: A Diff: 2 2) The Phillips curve shows that when the unemployment rate is higher than the natural rate, A) inflation is higher than expected.

B) inflation is lower than expected.

C) policy rate is higher than expected.

D) policy rate is lower than expected.

Answer: B Diff: 2 3) Okun's law shows that when the unemployment rate is above the natural rate, A) inflation is higher than expected.

B) inflation is lower than expected.

C) output is below potential.

D) output is above potential.

Answer: C Diff: 2 114 Copyright © 2021 Pearson Education, Inc.

4) Okun's law shows that when the unemployment rate is below the natural rate, A) inflation is higher than expected.

B) inflation is lower than expected.

C) output is below potential.

D) output is above potential.

Answer: D Diff: 2 5) Disposable income equals A) income minus saving.

B) income minus both saving and taxes.

C) consumption minus taxes.

D) the sum of consumption and saving.

E) none of these Answer: D Diff: 1

115 Copyright © 2021 Pearson Education, Inc.

6) In the IS-LM-PC model, which of the following is assumed to be exogenous?

A) G B) C C) I D) Y Answer: A Diff: 2 7) In the IS-LM-PC model, investment does not depend on A) T. B) Y. C) r.

D) x.

Answer: A Diff: 2 8) In the IS-LM-PC model, LM curve is A) flat.

B) upward sloping.

C) downward sloping.

D) vertical.

Answer: A Diff: 2 9) The change in the unemployment rate is approximately equal to A) the negative of the growth rate of output.

B) the negative policy rate.

C) the negative inflation rate.

D) the negative of the growth rate of money supply.

Answer: A Diff: 2 10) Empirically output growth 1% above normal for one year leads to a ________ in the employment rate.

A) 0.6% B) 0.7% C) 0.8% D) 0.5% Answer: A Diff: 2

116 Copyright © 2021 Pearson Education, Inc.

9.2

From the Short to the Medium Run

1) The natural rate of interest is not A) zero.

B) the neutral rate of interest.

C) Wicksellian rate of interest.

D) associated with the natural rate of unemployment.

Answer: A Diff: 2 2) If the output is too high, to achieve the medium run equilibrium, the central bank will A) increases policy rate.

B) reduces policy rate.

C) increase money supply.

D) increases inflation rate.

Answer: A Diff: 2 3) If the output is too low, to achieve the medium run equilibrium, the central bank will A) increases policy rate.

B) reduces policy rate.

C) increase money supply.

D) increases inflation rate.

Answer: B Diff: 2 9.3

Complications and How Things Can Go Wrong

1) The zero lower bound refers to the situation that A) the lowest the central bank can decrease the nominal policy rate is 0%.

B) real interest rate is 0%.

C) inflation rate is 0%.

D) risk premium is 0%.

Answer: A Diff: 2 2) When the policy rate increases, A) IS curve does not change.

B) IS curve shifts to the right.

C) IS curve shifts to the left.

D) LM curve shifts upward.

E) LM curve shifts downward.

Answer: A Diff: 2

117 Copyright © 2021 Pearson Education, Inc.

3) When the policy rate decreases, A) IS curve does not change.

B) IS curve shifts to the right.

C) IS curve shifts to the left.

D) LM curve shifts upward.

E) LM curve shifts downward.

Answer: A Diff: 2 9.4

Fiscal Consolidation Revisited

1) When a government reduces its deficits by increasing taxes, in the medium run, A) output returns to potential.

B) output increases.

C) interest rate is higher.

D) IS curve shifts inward to the left.

Answer: A Diff: 2 2) When a government reduces its deficits by increasing taxes, in the short run, A) output returns to potential.

B) output increases.

C) interest rate is higher.

D) IS curve shifts inward to the left.

Answer: A Diff: 2 3) As fiscal consolidation takes place, the central bank should A) decrease the policy rate.

B) increase the policy rate.

C) increase inflation rate.

D) decrease money supply.

Answer: A Diff: 2 4) Use the IS-LM-PC model to illustrate how the economy adjusts to an increase in taxes both in the short run and in the medium run.

Answer: Refer to figure 9-4 of the textbook.

Diff: 2

118 Copyright © 2021 Pearson Education, Inc.

9.5

The Effects of an Increase in the Price of Oil

1) What is the major reason for oil price to go up in the 1970s?

A) formation of the OPEC B) fast of growth of emerging economies C) new energy D) higher demand from the US Answer: A Diff: 2 2) From 1970 to the mid-1990s, the relative price of crude petroleum A) steadily increased.

B) steadily decreased.

C) increased dramatically, then decreased dramatically.

D) decreased dramatically, then increased dramatically.

E) remained more or less the same.

Answer: C Diff: 2 3) In the short run, a reduction in the price of oil will cause A) a reduction in output.

B) an increase in the price level.

C) a reduction in the interest rate.

D) all of these E) none of these Answer: C Diff: 2 4) What is the major reason for oil price to go up in the 2000s?

A) formation of the OPEC B) fast of growth of emerging economies C) new energy D) higher demand from the US Answer: B Diff: 2 5) The wage setting relation is A) downward sloping.

B) upward sloping.

C) vertical.

D) horizontal.

Answer: A Diff: 2

119 Copyright © 2021 Pearson Education, Inc.

6) The price setting relation is A) horizontal.

B) upward sloping.

C) downward sloping.

D) vertical.

Answer: A Diff: 2 7) An increase in the price of oil will cause which of the following in the medium run?

A) no change in the level of output B) no change in the price level C) an increase in the unemployment rate D) a reduction in the interest rate E) none of these Answer: C Diff: 2 8) For this question, assume that the economy is initially operating at the natural level of output.

An increase in the price of oil will cause which of the following in the medium run?

A) a reduction in the interest rate B) a reduction in output and an increase in the aggregate price level C) a reduction in output and a reduction in the interest rate D) a reduction in unemployment, an increase in the nominal wage and an increase in the aggregate price level E) a reduction in the aggregate price level and no change in output Answer: B Diff: 2 9) For this question, assume that the economy is initially operating at the natural level of output. A reduction in consumer confidence will cause A) an increase in the real wage in the medium run.

B) a reduction in the real wage in the medium run.

C) no change in the real wage in the medium run.

D) ambiguous effects on the real wage in the medium run.

Answer: C Diff: 2 10) For this question, assume that the economy is initially operating at the natural level of output.

A reduction in taxes will cause A) an increase in the real wage in the medium run.

B) a reduction in the real wage in the medium run.

C) no change in the nominal wage in the medium run.

D) ambiguous effects on the real wage in the medium run.

E) none of these Answer: E Diff: 2 120 Copyright © 2021 Pearson Education, Inc.

11) For this question, assume that the economy is initially operating at the natural level of output.

An increase in unemployment benefits will cause A) an increase in the real wage in the medium run.

B) a reduction in the real wage in the medium run.

C) no change in the real wage in the medium run.

D) ambiguous effects on the real wage in the medium run.

Answer: C Diff: 2 12) For this question, assume that the economy is initially operating at the natural level of output.

A monetary expansion will cause A) no change in the real wage in the medium run.

B) an increase in investment in the medium run.

C) a reduction in the interest rate in the medium run.

D) no change in the nominal wage in the medium run.

Answer: A Diff: 2 13) In the short run, an increase in the price of oil will cause A) an increase in output.

B) a reduction in the price level.

C) an increase in the interest rate.

D) all of these E) none of these Answer: C Diff: 2 14) For this question, assume that the economy is initially operating at the natural level of output.

An increase in consumer confidence will cause A) a reduction in the real wage in the medium run.

B) an increase in the real wage in the medium run.

C) no change in the real wage in the medium run.

D) ambiguous effects on the real wage in the medium run.

Answer: C Diff: 2 9.6

Conclusions

1) which of the following is not an example of a shock to the economy?

A) A firm shuts down.

B) increase in oil price C) sudden decline in consumer confidence D) sharp drop in investment spending Answer: A Diff: 1 Macroeconomics, 8e (Blanchard) Chapter 10: The Facts of Growth 121 Copyright © 2021 Pearson Education, Inc.

10.1

Measuring the Standard of Living

1) Of the following, the most often used measure of changing living standards is A) the growth rate of nominal GDP. B) the growth rate of real GDP. C) the growth rate of nominal GDP per capita.

D) the growth rate of real GDP per capita.

E) unemployment per capita.

Answer: D Diff: 1 2) Over the last hundred years, A) movements in output due to recessions and recoveries dominate the movement caused by long-run growth.

B) output has decreased in as many years as it has increased.

C) U.S. output has approximately doubled.

D) all of these E) none of these Answer: E Diff: 1 3) Suppose individuals wish to obtain the most accurate comparison of living standards between the Canada and Saudi Arabia. To do so, one would convert Saudi Arabian output into dollars using A) the current nominal exchange rate.

B) the current real exchange rate.

C) the prior year's real exchange rate.

D) an average of the last five years' exchange rates.

E) purchasing power parity methods.

Answer: E Diff: 1 4) Using current exchange rates, the U.S. standard of living is ranked A) higher than it would be under the purchasing power parity method.

B) lower than it would be under the purchasing power parity method.

C) number one in the world.

D) among the lowest in the world.

E) none of these Answer: B Diff: 1

122 Copyright © 2021 Pearson Education, Inc.

5) If output per capita grows by a constant 6% per year, then the standard of living would grow by about ________ over 3 years.

A) 12% B) 17% C) 18% D) 19% E) 20% Answer: D Diff: 1 6) Explain why economists do not use exchange rates to compare standards of living across countries. Also, discuss what economists do to avoid these problems.

Answer: Answers should include discussions about the effects of variations in exchange rates and of systematic differences in prices across countries. The use of PPP numbers reduces the problems associated with these two issues.

Diff: 2 7) What are the three main conclusions that can be drawn from an analysis of growth rates for developed countries?

Answer: There are three main conclusions. First, standards of living have increased significantly since 1950. Second, growth rates of output per capita decreased starting in the mid 1970s. And third, the levels of output per capita have tended to converge over time.

Diff: 2 8) To what extent have the three main facts of growth not held for certain countries? For which countries have they not generally held?

Answer: There are three main conclusions. First, standards of living have increased significantly since 1950. Second, growth rates of output per capita decreased starting in the mid 1970s. And third, the levels of output per capita have tended to converge over time. These three main conclusions do not apply to many African countries. For example, standards of living have actually decreased for some countries.

Diff: 2 10.2

Growth in Rich Countries since 1950

1) Which of the following is a main conclusion about growth for OECD countries and the four rich countries examined in the chapter?

A) There has been a large increase in the standard of living since 1950.

B) The growth rates have decreased since the mid-1970s.

C) There has been a convergence of output per capita since 1950.

D) all of these E) none of these Answer: D Diff: 1

123 Copyright © 2021 Pearson Education, Inc.

2) Which of the following best characterizes the economic growth for OECD countries since the mid-1970s?

A) Growth has come to a complete halt.

B) Growth has slowed down.

C) Growth has not changed since the 1950s and 1960s.

D) Growth has increased slightly.

E) Growth has increased dramatically.

Answer: B Diff: 1 3) Between 1950 and 2017, standards of living in the OECD countries A) did not change at all.

B) were converging.

C) all increased at the same rate.

D) decreased at the same rate.

E) decreased, but at different rates.

Answer: B Diff: 1 4) In the OECD countries, there is a negative relationship between output per capita in 1950 and A) growth since 1950.

B) output per capita in the 1990s.

C) distance from the equator.

D) population.

E) none of these Answer: A Diff: 2 5) Over the last half-century, which of the following countries has had the highest growth rate of output per capita?

A) Japan B) France C) United Kingdom D) United States Answer: A Diff: 1 6) When switching from the "current exchange rate" method to the "purchasing power parity" method, India's standard of living in dollars A) decreases.

B) remains essentially the same.

C) rises, but still remains far below that of the U.S. D) rises almost to the level of the U.S. E) leapfrogs over that of the U.S. Answer: C Diff: 2 124 Copyright © 2021 Pearson Education, Inc.

7) Which of the following countries had the highest level of output per capita in 1950?

A) United States B) France C) Japan D) United Kingdom Answer: A Diff: 1 8) Which of the following countries had the lowest level of output per capita in 1950?

A) United States B) France C) Japan D) United Kingdom Answer: C Diff: 1 9) Which of the following countries experienced the lowest level of output per capita in 2017?

A) United States B) France C) Japan D) United Kingdom Answer: D Diff: 1 10) Which of the following countries had the highest rate of growth of output per capita between 1950 and 2017?

A) United States B) France C) Japan D) United Kingdom Answer: C Diff: 2 11) By 2017, which of the following countries had the highest level of real output per capita?

A) United States B) France C) Japan D) United Kingdom Answer: A Diff: 1

125 Copyright © 2021 Pearson Education, Inc.

12) Research by Richard Layard indicates that an increase in a country's level of output per capita will A) always increase happiness in that country.

B) always decrease happiness in that country.

C) generally have no effect on happiness in that country.

D) increase happiness in that country if output per capita is relatively low.

Answer: D Diff: 2 13) Research by Richard Layard indicates that happiness A) increases as output per capita increases.

B) decreases as output per capita increases.

C) does not change as output per capita changes.

D) appears to depend on people's relative incomes.

Answer: D Diff: 2 14) Convergence refers to what phenomenon regarding growth theory?

Answer: Convergence refers to the phenomenon where the levels of output per capita for countries tend to move closer to one another over time. This implies that countries that start with relatively lower levels of output per worker catch up to other countries and, in some cases, actually pass other countries.

Diff: 1 10.3

A Broader Look across Time and Space

1) Which of the following is not among the four tigers?

A) China B) Taiwan C) Hong Kong D) Singapore Answer: A Diff: 1 2) "Convergence" has been occurring among the OECD countries because A) the richer countries give away more of their output than the poorer ones.

B) the poorer countries have had higher growth rates than the richer ones.

C) the richer countries have had higher growth rates than the poorer ones.

D) the poorer countries have had positive growth rates, while the richer ones have had negative growth rates.

E) the procedures for measuring output per capita have been changing.

Answer: B Diff: 1

126 Copyright © 2021 Pearson Education, Inc.

3) Explain Mathusian trap.

Answer: Thomas Robert Malthus, an English economist, argued that an increase in output would lead to a decrease in mortality, leading to an increase in population until output per person was back to its initial level. The stagnation of output per person is called a Malthusian trap.

Diff: 2 10.4

Thinking about Growth: A Primer

1) For this question, assume that there are decreasing returns to capital, decreasing returns to labor, and constant returns to scale. Now suppose that both capital and labor decrease by 5%. Given this information, we know that output (Y) will A) not change.

B) decrease by less than 5%.

C) decrease by 5%.

D) decrease by more than 5% but less than 10%.

E) none of these Answer: C Diff: 2 2) For this question, assume that there are decreasing returns to capital, decreasing returns to labor, and constant returns to scale. A reduction in the capital stock will cause which of the following?

A) a reduction in output B) no change in output C) an increase in output per capita D) increase the capital-labor ratio E) none of these Answer: A Diff: 1 3) For this question, assume that the production function exhibits the same characteristics as those presented in the textbook. Based on these characteristics (i.e., assumptions), successive and equal increases in capital per worker will cause which of the following to occur?

A) Output per worker will decline.

B) Output per worker will not change.

C) Output per worker will increase by a constant amount.

D) Output per worker will increase by a larger amount.

E) none of these Answer: A Diff: 2

127 Copyright © 2021 Pearson Education, Inc.

4) Which of the following will cause a reduction in output per worker in the long run run?

A) capital accumulation or technological progress B) capital accumulation C) an increase in the number of workers D) expansionary monetary policy E) none of these Answer: C Diff: 2 5) For this question, assume that a country experiences a permanent increase in its saving rate.

Which of the following will occur as a result of this increase in the saving rate?

A) a permanently faster growth rate of output B) a permanently higher level of output per capita C) a permanently higher level of capital per worker D) all of these E) a permamently higher level of output per capita and capital per worker.

Answer: E Diff: 2 6) For this question, assume that a country experiences a permanent reduction in its saving rate.

Which of the following will occur as a result of this reduction in the saving rate?

A) a permanently slower growth rate of output B) no permanent effect on the level of output per capita C) a permanently lower level of output per worker D) a permamently slower growth rate of output but no permanent effect on the level of output per capita Answer: C Diff: 2 7) When using a logarithmic scale to plot output per capita over time, an upward-sloping curve that becomes increasingly steep indicates A) output per capita is not changing.

B) output per capita is growing by a constant amount each year.

C) output per capita is growing by a constant percentage each year.

D) output per capita is growing by an increasing percentage each year.

E) output per capita is not defined.

Answer: D Diff: 2

128 Copyright © 2021 Pearson Education, Inc.

8) An upward-sloping straight line on a linear scale will become a (an) ________ on a logarithmic scale.

A) upward sloping straight line B) upward sloping curve that gets continually steeper C) upward sloping curve that gets continually flatter D) horizontal line E) downward sloping straight line Answer: C Diff: 2 9) Which of the following must occur to sustain economic growth in the long run?

A) technological progress B) capital accumulation C) a higher saving rate D) all of these Answer: A Diff: 2 10) Given the broadest interpretation of technology, technology will include which of the following?

A) how well firms are run B) the organization and sophistication of markets C) the political environment D) the list of blueprints defining the types of products and the techniques available to produce them E) all of these Answer: E Diff: 1 11) Given the narrow interpretation of technology, technology will include which of the following?

A) how well firms are run B) the organization and sophistication of markets C) the political environment D) none of these Answer: D Diff: 1 12) Suppose there are two countries that are identical with the following exception. The saving rate in country A is greater than the saving rate in country B. Given this information, we know that in the long run A) the growth rate of output per capita will be greater in B than in A. B) the growth rate of output per capita will be greater in A than in B. C) the capital-labor ratios (K/N) will be the same in both countries.

D) the growth rate of output per capita will be the same in both countries.

Answer: D Diff: 2 129 Copyright © 2021 Pearson Education, Inc.

13) Suppose there are two countries that are identical with the following exception. The saving rate in country A is greater than the saving rate in country B. Given this information, we know that in the long run A) the capital-labor ratio (K/N) will be greater in B than in A. B) the capital-labor ratio (K/N) will be greater in A than in B. C) the capital-labor ratio (K/N) will be the same in the two countries.

D) economic growth will be higher in A than in B. Answer: B Diff: 2 14) Suppose there are two countries that are identical with the following exception. The saving rate in country A is greater than the saving rate in country B. Given this information, we know that in the long run A) output per capita will be greater in B than in A. B) output per capita will be greater in A than in B. C) economic growth will be higher in A than in B. D) more information is needed to answer this question.

Answer: B Diff: 2 15) Which of the following will not cause an increase in aggregate output (Y) in the long run?

A) an increase in N B) an increase in K C) an increase in technology D) a reduction in the saving rate E) none of these Answer: D Diff: 1 16) Over the past fifty years, convergence has generally occurred for all of the following groups of countries with the exception of A) the five richest countries.

B) European countries.

C) the "four tigers" in Asia.

D) OECD countries.

E) none of these Answer: E Diff: 1

130 Copyright © 2021 Pearson Education, Inc.

17) Assume that constant returns to scale exists and that N and K both increase by 2%. Given this information, we know that A) output (Y) will increase by 4%.

B) Y will increase by 2%.

C) Y will increase by less than 2%.

D) Y will increase by less than 4% and more than 2%.

Answer: B Diff: 2 18) Assume that constant returns to scale exists and that N and K both decrease by 3%. Given this information, we know that A) output (Y) will decrease 6%.

B) Y will decrease by 3%.

C) Y will decrease by less than 3%.

D) the capital-labor ratio (K/N) will decrease.

Answer: B Diff: 2 19) Constant returns to scale implies that if N and K both increase by 3% that A) output (Y) will increase by 3%.

B) Y/N will increase by 3%.

C) Y/N will increase by less than 3%.

D) the capital-labor ratio will increase by 3%.

Answer: A Diff: 2 20) For this question, assume that the saving rate increases. We know that this increase in the saving rate will cause which of the following?

A) a temporary increase in the level of output per capita B) no permanent change in the level of output per capita C) a temporary increase in the rate of growth of output per capita D) a permanently higher rate of growth of output per capita E) none of these Answer: C Diff: 2 21) Which of the following will cause a reduction in output per worker (Y/N)?

A) a reduction in the capital stock (K) B) a reduction in the saving rate C) a reduction in K/N D) all of these Answer: D Diff: 2

131 Copyright © 2021 Pearson Education, Inc.

22) Assume that employment increases by 3%. Holding all other factors constant, we know with certainty that which of the following will occur?

A) output will increase by 3% B) output per capita will increase by 3% C) output will increase by less than 3% D) the capital labor ratio will increase E) none of these Answer: C Diff: 2 23) Suppose the stock of capital increases by 2% and employment increases by 2%. Given this information, we know that A) output per capita will increase by 6%.

B) output will increase by 4%.

C) output per capita will increase by less than 4% and more than 2%.

D) none of these Answer: D Diff: 3 24) Decreasing returns to capital (K) implies that a 4% increase in K will cause A) a reduction in output per worker (Y/N).

B) a reduction in K/N. C) Y to increase by exactly 4%.

D) Y to increase by less than 4%.

E) no change in Y/N. Answer: D Diff: 2 25) For this question, assume that the saving rate decreases. We know that this decrease in the saving rate will cause which of the following?

A) a temporary decrease in the level of output per capita B) no permanent change in the level of output per capita C) a temporary decrease in the rate of growth of output per capita D) a permanently lower rate of growth of output per capita E) none of these Answer: C Diff: 2 26) Which of the following will cause an increase in output per worker (Y/N)?

A) an increase in the capital stock (K) B) an increase in the saving rate C) an increase in K/N D) all of these Answer: D Diff: 2

132 Copyright © 2021 Pearson Education, Inc.

27) Decreasing returns to capital (N) implies that a 4% increase in N will cause A) Y to increase by more than 4%.

B) Y to increase by exactly 4%.

C) Y to increase by less than 4%.

D) no change in Y/N. Answer: C Diff: 2 28) Assume that employment decreases by 3%. Holding all other factors constant, we know with certainty that which of the following will occur?

A) output will decrease by 3% B) output per capita will decrease by 3% C) output will decrease by less than 3% D) the capital labor ratio will decrease E) none of these Answer: C Diff: 2 29) If output per capita grows by a constant 5% per year, then the standard of living would grow by about ________ over 3 years.

A) 12% B) 16% C) 17% D) 18% E) 20% Answer: B Diff: 1 30) If output per capita grows by a constant 3% per year, then the standard of living would grow by about ________ over 4 years.

A) 13% B) 14% C) 15% D) 16% E) 17% Answer: A Diff: 1 31) Discuss and explain what is meant by the "state of technology."

Answer: The state of technology can be defined either narrowly or more broadly. In a narrow sense, it allows firms to convert resources into goods and services. A broader interpretation would allow it to include/take into account the organization of firms, the organization of markets, and so on.

Diff: 1

133 Copyright © 2021 Pearson Education, Inc.

32) Explain each of the following: (1) constant returns to scale; (2) decreasing returns to capital; and (3) decreasing returns to labor.

Answer: All three of these things refer to characteristics of the production function. CRS means that if all inputs change by the same proportion, the level of output will change by the same proportion. Decreasing returns to capital and labor indicates that increases in either resource will cause output to increase but at a decreasing rate.

Diff: 1 33) Suppose the capital stock increases by 10% and the number of employed workers increases by 5%. Given this information, explain what will happen to output and to output per worker.

Answer: The level of output will obviously increase because the amount of inputs has increased.

Given that the capital stock increases by an amount greater than the amount of workers, we know that the capital labor ratio has increased. This implies that output per worker has also increased.

Diff: 2 34) First, what are the primary determinants of output per worker? And second, to what extent can each cause a permanent change in economic growth?

Answer: The two primary determinants of growth are capital accumulation and technological progress. Capital changes when there are changes in investment and, therefore, the saving rate.

Because the saving rate cannot increase forever, capital accumulation cannot cause permanent changes in economic growth. Technological progress, on the other hand, can result in permanent changes in economic growth.

Diff: 2 35) Briefly explain what effect a reduction in the saving rate will have on growth.

Answer: A reduction in the saving rate will reduce investment, capital and output. During the adjustment process, the rate of growth of output will be negative. However, at some point, I, K and Y will no longer fall. So, the reduction in the saving rate will not have a permanent effect on the rate of growth of output.

Diff: 2 36) Is it possible for a country to experience a permanent increase in output per worker over time?

If so, how can this occur?

Answer: Yes, it is possible for sustained growth to occur. For sustained growth to occur, technological progress must occur. Changes in the saving rate will not cause sustained changes in growth rates.

Diff: 2 37) Briefly explain the relationship between output per capita and happiness. Specifically, to what extent are these two variables related?

Answer: Research by Richard Layard indicates that the proportion of very happy people is higher among the rich than among the poor. At the country level, at low levels of output per capita, increases in output per capita do seem to cause increases in happiness. However, this relation is not as strong for those countries with higher levels of output per capita.

Diff: 2 38) Briefly explain what effect an increase in the saving rate will have on growth.

134 Copyright © 2021 Pearson Education, Inc.

Answer: An increase in the saving rate will increase investment, capital and output. During the adjustment process, the rate of growth of output will be positive. However, at some point, I, K and Y will no longer increase. So, the increase in the saving rate will not have a permanent effect on the rate of growth of output.

Diff: 2 39) Graphically show and explain the effects of an improvement in the state of technology.

Answer: An improvement in technology shifts the production function up, leading to an increase in output per worker for a given level of capital per worker.

Diff: 2 40) Consider the production function Y= a. Compute output when K = 81 and N = 100. b. Is this production function characterized by constant returns to scale? Explain.

Answer: a. Y = 9 * 10 = 90 b. If both K and N double, Y also doubles. Yes, this production function is characterized by constant returns to scale.

Diff: 2 41) Consider the production function, Y = , write the production function as a relation between output per worker and capital per worker.

Answer:

=

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 11: Saving, Capital Accumulation, and Output 11.1

Interactions between Output and Capital

1) An increase in the saving rate will affect which of the following variables in the long run?

A) output per worker B) capital per worker C) the level of investment D) all of these Answer: D Diff: 2 2) A reduction in the saving rate will not affect which of the following variables in the long run?

A) output per worker B) the growth rate of output per worker C) the amount of capital in the economy D) capital per worker E) none of these 135 Copyright © 2021 Pearson Education, Inc.

Answer: B Diff: 2 3) Which of the following will cause an increase in output per worker in the long run?

A) an increase in the saving rate B) a reduction in the depreciation rate C) an increase in the stock of human capital D) all of these Answer: D Diff: 2 4) Which of the following statements is always true?

A) Investment equals depreciation.

B) Investment equals the capital stock minus depreciation.

C) The capital stock is equal to investment minus depreciation.

D) Any change in the capital stock is equal to investment minus depreciation.

E) The increase in investment is equal to the capital stock minus depreciation.

Answer: D Diff: 1 5) Which of the following is not a flow variable?

A) investment B) saving C) the money supply D) output E) all of these Answer: D Diff: 1 6) The capital-labor ratio will tend to decrease over time when A) investment per worker equals saving per worker.

B) investment per worker is less than saving per worker.

C) investment per worker exceeds depreciation per worker.

D) saving per worker equals depreciation per worker.

E) output per worker exceeds capital per worker.

Answer: B Diff: 2 7) In the absence of technological progress, which of the following remains constant in the steady state equilibrium?

A) investment per worker B) output per worker C) saving per worker D) all of these E) investment per worker and output per worker Answer: D Diff: 2 136 Copyright © 2021 Pearson Education, Inc.

8) Suppose, due to the effects of a military conflict that has ended, that a country experiences a large reduction in its capital stock. Assume no other effects of this event on the economy. Which of the following will tend to occur as the economy adjusts to this situation?

A) a relatively low growth rate for some time B) a relative high growth rate for some time C) zero growth for some time, followed by a gradually increasing growth rate D) positive growth, followed by negative growth, and then zero growth E) none of these Answer: B Diff: 2 9) In the model where it is assumed that the state of technology does not change, what parameters and/or variables cause changes in steady state output per worker.

Answer: In general, output per worker will depend on the capital-labor ratio. The equilibrium capital-labor ratio will depend on the saving rate and on the rate of depreciation. Output will also depend on the amount of human capital per worker. So, changes in s, δ, and H will cause changes in output per worker.

Diff: 1 10) Explain the relationship among output, saving, and investment.

Answer: The level of output (per worker) will depend on the capital-labor ratio. The amount of capital will depend on investment (and depreciation). Investment will, in turn, depend on the amount of saving. Changes in saving will cause changes in investment, capital, and, therefore, output.

Diff: 2

137 Copyright © 2021 Pearson Education, Inc.

11) Explain what condition must occur for each of the following to occur: (1) the capital stock to increase; (2) the capital stock to decrease; and (3) the capital stock to remain constant.

Answer: The equation for the change in the capital stock (per worker) is given by the following: (Kt+1/N) - (Kt/N) = s(Yt/N) - δ(Kt/N). The capital stock will not change when investment equals depreciation. If investment/saving exceeds (is less than) depreciation, the capital stock will grow (decline).

Diff: 2 12) Suppose depreciation per worker is less than saving per worker. Given this situation, explain what will happen to each of the following variables over time: capital per worker, output per worker, saving per worker, and consumption per worker.

Answer: If depreciation is less than saving, it is also less than investment. Alternatively, there is excess investment to offset the amount of capital that wears out. So, the capital stock will increase.

This will cause an increase in K/N, Y/N, and S/N. As Y/N rises, so will C/N. Diff: 2 13) For an economy in which there is no technological progress, explain what must occur for the steady state to occur. Also explain what this implies about the rate of growth of output, output per worker, and the capital stock.

Answer: The steady occurs when the economy is in equilibrium. Specifically, the steady state refers to the situation where K/N and Y/N are constant. K/N will not change when investment per worker equals depreciation per worker. During the adjustment process, the growth rates of Y, Y/N, and K/N will all be negative. Once the steady state is reached, these variables are constant and the growth rates will be zero.

Diff: 2 11.2

The Implications of Alternative Saving Rates

1) For this question assume that technological progress does not occur. The rate of saving in Canada has generally been greater than the saving rate in the U.S. Given this information, we know that in the long run A) Canada's growth rate will be greater than the U.S. growth rate.

B) investment per worker in Canada will be no different than U.S. investment per worker.

C) capital per worker in Canada will be no different than U.S. capital per worker.

D) all of these E) none of these Answer: E Diff: 2 2) When an economy is operating at the steady state, we know that A) steady state saving equals consumption.

B) steady state saving is less than total consumption.

C) steady state saving is equal to depreciation per worker.

D) steady state saving exceeds depreciation each year by a constant amount.

E) none of these Answer: C Diff: 2 138 Copyright © 2021 Pearson Education, Inc.

3) In the absence of technological progress, which of the following is true when the economy is operating at the steady state?

A) The growth of output per worker is zero.

B) The growth of output per worker is equal to the saving rate.

C) The growth of output per worker is equal to the rate of investment.

D) The growth of output per worker is equal to the rate of depreciation.

E) none of these Answer: A Diff: 2 4) In the absence of technological progress, an increase in the saving rate will cause which of the following?

A) increase temporarily the growth of output per worker B) increase the steady state growth of output per worker C) decrease temporarily the growth of output per worker D) decrease the steady state growth of output per worker E) have an ambiguous effect on the growth of output per worker Answer: A Diff: 2 5) In the absence of technological progress, we know with certainty that an increase in the saving rate will cause which of the following?

A) increase steady state consumption B) decrease steady state consumption C) have no effect on steady state consumption D) increase steady state consumption only if the increase in saving exceeds the increase in depreciation E) increase steady state consumption only if the increase in saving is less than the increase in depreciation Answer: E Diff: 3 6) In the absence of technological progress, we know that the level of output per worker in the steady state will A) increase over time.

B) remain constant.

C) decrease as a result of decreasing returns to scale.

D) increase or decrease, depending on the rate of saving.

E) increase or decrease, depending on the rate of depreciation.

Answer: B Diff: 1

139 Copyright © 2021 Pearson Education, Inc.

7) As an economy adjusts to an increase in the saving rate, we would expect output per worker A) to increase at a constant rate and continue increasing at that rate in the steady state.

B) to increase at a permanently higher rate.

C) to decrease at a permanently higher rate.

D) to return to its original level.

E) none of these Answer: E Diff: 2 8) Our model of long-run economic growth suggests that A) the U.S. growth slowdown since 1950 has been caused largely by low saving in the U.S. B) a higher rate of saving in the U.S. cannot do much to increase the U.S. growth rate over the next two decades.

C) saving in the U.S. has exceeded the golden-rule level.

D) all of these E) none of these Answer: E Diff: 1 9) The Social Security system in the United States was introduced in which year?

A) 1915 B) 1935 C) 1945 D) 1955 E) none of these Answer: B Diff: 1 10) Suppose there is an increase in the saving rate. This increase in the saving rate must cause an increase in consumption per capita in the long run when A) capital per worker approaches the golden-rule level of capital per worker.

B) the saving is used for education rather than physical capital.

C) the rate of saving exceeds the rate of depreciation.

D) there is no technological progress.

E) technological progress depends on human capital.

Answer: A Diff: 2 11) When steady state capital per worker is above the golden-rule level, we know with certainty that an increase in the saving rate will A) increase consumption in both the short run and the long run.

B) decrease consumption in both the short run and the long run.

C) decrease consumption in the short run, and increase it in the long run.

D) increase consumption in the short run, and decrease it in the long run.

E) none of these Answer: B Diff: 2 140 Copyright © 2021 Pearson Education, Inc.

12) Suppose two countries are identical in every way with the following exception. Economy A has a higher saving rate than economy B. Given this information, we know with certainty that A) steady state consumption in A is higher than in B. B) steady state consumption in A is lower than in B. C) steady state consumption in A and in B are equal.

D) steady state growth of output per worker is higher in A than in B. E) none of these Answer: E Diff: 2 13) Suppose two countries are identical in every way with the following exception. Economy A has a greater quantity of human capital than economy B. Given this information, we know with certainty that A) steady state consumption in A is higher than in B. B) steady state consumption in A is lower than in B. C) steady state consumption in A and in B are equal.

D) steady state growth of output per worker is higher in A than in B. Answer: A Diff: 3 14) Suppose two countries are identical in every way with the following exception. Economy A has a higher rate of depreciation (δ) than economy B. Given this information, we know with certainty that A) steady state consumption in A is higher than in B. B) steady state consumption in A is lower than in B. C) steady state consumption in A and in B are equal.

D) steady state growth of output per worker is higher in A than in B. E) none of these Answer: B Diff: 3 15) The countries with the lowest output per capita A) are rich with human capital, but have little physical capital.

B) are rich with physical capital, but have little human capital.

C) are poor in both human and physical capital.

D) have low living standards in spite of relatively high levels of both human and physical capital.

E) may or may not be poor in human capital, depending on whether the exchange rate or purchasing power parity method is used for comparison.

Answer: C Diff: 1

141 Copyright © 2021 Pearson Education, Inc.

16) Which of the following are reasons to suspect spending on education might overestimate human capital investment?

A) Education spending leaves out foregone wages.

B) Part of total spending on education is really consumption.

C) Much human capital investment comes from on-the-job training.

D) all of these E) none of these Answer: B Diff: 1 17) If endogenous growth models are correct, a lower rate of growth in the long run could occur as a result of which of the following?

A) a lower rate of saving B) a lower rate of depreciation C) a redefinition of depreciation D) a redefinition of the steady state E) none of these Answer: A Diff: 2 18) Suppose the following situation exists for an economy: Kt+1/N > Kt/N. Given this information, we know that A) saving per worker equals depreciation per worker in period t.

B) saving per worker is less than depreciation per worker in period t.

C) saving per worker is greater than depreciation per worker in period t.

D) the saving rate fell in period t.

E) none of these Answer: C Diff: 2 19) Suppose the following situation exists for an economy: Kt+1/N = Kt/N. Given this information, we know that A) saving per worker equals depreciation per worker in period t.

B) saving per worker is less than depreciation per worker in period t.

C) saving per worker is greater than depreciation per worker in period t.

D) the saving rate fell in period t.

E) steady state consumption is equal to the golden rule level of steady state consumption.

Answer: A Diff: 2

142 Copyright © 2021 Pearson Education, Inc.

20) At the current steady state capital-labor ratio, assume that the steady state level of per capita consumption, (C/N)*, is less than the golden rule level of steady state per capita consumption.

Given this information, we can be certain that A) an increase in the saving rate will cause an increase in the steady state level of per capita consumption ((C/N)*).

B) a reduction in the capital-labor ratio will cause a reduction in (C/N)*.

C) the capital labor ratio will tend to increase over time.

D) the capital labor ratio will tend to decrease over time.

E) a reduction in the saving rate will have an ambiguous effect on (C/N)*.

Answer: E Diff: 2 21) Suppose the following situation exists for an economy: Kt+1/N < Kt/N. Given this information, we know that A) saving per worker equals depreciation per worker in period t.

B) consumption per worker will tend to fall as the economy adjusts to this situation.

C) saving per worker is greater than depreciation per worker in period t.

D) the saving rate increased in period t.

E) none of these Answer: E Diff: 2 22) The golden rule level of capital refers to A) the level of capital that maximizes output per worker.

B) the level of capital that maximizes the standard of living.

C) the level of capital that maximizes consumption per worker in the steady state.

D) all of these E) none of these Answer: E Diff: 1 23) Suppose the following situation exists for an economy: Kt+1/N = Kt/N. Given this information, we know with certainty that A) the economy is operating at the golden rule equilibrium in period t.

B) saving per worker is less than depreciation per worker in period t.

C) saving per worker is greater than depreciation per worker in period t.

D) investment per worker equals depreciation per worker in period t.

Answer: D Diff: 2

143 Copyright © 2021 Pearson Education, Inc.

24) Suppose the saving rate is initially less than the golden rule saving rate. We know with certainty that a reduction in the saving rate will cause A) a reduction in the capital labor ratio.

B) a reduction in output per worker.

C) a reduction in consumption per worker.

D) all of these E) none of these Answer: D Diff: 2 25) Suppose the saving rate is initially greater than the golden rule saving rate. We know with certainty that a reduction in the saving rate will cause A) a reduction in the rate of growth in the long run.

B) a reduction in output per worker.

C) a reduction in consumption per worker.

D) all of these E) none of these Answer: B Diff: 2 26) Suppose the saving rate is initially greater than the golden rule saving rate. We know with certainty that an increase in the saving rate will cause A) an increase in the rate of growth in the long run.

B) a reduction in output per worker.

C) a reduction in consumption per worker.

D) all of these E) none of these Answer: C Diff: 2 27) Which of the following represents the change in the capital stock?

A) consumption minus depreciation B) output minus depreciation C) investment minus saving D) investment minus depreciation Answer: D Diff: 1 28) When the economy is in the steady state, we know with certainty that A) investment per worker is equal to depreciation per worker.

B) consumption per worker is maximized.

C) output per worker is maximized.

D) the growth rate is maximized.

E) all of these Answer: A Diff: 1 144 Copyright © 2021 Pearson Education, Inc.

29) Which of the following represents the effects in period t of an increase in the saving rate in period t?

A) no change in K/N B) no change in Y/N C) a reduction in C/N D) all of these Answer: D Diff: 1 30) Suppose there are two countries that are identical in every way with the following exception: Country A has a lower depreciation rate (δ) than country B. Given this information, we know with certainty that A) the growth rate will be the same in the two countries.

B) the growth rate will be higher in A than in B. C) K/N will be higher in B. D) Y/N will be higher in B. Answer: A Diff: 2 31) Suppose the economy is initially in the steady state. An increase in the depreciation rate (δ) will cause A) a reduction in K/N. B) a reduction in Y/N. C) a reduction in C/N. D) all of these E) none of these Answer: D Diff: 2 32) Suppose the economy is initially in the steady state. A reduction in the depreciation rate (δ) will cause A) an increase in K/N. B) an increase in the growth rate in the long run.

C) a reduction in C/N. D) all of these Answer: A Diff: 2 33) Which of the following will likely cause an increase in output per worker?

A) an increase in education expenditures B) an increase in the saving rate C) an increase in on-the-job training D) all of these Answer: D Diff: 2

145 Copyright © 2021 Pearson Education, Inc.

34) Based on our understanding of the model presented in chapter 11, which of the following will cause a permanent increase in growth?

A) an increase in education spending B) an increase in the saving rate C) an increase in capital accumulation D) all of these E) none of these Answer: E Diff: 2 35) An increase in the saving rate will not affect which of the following variables in the long run?

A) output per worker B) the growth rate of output per worker C) the amount of capital in the economy D) capital per worker E) none of these Answer: B Diff: 2 36) The capital-labor ratio will tend to increase over time when A) investment per worker equals saving per worker.

B) investment per worker exceeds saving per worker.

C) investment per worker is less than depreciation per worker.

D) saving per worker equals depreciation per worker.

E) output per worker is less than capital per worker.

Answer: B Diff: 2 37) In the absence of technological progress, a decrease in the saving rate will cause which of the following?

A) decrease temporarily the growth of output per worker B) decrease the steady state growth of output per worker C) increase temporarily the growth of output per worker D) increase the steady state growth of output per worker E) have an ambiguous effect on the growth of output per worker Answer: A Diff: 2

146 Copyright © 2021 Pearson Education, Inc.

38) In the absence of technological progress, we know with certainty that an decrease in the saving rate will cause which of the following?

A) decrease steady state consumption B) increase steady state consumption C) have no effect on steady state consumption D) decrease steady state consumption only if the decrease in saving exceeds the increase in depreciation E) decrease steady state consumption only if the decrease in saving is less than the decrease in depreciation Answer: E Diff: 3 39) As an economy adjusts to an decrease in the saving rate, we would expect output per worker A) to decrease at a constant rate and continue decreasing at that rate in the steady state.

B) to decrease at a permanently higher rate.

C) to increase at a permanently higher rate.

D) to return to its original level.

E) none of these Answer: E Diff: 2 40) Suppose the following situation exists for an economy: Kt+1/N < Kt/N. Given this information, we know that A) saving per worker equals depreciation per worker in period t.

B) saving per worker is less than depreciation per worker in period t.

C) saving per worker is greater than depreciation per worker in period t.

D) the saving rate fell in period t.

E) none of these Answer: B Diff: 2 41) At the current steady state capital-labor ratio, assume that the steady state level of per capita consumption, (C/N)*, is greater than the golden rule level of steady state per capita consumption.

Given this information, we can be certain that A) a reduction in the saving rate will cause a decrease in the steady state level of per capita consumption ((C/N)*).

B) an increase in the capital-labor ratio will cause an increase in (C/N)*.

C) the capital labor ratio will tend to decrease over time.

D) the capital labor ratio will tend to increase over time.

E) a reduction in the saving rate will have an ambiguous effect on (C/N)*.

Answer: E Diff: 2

147 Copyright © 2021 Pearson Education, Inc.

42) Suppose the economy is initially in the steady state. A reduction in the depreciation rate (δ) will cause A) an increase in K/N. B) an increase in Y/N. C) an increase in C/N. D) all of these E) none of these Answer: D Diff: 2 43) Which of the following will likely cause a reduction in output per worker?

A) a reduction in education expenditures B) a reduction in the saving rate C) a reduction in on-the-job training D) all of these Answer: D Diff: 2 44) In the model where it is assumed that the state of technology does not change, what parameters and/or variables cause changes in steady state output per worker?

A) savings rate B) depreciation rate C) human capital per worker D) all of these E) none of these Answer: D Diff: 2 45) Suppose there is an increase in the saving rate. Explain what effect this will have on output, output per worker, the rate of growth of output, and the rate of growth of output per worker.

Answer: The increase in s will cause an increase in S/N and I/N. At the initial K/N, depreciation is less than investment. Alternatively, there is excess investment to offset the amount of capital that wears out. So, the capital stock will increase. This will cause an increase in K/N, Y/N, and S/N. As Y/N rises, so will C/N. Diff: 2 46) During the latter half of the 1990s, the U.S. saving rate decreased. Will this reduction in the saving rate have a permanent effect on the rate of growth of output per worker? Explain.

Answer: Changes in the saving rate can only cause temporary changes in the growth rate. Once the new steady state is reached (caused by the drop in s), the growth rates would return to zero.

Diff: 2

148 Copyright © 2021 Pearson Education, Inc.

47) Graphically illustrate and explain the effects of an increase in the saving rate on the Solow growth model. In your graph, clearly label all curves and equilibria.

Answer: The graph is easy. The increase in s will cause an increase in S/N and I/N. At the initial K/N, depreciation is less than investment. Alternatively, there is excess investment to offset the amount of capital that wears out. So, the capital stock will increase. This will cause an increase in K/N, Y/N, and S/N. As Y/N rises, so will C/N. This is all shown easily with the graph of the model.

Diff: 2 48) Graphically illustrate and explain the effects of an increase in the rate of depreciation (δ) on the Solow growth model. In your graph, clearly label all curves and equilibria.

Answer: The depreciation line becomes steeper and at the initial K/N depreciation is now greater than investment. In this case, K/N and Y/N will fall. If depreciation is greater than saving, it is also greater than investment. Alternatively, there is insufficient investment to offset the amount of capital that wears out. So, the capital stock will decrease. This will cause a reduction in K/N, Y/N, and S/N. As Y/N falls, so will C/N. Diff: 2 49) Suppose policy makers wish to increase steady state consumption per worker. Explain what must happen to the saving rate to achieve this objective.

Answer: Answer: it depends! Whether the saving rate must increase, decrease, or remain constant depends on what the current saving rate is compared to the golden rule saving rate. If s < sg, the saving rate must increase to increase steady state consumption. If s > sg, the opposite must occur.

Diff: 2 50) Suppose the saving rate is greater than the golden rule saving rate (sG). First, explain what must happen to the saving rate in order to increase steady state consumption. Second, what are the advantages and disadvantages of this policy to increase steady state consumption.

Answer: The saving rate must decrease. This will cause an initial increase in consumption per worker. As the economy responds to this reduction in s, K/N and Y/N will fall. In fact, C/N will rise (as long as the drop in s does not go past the golden rule rate) as well and eventually exceed its initial level. The advantage of such a policy is that it will increase C/N initially and in the long run (given the previous qualifier). The are few if any disadvantages. It is possible to cut s too much (this has not been discussed here).

Diff: 2 51) Suppose there is a reduction in the saving rate. Explain what effect this will have on output, output per worker, the rate of growth of output, and the rate of growth of output per worker.

Answer: The reduction in s will cause a decrease in S/N and I/N. At the initial K/N, depreciation is more than investment. Alternatively, there is not enough investment to offset the amount of capital that wears out. So, the capital stock will decrease. This will cause a decrease in K/N, Y/N, and S/N. As Y/N falls, so will C/N. Diff: 2

149 Copyright © 2021 Pearson Education, Inc.

52) Graphically illustrate and explain the effects of a decrease in the saving rate on the Solow growth model. In your graph, clearly label all curves and equilibria.

Answer: The decrease in s will cause a reduction in S/N and I/N. At the initial K/N, depreciation is more than investment. Alternatively, there is not enough investment to offset the amount of capital that wears out. So, the capital stock will decrease. This will cause a decrease in K/N, Y/N, and S/N. As Y/N falls, so will C/N. This is all shown easily with the graph of the model.

Diff: 2 53) Graphically illustrate and explain the effects of a decrease in the rate of depreciation (δ) on the Solow growth model. In your graph, clearly label all curves and equilibria.

Answer: The depreciation line becomes flatter and at the initial K/N depreciation is now less than investment. In this case, K/N and Y/N will rise. If depreciation is less than saving, it is also less than investment. Alternatively, there is excess investment to offset the amount of capital that wears out. So, the capital stock will increase. This will cause an increase in K/N, Y/N, and S/N. As Y/N rises, so will C/N. This is all shown easily with the graph of the model.

Diff: 2 54) Explain the difference between fully funded social security system and pay-as-you-go social security system.

Answer: Fully funded social security system taxes workers, invests their contributions in financial assets, and pays back the principal plus the interest to the workers when they retire.

Pay-as-you-go system taxes workers and redistributes the tax contribution as benefits to the current retirees. There are two major differences between the two systems. First, what retirees receive is different in each case. Second, the two systems have different macroeconomic implications. In both systems private saving goes down. But in the fully funded system, public saving goes up and it has no effect on total saving and no effect on capital accumulation. In the pay-as-you-go system, the decrease in private saving is not compensated by an increase in public saving. Total saving goes down, and so does capital accumulation.

Diff: 2 55) Explain the two relations that determine the evolution of output in the long run.

Answer: The amount of capital determines the amount of output being produced. The amount of output determines the amount of saving and in turn, the amount of capital being accumulated over time.

Diff: 1

150 Copyright © 2021 Pearson Education, Inc.

11.3

Getting a Sense of Magnitudes

1) If the saving rate is 1 (i.e., s = 1), we know that A) K/N will be at its highest level.

B) Y/N will be at its highest level.

C) C/N = 0.

D) all of these Answer: D Diff: 2 2) Suppose an economy experiences a 5% increase in human capital. We know that this will cause A) Y/N to increase by more than 5%.

B) Y/N to increase by exactly 5%.

C) Y/N to increase by less than 5%.

D) no change in Y/N. E) a reduction in output per worker.

Answer: C Diff: 2 3) Suppose an economy experience a 4% increase in each of the following variables: N, K, and H (human capital). Given this information, we know with certainty that A) Y will increase by more than 4%.

B) Y will increase by exactly 4%.

C) Y will increase by less than 4%.

D) Y will increase by less than 12% but by more than 4%.

E) none of these Answer: D Diff: 2 4) Suppose there are two countries that are identical in every way with the following exception: Country A has a higher saving rate than country B. Given this information, we know with certainty that A) the growth rate will be higher in A than in B. B) the growth rate will be the same in the two countries.

C) the level of consumption per worker will be higher in A. D) the level of consumption per worker will be higher in B. Answer: B Diff: 2

151 Copyright © 2021 Pearson Education, Inc.

11.4

Physical versus Human Capital

1) Suppose there are two countries that are identical in every way with the following exception: Country A has a higher stock of human capital than country B. Given this information, we know with certainty that A) the growth rate will be higher in A than in B. B) the growth rate will be the same in the two countries.

C) output per worker will be the same in the two countries.

D) K/N will be higher in B. Answer: B Diff: 2 2) Explain what human capital is and discuss how changes in human capital can affect output per worker.

Answer: Human capital represents the set of skills possessed by labor. In addition to physical capital, changes in H will also cause changes in output. So, an increase in H/N will also cause an increase in Y/N. Diff: 1 Macroeconomics, 8e (Blanchard) Chapter 12: Technological Progress and Growth 12.1

Technological Progress and the Rate of Growth

1) In the following production function, Y = f(K, NA), a 20% increase in A will cause which of the following variables to increase by 20%?

A) labor B) effective labor C) output D) output per worker E) none of these Answer: B Diff: 2 2) In the following production function, Y = f(K, NA), suppose A increases by 20%. This 20% increase in A implies that A) the same output can be produced with 20% less labor.

B) the effective quantity of labor has increased by 20%.

C) output will increase by less than 20%.

D) all of these Answer: D Diff: 2 3) In the production function Y = f(K, NA), for a given state of technology, constant returns to scale implies that output (Y) will increase by 7% when A) K or NA increase by 7%.

B) K and N increase by 7%.

C) N or A increase by 7%.

152 Copyright © 2021 Pearson Education, Inc.

D) N and A increase by 7%.

E) all of these Answer: B Diff: 2 4) Which of the following will cause an increase in output per effective worker?

A) an increase in population growth B) an increase in the rate of depreciation C) a reduction in the saving rate D) an increase in the rate of technological progress E) an increase in the saving rate Answer: E Diff: 2

153 Copyright © 2021 Pearson Education, Inc.

Use the following information to answer the question(s) below: (1) the rate of depreciation is 10% per year, (2) the population growth rate is 2% per year, and (3) the growth rate of technology is 3% per year.

5) Refer to the information above. Which of the following equals the annual growth rate of "effective labor" in the steady state in this economy?

A) 2% B) 3% C) 5% D) 10% E) 15% Answer: C Diff: 2 6) Refer to the information above. Which of the following represents the level of investment needed to maintain a constant capital stock (K) in this economy?

A) .02K B) .03K C) .05K D) .10K E) .15K Answer: D Diff: 2 7) Refer to the information above. Which of the following represents the level of investment needed to maintain constant capital per effective worker (K/NA) in this economy?

A) .02K B) .03K C) .05K D) .10K E) .15K Answer: E Diff: 2 8) Refer to the information above. Which of the following represents the steady-state growth rate of output in this economy?

A) 2% B) 3% C) 5% D) 10% E) 15% Answer: C Diff: 2

154 Copyright © 2021 Pearson Education, Inc.

9) Refer to the information above. Which of the following represents the steady-state growth rate of output per worker in this economy?

A) 2% B) 3% C) 5% D) 10% E) 15% Answer: B Diff: 2 10) Which of the following will cause an increase in the steady-state growth rate of capital?

A) an increase in the saving rate B) an increase in the population growth rate C) a temporary increase in technological progress D) all of these E) none of these Answer: B Diff: 3 11) Which of the following will cause a reduction in the steady-state growth rate of output per worker?

A) a reduction in the saving rate B) an increase in the population growth rate C) an increase in the rate of depreciation D) an increase in the saving rate E) none of these Answer: E Diff: 2 12) Which of the following is always true after an economy reaches a balanced growth equilibrium?

A) the growth rate of output equals the rate of depreciation B) population growth is zero C) the growth rate of capital is equal to the growth rate of the effective work force D) the growth rate of capital is equal to the savings rate E) none of these Answer: C Diff: 2

155 Copyright © 2021 Pearson Education, Inc.

13) Suppose there is an increase in the saving rate. This increase in the saving rate will cause an increase in which of the following once the economy reaches its new steady state equilibrium?

A) growth rate of output B) growth rate of capital C) growth rate of capital per worker D) all of these E) none of these Answer: E Diff: 2 14) Suppose output per worker in a country has grown at the same rate as technology over for many years. This country's growth would be described as A) "appropriable" growth.

B) "balanced" growth.

C) "effective" growth.

D) "diffuse" growth.

E) none of these Answer: B Diff: 1 15) Which of the following represents a dimension of technological progress?

A) larger quantities of output for given quantities of capital and labor B) better products C) a larger variety of products D) new products E) all of these Answer: E Diff: 1 16) Assume that an economy experiences both positive population growth and technological progress. In this economy, which of the following is constant when balanced growth is achieved?

A) K B) NA C) K/N D) Y/NA E) none of these Answer: D Diff: 2

156 Copyright © 2021 Pearson Education, Inc.

17) Assume that an economy experiences both positive population growth and technological progress. In this economy, which of the following is constant when balanced growth is achieved?

A) I B) S C) Y/N D) all of these E) none of these Answer: E Diff: 2 18) Which of the following is not constant when balanced growth is obtained?

A) Y/NA B) NA C) K/NA D) all of these E) none of these Answer: B Diff: 2 19) Assume that an economy experiences both positive population growth and technological progress. Once the economy has achieved balanced growth, we know that the capital stock is A) constant.

B) growing at a rate of gA. C) growing at a rate of gN. D) growing at a rate of gA + gN. E) none of these Answer: D Diff: 2 20) Assume that an economy experiences both positive population growth and technological progress. Once the economy has achieved balanced growth, we know that output (Y) is A) constant.

B) growing at a rate of gA + gN. C) growing at a rate of gN. D) growing at a rate of gA. E) growing at a rate of gA - gN. Answer: B Diff: 2

157 Copyright © 2021 Pearson Education, Inc.

21) Assume that an economy experiences both positive population growth and technological progress. Once the economy has achieved balanced growth, we know that the capital per effective worker ratio (K/NA) is A) growing at a rate of δ + gA + gN. B) growing at a rate of gA + gN. C) growing at a rate of gN. D) growing at a rate of gA. E) none of these Answer: A Diff: 2 22) Assume that an economy experiences both positive population growth and technological progress. Once the economy has achieved balanced growth, we know that the output per effective worker ratio (Y/NA) is A) growing at a rate of 0.

B) growing at a rate of gA + gN. C) growing at a rate of gN. D) growing at a rate of gA. E) none of these Answer: A Diff: 2 23) Assume that an economy experiences both positive population growth and technological progress. Once the economy has achieved balanced growth, we know that the output per worker ratio (K/N) is A) constant.

B) growing at a rate of gA - gN. C) growing at a rate of gN. D) growing at a rate of gA. E) growing at a rate of δ + gA + gN. Answer: D Diff: 2 24) Assume that an economy experiences both positive population growth and technological progress. Once the economy has achieved balanced growth, we know that the capital per worker ratio (K/N) is A) constant.

B) growing at a rate of gA - gN. C) growing at a rate of gN. D) growing at a rate of gA. E) growing at the same rate as Y/N. Answer: E Diff: 2

158 Copyright © 2021 Pearson Education, Inc.

25) Assume that an economy experiences both positive population growth and technological progress. Once the economy has achieved balanced growth, we know that A) S/NA = (δ + gA + gN)K/NA. B) S/NA = (gA + gN)K/NA. C) I/NA = (δ)K/NA. D) I = δK. E) none of these Answer: A Diff: 2 26) Assume that an economy experiences both positive population growth and technological progress. Once the economy has achieved balanced growth, we know that growth rate of K/NA is A) gA gN. B) gA + gN. C) 0.

D) gA. E) none of these Answer: C Diff: 2 27) Let α represent labor's share of total output. The Solow residual is represented by A) gy - [αgN + (1 - α)gK].

B) gy.

C) gK. D) αgN. E) 1/(1 - α).

Answer: A Diff: 2 28) Let α represent labor's share of total output. The Solow residual is, therefore, represented by A) αgy.

B) αgA. C) αgK. D) αgN. E) 1/α.

Answer: B Diff: 2

159 Copyright © 2021 Pearson Education, Inc.

Use the information provided below to answer the following question(s). δ = .11 gA = .03 gN = .02 29) Refer to the information above. Given this information, we know that effective labor (NA) grows at which rate?

A) 0 B) 1% C) 4% D) 5% E) 15% Answer: D Diff: 1 30) Refer to the information above. Which of the following represents the amount of investment per effective worker needed to maintain a constant level of capital per effective worker (K/NA)?

A) .02(K/NA) B) .03(K/NA) C) .05(K/NA) D) .13(K/NA) E) .16(K/NA) Answer: E Diff: 2 31) Refer to the information above. Given this information, the steady state rate of growth of Y/NA is A) 0.

B) 2%.

C) 3%.

D) 5%.

E) 16%.

Answer: A Diff: 1 32) Refer to the information above. Given this information, the steady state rate of growth of output per worker is A) 0.

B) 2%.

C) 3%.

D) 5%.

E) 16%.

Answer: C Diff: 1

160 Copyright © 2021 Pearson Education, Inc.

33) Refer to the information above. Given this information, the steady state rate of growth of output is A) 0.

B) 2%.

C) 3%.

D) 5%.

E) 16%.

Answer: D Diff: 1 34) Assume that an economy experiences both positive population growth and technological progress. A reduction in the saving rate will cause A) no change in K/NA. B) a permanent reduction in the rate of growth of output per worker.

C) a permanent reduction in the rate of growth of output.

D) no change in Y/NA. E) none of these Answer: E Diff: 2 35) Which of the following will cause an increase in the steady-state growth rate of output per worker?

A) an increase in the saving rate B) a reduction in the population growth rate C) a reduction in the rate of depreciation D) a reduction in the saving rate E) none of these Answer: E Diff: 2 36) Suppose there is a reduction in the saving rate. This decrease in the saving rate will cause a reduction in which of the following once the economy reaches its new steady state equilibrium?

A) growth rate of output B) growth rate of capital C) growth rate of capital per worker D) all of these E) none of these Answer: E Diff: 2 37) Explain the different dimensions of technological progress.

Answer: There are several dimensions of technological progress: more output for a given amount of inputs, better products, new products, a larger variety of products.

Diff: 1

161 Copyright © 2021 Pearson Education, Inc.

38) Explain what factors determine how much investment is required to maintain a given level of capital per effective worker.

Answer: There are three factors that will affect the amount of required investment: depreciation, population growth, and rate of technological progress.

Diff: 1 39) Explain what factors determine the slope of the required investment line.

Answer: The slope of the required investment line will depend on: the rate of depreciation, population growth, and rate of technological progress.

Diff: 1 40) Assume the economy has achieved the balanced growth steady state. Explain what factors determine the rates of growth of each of the following variables when balanced growth is achieved: output per effective worker, capital per effective worker, output per worker, output, and consumption per worker.

Answer: When balanced growth is achieved, K/NA and Y/NA are constant so their rates of growth are 0. K and Y must, therefore, grow at the same rate as NA which equals the sum of population growth and rate of TP. The rate of growth of Y/N will equal the rate of growth of TP. C will grow at the same rate as Y. Diff: 2 41) Suppose there is an increase in the saving rate. Explain what effect this increase in the saving rate will have on the rate of growth of output per worker.

Answer: As described in answers for the previous chapter, an increase in the saving rate will only temporarily affect the growth rates of Y and Y/N. Once the new balanced growth equilibrium is achieved, the growth rates of Y and Y/N will return to their original levels.

Diff: 2 42) Graphically illustrate and explain the effects of an increase in the saving rate on the Solow growth model. In your answer, you must clearly label all curves and the initial and final equilibria.

In your answer, explain what happens to the rate of growth of output per worker and the rate of growth of output as the economy adjusts to this increase in the saving rate.

Answer: The graph is easy. The saving rate increases causing the saving/investment function to shift up. K/NA and Y/NA will rise to some permanently higher level. The growth rates of Y and Y/N will temporarily increase and then return to their original levels.

Diff: 2 43) Graphically illustrate and explain the effects of an increase in the rate of technological progress on the Solow growth model. In your answer, you must clearly label all curves and the initial and final equilibria. In your answer, explain what happens to the rate of growth of output per worker and the rate of growth of output as the economy adjusts to this increase in the rate of technological progress.

Answer: The increase in the rate of TP will cause the required investment line to become steeper.

K/NA and Y/NA will fall over time to some permanently lower level. The increase in the rate of TP will cause the rate of growth of Y and Y/N to increase over time and to reach a permanently higher level.

Diff: 2 162 Copyright © 2021 Pearson Education, Inc.

44) Graphically illustrate and explain the effects of an increase in population growth on the Solow growth model. In your answer, you must clearly label all curves and the initial and final equilibria.

In your answer, explain what happens to the rate of growth of output per worker and the rate of growth of output as the economy adjusts to this increase in population growth.

Answer: An increase in the rate of population growth will also cause the required investment line to become steeper. This will also cause K/NA and Y/NA to fall over time. This implies that during the adjustment process Y will grow slower than the now more rapidly increasing NA. So, the growth rate of Y/N actually temporarily decreases here. Once the new equilibrium is achieved, K and Y will now grow more quickly as a result of the increase in population growth. However, the rate of growth of Y/N is still determined by the rate of TP. Diff: 2 45) Suppose policy makers pass a budget that results in an increase in the budget deficit. Also assume that this fiscal policy action results in a reduction in the saving rate. To what extent will this reduction in the saving rate cause permanent changes in the rate of growth of output per worker? Explain.

Answer: A budget that causes an increase in the budget deficit will cause a reduction in the saving rate. Reductions in the saving rate will only temporarily affect the growth rates of Y and Y/N. Once the new balanced growth equilibrium is achieved, the growth rates of Y and Y/N will return to their original levels.

Diff: 2 46) To what extent can changes in the rate of technological progress cause permanent changes in the rate of growth of output per worker? Explain.

Answer: For example, an increase in the rate of TP will cause the required investment line to become steeper. K/NA and Y/NA will fall over time to some permanently lower level. The increase in the rate of TP will cause the rate of growth of Y and Y/N to increase over time and to reach a permanently higher level.

Diff: 2 12.2

The Determinants of Technological Progress

1) Which of the following best describes a situation where research is considered relatively fertile?

A) research that translates into many new products B) research that costs the firms relatively little money C) research that cannot be easily copied by other firms D) all of these E) none of these Answer: A Diff: 1

163 Copyright © 2021 Pearson Education, Inc.

2) Which of the following best describes a situation where research is considered appropriable?

A) research that is well suited to its commercial purpose B) research that is easily copied by another firm C) research that translates into many new products D) all of these E) none of these Answer: D Diff: 1 3) Patent protection is important in affecting technological progress because it makes research and development A) diffuse more quickly.

B) more fertile.

C) more easily available.

D) more appropriable.

E) none of these Answer: D Diff: 1 4) Which of the following represents the appropriability of research?

A) the protection given to new products by the law B) how R&D spending translates into new ideas C) the extent to which firms benefit from the results of their own R&D spending D) the rate of technological progress Answer: C Diff: 1 5) Which of the following represents the fertility of research?

A) the protection given to new products by the law B) how R&D spending translates into new ideas C) the extent to which firms benefit from the results of their own R&D spending D) the rate of technological progress Answer: B Diff: 1 6) Patents represent A) the protection given to new products by the law.

B) how R&D spending translates into new ideas.

C) the extent to which firms benefit from the results of their own R&D spending.

D) the rate of technological progress.

Answer: A Diff: 1

164 Copyright © 2021 Pearson Education, Inc.

7) Convergence of output per capita across countries has come from A) a convergence of saving rates.

B) a convergence of the accumulation of capital.

C) higher technological progress from the countries that started behind.

D) all of these Answer: C Diff: 1 8) Which of the following is hypothesized to explain the reduction in the rate of technological progress?

A) measurement error B) the increase in the size of the service sector C) a reduction in R&D spending D) all of these E) none of these Answer: D Diff: 1 9) Based on recent research, which of the following is the most likely cause of the reduction in the rate of technological progress?

A) measurement error B) the increase in the size of the service sector C) a reduction in R&D spending D) a reduction in the fertility of research E) all of these Answer: D Diff: 1 10) Which of the following can help explain the technology gap that exists between some countries?

A) poorly established property rights B) political instability C) the relative absence of entrepreneurs D) all of these E) none of these Answer: D Diff: 1 11) The method of constructing a measure of technological progress relies on which of the following assumptions?

A) each factor of production is paid its marginal product B) population growth does not change C) population growth is zero D) the saving rate does note change Answer: A Diff: 2 165 Copyright © 2021 Pearson Education, Inc.

12) Explain what is meant by the fertility and appropriability of the research process.

Answer: The fertility of research indicates the extent to which research yields new ideas. The appropriability refers to the extent to which firms can benefit from these new ideas.

Diff: 2 13) What factors determine technological progress?

Answer: Technological progress depends on (1) the fertility of research and development-how spending on R&D translates into new ideas and new products, and (2) the appropriability of the results of R&D-the extent to which firms benefit from the results of their R&D. Diff: 2 12.3

Institutions, Technological Progress, and Growth

1) When was the last year that GDP per capita in North Korea was approximately equal to GDP per capita in South Korea?

A) 1950 B) 1970 C) 1990 D) 2000 E) none of these Answer: B Diff: 1 2) Graphically illustrate and explain the effects of a reduction in the saving rate on the Solow growth model. In your answer, you must clearly label all curves and the initial and final equilibria.

In your answer, explain what happens to the rate of growth of output per worker and the rate of growth of output as the economy adjusts to this decrease in the saving rate.

Answer: The graph is easy. The saving rate reduction causing the saving/investment function to shift down. K/NA and Y/NA will fall to some permanently lower level. The growth rates of Y and Y/AN will temporarily decrease and then return to their original levels.

Diff: 2 3) Suppose policy makers pass a budget that results in a reduction in the budget deficit. Also assume that this fiscal policy action results in an increase in the saving rate. To what extent will this increase in the saving rate cause permanent changes in the rate of growth of output per worker? Explain.

Answer: A budget that causes a reduction in the budget deficit will cause an increase in the saving rate. Increases in the saving rate will only temporarily affect the growth rates of Y and Y/N. Once the new balanced growth equilibrium is achieved, the growth rates of Y and Y/N will return to their original levels.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 13: The Challenges of Growth 13.1

The Future of Technological Progress

1) Technological unemployment is a macroeconomic phenomenon that occurs when 166 Copyright © 2021 Pearson Education, Inc.

A) unemployment changes due to the effects of technology in high-technology industries.

B) unemployment changes due to the effects of monetary and fiscal policy in the New Economy.

C) hysterisis.

D) Eurosclerosis.

E) unemployment changes as a result of technological change.

Answer: E Diff: 1 2) Which of the following statements about the United States during the twentieth century is correct?

A) Output growth has been approximately equal to employment growth.

B) Output growth has been slower than employment growth.

C) Output growth has been faster than employment growth.

D) Output has increased largely due to monetary and fiscal policy.

E) Output has decreased largely due to monetary and fiscal policy.

Answer: C Diff: 1 3) Suppose an economy experiences an increase in technological progress. This increase in technological progress will A) allow more output to be produced with the same number of workers.

B) allow the same amount of output to be produced with fewer workers.

C) lead to changes in the types of goods produced.

D) all of these E) none of these Answer: D Diff: 2 4) Some believe that technological progress leads to higher unemployment in the medium run.

This claim that technological progress results in an increase in unemployment in the medium is supported by A) economic theory, but contradicted by the evidence.

B) theory and evidence.

C) the evidence, but contradicted by theory.

D) neither theory nor evidence.

E) none of these Answer: D Diff: 1

167 Copyright © 2021 Pearson Education, Inc.

5) The evidence suggests that recent technological change A) permanently increased the natural rate of unemployment.

B) is different from past technological change, in that it has no impact on productivity.

C) has increased productivity in the service sector only.

D) has increased productivity in the manufacturing sector only.

E) has increased the wage gap between skilled and unskilled workers.

Answer: E Diff: 2 6) When the production function is represented by Y = NA, labor productivity is represented by which of the following expressions?

A) 1/A B) NA C) A/Y D) Y/A E) none of these Answer: E Diff: 2 7) When the unemployment rate is on the horizontal axis and the real wage is on the vertical axis, an increase in productivity will cause which of the following to occur?

A) The wage-setting and price-setting curves will both shift downward.

B) The wage-setting and price-setting curves will both shift upward.

C) The price-setting curve to shift downward, and no shift in the wage-setting curve.

D) The wage-setting curve to shift upward, and the price-setting curve to shift downward.

E) The wage-setting curve to shift downward, and the price-setting curve to shift upward.

Answer: B Diff: 2 8) The number of workers employed will not change as a result of an increase in productivity when which of the following occurs?

A) The AS curve shifts downward.

B) Output growth exceeds productivity growth.

C) Productivity growth is equal to output growth.

D) The AD curve shifts to the right.

E) none of these Answer: C Diff: 2

168 Copyright © 2021 Pearson Education, Inc.

9) An increase in productivity will cause which of the following according to the price-setting behavior of firms?

A) a reduction in prices set by firms B) an increase in the real wage paid by firms C) a reduction in the markup set by firms D) all of these E) none of these Answer: D Diff: 2 10) Based on price setting behavior, which of the following will cause an increase in the price level?

A) a reduction in productivity B) an increase in the nominal wage C) an increase in the markup D) all of these E) none of these Answer: D Diff: 2 11) Based on our understanding of the wage setting equation, which of the following will not cause a reduction in the nominal wage?

A) an increase in unemployment B) a reduction in the expected price level C) a reduction in expected productivity D) all of these E) none of these Answer: E Diff: 2 12) Suppose workers' and firms' expectations of the price level and productivity are accurate. In this case, an increase in productivity will cause which of the following?

A) an increase in both the real wage and the natural rate of unemployment B) a decrease in both the real wage and the natural rate of unemployment C) an increase in the real wage and no change in the natural rate of unemployment D) a decrease in the real wage and an increase in the natural rate of unemployment E) none of these Answer: C Diff: 2

169 Copyright © 2021 Pearson Education, Inc.

13) The empirical evidence suggests that periods of high productivity growth will cause which of the following in the short run?

A) higher markups B) lower unemployment C) constant real wages D) greater equality in wages E) none of these Answer: B Diff: 2 14) For this question, assume that firms' of productivity are accurate while workers' expectations of productivity adjust slowly over time. In this case, an increase in productivity will cause which of the following?

A) an increase in both the real wage and the natural rate of unemployment B) a decrease in both the real wage and the natural rate of unemployment C) an increase in the real wage and a reduction in the natural rate of unemployment D) a decrease in the real wage and an increase in the natural rate of unemployment E) none of these Answer: C Diff: 2 15) For this question, assume productivity has been increasing by 5% per year. Also assume that workers' expectations of productivity growth adjust slowly over time. For this economy, a reduction in productivity growth from 5% to 2% will most likely cause which of the following to occur?

A) an increase in the natural rate of unemployment B) a reduction in the real wage C) an increase in the markup over labor costs D) all of these E) none of these Answer: A Diff: 2 16) A major explanation for the decline in employment projected in textiles is A) increases in income.

B) social problems in the U.S. C) shifts in production toward low-wage countries.

D) inaccurate expectations about productivity growth.

E) inaccurate expectations about the price level.

Answer: C Diff: 1

170 Copyright © 2021 Pearson Education, Inc.

17) Assume an economy experiences, for a given period, a 4% increase in output and a 2% increase in productivity. Given this information, we know that which of the following occurred for this economy during this period?

A) The unemployment rate increased during this period.

B) The unemployment rate decreased during this period.

C) The unemployment rate did not change during this period.

D) The effects on the unemployment rate are ambiguous.

E) none of these Answer: B Diff: 2 18) Assume an economy experiences, for a given period, a 4% increase in output and a 4% increase in productivity. Given this information, we know that which of the following occurred for this economy during this period?

A) The unemployment rate increased during this period.

B) The unemployment rate decreased during this period.

C) The unemployment rate did not change during this period.

D) The effects on the unemployment rate are ambiguous.

E) none of these Answer: C Diff: 2 19) Assume an economy experiences, for a given period, a 1% increase in output and a 5% increase in productivity. Given this information, we know that which of the following occurred for this economy during this period?

A) The unemployment rate increased during this period.

B) The unemployment rate decreased during this period.

C) The unemployment rate did not change during this period.

D) The effects on the unemployment rate are ambiguous.

E) none of these Answer: A Diff: 2 20) Because of labor hoarding, an increase in output may signal A) an increase in employment.

B) a reduction in employment.

C) no change in employment.

D) a reduction in productivity.

Answer: C Diff: 1

171 Copyright © 2021 Pearson Education, Inc.

21) Because of labor hoarding, a reduction in output may signal A) an increase in employment.

B) a reduction in employment.

C) no change in employment.

D) a reduction in productivity.

Answer: C Diff: 1 22) Suppose the aggregate production function is represented by Y = AN. Which of the following expressions represents the number of additional workers required to increase production by one unit?

A) 1/A B) Y/N C) 1/N D) 1/Y E) none of these Answer: A Diff: 1 23) For this question, assume that the aggregate production function is represented by Y = A. Which of the following represents the marginal cost of producing an additional unit of output?

A) W B) W/A C) A/W D) (1 + A)W E) 1/W Answer: B Diff: 2 24) For this question, assume that the aggregate production function is represented by Y = AN. Which of the following represents the price setting relation for this economy?

A) (1 + m)A B) (1 + m)A/W C) (1 + m)W D) W/A E) none of these Answer: E Diff: 2

172 Copyright © 2021 Pearson Education, Inc.

25) Which of the following represents the wage setting relation when changes in labor productivity are allowed to occur?

A) W = PeF(u,z) B) W = P(1 + m) C) W = PeF(u,z)/A D) W = AP/(1 + m) E) none of these Answer: E Diff: 2 26) For this question, assume that expectations of P and A are correct. Based on price setting behavior, the real wage will be equal to which of the following?

A) A/(1 + m) B) AP/(1 + m) C) APF(u,z) D) P(1 + m) E) none of these Answer: A Diff: 2 27) Which of the following is not believed to cause recent increases in wage inequality?

A) international trade B) contractionary monetary policy C) skill-biased technological progress D) all of these E) none of these Answer: B Diff: 1 28) For this question, assume that expectations of P and A are correct. Now suppose that there is a 4% increase in A. Given this information, which of the following will occur?

A) The PS relation will shift up by 4%.

B) The WS relation will shift up by less than 4%.

C) The WS relation will shift down by 4%.

D) The PS relation will shift down by 4%.

Answer: A Diff: 2 29) For this question, assume that expectations of P and A are correct. Now suppose that there is a 1% increase in A. Given this information, which of the following will occur?

A) a 1% increase in the real wage and a reduction in the natural rate of unemployment B) a 1% increase in the real wage and no change in the natural rate of unemployment C) no change in the real wage and an increase in the natural rate of unemployment D) no change in the real wage and a reduction in the natural rate of unemployment Answer: B Diff: 2 173 Copyright © 2021 Pearson Education, Inc.

30) For this question, assume expectations of P and A are correct. Now suppose that there is a 3% reduction in A. Given this information, which of the following will occur?

A) The PS relation will shift up by 2%.

B) The WS relation will shift down by less than 2%.

C) The WS relation will shift down by 2%.

D) There will be no change in the real wage.

Answer: C Diff: 2 31) For this question, assume that expectations of productivity are slow to adjust. Further assume that A had been increasing by 6% a year. Now suppose that A only increases by 2% in period t.

This slowdown in productivity growth will cause A) the PS relation to shift up more than the WS relation.

B) the WS relation to shift up more than the PS relation.

C) the natural rate of unemployment to fall.

D) the real wage to fall.

Answer: B Diff: 2 32) For this question, assume that expectations of productivity are slow to adjust. Further assume that A had been increasing by 2% a year. Now suppose that A increases by 5% in period t. This increase in productivity growth will cause A) the real wage to rise and no change in the natural rate of unemployment.

B) the WS relation to shift up more than the PS relation.

C) the natural rate of unemployment to fall.

D) the real wage to fall.

Answer: C Diff: 2 33) For this question, assume that expectations of productivity are slow to adjust. An increase in productivity growth from 1% to 3% will cause A) an increase in the real wage of 1% and an increase in un.

B) an increase in the real wage of 1% and a reduction in un.

C) an increase in the real wage of 3% and an increase in un.

D) an increase in the real wage of 3% and a reduction in un.

Answer: D Diff: 2 34) Among the reasons that the poor countries have been unable to close the "technology gap" with the rich countries is A) poorly established property rights.

B) poorly developed financial markets.

C) low education levels.

D) all of these E) none of these Answer: D Diff: 1 174 Copyright © 2021 Pearson Education, Inc.

35) Based on price setting behavior, which of the following will cause a reduction in the price level?

A) an increase in productivity B) a reduction in the nominal wage C) a reduction in the markup D) all of these E) none of these Answer: D Diff: 2 36) There are some concerns that technological progress can lead to an increase in unemployment.

Explain the two related but separate dimensions of technological progress.

Answer: First, TP allows for a greater quantity of goods produced with the same inputs. Second, TP results in the production of new goods and the disappearance of old ones.

Diff: 2 37) Joseph Schumpeter argued that growth was a process of creative destruction. Explain what is meant by the phrase, "creative destruction."

Answer: When TP occurs and new goods are developed, old goods will disappear. In those industries that produced these "old" goods, employment will decrease. It is this process of technological progress causing the destruction of old jobs that is referred to as "creative destruction."

Diff: 2 38) For this question, assume that expectations of productivity growth adjust slowly. Now, suppose that there is a 3% reduction in productivity. Explain how this 3% reduction in productivity can cause changes in the unemployment rate.

Answer: The PS curve will shift up as productivity growth occurs; however, it will not shift up as much. If expectations of productivity are slow to adjust, the WS curve continues to shift up by a larger amount (based on past increases in A). The real wage will rise by the actual change in productivity. The unemployment rate will, however, increase because of the larger shift in the WS curve.

Diff: 2 39) For this question, assume that expectations of productivity growth adjust slowly. Now, suppose that there is a 5% increase in productivity. Explain how this 5% increase in productivity can cause changes in the unemployment rate.

Answer: The PS curve will shift up as productivity growth occurs; however, it will now shift up by a greater amount. If expectations of productivity are slow to adjust, the WS curve continues to shift up by a smaller amount (based on past increases in A). The real wage will rise by the actual change in productivity. The unemployment rate will, however, decrease because of the smaller shift in the WS curve.

Diff: 2

175 Copyright © 2021 Pearson Education, Inc.

13.2

Robots and Unemployment

1) For this question, assume that workers expectations of the price level and productivity are accurate. Now suppose that the economy experiences an increase in productivity. Which of the following will occur in the medium run?

A) no change in unemployment B) an increase in unemployment C) a reduction in unemployment D) no change in the natural level of output if the unemployment rate does not change E) none of these Answer: A Diff: 2 2) Since 1971, the annual growth rate of real wages has been A) remarkably high.

B) positive, but low.

C) zero.

D) negative.

E) impossible to measure accurately, and so has not been reported.

Answer: D Diff: 1 3) In recent years, real wages of the least educated workers A) have increased faster than the real wages of college-educated workers.

B) have increased, but by less than the real wages of college-educated workers.

C) have decreased, but by less than the real wages of college-educated workers.

D) have decreased, while the real wages of college-educated workers have increased.

E) have decreased at about the same rate as the real wages of college-educated workers.

Answer: D Diff: 2 4) In recent years, the increasing relative wage of skilled labor has been mostly due to A) a decrease in the supply of skilled labor that exceeds the decrease in demand.

B) an increase in the demand for skilled labor that exceeds the increase in supply.

C) a decrease in the supply of, and increase in the demand for, skilled labor.

D) government laws promoting the hiring of skilled labor.

E) government subsidies provided to college students.

Answer: B Diff: 1

176 Copyright © 2021 Pearson Education, Inc.

5) Which of the following would increase the gap in wages between skilled and unskilled workers?

A) less technological progress of the kind we've experienced in the past 15 years B) new types of production technology that require workers to have more skills C) an increase in the costs of going to college D) all of these E) none of these Answer: D Diff: 2 6) Which of the following is not true about technological progress?

A) allow for the production of a larger quantity of goods using the same number of workers B) lead to the production of new goods C) lead to the disappearance of old goods D) cause a reduction in employment in the short run E) none of these Answer: E Diff: 1 7) Suppose the aggregate production function is represented by the following: Y = AN. Given this information, labor productivity is given by A) Y. B) N/A. C) A/N. D) A. E) none of these Answer: D Diff: 1 8) Assume an economy experiences an increase in productivity that occurs as a result of a more widespread implementation of a major technological breakthrough. Given this information, we would expect which of the following to occur?

A) aggregate demand would not change B) aggregate demand would shift to the right C) aggregate demand would shift to the left D) both the aggregate demand and aggregate supply curves would shift to the left Answer: B Diff: 2

177 Copyright © 2021 Pearson Education, Inc.

9) Assume an economy experiences an increase in productivity that occurs as a result of the more efficient use of existing technologies. Given this information, we would expect which of the following to occur?

A) aggregate demand would not change B) aggregate demand would shift to the right C) aggregate demand would shift to the left D) both the aggregate demand and aggregate supply curves would shift to the left Answer: C Diff: 2 10) When the unemployment rate is on the horizontal axis and the real wage is on the vertical axis, a reduction in productivity will cause which of the following to occur?

A) The wage-setting and price-setting curves will both shift downward.

B) The wage-setting and price-setting curves will both shift upward.

C) The price-setting curve to shift downward, and no shift in the wage-setting curve.

D) The wage-setting curve to shift upward, and the price-setting curve to shift downward.

E) The wage-setting curve to shift downward, and the price-setting curve to shift upward.

Answer: A Diff: 2 11) Based on price setting behavior, which of the following will cause a reduction in the price level?

A) an increase in productivity B) a reduction in the nominal wage C) a reduction in the markup D) all of these E) none of these Answer: D Diff: 2 12) Suppose workers' and firms' expectations of the price level and productivity are accurate. In this case, a reduction in productivity will cause which of the following?

A) a decrease in both the real wage and the natural rate of unemployment B) an increase in both the real wage and the natural rate of unemployment C) a decrease in the real wage and no change in the natural rate of unemployment D) an increase in the real wage and a decrease in the natural rate of unemployment E) none of these Answer: C Diff: 2

178 Copyright © 2021 Pearson Education, Inc.

13) Assume an economy experiences, for a given period, a 5% increase in output and a 1% increase in productivity. Given this information, we know that which of the following occurred for this economy during this period?

A) The unemployment rate increased during this period.

B) The unemployment rate decreased during this period.

C) The unemployment rate did not change during this period.

D) The effects on the unemployment rate are ambiguous.

E) none of these Answer: B Diff: 2 14) Suppose an economy experiences a reduction in productivity. Explain both the short-run and medium-run effects of this reduction in productivity on output, employment, and the unemployment rate.

Answer: In both the short run and medium run, TP will cause a reduction in output (assuming, of course, that any change in AD, if it occurs, is offset by the shift in the AS curve). What happens to employment in the medium? Given that Y will fall by the full change in TP in the medium, we know that N and u will not be affected in the medium run. In the short run, N will fall and u will rise if the percentage change in Y is less than the percentage change in TP. Diff: 2 15) Some commentators will argue that increases in productivity may have no effect or even a negative effect on employment in the short run. Explain what must occur for an increase in productivity to have no effect or even a negative effect on employment in short run.

Answer: An increase in productivity will have no effect on employment if the percentage change in output equals the percentage change in productivity. Employment will fall if the percentage change in output is less than the percentage change in productivity. This can be seen from Y = AN which implies that N = Y/A. Diff: 2 16) Explain what effect a reduction in productivity has on wage setting behavior, price setting behavior, the equilibrium real wage, the natural rate of unemployment, and the natural level of output.

Answer: A reduction in A will cause a reduction in the real wage based on WS behavior; therefore, the WS curve shifts down by the change in A. The reduction in A increases the marginal cost of an additional unit of output so firms will raise the price. Hence, the real wage based on PS behavior will fall by A and the PS curve shifts down by A. Given the size of the shifts in the WS and PS curves, u does not change; however, the real wage does fall.

Diff: 2 17) Explain how technological change can cause changes in wage inequality.

Answer: If the technological progress favors skilled workers, the demand for skilled workers will rise and the demand for relatively unskilled workers will fall. This would cause the wage gap to increase.

Diff: 2

179 Copyright © 2021 Pearson Education, Inc.

18) Explain some of the causes of increased wage inequality.

Answer: Possible causes: skill-biased technological progress and international trade.

Diff: 2 19) First, explain each of the following: hysterisis and Eurosclerosis. Second, explain how each of them can be used to explain the relatively high natural rate of unemployment in Europe.

Answer: Hysteresis suggests that the natural unemployment rate is not independent of the actual unemployment rate. In Europe, high unemployment would result in an increase in unemployment benefits that would cause an increase in the natural rate. Eurosclerosis suggests that the high natural rate is a result of structural problems such as high minimum wage, reluctance of labor unions to accept wage cuts.

Diff: 2 20) Suppose an economy experiences an increase in productivity. Explain both the short-run and medium-run effects of this increase in productivity on output, employment, and the unemployment rate.

Answer: In both the short run and medium run, TP will cause an increase in output (assuming, of course, that any change in AD, if it occurs, is offset by the shift in the AS curve). What happens to employment in the medium? Given that Y will rise by the full change in TP in the medium, we know that N and u will not be affected in the medium run. In the short run, N will rise and u will fall if the percentage change in Y is greater than the percentage change in TP. Diff: 2 21) Assume expectations of both prices and productivity are accurate,use the PS/WS relations, graphically illustrate and explain the effects of an increase in the productivity on the natural rate of unemployment.

Answer: An increase in productivity shifts both the wage and the price-setting curves by the same proportion and thus has no effect on the natural rate.

Diff: 2 22) Assume expectations of prices are correct but expectations of productivity adjust slowly. Use the PS/WS relations, graphically illustrate and explain the effects of a decrease in productivity growth on the natural rate of unemployment.

Answer: The PS relation shifts up by a factor A. The WS relation shifts up by a factor Ae. If Ae>A, the PS curve shifts up by less than the WS relation shifts up, leading to an increase in the natural rate of unemployment for some time.

Diff: 2 23) Suppose an economy is characterized by the equations below: Price setting: P= (1 + m) (W/A) Wage setting: W=AP(1 - u) Solve for the natural rate of unemployment if the markup (m) is equal to 4%.

Answer: u = 4% Diff: 2 180 Copyright © 2021 Pearson Education, Inc.

13.3

Growth, Churn, and Inequality

1) "Churning" refers to A) changes in the real wage over the business cycle.

B) changes in the markup over the business cycle.

C) structural change associated with technological progress.

D) the increase in productivity caused by an increase in output.

E) the increase in output caused by an increase in productivity.

Answer: C Diff: 1 2) A large increase in wage inequality in the U.S. in the past 35 years is due to A) technological change.

B) budget deficits.

C) trade deficits.

D) schooling.

Answer: A Diff: 1 3) The share of income going into households in the top 1% is about ________ today.

A) 22% B) 9% C) 50% D) 13% Answer: A Diff: 1 4) A Gini coefficient of 0 means A) complete equality.

B) complete inequality.

C) one person receiving all the income.

D) none of these Answer: A Diff: 1 5) A Gini coefficient of 1 means A) complete equality.

B) complete inequality.

C) everybody having the same income.

D) none of these Answer: B Diff: 1

181 Copyright © 2021 Pearson Education, Inc.

13.4

Climate Change and Global Warming

1) ________ is now the main source of CO2.

A) China B) U.S. C) Europe D) India Answer: A Diff: 1 2) Global average temperature has increased by roughly ________ degrees Celsius since 1850.

A) 1.2 B) 1.4 C) 0.8 D) 0.6 Answer: A Diff: 1 Macroeconomics, 8e (Blanchard) Chapter 14: Financial Markets and Expectations 14.1

Expected Present Discounted Values

1) Assume that the current one-year rate is 5% and the two-year rate is 7%. Given this information, the one-year rate expected one year from now is A) 5%.

B) 6%.

C) 7%.

D) 9%.

E) 12%.

Answer: D Diff: 2 2) Suppose the current one-year interest rate is 4%, and financial markets expect the one-year interest rate next year to be 8%. Given this information, the yield to maturity on a two-year bond will be approximately A) 4%.

B) 6%.

C) 8%.

D) 12%.

E) none of these Answer: B Diff: 2 3) Suppose the current one-year interest rate is 4%. Also assume that financial markets expect the one-year interest rate next year to be 5%, and expect the one-year rate to be 6% the year after that.

Given this information, the yield to maturity on a three-year bond will be approximately A) 4%.

182 Copyright © 2021 Pearson Education, Inc.

B) 5%.

C) 6%.

D) 15%.

Answer: B Diff: 2 4) Which of the following bonds (of equal maturity) would have the largest risk premium?

A) U.S. government bonds B) German government bonds C) the bonds of a financially stable corporation, like IBM D) Bonds rated AAA by Moody's E) junk bonds Answer: E Diff: 1

183 Copyright © 2021 Pearson Education, Inc.

5) Suppose there is a decrease in the short-term interest rate. Give this reduction in the current short-term interest rate, which of the following will most likely occur?

A) The long-term interest rate will increase.

B) The long-term interest rate will remain the same.

C) The long-term interest rate will decrease by more than the short-term rate.

D) The long-term interest rate will decrease by the same amount as the short-term rate.

E) The long-term interest rate will decrease, but by less than the short-term rate.

Answer: E Diff: 2 6) Which of the following statements about indexed bonds is correct?

A) They were relatively recently introduced in the United States.

B) They exist in England.

C) They have a nominal interest rate that rises when the inflation rate rises.

D) all of these E) none of these Answer: D Diff: 1 7) Which of the following best explains why the long-term interest rate will generally change by less than 1% when the short-term interest rate changes by 1%?

A) The mathematical calculations are more difficult for analysts in the case of long-term bonds.

B) Long-term rates are always lower than short-term rates, so there is less room for them to change.

C) Financial market participants will not expect this increase in the short-term interest rate to persist fully in the future.

D) Financial markets are often affected by bubbles and fads.

E) none of these Answer: C Diff: 2 8) Suppose the yield curve is initially horizontal. Suppose the current one-year interest rate increases by 4% while the expected future one-year interest rate does not change. Which of the following will tend to occur?

A) i2t will increase by 4% B) i2t will increase by 2% C) i2t will increase by less than 2% D) i2t will decrease by 2% Answer: B Diff: 2

184 Copyright © 2021 Pearson Education, Inc.

9) A consol bond promises to pay $1000 each year, forever, starting next year. If the nominal interest rate is 5%, the present discounted value of this consol is A) $900.00.

B) $995.00.

C) $2,500.00.

D) $20,000.00.

E) $25,000.00.

Answer: D Diff: 2 14.2

Bond Prices and Bond Yields

1) The length of time over which a bond promises to make payments to the holder is called which of the following?

A) the term structure of interest rates B) the face value C) the yield to maturity D) the holding period E) none of these Answer: E Diff: 1 2) A "junk bond" is a bond with a A) low yield to maturity.

B) value of zero.

C) low face value, but high coupon rate.

D) high default risk.

E) very low maturity.

Answer: D Diff: 1 3) A bond has a face value of $10,000, a price of $12,000, and coupon payments of $2000 for two years. The coupon rate of this bond is A) 10%.

B) 16.7%.

C) 20%.

D) 30%.

E) none of these Answer: C Diff: 1

185 Copyright © 2021 Pearson Education, Inc.

4) A discount bond is a bond A) with no coupon payments.

B) where the price of the bond is greater than its face value.

C) where the interest rate is zero.

D) where the face value is zero.

E) that never matures.

Answer: A Diff: 1 5) For this question, assume that one-year and two-year bonds have the same risk; therefore, you can ignore risk here. Assuming that there is arbitrage between one-year bonds and two-year bonds, we know that the expected rate of return on two-year bonds A) will equal the expected rate of return from holding a one-year bond for one year.

B) will equal the expected rate of return from holding a one-year bond for two years.

C) will be larger than the expected rate of return from holding a one-year bond for one year.

D) will be smaller than the expected rate of return from holding a one-year bond for one year.

E) will be exactly half the rate of return on one-year bonds.

Answer: A Diff: 2 6) A bond has a face value of $1,000, a price of $1,200, and coupon payments of $100 for two years. The "current yield" of this bond is A) 8.33%.

B) 10%.

C) 12%.

D) 83%.

E) none of these Answer: A Diff: 2 7) An upward-sloping yield curve suggests that financial market participants expect short-term interest rates will A) rise in the future.

B) fall in the future.

C) be unstable in the future.

D) not change in the future.

E) be equal to zero in the future.

Answer: A Diff: 2

186 Copyright © 2021 Pearson Education, Inc.

8) Suppose financial market participants expect short-term rates in the future to be less than current short-term interest rates. Given this information, we would expect A) an upward sloping yield curve.

B) a downward sloping yield curve.

C) an upward shifting yield curve.

D) a downward shifting yield curve.

E) a horizontal yield curve.

Answer: B Diff: 2 9) Which of the following represents the ratio of coupon payments to the face value of a bond?

A) the interest rate B) the discount rate C) the coupon rate D) the risk premium E) the current yield Answer: C Diff: 1 10) Suppose a bond promises to make a single payment at maturity. These types of bond are called A) junk bonds.

B) indexed bonds.

C) corporate bonds.

D) discount bonds.

E) constant maturity bonds.

Answer: D Diff: 1 11) Assume that the one-year interest rate is on the vertical axis of the IS-LM model and that the yield curve is initially upward sloping. Suppose that financial market participants expect that the central bank will pursue a monetary contraction in the future. Given this information, we would expect which of the following to occur?

A) The yield curve will become steeper.

B) The yield curve will become flatter.

C) The yield curve will become horizontal.

D) The yield curve will become downward sloping.

Answer: A Diff: 2

187 Copyright © 2021 Pearson Education, Inc.

12) Suppose that financial market participants expect that the central bank will pursue a monetary expansion in the future. Also assume that the yield curve is initially upward sloping. Given this information, we would expect which of the following to occur?

A) The yield curve will become steeper.

B) i2t will increase.

C) i2t will decrease.

D) The yield curve will become downward sloping.

Answer: C Diff: 2 13) Suppose that financial market participants now expect a future tax increase in one year. Also assume that the yield curve is initially upward sloping. Given this information, we would expect which of the following to occur?

A) The yield curve will become steeper.

B) i2t will increase C) i2t will decrease D) The yield curve will become downward sloping.

Answer: C Diff: 2 14) Suppose that financial market participants now expect a future tax cut and that the yield curve is initially upward sloping. Given this information, we would expect which of the following to occur?

A) The yield curve will become steeper.

B) The yield curve will become flatter.

C) The yield curve will become horizontal.

D) The yield curve will become downward sloping.

Answer: A Diff: 2 15) A bond has a face value of $10,000, a price of $12,000, and coupon payments of $2000 for two years. The current yield of this bond is A) 10%.

B) 16.7%.

C) 20%.

D) 30%.

E) none of these Answer: B Diff: 1

188 Copyright © 2021 Pearson Education, Inc.

16) Assume that the current one-year rate is 3% and the two-year rate is 5%. Given this information, the one-year rate expected one year from now is A) 5%.

B) 6%.

C) 7%.

D) 9%.

E) 12%.

Answer: C Diff: 2 17) Suppose the current one-year interest rate is 3%, and financial markets expect the one-year interest rate next year to be 5%. Given this information, the yield to maturity on a two-year bond will be approximately A) 4%.

B) 6%.

C) 8%.

D) 12%.

E) none of these Answer: A Diff: 2 18) Which of the following represents the ratio of coupon payments to the price of a bond?

A) the interest rate B) the discount rate C) the coupon rate D) the risk premium E) the current yield Answer: E Diff: 1 19) The yield curve is A) the term structure of interest rates.

B) yield of a bond.

C) maturity.

D) all of these Answer: A Diff: 1 20) Bonds with relatively high risk of default are called A) Brady bonds.

B) junk bonds.

C) zero coupon bonds.

D) investment grade bonds.

Answer: B Diff: 2

189 Copyright © 2021 Pearson Education, Inc.

21) Junk bonds, bonds with a low bond rating, are also known as A) high-yield bonds.

B) investment grade bonds.

C) high quality bonds.

D) zero-coupon bonds.

Answer: A Diff: 2 22) Explain what the term structure of interest rates represents.

Answer: The term structure of interest rates illustrates the relationship between the yield to maturity on bonds (with the same risk characteristics) and maturity.

Diff: 1 23) When interpreting bond prices as present values, discuss what factors determine the price of a two-year discount bond. Include in your answer an explanation of how changes in each of these factors affects the price of a two-year discount bond.

Answer: The price of the two-year bond will be a function of the face value, the current one-year rate and the future expected one-year rate. An increase in either of the one-year rates will reduce the present value of the bond and, therefore, reduce its price. An increase in the face value (constant) would increase the price.

Diff: 2 24) The yield curve indicates that the two-year interest rate will be a function of what variables?

Include in your answer an explanation of how changes in these variables will affect the two-year interest rate.

Answer: The two-year rate will be a function of the current one-year rate and the future expected one-year rate. In fact, it will be approximately equal to the average of these two rates. So, an increase in either rate will cause the two-year rate to rise.

Diff: 2 25) Suppose the yield curve is downward sloping. How should one interpret this particular yield curve?

Answer: Downward sloping yield curve implies that the future expected one-year rate is lower than the current one-year rate.

Diff: 2 26) Suppose the central bank implements a monetary expansion in the current period and is not expected to continue this policy in the future. Explain what effect this policy will have on the shape of the yield curve and on stock prices.

Answer: The current one-year rate will fall with no change in the expected future rate. The two-year rate, given that it is an average of the two one-year rates, will fall. The change in the two-year rate will approximately equal half the change in the one-year rate. The yield curve will shift down and get steeper. What happens to stock prices depends on whether this was fully or partially expected? If fully anticipated, stock prices do not change. If at least partially unexpected, stock prices will rise because of the interest rate effect and the higher output (changes in which were unexpected).

Diff: 2 190 Copyright © 2021 Pearson Education, Inc.

27) Suppose the yield curve is upward sloping. How should one interpret this particular yield curve?

Answer: Upward sloping yield curve implies that the future expected one-year rate is higher than the current one-year rate.

Diff: 2 14.3

The Stock Market and Movements in Stock Prices

1) Equity finance is represented by which of the following?

A) when a firm borrows money from banks B) when a firm sells bonds C) when a firm sells shares of stock D) when a firm draws down retained earnings E) when a firm sells off part of its capital stock Answer: C Diff: 1 2) Among the following, which is the broadest measure of stock prices in the United States?

A) Dow Jones Index B) FT index C) Nikkei Index D) Term Structure Index E) Standard and Poor's 500 Composite Index Answer: E Diff: 1 3) The fundamental value of a share of stock is equal to which of the following?

A) the sum of expected dividends B) the present value of expected dividends C) the sum of coupon payments D) the present value of coupon payments E) the present value of the expected yield Answer: B Diff: 1 4) A share of stock will pay a dividend of $25 in one year, and will be sold for an expected price of $500 at that time. If the current one-year interest rate is 5%, the current price of the stock will be approximately equal to A) $100.

B) $475.

C) $500.

D) $525.

E) none of these Answer: C Diff: 2 191 Copyright © 2021 Pearson Education, Inc.

5) For this question, assume that there is perfect arbitrage in the stock market. Given this assumption, economists believe that A) movements in stock prices can be easily predicted.

B) movements in stock prices are largely unpredictable.

C) most stocks will diverge from their fundamental value.

D) stocks will generally earn a lower rate of return than bonds.

E) the rate of return on stocks will be equal to the rate of return on bonds.

Answer: B Diff: 2 6) Suppose the central bank implements a monetary contraction that is fully expected by financial market participants. Given this information, we would expect A) stock prices to rise.

B) stock prices to fall.

C) stock prices to remain unchanged.

D) an ambiguous effect on stock prices.

E) stock prices to fall and the interest rate to rise.

Answer: C Diff: 2 7) Suppose the central bank implements a monetary expansion that is not fully anticipated by financial markets. Given this information, we would expect A) stock prices to rise.

B) stock prices to fall.

C) stock prices to remain unchanged.

D) an ambiguous effect on stock prices.

E) none of these Answer: A Diff: 2 8) Suppose policy makers implement a fiscal expansion that is not fully anticipated by financial market participants. We know that this will A) always cause stock prices to fall.

B) always cause stock prices to rise.

C) tend to cause stock prices to rise if the LM curve is very flat.

D) tend to cause stock prices to rise if the LM curve is vertical.

Answer: C Diff: 2

192 Copyright © 2021 Pearson Education, Inc.

9) Suppose policy makers implement an unexpected fiscal expansion. Further assume that monetary policy is expected to keep interest rates constant in response to this unexpected fiscal expansion. Given this information, we would expect that A) stock prices will rise.

B) stock prices will remain constant.

C) this policy will have an ambiguous effect on stock prices.

D) the effect on stock prices will depend on the slope of the IS curve.

Answer: A Diff: 2 10) Which of the following represents a stock's fundamental value?

A) the price the stock would sell at in the midst of a rational bubble B) the price the stock would sell at if the interest rate were zero C) the present value of its expected future dividend payments D) the simple sum of its future dividend payments E) none of these Answer: C Diff: 1 11) Which of the following does not represent a form of debt finance?

A) bonds B) loans C) stock D) all of these Answer: C Diff: 1 12) Which of the following represents a form of equity finance?

A) stock B) loans C) bonds D) all of these E) none of these Answer: A Diff: 1 13) Which of the following variables would not influence the ex-dividend price of a share of stock at time t?

A) i1et+1 B) i1t C) $Det+1 D) none of these Answer: D Diff: 1

193 Copyright © 2021 Pearson Education, Inc.

14) An expected reduction in the money supply will tend to cause A) an increase in stock prices.

B) a reduction in stock prices.

C) no change in stock prices.

D) an ambiguous effect on stock prices.

Answer: C Diff: 2 15) An expected increase in the money supply will tend to cause A) an increase in stock prices.

B) a reduction in stock prices.

C) no change in stock prices.

D) an ambiguous effect on stock prices.

Answer: C Diff: 2 16) An expected tax cut will tend to cause A) an increase in stock prices.

B) a reduction in stock prices.

C) no change in stock prices.

D) an ambiguous effect on stock prices.

Answer: C Diff: 2 17) An expected tax increase will tend to cause A) an increase in stock prices.

B) a reduction in stock prices.

C) no change in stock prices.

D) an ambiguous effect on stock prices.

Answer: C Diff: 2 18) An unexpected reduction in the money supply will tend to cause A) an increase in stock prices.

B) a reduction in stock prices.

C) no change in stock prices.

D) an ambiguous effect on stock prices.

Answer: B Diff: 2 19) An unexpected increase in the money supply will tend to cause A) an increase in stock prices.

B) a reduction in stock prices.

C) no change in stock prices.

D) an ambiguous effect on stock prices.

Answer: A Diff: 2 194 Copyright © 2021 Pearson Education, Inc.

20) Suppose households unexpectedly increase consumption. Which of the following will occur as a result of this unexpected increase in consumption?

A) an increase in stock prices B) a reduction in stock prices C) no change in stock prices D) an ambiguous effect on stock prices Answer: D Diff: 2 21) Suppose households unexpectedly decrease consumption. Which of the following will occur as a result of this unexpected reduction in consumption?

A) an increase in stock prices B) a reduction in stock prices C) no change in stock prices D) an ambiguous effect on stock prices Answer: D Diff: 2 22) Suppose there are two types of bonds (one-year bonds and two-year bonds) and that the yield curve is initially upward sloping in period t. Note: For this question assume that: (1) expected inflation is zero; and (2) the relevant interest rate on the vertical axis of the IS-LM model is the one-year interest rate. Based on our understanding of the IS-LM model, of the yield curve and of financial markets, we know with certainty that an announcement in period t of a partially unexpected future increase in taxes (to be implemented in period t + 1) will have which of the following effects?

A) stock prices will increase in period t B) stock prices will fall in period t C) the yield curve will become steeper in period t D) none of these Answer: D Diff: 2 23) For this question, assume that the Fed is expected to respond to any event by keeping the interest rate constant (i.e., equal to its initial level). An unexpected tax increase will cause A) stock prices to fall.

B) stock prices to rise.

C) no change in stock prices.

D) an ambiguous effect on stock prices.

Answer: A Diff: 2

195 Copyright © 2021 Pearson Education, Inc.

24) For this question, assume that the Fed is expected to respond to any event by keeping the interest rate constant (i.e., equal to its initial level). An unexpected tax cut will cause A) stock prices to fall.

B) stock prices to rise.

C) no change in stock prices.

D) an ambiguous effect on stock prices.

Answer: B Diff: 2 25) For this question, assume that the Fed is expected to respond to any event by keeping output constant (i.e., equal to its initial level). An unexpected increase in taxes will cause A) stock prices to fall.

B) stock prices to rise.

C) no change in stock prices.

D) an ambiguous effect on stock prices.

Answer: B Diff: 2 26) For this question, assume that the Fed is expected to respond to any event by keeping output constant (i.e., equal to its initial level). An unexpected increase in government spending will cause A) stock prices to fall.

B) stock prices to rise.

C) no change in stock prices.

D) an ambiguous effect on stock prices.

Answer: A Diff: 2 27) As the LM curve becomes steeper, an unexpected increase in consumer confidence A) will cause a relatively large increase in output and relatively large increase in the interest rate.

B) will cause a relatively small increase in output and relatively small increase in the interest rate.

C) is more likely to cause stock prices to rise.

D) is more likely to cause stock prices to fall.

Answer: D Diff: 2 28) As the LM curve becomes steeper, an unexpected decrease in consumer confidence A) will cause a relatively large increase in output and relatively large increase in the interest rate.

B) will cause a relatively small increase in output and relatively small increase in the interest rate.

C) is more likely to cause stock prices to rise.

D) is more likely to cause stock prices to fall.

Answer: C Diff: 2

196 Copyright © 2021 Pearson Education, Inc.

29) A share of stock will pay a dividend of $20 in one year, and will be sold for an expected price of $500 at that time. If the current one-year interest rate is 5%, the current price of the stock will be approximately equal to A) $100.

B) $495.

C) $500.

D) $525.

E) none of these Answer: B Diff: 2 30) Suppose individuals expect an increase in future taxes. Explain what effect this expected increase in future taxes will have on the yield curve and on stock prices in the current period.

Answer: The increase in future taxes will cause the future one-year rate to fall. This reduction in the expected one-year rate will cause the two-year rate to fall by approximately half the change in the future expected rate. The current one-year rate does not change. So, the yield curve pivots; it gets flatter (as the long-term rate falls). The effects on stock prices again depend on whether it is anticipated or not. If anticipated, stock prices do not change. If partially unexpected, the effect on stock prices is ambiguous: the drop in future i will increase stock prices while the drop in future Y will depress stock prices.

Diff: 2 31) Explain what is meant by the fundamental value of a share of stock.

Answer: The fundamental value of a share of stock is simply the discounted present value of any current and future expected dividends.

Diff: 2 32) Give two explanations why stock prices might deviate from their fundamental values.

Answer: Answers should discuss speculative bubbles and fads.

Diff: 2 33) Suppose the Fed implements a monetary expansion that is at least partially unexpected.

Explain what effect this will have on stock prices.

Answer: This will cause the interest rate to fall and output to rise. The lower interest rate will increase the present value of future dividends. The increase in output will cause an increase in expected dividends because profits are now expected to be higher. Both of these effects cause stock prices to rise.

Diff: 2 34) Suppose a cut in government spending occurs that is at least partially unexpected. Explain what effect this will have on stock prices.

Answer: Output falls and interest rates fall. Here, the effects are ambiguous. The drop in the interest rate will raise stock prices while the drop in Y will lower them.

Diff: 2

197 Copyright © 2021 Pearson Education, Inc.

35) Suppose there is a report that the unemployment rate unexpectedly increased in the previous month. To what extent will the expected central bank response to this news affect how stock prices will respond to this report of a higher than expected unemployment rate? Explain.

Answer: The effect on stock prices will be ambiguous, all else fixed. What the Fed is expected to do in response can change this. If the Fed is expected to act to keep interest rates constant, Y will fall and stock prices will fall. If the Fed is expected to offset any output effects by reducing rates, stock prices will rise.

Diff: 2 36) Suppose the central bank implements a monetary contraction in the current period and is not expected to continue this policy in the future. Explain what effect this policy will have on the shape of the yield curve and on stock prices.

Answer: The current one-year rate will rise with no change in the expected future rate. The two-year rate, given that it is an average of the two one-year rates, will rise. The change in the two-year rate will approximately equal half the change in the one-year rate. The yield curve will shift up and get flatter. What happens to stock prices depends on whether this was fully or partially expected? If fully anticipated, stock prices do not change. If at least partially unexpected, stock prices will fall because of the interest rate effect and the higher output (changes in which were unexpected).

Diff: 2 37) Suppose individuals expect a cut in future taxes. Explain what effect this expected reduction in future taxes will have on the yield curve and on stock prices in the current period.

Answer: The reduction in future taxes will cause the future one-year rate to rise. This increase in the expected one-year rate will cause the two-year rate to rise by approximately half the change in the future expected rate. The current one-year rate does not change. So, the yield curve gets steeper (as the long-term rate rises). The effects on stock prices again depend on whether it is anticipated or not. If anticipated, stock prices do not change. If partially unexpected, the effect on stock prices is ambiguous: the rise in future i will decrease stock prices while the increase in future Y will increase stock prices.

Diff: 2 38) Suppose an increase in government spending occurs that is at least partially unexpected.

Explain what effect this will have on stock prices.

Answer: Output rises and interest rates rise. Here, the effects are ambiguous. The rise in the interest rate will reduce stock prices while the increase in Y will increase them.

Diff: 2

198 Copyright © 2021 Pearson Education, Inc.

14.4

Risk, Bubbles, Fads, and Asset Prices

1) Which of the following bonds (of equal maturity) would have the lowest risk premium?

A) U.S. government bonds B) German government bonds C) the bonds of a financially stable corporation, like IBM D) Bonds rated AAA by Moody's E) junk bonds Answer: A Diff: 1 2) Some economists argue that there were good reasons for housing price to rise. Explain their argument.

Answer: First, the real interest rate was decreasing, increasing the present value of rents. Second, the nominal interest rate was also decreasing, and this mattered because nominal interest payments are tax deductible. Third, the mortgage market was changing: More people was able to borrow and buy a house; people who borrowed were able to borrow a larger proportion of the value of the house. Both of these factors led to an increase in demand, and thus an increase in house prices.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 15: Expectations, Consumption, and Investment 15.1

Consumption

1) Human wealth is A) the present discounted value of expected future after-tax labor income.

B) the sum of financial and housing wealth.

C) the discounted present value of all financial assets.

D) financial wealth minus housing wealth.

E) total wealth minus housing wealth.

Answer: A Diff: 1 2) Which of the following represents non-human wealth?

A) total wealth minus housing wealth B) total wealth minus financial wealth C) wealth that cannot be taken from a person, by law D) financial wealth minus housing wealth E) none of these Answer: E Diff: 1 3) Which of the following best defines total wealth?

A) financial wealth only B) financial wealth and housing wealth only C) human wealth only D) non-human wealth and human wealth 199 Copyright © 2021 Pearson Education, Inc.

E) none of these Answer: D Diff: 1 4) Which of the following would cause an increase in human wealth?

A) a permanent increase in salary B) an increase in the value of one's house C) an increase in the value of one's stock portfolio D) all of these E) none of these Answer: A Diff: 1

200 Copyright © 2021 Pearson Education, Inc.

5) An economist conducts a "natural experiment" by A) choosing two groups of people — a control group and a test group — and providing special treatment for the test group.

B) using animal behavior to make inferences about human behavior.

C) using his or her own intuition to surmise what people will do in a given situation.

D) polling other economists to see if they believe a theory.

E) taking real-world data as it is given, and using it to test a theory.

Answer: E Diff: 1 6) Consumption is most likely to respond one-for-one with changes in current income when A) the change in current income results from a one-time bonus.

B) people believe the change in their current income is temporary.

C) people are able to borrow as much as they wish, as long as they pay it back.

D) the change in current income is caused by the business cycle.

E) none of these Answer: E Diff: 1 7) Which of the following is evidence that consumption depends on total wealth, and not just on current income?

A) People save very little for their retirement.

B) The pre-announced phased-in tax cuts of 1981-83 caused little change in consumption in 1981.

C) A drop in consumer confidence, with unchanged current income, often causes total consumption spending to fall.

D) all of these E) none of these Answer: C Diff: 2 8) Which of the following is a reason that consumption depends on current income, and not just on total wealth?

A) Banks will not always lend money to those who want to consume more than their income.

B) The anticipation of future financial distress makes some people reluctant to borrow.

C) Low income people may prefer to postpone some consumption until later years, when their incomes are higher.

D) all of these E) none of these Answer: D Diff: 1

201 Copyright © 2021 Pearson Education, Inc.

9) Which of the following people—none of whom has any financial or housing wealth—is most likely to be spending all of their current income?

A) a low income person expecting continued low income throughout life B) a low income person expecting a dramatic rise in income in the future C) a high income person expecting continued high income throughout life D) a high income person expecting a dramatic drop in income in the future E) a high income person expecting to retire soon, and live for a long time afterward Answer: B Diff: 1 10) Figures on "mean wealth" of the elderly (ages 65-69) show that most wealth consists of A) home equity.

B) personal savings.

C) stocks and bonds.

D) social security benefits.

E) collectibles, like stamps, coins and art.

Answer: D Diff: 1 11) For this question, ignore tax considerations of each of the following. Assume that consumption decisions are made according to the permanent income theory. Which of the following would lead to the smallest increase in current consumption?

A) winning $10,000 in the lottery B) inheriting $10,000 from a relative C) obtaining $10,000 by winning a lawsuit D) getting a one-time $10,000 bonus from your employer E) all of these Answer: E Diff: 1 12) The "life cycle" and "permanent income" theories of consumption share which of the following features?

A) Consumption spending depends on income, rather than wealth.

B) Consumption spending should fluctuate widely from year to year.

C) Consumers look ahead to the future in making current spending decisions.

D) all of these E) none of these Answer: C Diff: 2

202 Copyright © 2021 Pearson Education, Inc.

13) Suppose you are given a rare antique by a long-lost relative. The value of this rare antique would be included in which of the following types of wealth?

A) financial wealth B) housing wealth C) human wealth D) none of these Answer: A Diff: 1 14) As of 2005, some analysts were concerned that there was a "bubble" in the U.S. housing market. Suppose there is a reduction in real estate prices. This reduction in real estate prices would have the most direct effect on which of the following types of wealth?

A) financial wealth B) housing wealth C) human wealth D) none of these Answer: B Diff: 1 15) The reduction in stock prices will have the most direct effect on which of the following types of wealth?

A) financial wealth B) housing wealth C) human wealth D) none of these Answer: A Diff: 1 16) Suppose there is a tax cut. This tax cut would have a direct effect on which of the following?

A) financial wealth B) housing wealth C) human wealth D) none of these Answer: C Diff: 1 17) Suppose there is an increase in income. This increase in income would have a direct effect on which of the following?

A) financial wealth B) housing wealth C) human wealth D) all of these Answer: C Diff: 1

203 Copyright © 2021 Pearson Education, Inc.

18) Human wealth is a function (i.e., affected by changes in) of which of the following variables?

A) future expected income B) future expected taxes C) current interest rates D) all of these E) none of these Answer: D Diff: 2 19) Explain what decisions and calculations a very foresighted consumer must make to determine her consumption decisions in any period.

Answer: An individual would have to calculate her financial wealth, housing wealth, and human wealth. Of course, this implies that the individual would have to form expectations of future interest rates, income, and taxes for the remainder of her working life. Once done, the individual would then calculate the amount of consumption per year she preferred given this total wealth. If in the current period, current disposable income is less than this level of C, she would borrow the difference.

Diff: 1 20) Discuss the various components of wealth.

Answer: Housing, financial, and human wealth.

Diff: 1 21) Explain why current consumption is likely to respond less than one for one to changes in current income.

Answer: A change in current income is not likely to be viewed with certainty as permanent. So, part of any change in temporary income will be saved and, therefore, consumption will increase by an amount less than the change in income. If the change were permanent, the change in C would be greater.

Diff: 2 22) Explain why current consumption might change even if current income does not change.

Answer: C also depends on wealth. If any of the determinants of wealth change, without current disposable income changing, individuals will change current consumption. In short, there are other determinants of current consumption.

Diff: 2 23) Suppose individuals expect future output to be higher and future interest rates to be higher.

Given this information, how will individuals alter consumption in the current period? Explain.

Answer: The effects are ambiguous. The increase in future Y will increase human wealth and cause C to increase. The increase in future rates will reduce the present value of future disposable income and reduce C. Diff: 2

204 Copyright © 2021 Pearson Education, Inc.

24) Suppose individuals expect future output to be lower and future interest rates to be lower.

Given this information, how will individuals alter consumption in the current period? Explain.

Answer: The effects are ambiguous. The reduction in future Y will reduce human wealth and cause C to decrease. The decrease in future rates will increase the present value of future disposable income and increase C. Diff: 2 25) Explain how expectations affect consumption.

Answer: Expectations affect consumption in two ways. First, expectations affect consumption directly through human wealth: To compute their human wealth, consumers have to form their own expectations about future labor income, real interest rates, and taxes. Second, expectations affect consumption indirectly, through nonhuman wealth-stocks, bonds and housing: The prices of these assets depend on expectations of future cash flows and interest rates.

Diff: 2 15.2

Investment

1) Which of the following will cause an increase in the rental cost/user cost of capital?

A) The rate of depreciation increases.

B) The real interest rate decreases.

C) The expected profit from the machine decreases.

D) all of these E) none of these Answer: E Diff: 1 2) The "depreciation rate" tells us A) the interest rate that should be used in present discounted value calculations.

B) the rate at which consumers deplete their total wealth in retirement.

C) the difference between current and expected income.

D) the difference between current and expected profits.

E) how much usefulness a machine loses from year to year.

Answer: E Diff: 1 3) Which of the following will cause the rental cost/user cost of capital to decrease?

A) The rate of depreciation decreases.

B) The real interest rate increases.

C) The expected profit from the machine decreases.

D) all of these E) none of these Answer: B Diff: 1

205 Copyright © 2021 Pearson Education, Inc.

4) Assume the following: (1) the real cost of a unit of capital is one; (2) the unit of capital is expected to increase a firm's real profit by $10,000 each year, and depreciate by 8% each year (δ = .08); and (3) The real interest rate is 2% (r = .02). What is the "user cost" or "rental cost" of this unit of capital?

A) .02 B) .06 C) .10 D) .08/.02 = 4 E) none of these Answer: C Diff: 2 5) A painting is currently worth $100,000, and is expected to maintain its real value for three years.

The real interest rate is expected to remain constant at 10%. What is the present value of the painting's expected price at the end of the third year?

A) $75,131 B) $88,899 C) $96,153 D) $100,000 E) $70,000 Answer: B Diff: 2 6) The data for the U.S. show that investment and profits A) have a strong negative relationship.

B) are positively related during recessions, and negatively related during expansions.

C) move independently.

D) are positively related during expansions, and negatively related during recessions.

E) none of these Answer: E Diff: 1 7) A change in which of the following variables would affect the cash flow for a firm?

A) changes in the nominal interest rate B) expected future profit C) changes in the real interest rate D) changes in expected inflation E) none of these Answer: E Diff: 2

206 Copyright © 2021 Pearson Education, Inc.

8) The data shows that total profit in the U.S. economy A) has decreased steadily over time.

B) is not influenced by the business cycle.

C) tends to decrease in recessions, increase in expansions.

D) tends to increase in recessions, decrease in expansions.

E) tends to increase in even years, and decrease in odd years, although no one can explain why.

Answer: C Diff: 1 9) Suppose that, when the price of steel drops, steel companies tend to cut back on investment in their non-steel activities more than other firms in these same non-steel activities. This would support the idea that A) cash flow matters for investment.

B) cash flow does not matter for investment.

C) business firms do not care about profit.

D) business firms do not care about interest rates.

E) business firms do not use discounting.

Answer: A Diff: 2 10) An increase in which of the following variables should cause an increase in profit per unit of capital?

A) total wages and salaries B) total sales C) the capital stock D) the ratio of total sales to the capital stock E) the ratio of total sales to total wages and salaries Answer: D Diff: 2 11) Which of the following statements is true?

A) A change in sales should have more impact on current investment if it is expected to be permanent rather than temporary.

B) On a percentage basis, investment is more volatile than consumption.

C) In terms of dollars, investment and consumption are about equally volatile.

D) all of these E) none of these Answer: D Diff: 1

207 Copyright © 2021 Pearson Education, Inc.

12) The user cost of capital is represented by which of the following variables?

A) Πt B) rt C) 1/(rt + δ) D) Πt /( rt + δ) E) none of these Answer: E Diff: 2 13) An increase in which of the following variables will cause an increase in the user cost of capital?

A) δ B) Πt C) Πet D) all of these E) none of these Answer: A Diff: 2 14) An increase in which of the following variables will cause an increase in the user cost of capital?

A) rt B) Πt C) Πet D) all of these E) none of these Answer: A Diff: 2 15) Which of the following will occur when the capital stock increases?

A) profit per unit of capital will increase B) profit per unit of capital will decrease C) there will be no change in profit per unit of capital D) there will be an ambiguous effect on profit per unit of capital E) none of these Answer: B Diff: 2 16) Which of the following will occur when the capital stock falls?

A) profit per unit of capital will increase B) profit per unit of capital will decrease C) there will be no change in profit per unit of capital D) there will be an ambiguous effect on profit per unit of capital E) none of these Answer: A Diff: 2 208 Copyright © 2021 Pearson Education, Inc.

17) For this question, assume that firms experience an increase in sales. We would expect that this increase in sales will cause A) an increase in profit per unit of capital.

B) a decrease in profit per unit of capital.

C) no change in profit per unit of capital.

D) ambiguous effects on profit per unit of capital.

E) none of these Answer: A Diff: 1 18) A reduction in sales will generally cause A) an increase in profit per unit of capital.

B) a decrease in profit per unit of capital.

C) no change in profit per unit of capital.

D) ambiguous effects on profit per unit of capital.

E) none of these Answer: B Diff: 1 19) A reduction in which of the following variables will cause a reduction in the user cost of capital?

A) δ B) Πt C) Πet D) all of these E) none of these Answer: A Diff: 2 20) A reduction in which of the following variables will cause a reduction in the user cost of capital?

A) rt B) Πt C) Πet D) all of these E) none of these Answer: A Diff: 2

209 Copyright © 2021 Pearson Education, Inc.

21) Explain what decisions and calculations a firm must make when it is considering the purchase of new capital (i.e., making an investment decision).

Answer: A firm must form expectations of future expected profits (per unit of capital). This implies that they must also form expectations of future output which are correlated with future profit. They must also form expectations of future interest rates to calculate present values. And finally, they must know the current price of the project and the rate of depreciation. Once they do all of this, they calculate the discounted present value of the project and compare that with its price.

Diff: 2 22) Explain each of the determinants of the present value of expected profits from a buying a new machine.

Answer: A firm must form expectations of future expected profits (per unit of capital). This implies that they must also form expectations of future output which are correlated with future profit. They must also form expectations of future interest rates to calculate present values. And finally, they must know the current price of the project and the rate of depreciation. Once they do all of this, they calculate the discounted present value of the project and compare that with its price.

Diff: 2 23) First, briefly explain what the user cost or rental cost of capital represents. Second, explain what factors would cause an increase in the user cost or rental cost of capital.

Answer: The user cost of capital is the sum of the real rate and rate of depreciation. If a rental agency rented capital, it would have to charge enough to cover any depreciation that occurs plus an amount equal to what it could get if it simply bought bonds (the real rate). Therefore, either an increase in the real interest rate or an increase in depreciation will cause an increase in the user cost of capital.

Diff: 2 24) Explain the difference between "profitability" and "cash flow."

Answer: Some firms are borrowing constrained. Their only source of funds to buy investment is current profit. So, when current profit rises, those borrowing constrained firms increase investment. This summarizes how "cash flow" can affect a firm's investment decision.

"Profitability" simply refers to how changes in the expected present value of future profits affect investment.

Diff: 2 25) Explain how a change in expected future output could affect current output.

Answer: There are two channels here. An increase in future expected output will increase future expected profits. When future expected profits rise, the discounted present value of profits will be higher. More projects will now occur. As investment today rises, demand rises, and, therefore, current output will rise. An increase in future expected output will also increase human wealth and, therefore, cause consumption to increase. The rise in consumption will increase demand and current output.

Diff: 2

210 Copyright © 2021 Pearson Education, Inc.

26) Suppose firms expect future output to be higher and future interest rates to be higher. Given this information, how will firms alter investment in the current period? Explain.

Answer: The increase in expected future output will cause firms to revise upwards their expectations of future profits. This, all else fixed, will cause an increase in the present value of future expected profits and will tend to increase investment. The increase in the interest rate, however, will tend to decrease investment because it will reduce the discounted present value of future expected profits. The effects, therefore, on investment are ambiguous.

Diff: 2 27) Suppose firms expect future output to be lower and future interest rates to be lower. Given this information, how will firms alter investment in the current period? Explain.

Answer: The reduction in expected future output will cause firms to revise downwards their expectations of future profits. This, all else fixed, will cause a reduction in the present value of future expected profits and will tend to decrease investment. The reduction in the interest rate, however, will tend to increase investment because it will increase the discounted present value of future expected profits. The effects, therefore, on investment are ambiguous.

Diff: 2 28) What is Tobin's q? How tight is the relation between Tobin's q and investment?

Answer: Tobin constructed a variable corresponding to the value of a unit of capital in place relative to its purchase price. This variable is called Tobin's q. The data shows that it appears that there is a strong relation between investment this year and Tobin's q last year. Put another way, movements in investment this year are more closely associated with movements in the stock market last year. This is because investment decisions and stock market prices depend very much on the same factors-expected future profits and expected future interest rates.

Diff: 2 15.3

The Volatility of Consumption and Investment

1) Suppose an individual experiences a $20,000 increase in real income and the individual believes this increase in income is permanent. Economic theory suggests that this individual's current consumption will A) remain unchanged.

B) increase by more than $20,000.

C) increase by at most $20,000.

D) decrease or remain unchanged, depending on the value of the real interest rate.

E) decrease, remain unchanged, or increase, depending on the value of the real interest rate.

Answer: C Diff: 2

211 Copyright © 2021 Pearson Education, Inc.

2) Suppose current sales increase by $100 million. Investment theory suggests that current investment must A) decrease exactly by $100 million.

B) increase by exactly $100 million.

C) increase by less than $100 million.

D) decrease, but by less than $100 million.

E) none of these Answer: E Diff: 2 3) Which of the following individuals is responsible for developing the permanent income theory of consumption?

A) Friedman B) Modigliani C) Keynes D) Lucas Answer: A Diff: 1 4) Which of the following individuals is responsible for developing the life cycle theory of consumption?

A) Friedman B) Modigliani C) Keynes D) Lucas Answer: B Diff: 1 5) Which of the following statements about consumption and investment is correct?

A) Consumption is more volatile than investment.

B) Investment and consumption exhibit approximately the same degree of volatility.

C) A permanent change in income will have a relatively larger effect on consumption than on investment.

D) none of these Answer: D Diff: 1 6) Which of the following events would likely cause the largest reduction in current consumption?

A) a permanent reduction in annual salary of $2000 B) a one-time tax increase of $4000 C) a one-time reduction in income (e.g. a bonus) of $4000 D) none of these Answer: A Diff: 2

212 Copyright © 2021 Pearson Education, Inc.

7) Suppose there is an increase in profitability. This suggests that A) firms have increased their expectations of future profits.

B) the real interest rate has increased.

C) the rate of depreciation has increased.

D) all of these Answer: A Diff: 2 8) Suppose there is a reduction in cash flow. This suggests that A) firms have decreased their expectations of future profits.

B) the real interest rate has increased.

C) the rate of depreciation has increased.

D) current profits have decreased.

E) all of these Answer: D Diff: 2 9) Which of the following will cause a reduction in current consumption?

A) a reduction in current disposable income B) a reduction in financial wealth C) a reduction in human wealth D) all of these E) none of these Answer: D Diff: 1 10) An increase in the rate of depreciation will cause the discounted present value of expected profits to A) decrease.

B) increase.

C) remain unchanged if the real interest rate increases by the same amount.

D) none of these Answer: A Diff: 2 11) Which of the following would cause a reduction in human wealth?

A) a permanent reduction in salary B) a reduction in the value of one's house C) a reduction in the value of one's stock portfolio D) all of these E) none of these Answer: A Diff: 1

213 Copyright © 2021 Pearson Education, Inc.

12) For this question, assume that firms experience a reduction in sales. We would expect that this decrease in sales will cause A) an increase in profit per unit of capital.

B) a decrease in profit per unit of capital.

C) no change in profit per unit of capital.

D) ambiguous effects on profit per unit of capital.

E) none of these Answer: B Diff: 1 13) Which of the following events would likely cause the largest increase in current consumption?

A) a permanent increase in annual salary of $2000 B) a one-time tax cut of $4000 C) a one-time increase in income (e.g. a bonus) of $4000 D) none of these Answer: A Diff: 2 14) Which of the following will cause an increase in current consumption?

A) an increase in current disposable income B) an increase in financial wealth C) an increase in human wealth D) all of these E) none of these Answer: D Diff: 1 15) A reduction in the rate of depreciation will cause the discounted present value of expected profits to A) decrease.

B) increase.

C) remain unchanged if the real interest rate increases by the same amount.

D) none of these Answer: B Diff: 2 16) Investment accounts for ________ of US GDP. A) 15% B) 20% C) 50% D) 70% Answer: A Diff: 2

214 Copyright © 2021 Pearson Education, Inc.

17) Investment depends on A) current profit.

B) present value of of expected future profits.

C) user cost of capital.

D) all of these E) none of these Answer: D Diff: 2 18) Suppose a firm has 100 machines and 100 shares outstanding. The price per share is $2, and the purchase price of a machine is $1. So Tobin's q is equal to A) 2.

B) 1.

C) 0.5.

D) 1.5.

Answer: A Diff: 2 19) Explain why consumption is less volatile than investment.

Answer: At most, we would observe a one-for-one relationship between output and consumption.

This is not the case with investment. When Y increases and is viewed as permanent by firms, they may increase investment to maintain a given capital-sales ratio. If this ratio is, say, 2, an increase in sales and output of 100 would require that I increase by 200. So, I will change more than C. Diff: 2 20) Are changes in consumption and investment typically occur in the same direction and at roughly the same magnitude? Explain.

Answer: Consumption and investment usually move together but investment is much more volatile than consumption. Because the level of investment is much smaller than the level of consumption, changes in investment from one year to the next are of the same overall magnitude as changes in consumption.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 16: Expectations, Output, and Policy 16.1

Expectations and Decisions: Taking Stock

1) Changes in future expected interest rates can affect current consumption. Suppose individuals expect future interest rates to decrease. Consumption will change as a result of this lower expected future interest rate because of its effects on which of the following?

A) human wealth B) the value of stocks C) the value of bonds D) all of these E) none of these Answer: D Diff: 2 215 Copyright © 2021 Pearson Education, Inc.

2) Which of the following will not cause aggregate private spending to increase?

A) an increase in expected future real interest rates B) an increase in government spending C) a reduction in future taxes D) all of these E) none of these Answer: A Diff: 1 3) Which of the following will cause aggregate private spending to decrease?

A) a reduction in government spending B) an increase in expected future interest rates C) an increase in expected future taxes D) all of these E) none of these Answer: D Diff: 1 4) The IS curve shifts to the left where there is A) a reduction in current taxes.

B) an increase in expected future taxes.

C) an increase in expected future output.

D) all of these E) none of these Answer: B Diff: 1

216 Copyright © 2021 Pearson Education, Inc.

5) Suppose individuals now believe that there will be a future tax cut. This reduction in expected future taxes will cause which of the following to occur in the current period?

A) the LM curve to shift down B) the LM curve to shift up C) the IS curve to shift rightward D) the IS curve to shift leftward E) none of these Answer: C Diff: 1 6) Suppose individuals now believe that there will be an increase in the future expected interest rate. This increase in the expected future interest rate will cause which of the following to occur in the current period?

A) an upward shift of the LM curve B) a leftward shift of the IS curve C) the IS curve to become flatter D) the LM curve to become steeper E) none of these Answer: B Diff: 1 7) Suppose there is a fiscal expansion in the current period. This fiscal expansion will tend to cause a smaller increase in current output when A) an increase in current output causes an increase in expected future output.

B) an increase in the current interest rate causes expectations of expansionary monetary policy in the future.

C) an increase in the current interest rate causes an increase in expected future interest rates.

D) none of these E) all of these Answer: C Diff: 2 8) Which of the following will not cause aggregate private spending to decrease?

A) a reduction in expected future real interest rates B) a reduction in government spending C) an increase in future taxes D) all of these E) none of these Answer: A Diff: 1

217 Copyright © 2021 Pearson Education, Inc.

9) Which of the following will cause aggregate private spending to increase?

A) an increase in government spending B) a reduction in expected future interest rates C) a reduction in expected future taxes D) all of these E) none of these Answer: D Diff: 1 10) The IS curve shifts to the right where there is A) an increase in current taxes.

B) a reduction in expected future taxes.

C) a reduction in expected future output.

D) all of these E) none of these Answer: B Diff: 1 11) Suppose individuals now believe that there will be a future tax increase. This increase in expected future taxes will cause which of the following to occur in the current period?

A) the LM curve to shift down B) the LM curve to shift up C) the IS curve to shift rightward D) the IS curve to shift leftward E) none of these Answer: D Diff: 1 12) Suppose there is a reduction in expected future output. This will cause which of the following to occur?

A) the IS curve to shift left in the current period B) the IS curve to shift right in the current period C) the LM curve to shift up in the current period D) the LM curve to shift down in the current period Answer: A Diff: 2 13) Suppose there is a reduction in the expected future interest rate. This will cause which of the following to occur?

A) the IS curve to shift left in the current period B) the IS curve to shift right in the current period C) the LM curve to shift up in the current period D) the LM curve to shift down in the current period Answer: B Diff: 2

218 Copyright © 2021 Pearson Education, Inc.

14) Explain why the new IS curve that takes into account expectations is likely steeper than the original IS curve that ignored expectations.

Answer: There are several factors that determine the size of the slope of the IS curve: the multiplier and the interest rate sensitivity of investment. The multiplier is now smaller because changes in current Y do not have as large an effect on current C. So, the mpc is smaller, the multiplier smaller, and the IS curve steeper. Also, a drop in the interest rate that is now temporary will not cause I to increase as much so the IS curve will be steeper. In the original IS-LM model, changes in Y and the interest rate were implicitly assumed permanent.

Diff: 2 15) Explain the determinants of aggregate private spending.

Answer: Aggregate private spending, A, equals C plus I. So, A is a function of current income, future expected income, current taxes, future expected taxes, current interest rates, and future expected interest rates.

Diff: 2 16) Explain what effect an increase in future expected output will have on the IS curve and LM curve in the current period.

Answer: An increase in Ye will cause human wealth to be higher. Individuals will increase their current consumption and the IS curve will shift right. An increase in Ye will also cause firms to increase their expectations of future expected profits. When this occurs, the discounted present value of future profits is higher causing I to increase. As I increases, the IS curve shifts right. This will have no effect on the LM curve.

Diff: 2 17) Explain what effect a reduction in the future expected interest rate will have on the IS curve and LM curve in the current period.

Answer: A reduction in the future expected interest rate will cause an increase in the present value of future disposable income and, therefore, human wealth. This causes current C to increase and the IS curve to shift right. The reduction in the future expected rate will also cause an increase in the present value of future profits. This will cause an increase in investment and another rightward shift in the IS curve. The LM curve will not be affected.

Diff: 2 18) Compare the following three ways to model expectations: animal spirits, adaptive expectations, and rational expectations.

Answer: Animal spirits assumed that expectations were simply random. Adaptive expectations assumed that individuals formed expectations by looking at past changes in a variable. Rational expectations assumed that individuals form expectations by using all currently available information and an understanding of the model and policy.

Diff: 2

219 Copyright © 2021 Pearson Education, Inc.

19) Explain what effect a reduction in future expected output will have on the IS curve and LM curve in the current period.

Answer: A reduction in Ye will cause human wealth to be higher. Individuals will reduce their current consumption and the IS curve will shift left. A reduction in Ye will also cause firms to decrease their expectations of future expected profits. When this occurs, the discounted present value of future profits is lower causing I to decrease. As I decreases, the IS curve shifts left. This will have no effect on the LM curve.

Diff: 2 20) Explain what effect an increase in the future expected interest rate will have on the IS curve and LM curve in the current period.

Answer: An increase in the future expected interest rate will cause a reduction in the present value of future disposable income and, therefore, human wealth. This causes current C to decrease and the IS curve to shift left. The increase in the future expected rate will also cause a reduction in the present value of future profits. This will cause a reduction in investment and another leftward shift in the IS curve. The LM curve will not be affected.

Diff: 2 16.2

Monetary Policy, Expectations, and Output

1) Which of the following will cause the LM curve to shift up?

A) an increase in the expected future interest rate B) an increase in current income C) an increase in expected future taxes D) all of these E) none of these Answer: E Diff: 1 2) A change in which of the following will have a direct effect on the amount of money individuals wish to hold in the current period?

A) the current nominal interest rate B) the current real interest rate C) the expected future nominal interest rate D) the expected future real interest rate E) all of these Answer: A Diff: 2

220 Copyright © 2021 Pearson Education, Inc.

3) A reduction in which of the following variables will cause an increase in the amount of money individuals wish to hold in the current period?

A) current income B) the current nominal interest rate C) the current real interest rate D) expected future income E) all of these Answer: B Diff: 2 4) Suppose individuals expect that interest rates will increase in the future. Also assume that the Fed wants to prevent any change in current output. Given this goal of the Fed, the Fed should implement a policy in the current period that A) shifts the IS curve rightward.

B) shifts the IS curve leftward.

C) shifts the IS curve leftward and the LM curve upward.

D) shifts the LM curve upward.

E) shifts the LM curve downward.

Answer: E Diff: 2 5) A change in which of the following variables will cause a shift of the IS curve in the current period?

A) the current interest rate B) current output C) current taxes D) all of these E) none of these Answer: D Diff: 1 6) The IS curve becomes steeper when A) government spending is relatively small.

B) the income tax rate in the current period is relatively small.

C) current changes in the real interest rate cause large changes in current real output.

D) changes in the current real interest rate cause small changes in current demand.

E) none of these Answer: D Diff: 2

221 Copyright © 2021 Pearson Education, Inc.

7) Assume that the current demand for goods DOES depend on expectations in the IS-LM model.

A monetary expansion in the current period will cause a rightward shift in the IS curve if A) current and expected future real interest rates are positively related.

B) current and expected future real interest rates are negatively related.

C) current and expected future real interest rates are unrelated.

D) the central bank is expected to reverse any current movements in monetary policy in the future.

E) monetary policy cannot affect, directly or indirectly, the position of the IS curve in the current period.

Answer: A Diff: 2 8) Rational expectations assumes that individuals A) can accurately predict the future.

B) make predictions based on the past behavior of the economy.

C) form their predictions of macroeconomic variables randomly.

D) have perfect foresight.

E) none of these Answer: E Diff: 1 9) Adaptive expectations assumes that individuals A) can accurately predict the future.

B) base predictions on random events (i.e., animal spirits).

C) form their predictions of macroeconomic variables randomly.

D) use all available information in predicting the future.

E) none of these Answer: E Diff: 1 10) "Animal spirits" refers to A) the stubborn refusal of many economic decision-makers to use rational expectations.

B) movements in investment that cannot be explained by changes in current variables.

C) the often-observed Fed refusal to cooperate with the government in setting its monetary policy.

D) the impact of tax-evasion on the budget deficit.

E) an exotic alcoholic drink favored by Wall Street traders.

Answer: B Diff: 1

222 Copyright © 2021 Pearson Education, Inc.

11) Which of the following would be a violation of the rational expectations assumption?

A) "Over the past twenty years, people have consistently under-predicted the inflation rate for the following year."

B) "Over the past twenty years, people have never once accurately predicted the inflation rate for the following year."

C) "The Fed's announcement that it might ease interest rates caused an immediate drop in short-term rates, even before the Fed took any action."

D) all of these E) none of these Answer: A Diff: 1 12) Suppose the Fed increases the money supply in the current period with no other policy change implemented or anticipated. This policy action will cause which of the following shifts in the IS and/or LM curves in the current period?

A) IS left; LM up B) IS right; LM up C) no shift in IS; LM down D) IS left; LM down E) IS right; LM down Answer: C Diff: 2 13) Assume individuals consider only the short-run effects of changes in future macro variables when forming expectations of future output and future interest rates. A permanent increase in the money supply, with no other policy change implemented or anticipated, will most likely cause A) an increase in the current interest rate.

B) an increase in future output and an increase in the future interest rate.

C) an unknown effect on the current interest rate.

D) all of these E) none of these Answer: C Diff: 2 14) Suppose the central bank reduces the money supply. This monetary contraction will always cause a greater reduction in output when it is accompanied by A) an increase in expected future taxes.

B) an increase in expected future interest rates.

C) a reduction in expected future output.

D) all of these E) none of these Answer: D Diff: 2

223 Copyright © 2021 Pearson Education, Inc.

15) Which of the following will cause the LM curve to shift down?

A) a reduction in the expected future interest rate B) a reduction in current income C) a reduction in expected future taxes D) all of these E) none of these Answer: E Diff: 1 16) An increase in which of the following variables will cause a reduction in the amount of money individuals wish to hold in the current period?

A) current income B) the current nominal interest rate C) the current real interest rate D) expected future income E) all of these Answer: B Diff: 2 17) Suppose individuals expect that interest rates will decrease in the future. Also assume that the Fed wants to prevent any change in current output. Given this goal of the Fed, the Fed should implement a policy in the current period that A) shifts the IS curve rightward.

B) shifts the IS curve leftward.

C) shifts the IS curve leftward and the LM curve upward.

D) shifts the LM curve upward.

E) shifts the LM curve downward.

Answer: D Diff: 2 18) Suppose the Fed reduces the money supply in the current period with no other policy change implemented or anticipated. This policy action will cause which of the following shifts in the IS and/or LM curves in the current period?

A) IS left; LM up B) IS right; LM up C) no shift in IS; LM up D) IS left; LM down E) IS right; LM down Answer: C Diff: 2

224 Copyright © 2021 Pearson Education, Inc.

19) Suppose the central bank implements a monetary expansion in the current period and is expected to continue this monetary expansion in the future. Use the IS-LM model to illustrate graphically and explain the effects of this policy on current output and the current interest rate.

Answer: In the current period, the LM curve will shift down causing r to fall and Y to rise. The expectation that this will continue will cause individuals to expect lower future rates and higher future output. The lower future rates will increase current C and current I. The higher future Y will do the same. So, we will also see a rightward shift in the current IS curve. This will tend to increase the current r and current Y as well.

Diff: 2 20) Suppose the central bank announces that it will pursue a monetary expansion in the current period and a monetary expansion in the future. Explain how the credibility of the central bank might influence the effectiveness of this monetary policy action and announcement of a future monetary policy action.

Answer: If individuals do not believe the Fed, we will observe the downward shift in the LM curve causing current rates to fall and current output to rise (with no shift in the IS curve). If individuals believe that the Fed will follow through with this in the future, the LM curve will shift down causing r to fall and Y to rise. The expectation that this will continue will cause individuals to expect lower future rates and higher future output. The lower future rates will increase current C and current I. The higher future Y will do the same. So, we will also see a rightward shift in the current IS curve. This will tend to increase the current r and current Y as well. In short, we would observe a shift in the IS curve causing current Y to increase even more. So, the credibility of the Fed plays a critical role in influencing the effectiveness of monetary policy.

Diff: 2 21) Suppose the central bank implements a monetary contraction in the current period and is expected to continue this monetary contraction in the future. Use the IS-LM model to illustrate graphically and explain the effects of this policy on current output and the current interest rate.

Answer: In the current period, the LM curve will shift up causing r to rise and Y to fall. The expectation that this will continue will cause individuals to expect higher future rates and lower future output. The higher future rates will decrease current C and current I. The lower future Y will do the same. So, we will also see a leftward shift in the current IS curve. This will tend to decrease the current r and current Y as well.

Diff: 2 22) Explain the three channels economists have identified through which quantitative or credit easing may affect the economy.

Answer: 1) When arbitrage fails, credit easing can work. 2) Quantitative easing may affect expectations of future nominal interest rates. 3) Quantitative easing may affect expectations of inflation.

Diff: 1

225 Copyright © 2021 Pearson Education, Inc.

16.3

Deficit Reduction, Expectations, and Output

1) Suppose policy makers pass a budget that reduces the budget deficit. A deficit reduction package such as this has a greater chance of increasing current output when A) the policy is front-loaded.

B) financial markets believe that taxes will not increase in the future.

C) financial markets believe the Fed will lower interest rates in the future.

D) all of these E) none of these Answer: C Diff: 2 2) Suppose there is an increase in expected future output. This will cause which of the following to occur?

A) the IS curve to shift left in the current period B) the IS curve to shift right in the current period C) the LM curve to shift up in the current period D) the LM curve to shift down in the current period Answer: B Diff: 2 3) Suppose there is a simultaneous reduction in expected future output and reduction in the future expected interest rate. This will cause which of the following to occur?

A) the IS curve to shift left in the current period B) the IS curve to shift right in the current period C) the LM curve to shift up in the current period D) the LM curve to shift down in the current period E) an ambiguous effect on the position of the IS curve in the current period Answer: E Diff: 2 4) Suppose there is an increase in the expected future interest rate. This will cause which of the following to occur?

A) the IS curve to shift left in the current period B) the IS curve to shift right in the current period C) the LM curve to shift up in the current period D) the LM curve to shift down in the current period Answer: A Diff: 2

226 Copyright © 2021 Pearson Education, Inc.

5) Suppose there is a simultaneous reduction in the expected future interest rate and increase in future expected output. This will cause which of the following to occur?

A) the IS curve to shift left in the current period B) the IS curve to shift right in the current period C) the LM curve to shift up in the current period D) the LM curve to shift down in the current period E) an ambiguous effect on the position of the IS curve in the current period Answer: B Diff: 2 6) Suppose there is an increase in expected future taxes. This will cause which of the following to occur?

A) the IS curve to shift left in the current period B) the IS curve to shift right in the current period C) the LM curve to shift up in the current period D) the LM curve to shift down in the current period Answer: A Diff: 2 7) Suppose there is a reduction in expected future taxes. This will cause which of the following to occur?

A) the IS curve to shift left in the current period B) the IS curve to shift right in the current period C) the LM curve to shift up in the current period D) the LM curve to shift down in the current period Answer: B Diff: 2 8) Which of the following individuals was responsible for introducing rational expectations into macroeconomic models?

A) Keynes B) Tobin C) Phillips D) Solow E) none of these Answer: E Diff: 2

227 Copyright © 2021 Pearson Education, Inc.

9) When answering this question, assume individuals consider only the short-run effects of changes in future variables when forming expectations of future output and future interest rates.

Suppose policy makers announce a reduction in future government spending. Which of the following will occur as a result of this expected reduction in government spending?

A) a reduction in the expected future interest rate and no change in expected future output B) a reduction in the expected future interest rate and an increase in expected future output C) a reduction in the expected future interest rate and an ambiguous effect on expected future output D) none of these Answer: D Diff: 2 10) When answering this question, assume individuals consider only the medium-run effects of changes in future variables when forming expectations of future output and future interest rates Suppose policy makers announce a reduction in future government spending. Which of the following will occur as a result of this expected reduction in government spending?

A) a reduction in the expected future interest rate and no change in expected future output B) a reduction in the expected future interest rate and an increase in expected future output C) a reduction in the expected future interest rate and a reduction in expected future output D) a reduction in the expected future interest rate and an ambiguous effect on expected future output Answer: A Diff: 2 11) Assume individuals consider only the long run effects of changes in future macro variables when forming expectations of future output and future interest rates. Suppose individuals expect future government spending to decrease. Given this information, individuals will expect A) a reduction in the expected future interest rate and no change in expected future output.

B) a reduction in the expected future interest rate and an increase in expected future output.

C) a reduction in the expected future interest rate and a reduction in expected future output.

D) a reduction in the expected future interest rate and an ambiguous effect on expected future output.

Answer: B Diff: 2 12) Assume individuals consider only the short run effects of changes in future macro variables when forming expectations of future output and future interest rates. Suppose individuals expect future taxes to decrease. Given this information, individuals will expect A) an increase in the expected future interest rate and no change in expected future output.

B) an increase in the expected future interest rate and an increase in expected future output.

C) an increase in the expected future interest rate and a reduction in expected future output.

D) an increase in the expected future interest rate and an ambiguous effect on expected future output.

Answer: B Diff: 2

228 Copyright © 2021 Pearson Education, Inc.

13) Assume individuals consider only the medium run effects of changes in future macro variables when forming expectations of future output and future interest rates. Suppose individuals expect future taxes to decrease. Given this information, individuals will expect A) an increase in the expected future interest rate and no change in expected future output.

B) an increase in the expected future interest rate and an increase in expected future output.

C) an increase in the expected future interest rate and a reduction in expected future output.

D) an increase in the expected future interest rate and an ambiguous effect on expected future output.

Answer: A Diff: 2 14) Assume individuals consider only the long run effects of changes in future macro variables when forming expectations of future output and future interest rates. Suppose individuals expect future government spending to increase. Given this information, individuals will expect A) an increase in the expected future interest rate and no change in expected future output.

B) an increase in the expected future interest rate and an increase in expected future output.

C) an increase in the expected future interest rate and a reduction in expected future output.

D) an increase in the expected future interest rate and an ambiguous effect on expected future output.

Answer: C Diff: 2 15) Assume individuals consider only the short run effects of changes in future macro variables when forming expectations of future output and future interest rates. Suppose current taxes are cut and that individuals expect future taxes to decrease. Given this information, we know with certainty that A) current output and the current interest rate will both increase.

B) current output will increase.

C) the current interest rate will increase.

D) the current output effects are ambiguous.

Answer: D Diff: 2 16) Assume individuals consider only the medium run effects of changes in future macro variables when forming expectations of future output and future interest rates. Suppose current taxes are cut AND that individuals expect future taxes to decrease. Given this information, we know with certainty that A) current output and the current interest rate will both increase.

B) current output will increase.

C) the current interest rate will increase.

D) the expected future interest rate will increase.

Answer: D Diff: 2

229 Copyright © 2021 Pearson Education, Inc.

17) Assume individuals consider only the long run effects of changes in future macro variables when forming expectations of future output and future interest rates. Suppose current government spending increases and that individuals expect future government spending to increase. Given this information, we know with certainty that A) current output and the current interest rate will both increase.

B) current output will not change.

C) future expected output will decrease.

D) future expected output will not change.

Answer: C Diff: 2 18) Suppose current government spending increases and that individuals expect future government spending to increase. Given this information, in which of the following cases will output in the current period be more likely to increase?

A) Individuals consider only the short run effects of changes in future macro variables when forming expectations of future output and future interest rates.

B) Individuals consider only the medium run effects of changes in future macro variables when forming expectations of future output and future interest rates.

C) Individuals consider only the long run effects of changes in future macro variables when forming expectations of future output and future interest rates.

D) Individuals consider both medium and long term effects Answer: A Diff: 2 19) Suppose current government spending increases and that individuals expect future government spending to increase. Given this information, in which of the following cases will output in the current period be more likely to decrease?

A) Individuals consider only the short run effects of changes in future macro variables when forming expectations of future output and future interest rates.

B) Individuals consider only the medium run effects of changes in future macro variables when forming expectations of future output and future interest rates.

C) Individuals consider only the long run effects of changes in future macro variables when forming expectations of future output and future interest rates.

D) Individuals consider both medium and long term effects.

Answer: C Diff: 2

230 Copyright © 2021 Pearson Education, Inc.

20) Suppose current government spending decreases and that individuals expect future government spending to decrease. Given this information, in which of the following cases will output in the current period be more likely to decrease?

A) Individuals consider only the short run effects of changes in future macro variables when forming expectations of future output and future interest rates.

B) Individuals consider only the medium run effects of changes in future macro variables when forming expectations of future output and future interest rates.

C) Individuals consider only the long run effects of changes in future macro variables when forming expectations of future output and future interest rates.

D) Individuals consider both medium and long term effects.

Answer: A Diff: 2 21) Suppose current government spending decreases and that individuals expect future government spending to decrease. Given this information, in which of the following cases will output in the current period be more likely to increase?

A) Individuals consider only the short run effects of changes in future macro variables when forming expectations of future output and future interest rates.

B) Individuals consider only the medium run effects of changes in future macro variables when forming expectations of future output and future interest rates.

C) Individuals consider only the long run effects of changes in future macro variables when forming expectations of future output and future interest rates.

D) Individuals consider both medium and long term effects.

Answer: C Diff: 2 22) Assume individuals consider only the short run effects of changes in future macro variables when forming expectations of future output and future interest rates. Suppose individuals expect the central bank to pursue a monetary expansion in the future. Given this information, we know with certainty that A) current output and the current interest rate will both increase.

B) current output will decrease.

C) the current interest rate will decrease.

D) the current output effects are ambiguous.

Answer: A Diff: 2

231 Copyright © 2021 Pearson Education, Inc.

23) Assume individuals consider only the medium run effects of changes in future macro variables when forming expectations of future output and future interest rates. Suppose individuals expect the central bank to pursue a monetary expansion in the future. Given this information, we know with certainty that A) current output and the current interest rate will both increase.

B) current output will decrease.

C) the current interest rate will decrease.

D) the current output effects are ambiguous.

E) current output will not change.

Answer: E Diff: 2 24) Suppose fiscal policy makers pass a budget that increases taxes in the current period and are expected to raise taxes in the future. Use the IS-LM model to illustrate graphically and explain the effects of this policy on current output and the current interest rate.

Answer: The increase in current T will cause disposable income to fall and current C to fall. This will cause the IS curve to shift left. The increase in future expected taxes will, all else fixed, decrease human wealth and current consumption. This will also cause the IS curve to shift left. As future T is raised, future Y will fall. This will depress both current C and I and, again, IS shifts to the left. The drop in future interest rates will have the opposite effect on C and I causing the IS curve to shift right. In theory, the effects on current output are ambiguous. The lower expected future interest rates have a positive effect on current demand. All other factors have the opposite effect.

Diff: 2 25) Explain whether a policy that results in a larger budget deficit in the current period can lead to a reduction in current output.

Answer: In short, yes. If the effects of the higher future interest rates dominate the other effects, current demand could fall causing current Y to fall.

Diff: 2 26) Explain whether a fiscal policy that causes an increase in current and future government spending can cause a reduction in current output.

Answer: Current output could fall. The increase in G will cause the IS curve to shift to the right.

The increase in future G will cause an increase in future output which will also shift the IS curve to the right. The increase in future rates, however, will cause current demand to fall and shift the current IS curve to the left. If these effects dominate (or if the Fed is expected to contract in the future), Y could fall in the current period.

Diff: 2

232 Copyright © 2021 Pearson Education, Inc.

27) Suppose fiscal policy makers pass a budget that cuts taxes in the current period and are expected to cut taxes in the future. Use the IS-LM model to illustrate graphically and explain the effects of this policy on current output and the current interest rate.

Answer: The cut in current T will cause disposable income to rise and current C to rise. This will cause the IS curve to shift right. The reduction in future expected taxes will, all else fixed, increase human wealth and current consumption. This will also cause the IS curve to shift right. As future T is cut, future Y will rise. This will increase both current C and I and, again, IS shifts to the right.

The increase in future interest rates will have the opposite effect on C and I causing the IS curve to shift left. In theory, the effects on current output are ambiguous. The higher expected future interest rates have a negative effect on current demand. All other factors have the opposite effect.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 17: Openness in Goods and Financial Markets 17.1

Openness in Goods Markets

1) A tariff is A) a foreign bond.

B) an order for foreign goods that have not yet been delivered.

C) a barter arrangement between importers and exporters.

D) a tax on imported goods.

E) a restriction on the quantity of imported goods allowed into the country.

Answer: D Diff: 1 2) In the U.S., over the past forty years, A) exports as a percentage of GDP have increased, while imports has a percentage of GDP have decreased.

B) exports as a percentage of GDP have decreased, while imports has a percentage of GDP have increased.

C) both exports and imports as a percentage of GDP have decreased.

D) both exports and imports as a percentage of GDP have increased.

E) both exports and imports as a percentage of GDP have remained constant.

Answer: D Diff: 1 3) In 2017, which of the following countries had the highest ratio of exports to GDP? A) Germany B) Netherlands C) Japan D) United States E) Austria Answer: B Diff: 1 4) The ratio of a country's exports to its GDP must A) be greater than one.

233 Copyright © 2021 Pearson Education, Inc.

B) be less than one.

C) equal the ratio of imports to GDP. D) be larger than the ratio of imports to GDP. E) none of these Answer: E Diff: 1

234 Copyright © 2021 Pearson Education, Inc.

5) Which of the following best defines the real exchange rate?

A) the price of foreign bonds in terms of domestic bonds B) the price of foreign currency in terms of domestic currency C) the price of domestic goods in terms of foreign goods D) the price of domestic currency in terms of foreign currency E) none of these Answer: C Diff: 1 6) Which of the following, all else fixed, will cause the real exchange rate to increase?

A) a nominal depreciation B) a reduction in the foreign price level C) a reduction in the domestic price level D) all of these E) none of these Answer: B Diff: 2 7) From the perspective of the United States, an increase in the nominal exchange rate will cause which of the following?

A) the dollar becomes less expensive to foreigners B) foreign goods are more expensive to Americans C) foreign currency is more expensive to Americans D) American goods are more expensive to foreigners E) none of these Answer: D Diff: 1 8) When the dollar appreciates relative to the pound, the pound price of the dollar A) increases.

B) decreases.

C) does not change.

D) increases or decreases, depending on the amount of the depreciation.

E) changes in the next period.

Answer: A Diff: 1 9) Suppose there is a real depreciation of the dollar. Which of the following may have occurred?

A) foreign currency has become more expensive in dollars.

B) foreign goods have become more expensive to Americans.

C) the foreign price level has increased relative to the U.S. price level.

D) all of these E) none of these Answer: D Diff: 1

235 Copyright © 2021 Pearson Education, Inc.

10) Suppose that over the past decade, U.S. inflation is less than that in Mexico. Further assume that during this same period, the dollar depreciates relative to the Mexican peso. Given this information, A) the real exchange rate remains unchanged.

B) the real exchange rate must decrease.

C) the real exchange rate must increase.

D) the real exchange rate can increase or remain the same, but not decrease.

E) the real exchange rate can decrease or remain the same, but not increase.

Answer: B Diff: 2 11) America's largest trading partner is A) Canada.

B) Japan.

C) Mexico.

D) European Union.

E) China Answer: E Diff: 1 12) If the exchange rate between the dollar and the pound (the pound price of the dollar) is currently 1.50, and is expected to be 1.35 in one year, then the expected rate of A) depreciation of the dollar is 10%.

B) depreciation of the dollar is 15%.

C) appreciation of the dollar is 10%.

D) appreciation of the dollar is 15%.

E) none of these Answer: A Diff: 2 13) Assume that the uncovered interest parity condition holds. Also assume that the U.S. interest rate is less than the U.K. interest rate. Given this information, we know that investors expect A) the pound to depreciate.

B) the pound to appreciate.

C) the dollar-pound exchange rate to remain fixed.

D) the U.S. interest rate to fall.

E) none of these Answer: A Diff: 2

236 Copyright © 2021 Pearson Education, Inc.

14) Assume that the interest rate in a foreign country is 7% and that the foreign currency is expected to depreciate by 3% during the year. For each dollar that a U.S. resident invests in foreign bonds, he/she can expect to get back an approximate total of A) $.93.

B) $.96.

C) $1.04.

D) $1.07.

E) $1.10.

Answer: C Diff: 2 15) Suppose two countries make a credible commitment to fix their bilateral exchange rate. In such a situation, we know that A) the uncovered interest parity condition no longer holds.

B) the real exchange rate must be constant as well.

C) each country can freely allow its interest rate to diverge from that of the other country.

D) the interest rate in the two countries must be equal.

E) neither country will run a trade deficit.

Answer: D Diff: 1 16) In 2017, exports as a percentage of GDP for the United States are approximately A) between 1% and 5%.

B) between 10% and 20%.

C) between 20% and 40%.

D) between 40% and 75%.

E) between 75% and 90%.

Answer: B Diff: 1 17) As of 2017, the ratio of exports to GDP for Netherlands was approximately equal to A) 20%.

B) 40%.

C) 60%.

D) 86%.

Answer: D Diff: 1 18) If the price level in Japan is 1.0, the price level in the U.S. is 2.0, and it costs 100 Yen to buy one dollar, then the real exchange rate between the U.S. and Japan is A) 2.

B) 10.

C) 50.

D) 100.

E) 200.

Answer: E Diff: 2 237 Copyright © 2021 Pearson Education, Inc.

19) Year-to-year movements in real exchange rates between industrialized countries like the U.S. and Canada are caused mostly by A) changes in relative rates of inflation.

B) changes in relative growth rates of output.

C) changes in quotas or tariffs.

D) changes in capital controls.

E) changes in nominal exchange rates.

Answer: E Diff: 1 20) Suppose the U.S. one-year interest rate is 3% per year, while a foreign country has a one-year interest rate of 5% per year. Ignoring risk and transaction costs, a U.S. investor should invest in foreign bonds as long as the expected yearly rate of depreciation of the foreign currency is A) less than 5%.

B) greater than 5%.

C) greater than 2%.

D) less than 2%.

E) less than 1%.

Answer: D Diff: 2 21) Which of the following has occurred for the United States since 1960?

A) The ratio of exports to GDP (X/Y) and the ratio of imports to GDP (IM/Y) have both increased.

B) X/Y has increased while IM/Y has decreased.

C) X/Y has decreased and IM/Y has increased.

D) X/Y has decreased and IM/Y has decreased.

Answer: A Diff: 1 22) Which of the following has occurred for the United States since 1960?

A) The ratio of exports to GDP (X/Y) and the ratio of imports to GDP (IM/Y) have both decreased.

B) X/Y has increased while IM/Y has decreased.

C) X/Y has decreased and IM/Y has increased.

D) X/Y and IM/Y have stayed relatively constant.

E) none of these Answer: E Diff: 1

238 Copyright © 2021 Pearson Education, Inc.

23) The ratio of exports to GDP for the United States in 2017 is approximately equal to A) 6%.

B) 12%.

C) 21%.

D) 31%.

Answer: B Diff: 1 24) Estimates are that tradable goods in the U.S. account for approximately what share of GDP in the U.S.?

A) 10% B) 16% C) 25% D) none of these Answer: D Diff: 1 25) In 2017, which of the following countries had the lowest ratio of exports to GDP? A) Japan B) Switzerland C) Austria D) Netherlands E) United States Answer: E Diff: 1 26) In 2017, which of the following countries had the highest ratio of exports to GDP? A) United States B) Germany C) Japan D) Netherlands Answer: D Diff: 1 27) The differences in the ratios of exports to GDP across countries are believed to be caused primarily by A) trade barriers.

B) each country's size.

C) monetary policy.

D) fiscal policy.

E) inflation in the domestic country.

Answer: B Diff: 1

239 Copyright © 2021 Pearson Education, Inc.

28) The differences in the ratios of exports to GDP across countries are believed to be caused primarily by A) trade barriers.

B) each country's size.

C) geography.

D) all of these E) a country's size and geography Answer: E Diff: 1 29) The nominal exchange rate (E) as defined in the text represents A) the number of units of foreign currency you can obtain with one unit of domestic currency.

B) the number of units of domestic goods you can obtain with one unit of foreign goods.

C) the price of domestic currency in terms of foreign currency.

D) none of these E) the number of units of foreign currency you can obtain with one unit of domestic currency and the price of domestic currency in terms of foreign currency.

Answer: E Diff: 1 30) When E increases by 5%, we know that A) a real appreciation will occur if P decreases by 5%.

B) a real depreciation will occur if P also increases by 5%.

C) a nominal appreciation will occur.

D) a nominal depreciation will occur.

Answer: C Diff: 2 31) When E decreases by 3%, we know that A) a real appreciation will occur if P also falls by 3%.

B) a real depreciation will occur if P increases by 3%.

C) nominal appreciation.

D) nominal depreciation.

Answer: D Diff: 2 32) A nominal depreciation of the Mexican peso (against all currencies) indicates that A) the peso price of foreign currency has fallen.

B) the Mexican real exchange rate will not change if the price level in Mexico falls.

C) the peso price of, for example, the U.K. pound has increased.

D) the number of units of foreign currency that one can obtain with one peso has decreased.

Answer: C Diff: 2

240 Copyright © 2021 Pearson Education, Inc.

33) A nominal appreciation of the Japanese yen (against all currencies) indicates that A) the yen price of the U.S. dollar has increased.

B) the yen price of the U.K. pound has increased.

C) the number of units of foreign currency that one can obtain with one yen has increased.

D) all of these Answer: D Diff: 2 34) Which of the following expressions represents the real exchange rate (ε)?

A) E/P. B) EP*/P. C) EP*.

D) EP/P*.

E) none of these Answer: D Diff: 2 35) Which of the following expressions represents the dollar price of foreign currency?

A) EP*/P B) EP/P* C) 1/E D) E E) none of these Answer: C Diff: 1 36) Assume that the nominal exchange rate decreases by 4%. If prices (both domestic and foreign do not change), we know that A) foreign goods are now relatively cheaper.

B) foreign goods are now relatively more expensive.

C) domestic goods are now relatively more expensive.

D) foreign goods are now relatively cheaper and domestic goods are now relatively more expensive.

Answer: B Diff: 2 37) Assume that the nominal exchange rate increases by 2%. If prices (both domestic and foreign do not change), we know that A) domestic goods are now relatively cheaper.

B) domestic goods are now relatively more expensive.

C) foreign goods are now relatively cheaper.

D) domestic goods are now relatively more expensive and foreign goods are now relatively cheaper.

Answer: D Diff: 2

241 Copyright © 2021 Pearson Education, Inc.

38) A reduction in the real exchange rate indicates that A) foreign goods are now relatively cheaper.

B) foreign goods are now relatively more expensive.

C) domestic goods are now relatively more expensive.

D) foreign goods are now relatively cheaper and domestic goods are now relatively more expensive.

Answer: B Diff: 1 39) An increase in the real exchange rate indicates that A) domestic goods are now relatively cheaper.

B) domestic goods are now relatively more expensive.

C) foreign goods are now relatively cheaper.

D) domestic goods are now relatively more expensive and foreign goods are now relatively cheaper.

Answer: D Diff: 1 40) Which of the following will cause a real appreciation?

A) a reduction in E B) a decrease in P C) an increase in P* D) none of these Answer: D Diff: 2 41) Which of the following will cause a real depreciation?

A) an increase in E B) a reduction in P* C) a reduction in P D) all of these E) none of these Answer: A Diff: 1 42) Which of the following events will cause the smallest change in the real exchange rate (ε)?

A) a 6% drop in E and a 6% increase in the foreign price level (P*) B) a 6% increase in the domestic price level (P) and a 6% reduction in P* C) a 6% drop in E and a 6% reduction in P* D) a 3% increase in E E) a 2% increase in E and a 2% increase in P Answer: C Diff: 2

242 Copyright © 2021 Pearson Education, Inc.

43) Which of the following events will cause the largest real depreciation for the domestic economy?

A) a 6% reduction in E and a 6% increase in the foreign price level (P*) B) a 6% increase in the domestic price level (P) and a 6% reduction in P* C) a 6% reduction in E and a 6% reduction in P* D) a 3% increase in E E) a 2% increase in E and a 2% increase in P Answer: A Diff: 2 44) Explain the three distinct notions of openness.

Answer: There are three notions of openness. First, there is openness in the goods market where agents buy domestic and foreign goods and domestic firms sell goods abroad. Second, there is openness in financial markets where individuals can purchase, for example, domestic or foreign bonds. And third, there is openness in factor markets where firms can locate either domestically or in other countries. Workers can also move between countries.

Diff: 1 45) First, write out the expression/equation for the real exchange rate. Second, explain all factors that determine the real exchange rate.

Answer: The real exchange rate is the price of domestic goods in terms of foreign goods. It is represented as EP/P*. An increase in E, a nominal appreciation, raises the pound price of the dollar. This will also raise the relative price of domestic goods. An increase in P*, the foreign price level, reflects an increase in the foreign currency price of foreign goods. This will reduce the relative price of domestic goods. And finally, an increase in P, the domestic price level, reflects an increase in the dollar price of domestic goods. This will increase the relative price of domestic goods in terms of foreign goods.

Diff: 1 46) What are the differences between the real exchange rate and nominal exchange rate? Explain.

Answer: The real exchange rate, EP/P*, represents the relative price of domestic goods in terms of foreign goods. The nominal exchange rate, E, is the pound price of domestic currency or, equivalently, the relative price of domestic currency in terms of foreign currency.

Diff: 2 47) Discuss what factors could cause a real depreciation.

Answer: Decrease in E; increase in P*; and decrease in P. Diff: 2 48) Explain the difference between gross domestic product and gross national product.

Answer: GDP represents the market value of all final goods and services produced IN a country during a given period. GNP is the market value of all final goods and services produced by domestically owned factors of production in a given period.

Diff: 2

243 Copyright © 2021 Pearson Education, Inc.

17.2

Openness in Financial Markets

1) Another name for "current account transactions" is A) "capital account transactions."

B) "investment income."

C) "net transfers received."

D) "checking account transactions."

E) "transactions above the line."

Answer: E Diff: 1 2) Because the U.S. traditionally gives more foreign aid than it receives, the U.S. traditionally has a negative value for A) the capital account balance.

B) the trade balance.

C) investment income.

D) net transfers received.

E) all of these Answer: D Diff: 1 3) When the U.S. has a current account surplus, we know that it is also A) running a balanced trade account.

B) lending to the rest of the world.

C) borrowing from the rest of the world.

D) suffering from negative investment income.

E) none of these Answer: B Diff: 1 4) The difference between net capital flows and the current account deficit is called the A) capital account surplus.

B) capital account deficit.

C) international error.

D) missing number.

E) statistical discrepancy.

Answer: E Diff: 1

244 Copyright © 2021 Pearson Education, Inc.

5) In a country like Saudi Arabia, which earns substantial income from holding the stocks and bonds of other countries, we would expect A) GNP to be larger than GDP. B) a current account deficit.

C) a current account surplus larger than GNP. D) a current account surplus larger than GDP. E) GDP to be larger than GNP. Answer: A Diff: 1 6) Suppose you have one U.S. dollar with which you wish to purchase U.K. (one-year) bonds in period t. Which of the following expressions represents the amount of U.S. dollars you will receive in one year (i.e., period t + 1) from purchasing U.K. bonds in period t?

A) i B) 1 + i* C) (1 + i*)Eet+1/Et D) (1 + i*)Et/Eet+1 E) none of the above Answer: D Diff: 2 7) Suppose you have one U.S. dollar with which you wish to purchase U.K. (one-year) bonds in period t. Which of the following expressions represents the amount of U.K. pounds you will receive in one year (i.e., period t + 1) from purchasing U.K. bonds in period t?

A) i B) 1 + i* C) (1 + i*)Eet+1/Et D) (1 + i*)Et/Eet+1 E) none of the above Answer: B Diff: 2 8) Which of the following expressions represents the amount of foreign currency you can obtain with one U.S. dollar?

A) Et B) Eet+1 C) 1/ Eet+1 D) εt E) none of the above Answer: A Diff: 2

245 Copyright © 2021 Pearson Education, Inc.

9) For this question, assume the interest parity conditions holds. Also assume that the domestic interest rate is 9% and that the foreign interest rate is 5%. Given this information, we would expect that A) individuals will only hold foreign bonds.

B) individuals will only hold domestic bonds.

C) the domestic currency is expected to appreciate by 4%.

D) the domestic currency is expected to depreciate by 4%.

Answer: D Diff: 2 10) For this question, assume the interest parity conditions holds. Also assume that the domestic interest rate is 10% and that the foreign interest rate is 7%. Given this information, we would expect that A) individuals will only hold foreign bonds.

B) individuals will only hold domestic bonds.

C) the domestic currency is expected to appreciate by 3%.

D) the domestic currency is expected to depreciate by 3%.

Answer: D Diff: 2 11) Assume the interest parity condition holds and that individuals expect the dollar to appreciate by 5% during the coming year. Given this information, we know that A) the interest rate differential between the two countries is less than 5%.

B) i < i*.

C) i = i*.

D) individuals will only hold foreign bonds.

E) none of the above Answer: B Diff: 2 12) Which of the following conditions will occur when two countries are engaged in a credible, fixed exchange rate regime?

A) E = 1 B) E > 1 C) i = i* D) E < 1 Answer: C Diff: 2

246 Copyright © 2021 Pearson Education, Inc.

13) For this question, assume that the domestic interest rate is 8% and that the foreign interest rate is 6%. And finally, assume that the domestic currency is expected to depreciate by 3% during the coming year. Given this information, we know that A) individuals will only hold domestic bonds.

B) individuals will only hold foreign bonds.

C) individuals will be indifferent about holding domestic or foreign bonds.

D) the interest parity condition holds.

Answer: B Diff: 2 14) For this question, assume that the domestic interest rate is 6% and that the foreign interest rate 4%. And finally, assume that the domestic currency is expected to appreciate by 3% during the coming year. Given this information, we know that A) individuals will only hold domestic bonds.

B) individuals will only hold foreign bonds.

C) individuals will be indifferent about holding domestic or foreign bonds.

D) the interest parity condition holds.

Answer: A Diff: 2 15) For this question, suppose the domestic interest rate is 4% and that the foreign interest rate is 7%. And finally, assume that the domestic currency is expected to depreciate by 3% during the coming year. Given this information, we know that A) individuals will only hold domestic bonds.

B) individuals will only hold foreign bonds.

C) individuals will be indifferent about holding domestic or foreign bonds.

D) the interest parity condition holds.

Answer: B Diff: 2 16) Suppose the domestic interest rate is 3% and that the foreign interest rate is 6%. And finally, assume that the domestic currency is expected to appreciate by 4% during the coming year. Given this information, we know that A) individuals will only hold domestic bonds.

B) individuals will only hold foreign bonds.

C) individuals will be indifferent about holding domestic or foreign bonds.

D) the interest parity condition holds.

Answer: A Diff: 2

247 Copyright © 2021 Pearson Education, Inc.

17) Which of the following, all else fixed, will cause the real exchange rate to decrease?

A) a nominal appreciation B) an increase in the foreign price level C) an increase in the domestic price level D) all of the above E) none of the above Answer: B Diff: 2 18) From the perspective of the United States, a reduction in the nominal exchange rate will cause which of the following?

A) The dollar becomes more expensive to foreigners.

B) Foreign goods are less expensive to Americans.

C) Foreign currency is less expensive to Americans.

D) American goods are less expensive to foreigners.

E) none of the above Answer: D Diff: 1 19) When the dollar depreciates relative to the pound, the pound price of the dollar A) increases.

B) decreases.

C) does not change.

D) increases or decreases, depending on the amount of the depreciation.

E) changes in the next period.

Answer: B Diff: 1 20) Suppose that over the past decade, U.S. inflation is greater than that in Mexico. Further assume that during this same period, the dollar appreciates relative to the Mexican peso. Given this information, A) the real exchange rate remains unchanged.

B) the real exchange rate must decrease.

C) the real exchange rate must increase.

D) the real exchange rate can increase or remain the same, but not decrease.

E) the real exchange rate can decrease or remain the same, but not increase.

Answer: C Diff: 2

248 Copyright © 2021 Pearson Education, Inc.

21) Assume that the uncovered interest parity condition holds. Also assume that the U.S. interest rate is greater than the U.K. interest rate. Given this information, we know that investors expect A) the pound to depreciate.

B) the pound to appreciate.

C) the dollar-pound exchange rate to remain fixed.

D) the U.S. interest rate to fall.

E) none of the above Answer: B Diff: 2 22) A nominal appreciation of the Mexican peso (against all currencies) indicates that A) the peso price of foreign currency has risen.

B) the Mexican real exchange rate will not change if the price level in Mexico falls.

C) the peso price of, for example, the U.K. pound has decreased.

D) the number of units of foreign currency that one can obtain with one peso has increased.

Answer: C Diff: 2 23) Suppose you are considering the purchase of a bond issued in another country. What calculations must you do to calculate the expected return on a foreign bond? Explain.

Answer: You must first determine the amount of foreign currency you can obtain with one unit of domestic currency (E). You then must determine how much foreign currency you will obtain in one year after purchasing foreign bonds. And finally, you must then calculate how much domestic currency you will receive in one year when you convert the foreign currency back to domestic currency.

Diff: 2 24) Explain what factors determine the expected return on a foreign bond.

Answer: The current exchange rate, the current foreign interest rate, and the future expected exchange rate.

Diff: 2 25) Suppose the interest parity condition holds and that the domestic interest rate is greater than the foreign interest rate. What does this imply about the current versus future expected exchange rate?

Explain.

Answer: If i > i*, we know that the foreign currency must be expected to appreciate to equate the expected returns on the two bonds.

Diff: 2 26) Suppose the interest parity condition holds. Also assume that the one-year interest rate in the United States is 6% and that the one-year interest rate in Canada is 6%. What does this imply about the current versus future expected exchange rate (for the U.S. and Canadian dollars)? Explain.

Answer: This implies that there are no expected exchange gains or losses from holding foreign currency denominated assets for one year. So, the exchange rate that financial market participants expect to occur in one year is equal to the current exchange rate.

Diff: 2 249 Copyright © 2021 Pearson Education, Inc.

27) Assuming that the interest parity condition holds, what type of information is contained in interest rate differentials between domestic and foreign bonds? Explain.

Answer: Given that the domestic rate equals the foreign interest rate minus any expected rate of appreciation of the domestic currency, any difference in interest rates will reflect this expected depreciation/appreciation of the domestic currency.

Diff: 2 28) Explain why a comparison between the interest rates on domestic and foreign bonds might provide misleading information about which bonds yield the highest expected returns.

Answer: A simple comparison of interest rates will ignore the expected exchange gains/losses that can occur from holding assets denominated in a foreign currency. Hence, such a comparison will likely provide incorrect information about which bonds have a higher expected return.

Diff: 2 29) Suppose the interest parity condition holds and that the domestic interest rate is less than the foreign interest rate. What does this imply about the current versus future expected exchange rate?

Explain.

Answer: If i < i*, we know that the foreign currency must be expected to depreciate to equate the expected returns on the two bonds.

Diff: 2 30) Suppose the interest parity condition holds. Also assume that the one-year interest rate in the United States is 5% and that the one-year interest rate in Canada is 6%. What does this imply about the current versus future expected exchange rate (for the U.S. and Canadian dollars)? Explain.

Answer: If the interest rate in US is less than the interest rate in Canada, we know that Canadian dollars must be expected to depreciate to equate the expected returns on the two bonds.

Diff: 2 31) Suppose the interest parity condition holds. Also assume that the one-year interest rate in the United States is 6% and that the one-year interest rate in Canada is 5%. What does this imply about the current versus future expected exchange rate (for the U.S. and Canadian dollars)? Explain.

Answer: If the interest rate in US is greater than the interest rate in Canada, we know that Canadian dollars must be expected to appreciate to equate the expected returns on the two bonds.

Diff: 2 32) What is uncovered interest parity? Explain.

Answer: Uncovered interest parity or interest parity, is an arbitrage condition stating that the expected rates of return in terms of domestic currency on domestic bonds and foreign bonds must be equal. Interest parity implies that the domestic interest rate approximately equals the foreign interest rate minus the expected appreciation rate of the domestic currency.

Diff: 2

250 Copyright © 2021 Pearson Education, Inc.

33) Suppose the one-year nominal interest rate is 2.0% in the United States and 5.0% in Canada.

Should you hold Canadian bonds or U.S. bonds? Explain.

Answer: It depends whether you expect the Canadian dollars to depreciate relative to the dollar over the coming year by more or less than the difference between the U.S. interest rate and the Canada interest rate, or 3.0% in this case (5.0% - 2.0%). If you expect the Canadian dollars to depreciate by more than 3.0%, then, despite the fact that the interest rate is higher in Canada than in the United States, investing in Canadian bonds is less attractive than investing in U.S. bonds. By holding Canadian bonds, you will get higher interest payments next year, but the Canadian dollars will be worth less in terms of dollars next year, making investing in Canada bonds less attractive than investing in U.S. bonds. If you expect the Canadian dollars to depreciate by less than 3.0% or even to appreciate, then the reverse holds, and Canadian bonds are more attractive than U.S. bonds.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 18: The Goods Market in an Open Economy 18.1

The IS Relation in the Open Economy

1) Which of the following represents the demand for domestic goods?

A) C + I + G B) C + I + G + X C) C + I + G - εIM D) C + I + G + X + εIM E) C + I + G + X - IM/ε Answer: E Diff: 1 2) Which of the following represents the domestic demand for goods?

A) C + I + G B) C + I + G + X C) C + I + G - IM/ε D) C + I + G + X - εM/ε E) C + I + G + X + εIM Answer: A Diff: 1 3) The expression, IM, represents the value of imports in terms of A) foreign currency.

B) domestic currency.

C) foreign goods.

D) domestic goods.

E) exports.

Answer: C Diff: 2 4) The quantity of imports will increase when there is A) a reduction in the real exchange rate.

251 Copyright © 2021 Pearson Education, Inc.

B) an increase in domestic output.

C) an increase in foreign output.

D) all of these E) none of these Answer: B Diff: 1

252 Copyright © 2021 Pearson Education, Inc.

5) Exports will decrease when there is A) an increase in the real exchange rate.

B) an increase in domestic output.

C) an increase in foreign output.

D) all of these E) none of these Answer: A Diff: 2 6) Explain the difference between: (1) the demand for domestic goods; and (2) the domestic demand for goods.

Answer: The demand for domestic goods represents the demand for goods produced IN a country. This measure will take into account those goods produced domestically and sold abroad (exports) and the fact that some goods purchased domestically were produced abroad (imports).

The domestic demand for goods represents the demand for goods by domestic individuals, firms, and government: C + I + G. The difference between the two is NX. Diff: 2 7) Explain the determinants of exports and imports.

Answer: Exports are a function of foreign output and the real exchange rate. Imports are a function of domestic output and the exchange rate.

Diff: 1 8) Explain why the demand for domestic goods curve (ZZ) has a different shape than the domestic demand curve (DD).

Answer: The marginal propensity to import explains this. As Y increases, C and I will increase causing an increase in DD. Some of this increase in demand is for foreign goods. This must be subtracted from DD to obtain ZZ. So, a given increase in Y will have a larger effect on DD than it will on ZZ. Diff: 2 18.2

Equilibrium Output and the Trade Balance

1) Which of the following occurs when the goods market is in equilibrium?

A) Domestic output (Y) equals the demand for domestic goods.

B) Y equals the domestic demand for goods.

C) Y equals the domestic demand for domestic goods.

D) Net exports equals 0.

E) Demand for domestic goods equals the domestic demand for goods.

Answer: A Diff: 2

253 Copyright © 2021 Pearson Education, Inc.

2) Which of the following is true when a country is experiencing a trade surplus (NX > 0)?

A) Demand for domestic goods is equal to the domestic demand for goods.

B) Demand for domestic goods is greater than the domestic demand for goods.

C) Demand for domestic goods is less than the domestic demand for goods.

D) A budget surplus exists.

Answer: B Diff: 2 3) Which of the following is true when a county is experiencing a trade deficit (NX < 0)?

A) Demand for domestic goods is equal to the domestic demand for goods.

B) Demand for domestic goods is greater than the domestic demand for goods.

C) Demand for domestic goods is less than the domestic demand for goods.

D) A budget deficit exists.

Answer: C Diff: 2 4) Which of the following is true when a country's trade position is balanced (i.e., NX = 0)?

A) Demand for domestic goods is equal to the domestic demand for goods.

B) Demand for domestic goods is greater than the domestic demand for goods.

C) Demand for domestic goods is less than the domestic demand for goods.

D) Neither a budget surplus nor deficit exists (i.e., G - T = 0).

Answer: A Diff: 2 5) Assume the Marshall-Lerner condition holds. Which of the following will cause an increase in net exports?

A) an increase in government spending B) an increase in investment C) a reduction in foreign output D) a reduction in the real exchange rate E) all of these Answer: D Diff: 2 6) Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect a reduction in taxes will have on output, exports, imports, and net exports. Clearly label all curves and clearly label the initial and final equilibria.

Answer: A reduction in T will cause an increase in C and cause ZZ to shift up as demand rises. Y will increase causing an increase in C and S. As Y rises, imports will rise. Given that exports do not change, net exports will decrease.

Diff: 2

254 Copyright © 2021 Pearson Education, Inc.

7) Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect a reduction in foreign output (Y*) will have on output, exports, imports, and net exports. Clearly label all curves and clearly label the initial and final equilibria.

Answer: A reduction in foreign income, Y*, will cause a decrease in exports (the NX curve shifts up) and an decrease in demand. As demand falls, Y will decrease causing a fall in C and S. As Y decreases, imports will decrease as well. As shown in the text, the decrease in imports will be less than the fall in exports. So, NX will be lower.

Diff: 2 8) Explain why in practice policy coordination is hard to achieve.

Answer: One of reasons is that some countries might have to do more than others and may not want to do so. Second, countries have a strong incentive to promise to coordinate and then not deliver on that promise. Only when things are really bad, does coordination appear to take hold.

Diff: 2 9) Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect an increase in government spending will have on output, exports, imports, and net exports. Clearly label all curves and clearly label the initial and final equilibria.

Answer: An increase in government spending will cause ZZ to shift up as demand rises. Y will increase causing an increase in C and S. As Y rises, imports will rise. Given that exports do not change, net exports will decrease.

Diff: 2 18.3

Increases in Demand-Domestic or Foreign

1) In an open economy, an increase in government spending will cause A) a reduction in domestic output.

B) a reduction in imports.

C) a reduction in net exports.

D) all of these E) none of these Answer: D Diff: 2 2) In an open economy, which of the following will cause an increase in the size of the multiplier?

A) a reduction in the marginal propensity to import B) a reduction foreign output C) an increase in the marginal propensity to save D) all of these E) none of these Answer: A Diff: 2

255 Copyright © 2021 Pearson Education, Inc.

3) Suppose there is a reduction in foreign output (Y*). This reduction in Y* will cause which of the following in the domestic country?

A) a reduction in output B) a reduction in consumption C) a reduction in net exports D) all of these E) none of these Answer: D Diff: 2 4) Which of the following will always cause an increase in net exports?

A) a reduction in domestic output B) an increase in the real exchange rate C) an increase in government spending D) an increase in investment E) all of these Answer: A Diff: 2 5) An increase in government spending will have a greater impact on net exports when A) the marginal propensity to save is smaller.

B) the economy is closed.

C) the sensitivity of investment to income is smaller.

D) all of these E) none of these Answer: A Diff: 2 6) Which of the following will occur in a small country with a high marginal propensity to import?

A) Changes in government spending will cause large changes in output.

B) Changes in government spending will cause large changes in the trade balance.

C) A depreciation will cause only small changes in the trade balance.

D) There is no combination of policies that can eliminate the trade deficit.

E) all of these Answer: B Diff: 2 7) Which of the following would make the spending multiplier smaller?

A) a reduction in marginal propensity to save B) a small initial trade deficit C) a reduction in the marginal propensity to import D) a real appreciation E) none of these Answer: E Diff: 2 8) Suppose that the rest of the world experiences an economic boom causing an increase in foreign 256 Copyright © 2021 Pearson Education, Inc.

output (Y*). This increase in Y* will not cause which of the following to occur?

A) the domestic country's output to increase B) the domestic country's consumption to increase C) the domestic country's output to increase and its trade balance to worsen as imports increase D) all of these E) none of these Answer: C Diff: 2 9) In an open economy, net exports will be equal to which of the following?

A) X - IM/ε B) T - G C) DD D) Z E) S - I Answer: A Diff: 1 10) Which of the following will occur as a result of a tax increase?

A) private saving increases B) investment increases C) the trade balance improves D) the trade balance worsens E) the budget deficit increases Answer: C Diff: 2 11) An open economy with a low saving rate (private and public) must have A) low investment only.

B) high investment only.

C) a trade surplus only.

D) low investment or a trade deficit.

E) low investment or a trade surplus.

Answer: D Diff: 2 12) Policy coordination is difficult because each country A) prefers to be the one to increase demand.

B) prefers to be the one to appreciate its currency.

C) prefers that other countries increase their demand.

D) prefers to be the one to increase taxes.

E) prefers that other countries increase taxes.

Answer: C Diff: 1

257 Copyright © 2021 Pearson Education, Inc.

13) Which of the following conditions must be satisfied for the demand for domestic goods to be equal to the domestic demand for goods?

A) X = εIM B) X = 0 C) G - T = 0 D) S = I E) X = IM/ε Answer: E Diff: 1 14) An increase in which of the following variables will cause a reduction in the demand for domestic goods?

A) foreign income B) the real exchange rate C) consumer confidence D) domestic income E) all of these Answer: B Diff: 2 15) A change in which of the following variables will have no direct effect on the level of domestic demand?

A) domestic income B) the real exchange rate C) government spending D) the interest rate (r) E) none of these Answer: B Diff: 2 16) A change in which of the following variables will have no direct effect on domestic demand?

A) domestic income B) foreign income C) government spending D) the interest rate (r) E) none of these Answer: B Diff: 2 17) Assume a country is closed. Given this information, which of the following must occur?

A) demand for domestic goods will be less than the domestic demand for goods B) demand for domestic goods will be greater than the domestic demand for goods C) S + T = I + G D) a budget surplus exists E) S = I Answer: C Diff: 2 258 Copyright © 2021 Pearson Education, Inc.

18) Assume a country is open. Given this information, which of the following must occur?

A) demand for domestic goods will be equal to the domestic demand for goods B) demand for domestic goods will be greater than the domestic demand for goods C) demand for domestic goods will be less than the domestic demand for goods D) S + T = I + G E) none of these Answer: E Diff: 2 19) An increase in domestic demand will have which of the following effects in an open economy?

A) a smaller effect on output than in a closed economy and a positive effect on the trade balance B) a smaller effect on output than in a closed economy and a negative effect on the trade balance C) a larger effect on output than in a closed economy and a positive effect on the trade balance D) a larger effect on output than in a closed economy and a negative effect on the trade balance Answer: A Diff: 2 20) An increase in the marginal propensity to import will cause A) the ZZ line to become flatter and a given change in government spending (G) to have a larger effect on domestic output.

B) the ZZ line to become flatter and a given change in government spending (G) to have a smaller effect on domestic output.

C) the ZZ line to become steeper and a given change in government spending (G) to have a larger effect on domestic output.

D) the ZZ line to become steeper and a given change in government spending (G) to have a smaller effect on domestic output.

Answer: B Diff: 2 21) A reduction in the marginal propensity to import will cause A) the ZZ line to become flatter and a given change in government spending (G) to have a larger effect on domestic output.

B) the ZZ line to become flatter and a given change in government spending (G) to have a smaller effect on domestic output.

C) the ZZ line to become steeper and a given change in government spending (G) to have a larger effect on domestic output.

D) the ZZ line to become steeper and a given change in government spending (G) to have a smaller effect on domestic output.

Answer: C Diff: 2

259 Copyright © 2021 Pearson Education, Inc.

22) An increase in the marginal propensity to import will cause A) the multiplier to increase and a given change in government spending (G) to have a larger effect on domestic output.

B) the multiplier to increase and a given change in government spending (G) to have a smaller effect on domestic output.

C) the multiplier to decrease and a given change in government spending (G) to have a larger effect on domestic output.

D) the multiplier to decrease and a given change in government spending (G) to have a smaller effect on domestic output.

Answer: D Diff: 2 23) A reduction in the marginal propensity to import will cause A) the multiplier to increase and a given change in government spending (G) to have a larger effect on domestic output.

B) the multiplier to increase and a given change in government spending (G) to have a smaller effect on domestic output.

C) the multiplier to decrease and a given change in government spending (G) to have a larger effect on domestic output.

D) the multiplier to decrease and a given change in government spending (G) to have a smaller effect on domestic output.

Answer: A Diff: 2 24) In a large country, the effect of a given change in government spending A) on output is large and the effect on the trade balance is small.

B) on output is large and the effect on the trade balance is large.

C) on output is small and the effect on the trade balance is small.

D) on output is small and the effect on the trade balance is large.

Answer: A Diff: 2 25) In a small country, the effect of a given change in government spending A) on output is large and the effect on the trade balance is small.

B) on output is large and the effect on the trade balance is large.

C) on output is small and the effect on the trade balance is small.

D) on output is small and the effect on the trade balance is large.

Answer: D Diff: 2

260 Copyright © 2021 Pearson Education, Inc.

26) We will generally observe that the more open an economy A) the larger the effect of fiscal policy on output and the larger the effect of fiscal policy on the trade position.

B) the larger the effect of fiscal policy on output and the smaller the effect of fiscal policy on the trade position.

C) the smaller the effect of fiscal policy on output and the larger the effect of fiscal policy on the trade position.

D) the smaller the effect of fiscal policy on output and the smaller the effect of fiscal policy on the trade position.

Answer: C Diff: 2 27) We will generally observe that the less open an economy A) the larger the effect of fiscal policy on output and the larger the effect of fiscal policy on the trade position.

B) the larger the effect of fiscal policy on output and the smaller the effect of fiscal policy on the trade position.

C) the smaller the effect of fiscal policy on output and the larger the effect of fiscal policy on the trade position.

D) the smaller the effect of fiscal policy on output and the smaller the effect of fiscal policy on the trade position.

Answer: B Diff: 2 28) For an open economy, which of the following expressions represents saving (S)?

A) I + T - G + NX B) I + T - G - NX C) I + G - T + NX D) G - T + NX - I E) none of these Answer: C Diff: 1 29) For an open economy, which of the following expressions represents net exports (NX)?

A) S + G - T - I B) S + G - T + I C) S + T - G + I D) G - T + I - S E) none of these Answer: E Diff: 1

261 Copyright © 2021 Pearson Education, Inc.

30) Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect an increase in taxes will have on output, exports, imports, and net exports. Clearly label all curves and clearly label the initial and final equilibria.

Answer: An increase in T will cause a reduction in C and cause ZZ to shift down as demand falls.

Y will fall causing a reduction in C and S. As Y falls, imports will fall. Given that exports do not change, net exports will increase.

Diff: 2 31) Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect an increase in foreign output (Y*) will have on output, exports, imports, and net exports. Clearly label all curves and clearly label the initial and final equilibria.

Answer: An increase in foreign income, Y*, will cause an increase in exports (the NX curve shifts up) and an increase in demand. As demand rises, Y will increase causing a rise in C and S. As Y increases, imports will increase as well. As shown in the text, the increase in imports will be less than the rise in exports. So, NX will be higher.

Diff: 2 32) Explain why the multiplier in an open economy is different from the multiplier in a closed economy.

Answer: In a closed economy, the effects of any change in Y on demand all falls on domestic goods. In an open economy, some of the increased spending falls on imports. So, the final change in Y will be smaller in an open economy because of the existence of the marginal propensity to import.

Diff: 2 33) Assuming the Marshall-Lerner condition holds and using the ZZ/Y and NX graphs, illustrate graphically and explain what effect a real appreciation will have on output, exports, imports, and net exports. Clearly label all curves and clearly label the initial and final equilibria.

Answer: A real appreciation will cause NX to fall. The fall in NX will cause a decrease in demand. As demand falls, Y will decrease causing a fall in C and S. As Y decreases, imports will decrease as well. As shown in the text, the decrease in imports will be less than the fall in exports. So, NX will be lower.

Diff: 2 18.4

Depreciation, the Trade Balance, and Output

1) Suppose there is a real appreciation. This real appreciation is more likely to cause a reduction in net exports when A) domestic output is relatively low.

B) foreign output is relatively high.

C) the Marshall-Lerner condition does not hold.

D) imports are not at all sensitive to price changes.

E) exports and imports are relatively sensitive to price changes.

Answer: E Diff: 2

262 Copyright © 2021 Pearson Education, Inc.

2) The evidence suggests that in rich countries, a depreciation A) immediately improves the trade balance.

B) eventually improves the trade balance.

C) first improves, but then worsens the trade balance.

D) has no effect on the trade balance.

E) none of these Answer: B Diff: 1 3) Assume the Marshall-Lerner condition holds. Which of the following will cause a reduction in net exports?

A) a reduction in government spending B) a reduction in investment C) an increase in foreign output D) an increase in the real exchange rate E) all of these Answer: D Diff: 2 4) For this question, assume the Marshal-Lerner condition holds. Which of the following would occur as a result of an increase in the real exchange rate?

A) an improvement of the trade balance B) a reduction in the quantity of imports C) an increase in domestic output D) all of these E) none of these Answer: E Diff: 2 5) For this question, assume that the Marshall-Lerner condition does not hold. An increase in the real exchange rate will tend to cause which of the following to occur?

A) a reduction in NX and a reduction in Y B) a reduction in NX and an increase in Y C) an increase in NX and a reduction in Y D) an increase in NX and an increase in Y Answer: D Diff: 2 6) For this question, assume that the Marshall-Lerner condition does not hold. A reduction in the real exchange rate will tend to cause which of the following to occur?

A) a reduction in NX and a reduction in foreign output (Y*) B) a reduction in NX and an increase in domestic output (Y) C) an increase in NX and a reduction in Y D) an increase in NX and an increase in Y E) none of these Answer: E Diff: 2 263 Copyright © 2021 Pearson Education, Inc.

7) For this question, assume that equilibrium output is determined in the ZZ-Y diagram. Further assume that policy makers' goals are (1) to achieve balanced trade (i.e., NX = 0); and (2) to achieve a target level of output, say YT. Now, suppose that the initial level of equilibrium output is equal to YT (i.e., Y = YT) and that a trade deficit exists at this initial level of output. Which of the following policy actions would most likely enable the policy makers to achieve their two goals simultaneously?

A) a reduction in government spending B) convince the country's trading partners to pursue policies that will cause an increase in foreign income (Y*) C) a reduction in the real exchange rate D) a reduction in taxes E) a simultaneous increase in government spending and reduction in the real exchange rate F) none of these Answer: F Diff: 2 8) Suppose policy makers want to increase Y and increase NX. Which of the following policies would most likely achieve this?

A) an increase in government spending B) a real depreciation C) a reduction in taxes and an increase in the real exchange rate D) an increase in the real exchange rate Answer: B Diff: 2 9) Explain what the Marshall-Lerner condition represents.

Answer: The Marshall-Lerner condition is the condition that must be satisfied for a real depreciation to cause an increase in net exports. The sum of the percentage changes in exports and imports must exceed the percentage change in the real exchange rate. When a real depreciation occurs, three effects occur: the quantity of exports increases, the quantity of imports falls, and the real cost of imports rise. The first two effects must offset the last effect for NX to rise.

Diff: 1 10) Assuming the Marshall-Lerner condition holds and using the ZZ/Y and NX graphs, illustrate graphically and explain what effect a real depreciation will have on output, exports, imports, and net exports. Clearly label all curves and clearly label the initial and final equilibria.

Answer: A real depreciation will cause NX to rise. The rise in NX will cause an increase in demand. As demand rises, Y will increase causing a rise in C and S. As Y increases, imports will increase as well. As shown in the text, the increase in imports will be less than the rise in exports. So, NX will be higher.

Diff: 2

264 Copyright © 2021 Pearson Education, Inc.

18.5

Saving, Investment, and the Current Account Balance

1) Suppose policy makers want to increase Y and keep NX constant. Which of the following policies would most likely achieve this?

A) an increase in government spending B) a real depreciation C) an increase in government spending and a reduction in the real exchange rate D) a reduction in the real exchange rate E) encourage the country's trading partners to implement policies that will cause an increase in foreign income (Y*) Answer: C Diff: 2 2) Suppose policy makers want to increase NX and keep Y constant. Which of the following policies would most likely achieve this?

A) a reduction in government spending B) a real depreciation C) a reduction in government spending and a reduction in the real exchange rate D) a reduction in the real exchange rate and a tax cut Answer: C Diff: 2 3) Suppose the rest of the world experiences an expansion that causes an increase in foreign income (Y*). From the domestic economy's perspective, this increase in foreign income will cause which of the following as the domestic economy adjusts to the rise in Y*?

A) an increase in domestic income B) an increase in imports C) an increase in net exports D) all of these E) none of these Answer: D Diff: 2 4) Suppose the rest of the world experiences a recession that causes a reduction in foreign income (Y*). From the domestic economy's perspective, this reduction in foreign income will cause which of the following as the domestic economy adjusts to the drop in Y*?

A) a reduction in income and a reduction in imports B) a reduction in imports and an increase in net exports C) the NX line to shift up D) an ambiguous effect on net exports Answer: A Diff: 2

265 Copyright © 2021 Pearson Education, Inc.

5) An increase in the budget deficit can be reflected in A) an increase in private saving.

B) a reduction in investment.

C) a reduction in net exports.

D) all of these E) none of these Answer: D Diff: 1 6) A reduction in private saving (S) can be reflected in A) an increase in the budget deficit.

B) an increase in investment.

C) a reduction in net exports.

D) all of these Answer: C Diff: 1 7) The quantity of imports will decrease when there is A) an increase in the real exchange rate.

B) a reduction in domestic output.

C) a reduction in foreign output.

D) all of these E) none of these Answer: B Diff: 1 8) Exports will increase when there is A) a reduction in the real exchange rate.

B) a reduction in domestic output.

C) a reduction in foreign output.

D) all of these E) none of these Answer: A Diff: 2 9) In an open economy, a reduction in government spending will cause A) an increase in domestic output.

B) an increase in imports.

C) an increase in net exports.

D) all of these E) none of these Answer: D Diff: 2

266 Copyright © 2021 Pearson Education, Inc.

10) In an open economy, which of the following will cause a reduction in the size of the multiplier?

A) an increase in the marginal propensity to import B) an increase on foreign output C) a reduction in the marginal propensity to save D) all of these E) none of these Answer: A Diff: 2 11) Which of the following will always cause a reduction in net exports?

A) an increase in domestic output B) a reduction in the real exchange rate C) a reduction in government spending D) a reduction in investment E) all of these Answer: A Diff: 2 12) Which of the following will occur as a result of a tax cut?

A) private saving decreases B) investment decreases C) the trade balance improves D) the trade balance worsens E) the budget deficit decreases Answer: D Diff: 2 13) A reduction in the budget deficit can be reflected in A) a reduction in private saving.

B) an increase in investment.

C) an increase in net exports.

D) all of these E) none of these Answer: D Diff: 1 14) An increase in private saving (S) can be reflected in A) a reduction in the budget deficit.

B) a reduction in investment.

C) an increase in net exports.

D) all of these Answer: C Diff: 1

267 Copyright © 2021 Pearson Education, Inc.

15) In November 2008, the leaders of the ________ met in an emergency meeting in Washington to coordinate their responses in terms of both macroeconomic and financial policies.

A) G20 B) G7 C) OECD countries D) G8 Answer: A Diff: 1 16) Suppose a country is experiencing a situation where output is above the full employment level of output and a trade deficit. Further assume that the policy makers' goals are to achieve full employment output and balanced trade. Given this information, what type of exchange rate and/or fiscal policy can be used to achieve simultaneously these two goals? Explain.

Answer: Y must fall and NX must rise. An appreciation will not work. It would cause Y to fall but will NX will decrease even more. A fiscal contraction would work because it would reduce Y and also reduce imports which will cause NX to rise.

Diff: 2 17) Suppose a country's output is below the policy makers' desired level of output and is experiencing a trade surplus. Assume that the policy makers' goals are to achieve the desired level of output (i.e., full employment output) and balanced trade. Given this information, what type of exchange rate and/or fiscal policy can be used to achieve simultaneously these two goals? Explain.

Answer: Y must rise and NX must fall. A depreciation would cause Y to rise but NX would rise even more. In this case, a fiscal expansion would work. Y would rise causing imports to increase and NX to fall.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 19: Output, the Interest Rate, and the Exchange Rate 19.1

Equilibrium in the Goods Market

1) Assume that the price levels in two countries are constant. In this situation, we know that A) neither the real nor the nominal exchange rate can change.

B) the real exchange rate can change, while the nominal exchange rate is constant.

C) the nominal exchange rate can change, while the real exchange rate is constant.

D) the real and nominal exchange rate must move together, changing by the same percentage.

E) the nominal exchange rate will fluctuate more widely than the real exchange rate.

Answer: D Diff: 1 2) An increase in the real exchange rate will cause A) an increase in net exports.

B) an increase in the quantity of imports.

C) an increase in output.

D) a decrease in government spending.

E) all of these Answer: B 268 Copyright © 2021 Pearson Education, Inc.

Diff: 1 3) As the economy moves up and to the right along the IS curve, which of the following will occur when exchange rates are flexible?

A) investment spending increases B) consumption increases C) the domestic currency depreciates D) all of these E) none of these Answer: D Diff: 1 4) In an economy operating under flexible exchange rates, explain why the IS curve is downward sloping.

Answer: A reduction in i (assume zero inflation) will cause investment to increase for reasons discussed before. This causes an increase in Z and Y. There is a second effect now embedded in the IS curve. As i falls, the demand for the domestic currency drops causing a depreciation. This depreciation causes NX to rise and demand to rise even more. So, there are two components of demand that now change as i changes: I and NX. Diff: 2

269 Copyright © 2021 Pearson Education, Inc.

19.2

Equilibrium in Financial Markets

1) In order for an individual to be indifferent between holding foreign or domestic bonds, A) the Marshall-Lerner condition must hold.

B) the foreign and domestic interest rates must be equal.

C) the expected rate of depreciation of the domestic currency is zero.

D) the interest parity condition must hold.

Answer: D Diff: 1 2) The interest parity condition indicates that the domestic interest rate must be equal to A) the foreign interest rate.

B) the expected rate of depreciation of the domestic currency.

C) the expected rate of appreciation of the domestic currency.

D) the foreign interest rate minus the expected rate of appreciation of the foreign currency.

E) none of these Answer: E Diff: 1 3) Assume that the interest parity condition holds. Also assume that the U.S. interest rate is 8% while the U.K. interest rate is 6%. Given this information, financial markets expect the pound to A) depreciate by 14%.

B) depreciate by 2%.

C) appreciate by 2%.

D) appreciate by 6%.

E) appreciate by 14%.

Answer: C Diff: 2 4) Assume that the interest parity holds and that the dollar is expected to depreciate against the pound. Given this information, we know that A) U.S. and U.K. interest rates are equal.

B) the U.S. interest rate exceeds the U.K. interest rate.

C) the U.K. interest rate exceeds the U.S. interest rate.

D) individuals will prefer to hold U.S. bonds because the U.S. interest rate exceeds the U.K. interest rate.

E) none of these Answer: B Diff: 2

270 Copyright © 2021 Pearson Education, Inc.

5) In an open economy, we know that individuals must choose between which of the following?

A) domestic bonds and foreign currency B) foreign goods and domestic currency C) domestic and foreign bonds D) domestic goods and foreign currency E) none of these Answer: C Diff: 1 6) A real appreciation will tend to cause A) an increase in exports.

B) a reduction in imports.

C) an increase in net exports.

D) a reduction in demand for domestic goods.

E) none of these Answer: D Diff: 1 7) A reduction in the real exchange rate will cause A) a reduction in net exports.

B) a reduction in the quantity of imports.

C) a reduction in output.

D) an increase in government spending.

E) all of these Answer: B Diff: 1 8) Assume that the interest parity condition holds. Also assume that the U.S. interest rate is 6% while the U.K. interest rate is 8%. Given this information, financial markets expect the pound to A) depreciate by 14%.

B) depreciate by 2%.

C) appreciate by 2%.

D) appreciate by 6%.

E) appreciate by 14%.

Answer: B Diff: 2 9) Assume that the interest parity holds and that the dollar is expected to appreciate against the pound. Given this information, we know that A) U.S. and U.K. interest rates are equal.

B) the U.S. interest rate exceeds the U.K. interest rate.

C) the U.K. interest rate exceeds the U.S. interest rate.

D) individuals will prefer to hold U.S. bonds because the U.S. interest rate exceeds the U.K. interest rate.

E) none of these Answer: C Diff: 2 271 Copyright © 2021 Pearson Education, Inc.

10) A real depreciation will tend to cause A) a reduction in exports.

B) an increase in imports.

C) a reduction in net exports.

D) an increase in demand for domestic goods.

E) none of these Answer: D Diff: 1 11) Explain what the IP curve is and why it is upward sloping.

Answer: The IP curve represents the combinations of i and E that maintain the interest parity condition. As i falls, foreign bonds will have a higher expected return. The demand for the dollar will fall causing an immediate depreciation. So, the drop in i causes E to fall. E will fall until all of the drop in i is offset by the expected appreciation of the dollar.

Diff: 1 12) Suppose the domestic and foreign interest rates are both initially equal to 3%. Now suppose the domestic interest rate rises to 5%. Explain what effect this will have on the exchange rate. Also explain what must occur for the interest parity condition to be restored.

Answer: Domestic bonds will have a higher return causing the demand for the domestic currency to rise. The dollar will appreciate. It will continue to appreciate as long as the return on domestic bonds exceeds the return on foreign bonds. This immediate appreciation will equal an expected depreciation of the domestic currency that equates the expected returns. So, the dollar will appreciate by 2%.

Diff: 2 13) Suppose the domestic and foreign interest rates are both initially equal to 4%. Now suppose the foreign interest rate rises to 6%. Explain what effect this will have on the exchange rate. Also explain what must occur for the interest parity condition to be restored.

Answer: Domestic bonds will have a lower return causing the demand for the domestic currency to fall. The dollar will depreciate. It will continue to depreciate as long as the return on domestic bonds is less than the return on foreign bonds. This immediate depreciation will equal an expected appreciation of the domestic currency that equates the expected returns. So, the dollar will depreciate by 2%.

Diff: 2

272 Copyright © 2021 Pearson Education, Inc.

19.3

Putting Goods and Financial Markets Together

1) As the economy moves up and to the left along the IS curve, which of the following will occur when exchange rates are flexible?

A) investment spending decreases B) consumption decreases C) the domestic currency appreciates D) all of these E) none of these Answer: D Diff: 1 2) In an open economy under flexible exchange rates, a reduction in the interest rate will cause a reduction in which of the following?

A) investment B) the exchange rate, E C) net exports D) all of these E) none of these Answer: B Diff: 2 3) In an open economy under flexible exchange rates, a reduction in government spending will cause a reduction in which of the following?

A) net exports B) the exchange rate, E C) exports D) all of these E) none of these Answer: C Diff: 2 4) In an open economy under flexible exchange rates, a reduction in consumer confidence that causes a reduction in consumption will cause which of the following?

A) an appreciation of the domestic currency B) a reduction in the exchange rate, E C) a reduction in net exports D) all of these E) none of these Answer: A Diff: 2

273 Copyright © 2021 Pearson Education, Inc.

5) In an open economy under flexible exchange rates, expansionary monetary policy that results in an increase in the money supply will always cause A) an increase in output.

B) an increase in exports.

C) a reduction in the exchange rate, E. D) all of these E) none of these Answer: D Diff: 2 6) Assume that the interest parity condition holds and that both the expected exchange rate and foreign interest rate are constant. Given this information, a reduction in the domestic interest rate will cause A) a reduction in the exchange rate expected in the future.

B) a reduction in the current exchange rate.

C) greater depreciation of the domestic currency expected in the future.

D) all of these E) none of these Answer: B Diff: 2 7) The exchange rate policy of the United States is A) the EMS. B) a crawling peg.

C) a float.

D) a fixed rate within a band.

E) none of these Answer: C Diff: 1 8) In a flexible exchange rate regime, an increase in the foreign interest rate (i*) will cause A) the IP curve to shift to the left/up.

B) the IP curve to shift to the right/down.

C) a movement along the IP curve.

D) neither a shift nor movement along the IP curve.

Answer: B Diff: 3 9) In a flexible exchange rate regime, a reduction in the foreign interest rate (i*) will cause A) the IP curve to shift to the left/up.

B) the IP curve to shift to the right/down.

C) a movement along the IP curve.

D) neither a shift nor movement along the IP curve.

Answer: A Diff: 3

274 Copyright © 2021 Pearson Education, Inc.

10) In a flexible exchange rate regime, an increase in the expected future exchange rate will cause A) the IP curve to shift to the left/up.

B) the IP curve to shift to the right/down.

C) a movement along the IP curve.

D) neither a shift nor movement along the IP curve.

Answer: B Diff: 3 11) In a flexible exchange rate regime, a reduction in the expected future exchange rate will cause A) the IP curve to shift to the left/up.

B) the IP curve to shift to the right/down.

C) a movement along the IP curve.

D) neither a shift nor movement along the IP curve.

Answer: A Diff: 3 12) Assume the interest parity condition holds and that initially i = i*. A reduction in the domestic interest rate will cause A) an increase in the demand for the domestic currency.

B) a reduction in E. C) an expected depreciation of the domestic currency.

D) all of these Answer: D Diff: 2 13) Assume the interest parity condition holds and that initially i = i*. A reduction in the foreign interest rate (i*) will cause A) an increase in the demand for the domestic currency.

B) an increase in E. C) an expected depreciation of the domestic currency.

D) all of these Answer: C Diff: 3 14) Explain what effect each of the following events will have on the IS curve in a flexible exchange rate regime: (1) an increase in foreign output; (2) a reduction in the foreign interest rate; and (3) an increase in the domestic interest rate.

Answer: An increase in Y* causes X to rise, Z to rise, and the IS curve to shift to the right. A reduction in i* will cause an appreciation of the domestic currency, a reduction in NX, and a leftward shift in the IS curve. A change in i will only cause a movement along the IS curve.

Diff: 2

275 Copyright © 2021 Pearson Education, Inc.

15) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model, graphically illustrate and explain what effect a reduction in foreign output (Y*) will have on the domestic economy. In your graphs, clearly label all curves and equilibria.

Answer: A reduction in Y* will cause a reduction in X and NX. This causes the IS curve to shift to the left. As demand falls, production will drop. The drop in Y will cause a reduction in money demand. As money demand falls, i will fall causing a depreciation. So, some of the effects of Y* on NX will be offset by the increase in NX caused by the depreciation. We will observe a reduction in NX, a reduction in Y, a reduction in i, and a reduction in E. Diff: 2 16) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model, graphically illustrate and explain what effect an increase in foreign output (Y*) will have on the domestic economy. In your graphs, clearly label all curves and equilibria.

Answer: An increase in Y* will cause an increase in X and NX. This causes the IS curve to shift to the right As demand rises, production will increase. The increase in Y will cause an increase in money demand. As money demand rises, i will rise causing an appreciation. So, some of the effects of Y* on NX will be offset by the decrease in NX caused by the appreciation. We will observe an increase in NX, an increase in Y, an increase in i, and an increase in E. Diff: 2 19.4

The Effects of Policy in an Open Economy

1) For this question, assume that there is a simultaneous tax increase and monetary expansion. In a flexible exchange rate regime, we know with certainty that A) the exchange rate and output would both increase.

B) the exchange rate would increase and output would decrease.

C) the exchange rate would decrease.

D) the exchange rate would decrease and output would increase.

E) none of these Answer: C Diff: 2 2) For this question, assume that there is a simultaneous increase in government spending and monetary contraction. In a flexible exchange rate regime, we know with certainty that such a policy mix will cause which of the following?

A) an increase in the domestic interest rate B) an increase in the exchange rate C) a reduction in net exports D) all of these E) none of these Answer: D Diff: 2

276 Copyright © 2021 Pearson Education, Inc.

3) Suppose there are two countries that are identical in every way with the following exception.

Country A is pursuing a fixed exchange rate regime and country B is pursuing a flexible exchange rate regime. Suppose taxes are increased in both countries rises by the same amount. Given this information, we know that A) the change in output in A will be greater than in B. B) the change in output in B will be greater than in A. C) the change in output will be the same in both countries.

D) the relative output effects are ambiguous.

Answer: A Diff: 3 4) Contractionary monetary policy in a flexible exchange rate regime will cause A) a shift of the IP curve.

B) a depreciation of the domestic currency.

C) an increase in E. D) no change in E. Answer: C Diff: 1 5) Expansionary monetary policy in a flexible exchange rate regime will cause A) a shift of the IP curve.

B) an appreciation of the domestic currency.

C) a reduction in E. D) no change in E. Answer: C Diff: 1 6) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model, graphically illustrate and explain what effect an increase in government spending will have on the domestic economy. In your graphs, clearly label all curves and equilibria.

Answer: An increase in G will cause Z to increase and the IS curve to shift right. As demand increases, Y will rise causing an increase in money demand. The increase in money demand will cause an increase in i. As i rises, the demand for the domestic currency will increase causing an appreciation. This appreciation will cause a drop in NX. Any drop in I and the reduction in NX only partially offset the effects of the increase in G on demand and output.

Diff: 2 7) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model, graphically illustrate and explain what effect monetary contraction will have on the domestic economy. In your graphs, clearly label all curves and equilibria.

Answer: A reduction in M will cause the LM curve to shift up and the domestic interest rate to rise. As i rises, the return on domestic bonds is greater than foreign bonds. This causes an appreciation and a reduction in NX. So, the demand for goods falls via the drop in I and NX. We will observe a higher domestic interest rate, an increase in E, a drop in I, a reduction in NX, and a reduction in Y. Diff: 2 277 Copyright © 2021 Pearson Education, Inc.

19.5

Fixed Exchange Rates

1) Suppose a country with a fixed exchange rate decides to reduce the price of its currency. This change in policy is called A) an appreciation.

B) a depreciation.

C) a peg.

D) a devaluation.

E) a revaluation.

Answer: E Diff: 1 2) Under a "crawling peg" system, a country's exchange rate A) is fixed except for small, surprise changes.

B) changes at a predetermined rate against the dollar or some other major currency.

C) can fluctuate within a narrow band.

D) can change, but the changes are kept secret from the public.

E) is determined by the central bank of another country.

Answer: B Diff: 1 3) In 2005, China increased the price of its currency while continuing to pursue a fixed exchange rate. This change in policy is called A) an appreciation.

B) a depreciation.

C) a peg.

D) a devaluation.

E) a revaluation.

Answer: D Diff: 1 4) For this question, assume that the economy is operating in a fixed exchange rate regime and that perfect capital mobility exists. Given this information, which of the following will occur?

A) The domestic and foreign interest rates must be equal.

B) The central bank cannot use monetary policy to affect domestic output.

C) An expansionary fiscal policy will require that the central bank increase the money supply.

D) all of these E) none of these Answer: D Diff: 2

278 Copyright © 2021 Pearson Education, Inc.

5) Suppose a country switches from a fixed to a flexible exchange rate. Which of the following will occur as a result of this change?

A) Monetary policy will become a less effective tool for changing output.

B) A given change in government spending will now have a greater effect on output.

C) Both fiscal and monetary policy will become more effective in changing GDP. D) Both fiscal and monetary policy will become completely ineffective in changing GDP. E) none of these Answer: E Diff: 2 6) A common argument for fixed exchange rates is that they A) give central banks greater freedom in adjusting their economy's level of output.

B) forever free the central bank from have to adjust the exchange rate to fundamental changes in the economy.

C) make trade more costly, and thus encourage domestic citizens to buy domestically produced output.

D) all of these E) none of these Answer: E Diff: 1 7) In practice, under the EMS, a member country A) could never change its interest rate.

B) could change its interest rate only if other countries changed theirs as well.

C) must apply to a special European Commission in order to change its interest rate.

D) had complete freedom in choosing the interest rate it wanted.

E) had complete freedom in choosing its interest rate only if it is a very small country.

Answer: B Diff: 1 8) In the early 1990s, which nation took the lead in driving up European interest rates?

A) Spain B) France C) Germany D) England E) none of these Answer: E Diff: 1 9) In the early 1990s, European unemployment rose largely because of A) reductions in stock prices.

B) undervalued currencies.

C) overvalued currencies.

D) high inflation.

E) none of these Answer: A Diff: 1 279 Copyright © 2021 Pearson Education, Inc.

10) Assume that the current exchange rate between U.K. pound and the U.S. dollar is 2 (E = 2.0). If interest parity holds, and the U.S. interest rate is 6% while the U.K. interest rate is 8%, the expected exchange rate in one year is A) 1.98.

B) 1.99.

C) 2.01.

D) 2.02.

E) 2.04.

Answer: C Diff: 2 11) Assume policy makers in a fixed exchange rate regime decide to peg the exchange rate at a higher level. This is called A) a devaluation.

B) a revaluation.

C) a depreciation.

D) an appreciation.

Answer: A Diff: 1 12) Assume policy makers in a fixed exchange rate regime decide to peg the exchange rate at a lower level. This is called A) a devaluation.

B) a revaluation.

C) a depreciation.

D) an appreciation.

Answer: B Diff: 1 13) The European Monetary System represented a A) exchange rate regime with "bands.'

B) crawling peg.

C) a flexible exchange rate regime.

D) none of these Answer: A Diff: 1 14) Suppose policy makers are pursuing a policy to fix the exchange rate. In such a system with perfect capital mobility, an open market purchase of domestic bonds by the domestic central bank will eventually result in A) a permanent increase in the monetary base.

B) a permanent reduction in the monetary base.

C) a change in the composition of the monetary base.

D) a gradual reduction in the domestic interest rate.

Answer: C Diff: 2 280 Copyright © 2021 Pearson Education, Inc.

15) Suppose policy makers are pursuing a policy to fix the exchange rate. In such a system with perfect capital mobility, an open market sale of domestic bonds by the domestic central bank will eventually result in A) a permanent increase in the monetary base.

B) a permanent reduction in the monetary base.

C) a gradual reduction in the domestic interest rate.

D) a change in the composition of the monetary base.

Answer: D Diff: 2 16) Suppose a country is pursuing a fixed exchange rate regime with imperfect capital mobility.

The ability of that country to move its domestic interest rate while maintaining its exchange rate will depend on A) the degree of development of its financial markets.

B) the degree of capital controls.

C) the amount of foreign exchange it holds.

D) all of these E) none of these Answer: D Diff: 2 17) Under a fixed exchange rate regime, the central bank must act to keep A) P = P*.

B) the real exchange rate fixed.

C) i = i*.

D) E = 1.

E) none of these Answer: A Diff: 2 18) For this question, assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that an increase in stock market wealth causes an increase in consumption. Which of the following will tend to occur in a fixed exchange rate regime?

A) an increase in Y B) an increase in the money supply C) no change in the domestic interest rate D) all of these Answer: D Diff: 2

281 Copyright © 2021 Pearson Education, Inc.

19) For this question, assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that households decide to decrease consumption because of, for example, a reduction in consumer confidence. Given this information, we would expect which of the following to occur?

A) a reduction in the domestic interest rate B) an increase in E C) a reduction in E D) a reduction in investment E) none of these Answer: D Diff: 2 20) For this question, assume that policy makers are pursuing a fixed exchange rate regime. Now suppose a budget is passed that calls for a reduction in government spending. This reduction in government spending will cause which of the following to occur?

A) a reduction in i and an increase in E B) a reduction in investment C) no change in output D) no change in net exports E) an increase in imports Answer: B Diff: 2 21) Under a fixed exchange rate regime, suppose there is a reduction in housing wealth that causes a reduction in consumption. This wealth-induced reduction in consumption will cause A) a reduction in investment.

B) an increase in net exports.

C) a reduction in imports.

D) all of these E) none of these Answer: D Diff: 2 22) Under a fixed exchange rate regime, expansionary fiscal policy will tend to cause which of the following?

A) an increase in imports B) an increase in net exports C) a reduction in investment D) all of these Answer: A Diff: 2

282 Copyright © 2021 Pearson Education, Inc.

23) For this question, assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that a reduction in stock market wealth causes a decrease in consumption. Which of the following will tend to occur in a fixed exchange rate regime?

A) a reduction in Y B) a reduction in the money supply C) no change in the domestic interest rate D) all of these Answer: D Diff: 2 24) For this question, assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that households decide to increase consumption because of, for example, an increase in consumer confidence. Given this information, we would expect which of the following to occur?

A) an increase in the domestic interest rate B) a reduction in E C) an increase in E D) an increase in investment E) none of these Answer: D Diff: 2 25) Under a fixed exchange rate regime, suppose there is an increase in housing wealth that causes an increase in consumption. This wealth-induced increase in consumption will cause A) an increase in investment.

B) a reduction in net exports.

C) an increase in imports.

D) all of these E) none of these Answer: D Diff: 2 26) Under a fixed exchange rate regime, contractionary fiscal policy will tend to cause which of the following?

A) a reduction in imports B) a reduction in net exports C) an increase in investment D) all of these Answer: A Diff: 2 27) For a country pursuing a fixed exchange rate regime, what does the interest parity condition imply about domestic and foreign interest rates? Explain.

Answer: As long as the fixed exchange rate regime is credible, the interest rates must be equal. If the exchange rate regime is credible, we know that there will be no expected appreciation or depreciation so i = i*.

Diff: 1 283 Copyright © 2021 Pearson Education, Inc.

28) Assume the exchange rate is fixed. Using the IS-LM model, graphically illustrate and explain what effect a reduction in consumer confidence will have on the domestic economy. In your graphs, clearly label all curves and equilibria.

Answer: A reduction in consumer confidence will cause a drop in C and will cause demand to fall and the IS curve to shift to the left. As Y falls, money demand will fall and the domestic interest rate will tend to fall. If i falls, there will be tremendous pressure on the domestic currency to depreciate as demand falls. The central bank cannot let this occur. To prevent this, it must reduce the money supply so that i does not fall. We will observe a drop in Y, no change in i, a reduction in I (via the drop in I), and an increase in NX caused by the drop in imports.

Diff: 2 29) Assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that the foreign interest rate increases. Discuss what policy makers must do to maintain the pegged exchange rate. Also discuss what effect this will have on domestic output and net exports.

Answer: If i* increases, there will be pressure on the domestic currency to depreciate. To prevent this, the domestic central bank must raise its interest rate so that it rises by the same amount as i*.

In this case, the LM curve will shift up so that the new equilibrium interest rate is equal to the now higher foreign interest rate. As i rises, E does not change. However, I will fall causing a reduction in demand and output. As Y falls, imports will fall and NX will increase.

Diff: 2 30) To what extent can monetary policy be used to affect output in a fixed exchange rate regime?

Explain.

Answer: It cannot. To peg the exchange rate, the central bank must keep the domestic interest rate equal to the exogenous foreign interest rate. The domestic central bank cannot independently change its interest rate.

Diff: 2 31) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model, graphically illustrate and explain what effect a reduction in government spending will have on the domestic economy. In your graphs, clearly label all curves and equilibria.

Answer: A reduction in G will cause Z to decrease and the IS curve to shift left. As demand decreases, Y will fall causing a decrease in money demand. The decrease in money demand will cause an decrease in i. As i falls, the demand for the domestic currency will decrease causing a depreciation. This depreciation will cause a rise in NX. Any increase in I and the increase in NX only partially offset the effects of the reduction on demand and output.

Diff: 2 32) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model, graphically illustrate and explain what effect monetary expansion will have on the domestic economy. In your graphs, clearly label all curves and equilibria.

Answer: An increase in M will cause the LM curve to shift down and the domestic interest rate to fall. As i falls, the return on domestic bonds is less than foreign bonds. This causes an depreciation and an increase in NX. So, the demand for goods rises via the increase in I and NX. We will observe a lower domestic interest rate, a reduction in E, an increase in I, an increase in NX, and an increase in Y. Diff: 2 284 Copyright © 2021 Pearson Education, Inc.

33) Assume the exchange rate is fixed. Using the IS-LM model, graphically illustrate and explain what effect an increase in consumer confidence will have on the domestic economy. In your graphs, clearly label all curves and equilibria.

Answer: An increase in consumer confidence will cause an increase in C and will cause demand to rise and the IS curve to shift to the right. As Y rises, money demand will increase and the domestic interest rate will tend to rise. If i rises, there will be tremendous pressure on the domestic currency to appreciate as demand rises. The central bank cannot let this occur. To prevent this, it must increase the money supply so that i does not rise. We will observe an increase in Y, no change in i, an increase in I (via the increase in I), and a reduction in NX caused by the rise in imports.

Diff: 2 34) Assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that the foreign interest rate falls. Discuss what policy makers must do to maintain the pegged exchange rate. Also discuss what effect this will have on domestic output and net exports.

Answer: If i* falls, there will be pressure on the domestic currency to appreciate. To prevent this, the domestic central bank must reduce its interest rate so that it falls by the same amount as i*. In this case, the LM curve will shift down so that the new equilibrium interest rate is equal to the now lower foreign interest rate. As i falls, E does not change. However, I will rise causing an increase in demand and output. As Y rises, imports will rise and NX will decrease.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 20: Exchange Rate Regimes 20.1

The Medium Run

1) If the exchange rate between two countries is expected to remain fixed at its current rate, then A) output growth rates must be equal in the two countries.

B) price levels must be equal in the two countries.

C) inflation rates must be equal in the two countries.

D) nominal interest rates must be equal in the two countries.

E) none of these Answer: D Diff: 1 2) In a fixed exchange rate regime, a reduction in the price level will cause which of the following?

A) a real appreciation and a leftward shift in the aggregate demand curve B) a real appreciation and no shift in the aggregate demand curve C) a real depreciation and a rightward shift in the aggregate demand curve D) a real depreciation and no shift in the aggregate demand curve E) no change in the real exchange rate, and no change in aggregate demand Answer: B Diff: 1 3) A revaluation causes which of the following to occur in the short run in the AS/AD model?

A) a reduction in net exports B) a reduction in the price level 285 Copyright © 2021 Pearson Education, Inc.

C) a reduction in output D) all of these E) none of these Answer: D Diff: 2 4) A devaluation causes which of the following to occur in the medium run?

A) an increase in net exports B) an increase in the price level C) an increase in output D) all of these E) none of these Answer: B Diff: 1

286 Copyright © 2021 Pearson Education, Inc.

5) Suppose a country is perceived to have an overvalued real exchange rate does not devalue.

Which of the following would we expect to occur over time?

A) a reduction in its price level B) a real depreciation of its currency C) a reduction in its trade surplus D) all of these E) none of these Answer: D Diff: 1 6) In a fixed exchange rate regime, which of the following policies could be implemented to reduce a trade deficit and leave aggregate demand constant?

A) devalue the currency B) increase government spending C) decrease government spending D) decrease government spending and devalue the currency E) increase government spending and revalue the currency Answer: D Diff: 1 7) Under the Gold Standard, A) exchange rates could float.

B) real interest rates were fixed.

C) real exchange rates were fixed.

D) nominal interest rates were fixed.

E) none of these Answer: E Diff: 1 8) After Britain returned to the Gold Standard in the 1920s, the British pound was A) undervalued, contributing to a long period of inflation.

B) undervalued, contributing to a long period of recession.

C) overvalued, contributing to a long period of inflation.

D) overvalued, contributing to a long period of recession.

E) value about right, leading to a long period healthy growth with almost no inflation.

Answer: D Diff: 1

287 Copyright © 2021 Pearson Education, Inc.

9) Suppose foreign exchange markets anticipate a devaluation for country A. Further assume that policy makers in country A will continue to fix its nominal exchange rate. In order to peg the currency at its original level, which of the following must occur?

A) increase the domestic interest rate B) increase the domestic price level C) convince trading partners to raise their interest rates D) all of these E) none of these Answer: A Diff: 1 10) Part of the reason for the Mexican peso crisis of 1994 was Mexico's decision to A) allow the peso to depreciate too rapidly.

B) allow the peso to appreciate too rapidly.

C) maintain relatively low nominal interest rates in the face of relatively high inflation.

D) maintain a roughly fixed nominal exchange rate in the face of relatively high inflation.

E) run a very small budget deficit in the face of relatively high inflation.

Answer: D Diff: 1 11) Which of the following is an argument of opponents of devaluations?

A) Devaluations cause relatively slow adjustments.

B) Participants in foreign exchange markets have a short memory: if the expected devaluation doesn't occur within a short time-period, they will stop expecting it.

C) A devaluation causes a nation with fixed exchange rates to lose credibility in the medium run, driving its interest rate higher.

D) all of these E) none of these Answer: C Diff: 1 12) A country which does not devalue when financial markets expect it to will probably suffer A) a real appreciation of its currency.

B) higher interest rates.

C) a default on its national debt.

D) all of these E) none of these Answer: B Diff: 1

288 Copyright © 2021 Pearson Education, Inc.

Use the information provided below to answer the following question(s).

The exchange rate between the British pound and the U.S. dollar is 2. In England, the price level is 1.0 and the one-year interest rate is 20%. In the United States, the price level is .8 and the one-year interest rate is 8%. The inflation rate in both countries is zero.

13) Refer to the information above. The real exchange rate (from the United States' perspective) is A) .625.

B) .8.

C) 1.6.

D) 2.0.

E) none of these Answer: C Diff: 1 14) Refer to the information above. The price of U.S. goods measured in pounds is A) .8.

B) 1.0.

C) 1.6.

D) 2.

E) none of these Answer: C Diff: 1 15) For this question, assume that interest parity holds, the future expected exchange rate is constant, the current nominal exchange rate is 1.2, the one-year foreign interest rate is 6% and the one-year domestic interest rate is 3%. Given this information, one can conclude that A) financial market participants expect that the exchange rate (E) will increase by 3% over the coming year.

B) financial market participants expect that the exchange rate (E) will decrease by 3% over the coming year.

C) financial market participants expect that the domestic currency to depreciate by 3% over the coming year.

D) financial market participants expect that the exchange rate (E) will increase by 20% over the coming year.

Answer: A Diff: 2

289 Copyright © 2021 Pearson Education, Inc.

16) In chapter 20, the expected future nominal exchange rate in the long run say, Eet+n, is assumed to be the nominal exchange rate at which A) the current account is in balance.

B) the future rate of appreciation or depreciation is constant.

C) domestic and foreign price levels are equal.

D) one unit of foreign currency exchanges for one unit of domestic currency.

E) none of these Answer: A Diff: 1 17) Changes in which of the following variables will cause the current nominal exchange rate to change?

A) the future expected long-run nominal exchange rate, Eet+n B) future expected domestic nominal interest rates C) future expected foreign nominal interest rates D) all of these Answer: D Diff: 1 18) An increase in the foreign one-year interest rate expected to occur in, say, two years will, all else fixed, have which of the following effects in a flexible exchange rate regime?

A) The real exchange rate will decrease with no change in the nominal exchange rate.

B) The nominal exchange rate will decrease with no change in the real exchange rate.

C) Both the real and nominal exchange rate will decrease.

D) No change in either the nominal or real exchange rate.

E) Both the real and nominal exchange rate will increase.

Answer: C Diff: 2 19) An increase in the domestic one-year interest rate expected to occur in, say, two years will, all else fixed, have which of the following effects in a flexible exchange rate regime?

A) The real exchange rate will increase with no change in the nominal exchange rate.

B) The nominal exchange rate will increase with no change in the real exchange rate.

C) Both the real and nominal exchange rate will increase.

D) No change in either the nominal or real exchange rate.

Answer: C Diff: 1 20) In a fixed exchange rate regime, an increase in the price level will cause which of the following?

A) a real appreciation and a leftward shift in the aggregate demand curve B) a real appreciation and no shift in the aggregate demand curve C) a real depreciation and a rightward shift in the aggregate demand curve D) a real depreciation and no shift in the aggregate demand curve E) no change in the real exchange rate, and no change in aggregate demand Answer: D Diff: 1 290 Copyright © 2021 Pearson Education, Inc.

21) Suppose a reduction in the domestic one-year interest rate expected to occur in two years . All else fixed, will the reduction in interest rate have which of the following effects in a flexible exchange rate regime?

A) The real exchange rate will decrease with no change in the nominal exchange rate.

B) The nominal exchange rate will decrease with no change in the real exchange rate.

C) Both the real and nominal exchange rate will decrease.

D) No change in either the nominal or real exchange rate.

Answer: C Diff: 1 22) Suppose country A pegs its nominal exchange rate to country B and that country A has a lower inflation rate than country B. In this situation, country A will experience A) a real depreciation.

B) a better trade position.

C) a reduction in the real exchange rate.

D) all of these E) none of these Answer: D Diff: 1 23) Assume that policy makers are pursuing a fixed exchange rate regime. Assume that the economy is initially operating at the natural level (i.e., Y = Yn). Suppose fiscal policy makers increase government spending. This fiscal contraction will cause which of the following?

A) The real exchange rate will be permanently higher in the medium run.

B) The real exchange rate will be permanently lower in the medium run.

C) The effects of this devaluation on the real exchange rate will be ambiguous in the medium run.

D) The real exchange rate will be unchanged in the medium run.

E) none of these Answer: B Diff: 1 24) Assume that policy makers are pursuing a fixed exchange rate regime. Assume that the economy is initially operating at the natural level (i.e., Y = Yn). Suppose a reduction in wealth causes households to reduce consumption. This wealth-induced decrease in consumption will cause which of the following to occur?

A) The real exchange rate will be permanently higher in the medium run.

B) The real exchange rate will be permanently lower in the medium run.

C) The effects of this devaluation on the real exchange rate will be ambiguous in the medium run.

D) The real exchange rate will be unchanged in the medium run.

Answer: B Diff: 1

291 Copyright © 2021 Pearson Education, Inc.

25) In a fixed exchange rate regime, which of the following policies could lead to a greater trade deficit and leave aggregate demand constant?

A) Devalue the currency.

B) Increase government spending.

C) Decrease government spending.

D) Decrease government spending and devalue the currency.

E) Increase government spending and revalue the currency.

Answer: E Diff: 1 26) Suppose foreign exchange markets anticipate a revaluation for country A. Further assume that policy makers in country A will continue to fix its nominal exchange rate. In order to peg the currency at its original level, which of the following must occur?

A) Increase the domestic interest rate.

B) Increase the domestic price level.

C) Convince trading partners to raise their interest rates.

D) all of these E) none of these Answer: B Diff: 1 27) Explain what factors cause shifts of the aggregate demand curve in the open economy model.

Answer: The standard of list of determinants that appeared for the closed economy version of the AD relation still exists here (e.g. G, T, ... ). There are several international variables that must be added: Y*, E, P* and, in a fixed exchange rate regime, i*. The domestic price level also affects AD because of its effect on the real exchange rate.

Diff: 1 28) First, briefly explain why the AD curve is downward sloping in a closed economy. Second, briefly explain why the AD curve is downward sloping in an open economy under fixed exchange rates. And finally, briefly compare the size of the slopes of the two AD curves.

Answer: In a closed economy, P affects Y via its effects on M/P, i, and I. In fixed exchange rate regime, changes in P will affect M/P; however, the domestic interest rate cannot change. So, P now affects Y via its effects on the real exchange rate. A drop in P causes a real depreciation, an increase in NX, and an increase in Y. Because the change in P has a second effect in the open economy version, that would tend to make the AD curve steeper in the open economy under fixed exchange rates. However, recall that the multiplier will be smaller in an open economy because of the marginal propensity to import. This would have an offsetting effect. Answer: ambiguous.

Diff: 2

292 Copyright © 2021 Pearson Education, Inc.

20.2

Exchange Rate Crises under Fixed Exchange Rates

1) Suppose country A pegs its nominal exchange rate to country B and that country A has a higher inflation rate than country B. In this situation, country A will experience A) a real appreciation.

B) a worsening trade position.

C) an increase in the real exchange rate.

D) all of these E) none of these Answer: D Diff: 1 2) Suppose a country that has been pegging its currency is faced with a situation where financial market participants now expect some future devaluation. In such a situation, we would generally expect which of the following to occur?

A) a reduction in the domestic interest rate B) an announcement by the central bank that a large devaluation will occur in the near future C) reduction in demand for the country's currency D) all of these E) none of these Answer: A Diff: 2 3) An adjustment of central parities in the EMS is called a A) realignment.

B) nominal appreciation or nominal depreciation.

C) real appreciation or real depreciation.

D) re-coupling.

E) re-paritization.

Answer: A Diff: 1 4) During the EMS crisis in 1992, A) all the EMS countries abandoned the system.

B) Germany abandoned the system.

C) England and Italy abandoned the system.

D) France was put in charge of the system.

E) all the EMS countries stood firm, and refused to change central parities.

Answer: C Diff: 1

293 Copyright © 2021 Pearson Education, Inc.

5) After continuing crises in 1993, the EMS countries A) agreed to entirely abandon the system.

B) stood firm, refusing to adjust central parities.

C) narrowed the band of allowable fluctuations around central parities.

D) removed France from its leading role in the system.

E) widened the band of allowable fluctuations around central parities.

Answer: E Diff: 1 6) A country which does not revalue when financial markets expect it to will probably suffer A) a real depreciation of its currency.

B) lower interest rates.

C) a default on its national debt.

D) all of these E) none of these Answer: B Diff: 1 7) Suppose a country that has been pegging its currency is faced with a situation where financial market participants now expect some future revaluation. In such a situation, we would generally expect which of the following to occur?

A) an increase in the domestic interest rate B) an announcement by the central bank that a large revaluation will occur in the near future C) an increase in demand for the country's currency D) all of these E) none of these Answer: A Diff: 2 8) Suppose output is above the natural level of output. In a fixed exchange rate regime, explain the two ways the economy can return to the natural level of output.

Answer: Revaluation. Policy makers could revalue the currency. This would cause a reduction in NX, and reduction in demand, and a reduction in Y. Graphically, the AD curve would shift to the left. Economy self-corrects. With Y above the natural level, the expected price level (or expected inflation) will rise causing W to rise. As W rises, P will rise. As P rises, a real appreciation occurs and NX falls. We would move along the AD curve.

Diff: 2 9) Suppose the economy is operating below the natural level of output. Discuss the arguments for and against using a devaluation in such a situation.

Answer: With a devaluation, Y returns to the natural level much more rapidly. This would cause an increase in NX, an increase in demand, and an increase in Y. Graphically, the AD curve would shift to the right. Economy self-corrects. This is an advantage. However, with a devaluation, individuals might begin to doubt the country's commitment to a fixed exchange rate regime. This could lead to an exchange rate crisis.

Diff: 2 294 Copyright © 2021 Pearson Education, Inc.

10) Suppose the economy is initially operating above the natural level of output. In a fixed exchange rate regime, explain how the economy will adjust to this situation.

Answer: With Y below the natural level, the expected price level (or expected inflation) will fall causing W to fall. As W falls, P will fall. As P falls, a real depreciation occurs and NX increases.

We would move along the AD curve.

Diff: 2 11) Assume a country is in a fixed exchange rate regime. Explain what factors might cause individuals to expect that a country will revalue its currency.

Answer: The currency might be viewed as undervalued. This could be caused by relatively lower rates of inflation in the country. Also, domestic macro conditions (e.g. an expansion) might call for a revaluation.

Diff: 2 12) Assume a country is in a fixed exchange rate regime. Now suppose that individuals expect that policy makers will revalue its currency. Explain the various actions that policy makers can choose in response to this expected revaluation.

Answer: Policy makers can attempt to persuade (via official announcements) that they remain committed to pegging the currency at its current rate. Second, they may have to reduce domestic interest rates to prevent any appreciation of the currency. Eventually, they may be forced to revalue because of the expansionary effects of the lower i.

Diff: 2 13) Explain exchange rate crisis.

Answer: Exchange rate crisis typically start when participants in financial markets believe a currency may soon be devalued. Defending the parity then requires very high interest rates, with the potentially large adverse macroeconomic effects. These adverse effects may force the country to devalue, even if there were no initial plans for such a devaluation.

Diff: 2 20.3

Exchange Rate Movements under Flexible Exchange Rates

1) When policy makers decide to devalue the currency, such an action generally represents A) a decision to let the currency float.

B) an increase in the pegged value of the domestic currency.

C) a reduction in the foreign price level.

D) a reduction in the domestic price level.

E) none of these Answer: D Diff: 1

295 Copyright © 2021 Pearson Education, Inc.

2) When policy makers decide to revalue the currency, such an action generally represents A) an increase in the pegged value of the domestic currency.

B) a decision to let the currency float.

C) a reduction in the foreign price level.

D) an increase in the domestic price level.

E) none of these Answer: A Diff: 1 3) Suppose the country that pegs its currency has an overvalued real exchange rate and that output is currently above the natural level of output. Which of the following will occur as the economy adjusts to this situation?

A) P will decrease over time until Y = Yn. B) A reduction in the pegged value of the domestic currency will cause a leftward shift of the AD curve.

C) Net exports will increase as the economy adjusts to this situation.

D) Domestic goods will become less competitive as the economy adjusts by itself.

E) none of these Answer: D Diff: 1 4) For this question, assume that exchange rates flexible and that the exchange rate expected to occur in one year is not constant. Suppose that individuals now expect that the domestic central bank will pursue expansionary monetary policy in one year. This expected future monetary expansion will cause which of the following to occur?

A) The current nominal exchange rate will decrease.

B) The current nominal exchange rate will increase.

C) The current nominal exchange rate will not change.

D) The effects on the current nominal exchange rate are ambiguous.

Answer: A Diff: 1 5) For this question, assume that exchange rates are flexible and that the exchange rate expected to occur in one year is not constant. Suppose that individuals now expect that the foreign central bank will pursue expansionary monetary policy in one year. This expected future monetary expansion by the foreign central bank will cause which of the following to occur?

A) The current nominal exchange rate will decrease.

B) The current nominal exchange rate will increase.

C) The current nominal exchange rate will not change.

D) The effects on the current nominal exchange rate are ambiguous.

Answer: B Diff: 1

296 Copyright © 2021 Pearson Education, Inc.

6) When we no longer assume that the exchange rate expected to occur in one year is constant, explain what variables affect the current exchange rate in a flexible exchange rate regime. Include in your answer an explanation of how changes in these variables affect the current exchange rate.

Answer: The current one-year domestic rate and future expected one-year domestic rates. Also, the current one-year foreign rate and future expected one-year foreign rates. And finally, some long-run nominal expected future exchange rate. Changes in the current one-year domestic and foreign rates have the same effect as described earlier. Changes in the future expected domestic rate will effect the exchange rate that is expected to occur at some point. This will affect the current exchange rate. The same type of analysis applies to the foreign rate. And finally, the long-run expected exchange rate will affect E as well in the same way it did before.

Diff: 2 7) Explain why exchange rates are more volatile than is suggested by the relatively simply interest parity condition presented earlier in the course.

Answer: Put simply, there are more variables that can affect the current exchange rate. That is, there are variables in addition to the current domestic and foreign interest rates and one-year expected exchange rate that matter. A change in any of these variables will cause E to change.

Diff: 2 20.4

Choosing between Exchange Rate Regimes

1) Which of the following is an advantage of a common currency in Europe?

A) Each country could conduct its own, independent monetary policy.

B) Exchange rate uncertainty within the common currency area would be eliminated.

C) Each country could conduct its own, independent fiscal policy.

D) all of these E) none of these Answer: B Diff: 1 2) Which of the following, according to the Maastricht treaty, was a condition for participating in the common currency area?

A) a relatively small budget deficit-to-GDP ratio B) at least half the population of the country must speak German, French and English C) a promise that any future devaluations will be announced in advance D) the replacement of the country's prime minister with an appointee of the new "United States of Europe" E) a relatively small amount of foreign aid to countries outside the area Answer: A Diff: 1

297 Copyright © 2021 Pearson Education, Inc.

3) Assume that policy makers are pursuing a fixed exchange rate regime and that the economy is initially operating at the natural level. Which of the following will occur as a result of a evaluation?

A) The real exchange rate will be permanently higher in the medium run.

B) The real exchange rate will be permanently lower in the medium run.

C) The effects of this devaluation on the real exchange rate will be ambiguous in the medium run.

D) The nominal exchange rate will initially increase in the short run and then decrease in the medium run.

E) none of these Answer: E Diff: 1 4) Assume that policy makers are pursuing a fixed exchange rate regime and that the economy is initially operating at the natural level of output. Which of the following will occur as a result of a revaluation?

A) The real exchange rate will be permanently higher in the medium run.

B) The real exchange rate will be permanently lower in the medium run.

C) The effects of this revaluation on the real exchange rate will be ambiguous in the medium run.

D) The real exchange rate will be unchanged in medium run.

E) The nominal exchange will initially fall in the short run and then increase in the medium run.

Answer: D Diff: 1 5) Assume that policy makers are pursuing a fixed exchange rate regime. Assume that the economy is initially operating at the natural level (i.e., Y = Yn). Suppose fiscal policy makers increase taxes. This fiscal contraction will cause which of the following?

A) The real exchange rate will be permanently higher in the medium run.

B) The real exchange rate will be permanently lower in the medium run.

C) The effects of this devaluation on the real exchange rate will be ambiguous in the medium run.

D) The real exchange rate will be unchanged in the medium run.

E) none of these Answer: A Diff: 1 6) Assume that policy makers are pursuing a fixed exchange rate regime. Assume that the economy is initially operating at the natural level (i.e., Y = Yn). Suppose an increase in wealth causes households to increase consumption. This wealth-induced increase in consumption will cause which of the following to occur?

A) The real exchange rate will be permanently higher in the medium run.

B) The real exchange rate will be permanently lower in the medium run.

C) The effects of this devaluation on the real exchange rate will be ambiguous in the medium run.

D) The real exchange rate will be unchanged in the medium run.

Answer: B Diff: 1 7) A number of situations can arise that will cause individuals to believe that policy makers might change the pegged value of a fixed exchange rate. Suppose financial market participants expect a revaluation in the future. The interest parity condition will be maintained if which of the following 298 Copyright © 2021 Pearson Education, Inc.

policy actions are taken in the current period?

A) a reduction in the pegged value of the domestic currency B) an increase in i C) a reduction in i D) an increase in government spending Answer: C Diff: 1 8) For this question, assume that policy makers are pursuing a fixed exchange rate regime and that output is initially less than the natural level of output. The economy will tend to move toward the natural level of output when which of the following occur?

A) an increase in the price level B) a devaluation of the currency C) an increase in the domestic interest rate D) a reduction in the foreign price level E) none of these Answer: B Diff: 1 9) For this question, assume that policy makers are pursuing a fixed exchange rate regime and that output is initially greater than the natural level of output. The economy will tend to move toward the natural level of output when which of the following occur?

A) an increase in the price level B) a devaluation of the currency C) a reduction in the domestic interest rate D) an increase in the foreign price level E) none of these Answer: A Diff: 1 10) European currencies taken out of circulation and replaced with the Euro in A) 1992.

B) 1997.

C) 1999.

D) 2004.

E) none of these Answer: E Diff: 1

299 Copyright © 2021 Pearson Education, Inc.

11) The new European Central Bank is located in which country?

A) England B) Italy C) France D) Spain E) Germany Answer: E Diff: 1 12) Policy makers can select from a number of different exchange rate regimes and exchange rate policies. Which of the following policies would most likely represent a hard peg?

A) a revaluation B) a devaluation C) a flexible exchange rate regime D) a dollarization Answer: D Diff: 1 13) Policy makers can select from a number of different exchange rate regimes. One of those options is a "hard peg." Which of the following best represents a hard peg?

A) a revaluation B) a currency board C) a flexible exchange rate regime D) the EMS E) none of these Answer: B Diff: 1 14) Euro coins and bank notes were introduced in January A) 2002.

B) 2001.

C) 2000.

D) 1999.

Answer: A Diff: 1 15) Explain the cases for and against flexible and fixed exchange rate regimes.

Answer: Case for fixed: cannot trust the central bank to pursue responsible monetary policy, reduces relative price variability by fixing E. Case for flexible: enables monetary policy to serve as a stabilization tool.

Diff: 1

300 Copyright © 2021 Pearson Education, Inc.

16) What is an "optimal currency area"? Also, discuss the conditions that must be satisfied for an optimal currency area to exist.

Answer: An optimal currency area would be a region where one currency could be used. There are two conditions needed for this to be successful: similar shocks in the countries and high factor mobility.

Diff: 2 17) Explain each of the following and why each might be used: hard pegs, currency boards, and dollarizations.

Answer: A hard peg is a fixed exchange rate regime where policy makers, in some way, have made it symbolically or technically harder to change the peg. A dollarization occurs when the domestic currency is replaced by a foreign currency (typically the dollar). Under a currency board, the central bank is prepared to exchange foreign currency for domestic currency at some official rate. Furthermore, the central bank cannot engage in open market operations.

Diff: 2 18) Assume a country is in a fixed exchange rate regime. Explain what factors might cause individuals to expect that a country will devalue its currency.

Answer: The currency might be viewed as overvalued. This could be caused by relatively higher rates of inflation in the country. Also, domestic macro conditions might call for a devaluation.

Diff: 2 19) Assume a country is in a fixed exchange rate regime. Now suppose that individuals expect that policy makers will devalue its currency. Explain the various actions that policy makers can choose in response to this expected devaluation.

Answer: Policy makers can attempt to persuade (via official announcements) that they remain committed to pegging the currency at its current rate. Second, they may have to raise domestic interest rates to prevent any depreciation of the currency. Eventually, they may be forced to devalue because of the contractionary effects of the higher i.

Diff: 2 20) According to Mundell, countries to constitute an optimal currency area need to satisfy one of the two conditions. Explain these conditions.

Answer: Mundell argued these countries need to satisfy one of the two conditions: 1) the countries have to experience similar shocks, then they would have chosen roughly the same monetary policy; 2) Or, if the countries experience different shocks, they must have high factor mobility.

Diff: 2 21) Does Europe constitute an optimal common currency area? Why? Answer: There is less agreement on the question. This is because neither of the two Mundell conditions appears to be satisfied. European countries have experienced very different shocks in the past. Workers move much less within European countries than they do within the United States. Because of language and cultural differences among European countries, mobility between countries is even lower.

Diff: 2 Macroeconomics, 8e (Blanchard) 301 Copyright © 2021 Pearson Education, Inc.

Chapter 21: Should Policymakers be Restrained?

21.1

Uncertainty and Policy

1) In 1994, Republicans introduced their "Contract with America." This plan A) included a PAYGO rule.

B) would restrict the ability of monetary policy to affect the economy in the short run.

C) included a line item veto.

D) would make the Federal Reserve even more independent than it already is.

E) all of these Answer: C Diff: 1 2) Econometric models of the U.S. economy generally agree A) on the quantitative impact of monetary policy over a horizon of several years.

B) that an increase in money growth will increase output in the short run.

C) that an increase in money growth will decrease output in the short run.

D) that an increase in money growth will decrease output in the long run.

E) that "rational expectations" is the best way to generate policy forecasts.

Answer: B Diff: 1 3) All of the macroeconometric models currently in use A) originate in the United States.

B) incorporate rational expectations into their predictions.

C) originate with government or international agencies.

D) originate with commercial firms who sell their forecasts to other firms and governments.

E) none of these Answer: E Diff: 1 4) For this question, assume that the there exists uncertainty about the impact of monetary policy on the macroeconomy. Given this information, it would be most appropriate for the central bank to increase money growth A) at the midpoint of a recession.

B) by more than the increase that will yield the desired response.

C) by less than the increase that will yield the desired response.

D) by an amount equal to the increase that will yield the desired response.

E) only after it is certain that the economy has entered a recession.

Answer: C Diff: 2

302 Copyright © 2021 Pearson Education, Inc.

5) Given the uncertainty about the effects of macro policy, economists generally propose that A) macro policies should be more active, the lower the level of unemployment or inflation.

B) changes in money growth should only be used for fine tuning the economy, not for correcting large imbalances (such as high inflation).

C) money growth should be set at zero by constitutional amendment.

D) elected officials should have more input in the determination of monetary policy.

E) none of these Answer: E Diff: 2 6) As uncertainty about the effects of policy on output decreases, we would expect that A) policy makers would be more frequently implement fine tuning policies.

B) policy makers would implement more active policies.

C) policy makers would implement less active policies.

D) policy makers would be more frequently implement fine tuning policies and more active policies.

E) policy makers would be more frequently implement fine tuning policies and less active policies.

Answer: D Diff: 1 7) Who is best known for arguing about the fine tuning of monetary policy?

A) Friedman B) Keynes C) Modigliani D) Greenspan E) Bernanke Answer: C Diff: 1 8) Explain whether uncertainty should cause policy makers to do more or do less to stabilize the economy.

Answer: As uncertainty increases, policy makers should do less. Alternatively, more active policies would actually lead to more uncertainty. This is based on, as Blanchard notes, multiplicative uncertainty.

Diff: 1 9) What were some of the key features in terms of fiscal policy of the Stability and Growth Pact signed in 1997 by would-be members of the Euro?

Answer: The Stability and Growth pact: (1) committed countries to balance their budgets in the medium run; (2) countries avoid excessive deficits; and (3) imposed sanctions on countries that ran excessive deficits.

Diff: 2

303 Copyright © 2021 Pearson Education, Inc.

10) What are the new rules of the Euro Plus Pact adopted in 2011?

Answer: It requires member countries to translate the SGP rules into national legislation, either through a constitutional amendment or a framework law.

Diff: 2 11) What are the main rules of the Budget Enforcement Act of 1990?

Answer: The two main rules are: 1) it imposed constraints on spending; 2) it requires that a new transfer program could only be adopted if it could be shown not to increase deficits in the future.

Diff: 2 12) Explain spending caps set by the Budget Enforcement Act. Answer: The Budget Enforcement Act imposed constrains on spending. These constraints, called spending caps, were set on discretionary spending for the following five years. These caps were set in such a way as to require small but steady decrease in discretionary spending (in real terms).

Explicit provisions were made for emergencies.

Diff: 2 21.2

Expectations and Policy

1) The idea that the economy operates like a complicated, predictable machine is an important aspect of A) game theory.

B) attrition theory.

C) the theory of strategic interaction.

D) time inconsistency theory.

E) optimal control theory.

Answer: E Diff: 1 2) In macroeconomics, game theory focuses on the strategic interactions between which of the following groups of agents?

A) individuals; firms B) individuals and firms; policy makers C) policy makers; economic forecasters D) individuals and firms; economic forecasters Answer: B Diff: 1

304 Copyright © 2021 Pearson Education, Inc.

3) Which of the following best defines time inconsistency?

A) the increasing inaccuracy of econometric models as the time horizon becomes longer B) the tendency for the rise in output to be greater in the early years of a president's term, and smaller in the later years C) the effects of political electoral cycles on the business cycle D) the tendency for policy makers to deviate from a pre-announced optimal policy once agents in the economy have adjusted their behavior and expectations based on the pre-announced policy E) the effect of economic uncertainty on short-run stabilization policy Answer: D Diff: 1 4) The existence of the time inconsistency problem in macro policy suggests which of the following?

A) Use fiscal and monetary policy to fine tune the economy.

B) Reduce the independence of the central bank.

C) Appoint someone who is more conservative (economically) than the rest of the government to head the central bank.

D) Intervene frequently in the foreign exchange market.

E) Eliminate rational expectations from econometric models used for forecasting.

Answer: C Diff: 1 5) Once people believe the Fed's commitment to keep unemployment at the natural rate, the Fed can reduce unemployment below the natural rate A) in both the short run and the long run.

B) in both the short run and the long run, but only after changing peoples' expectations.

C) in the long run, but not the short run.

D) in the short run, but not in the long run.

E) none of these Answer: D Diff: 1 6) To solve the "time inconsistency" problem in macro policy, a nation may well have to A) restrict itself in the present from taking certain policy moves in the future.

B) lift all restrictions on future policy moves.

C) present policy moves to the public, for example, in a referendum.

D) use the courts to settle policy disputes.

E) make the central bank more responsive to the popular will.

Answer: A Diff: 1

305 Copyright © 2021 Pearson Education, Inc.

7) Research indicates that the more independent the central bank, A) the smaller the budget deficit.

B) the higher the nominal interest rate.

C) the lower the rate of inflation.

D) the larger the time inconsistency problem in making policy.

E) the greater the likelihood of a "war of attrition" over policy.

Answer: C Diff: 1 8) One surprising insight from viewing policy as a "game" is that A) central bankers should project an image of being conservative on economic policy matters, regardless of their personal views.

B) it is more difficult to control inflation when the central bank is highly independent.

C) uncertainty over the impact of policy makes little difference in designing an optimal policy.

D) money growth has little or no impact on inflation in the long run.

E) decreasing money growth may substantially increase the rate of inflation in the long run.

Answer: A Diff: 1 9) Which of the following is the most powerful argument for putting restraints on policy makers (as opposed to self-restraint by policy makers themselves)?

A) time inconsistency B) uncertainty about Okun's coefficient C) uncertainty about the natural rate of unemployment D) uncertainty about the timing of policy impacts E) disagreements about the proper structure of an econometric model Answer: A Diff: 1 10) To deal with the time inconsistency problem associated with monetary policy, some have suggested that A) the head of the central bank be chosen by election.

B) the central bank implement expansionary monetary policy prior to election years.

C) elected officials should have a direct influence on the implementation of monetary policy.

D) all of these E) none of these Answer: E Diff: 1 11) Research for a number of OECD countries suggests that inflation will be lower A) the more independent the central bank.

B) the less independent the central bank.

C) if the heads of central banks are chosen by election.

D) when the terms of the heads of central banks coincide with the terms of elected officials.

Answer: A Diff: 1 306 Copyright © 2021 Pearson Education, Inc.

12) Game theory analysis of macro policy suggests that as voters become more short-sighted A) policy makers will be tempted to raise taxes.

B) policy makers will be forced to balance the budget.

C) policy makers will adopt policies today to achieve balanced budgets in the future.

D) all of these E) none of these Answer: E Diff: 1 13) Which of the theory is better to think about policy?

A) game theory B) optimal control theory C) expectations theory D) none of these Answer: A Diff: 1 14) The hostage taking example was developed by A) John Nash.

B) Kydland and Prescott.

C) John Harsanyi.

D) Reinhard Selten.

Answer: B Diff: 1 15) Which of the following is not an example of the issue of time inconsistency?

A) a central bank announced to maintain low inflation and at the same time increased money supply B) a government stated that they will not negotiate with hostage takers. When someone is taken hostage, it negotiates C) a mom says to her kids no cookie before meals and she never gives cookies before her kids eat their meals D) a person on diet eats ice cream for dinner Answer: C Diff: 1 16) A "conservative" central banker cares A) less about inflation and more about unemployment than the government.

B) more about economic growth and less about inflation.

C) more about inflation and less about unemployment than the government.

D) less about economic growth and more about inflation.

Answer: C Diff: 1

307 Copyright © 2021 Pearson Education, Inc.

17) Wars of attrition arise in which of the following contexts?

A) fiscal policy B) deficit reduction C) hyperinflation D) all of these E) none of these Answer: D Diff: 1 18) First, what can be done to increase central bank credibility? Second, why is central bank credibility important?

Answer: Central bank credibility can be achieved by: (1) imposing rules on the central bank; (2) making the central bank independent (of political pressure); and (3) choosing a conservative central banker. Central bank credibility is important to minimize the chances of occurrence of the time inconsistency problem. Also, whenever a central bank implements a disinflationary policy, the output effects will be smaller the more credible is the central bank.

Diff: 2 19) Discuss the time inconsistency problem and explain how it relates to monetary policy.

Answer: The time inconsistency of optimal policy refers to game theory situations where an agent has an incentive to deviate from some stated rule/policy. In terms of monetary policy, central banks will typically announce certain goals (e.g. policies consistent with a certain rate of inflation).

Once such a policy is announced, the central bank might have an incentive to deviate from this policy and increase money growth in excess of the rate consistent with its inflation goal. There would be some increase in inflation; however, there would be a significant increase in output.

Diff: 2 20) Suppose a government have a stated policy that it will not negotiate with hostage takers. Now someone is taken hostage, what would be the best policy for the government? Explain.

Answer: The best policy of the government is to commit not to negotiate. By giving up the option to negotiate, it is likely to prevent hostage takings in the first place.

Diff: 2

308 Copyright © 2021 Pearson Education, Inc.

21.3

Politics and Policy

1) In which of the following political systems would a political business cycle be more likely to occur?

A) a democracy with elections that occur on a regular basis B) a parliamentary C) communist-type economies D) socialist-type economies E) a democracy with elections that occur on an irregular basis Answer: A Diff: 1 2) In the United States, presidential elections occur every four years. If a political business cycle exists in the United States, in which year of a presidential term, all else fixed, would we expect output growth to be highest?

A) the first year B) the second year C) the third year D) the fourth year Answer: D Diff: 1 3) In the United States, presidential elections occur every four years. If a political business cycle exists in the United States, in which year of a presidential term, all else fixed, would we expect output growth to be lowest?

A) the first or second year B) the second or third year C) the third or fourth year D) the fourth year Answer: A Diff: 1 4) Which of the following statements is true about the United States over the past fifty years?

A) There is no evidence of political business cycles in the United States.

B) The debt-to-GDP ratio has been roughly constant.

C) Under either party, output growth has been generally higher in the year preceding an election than in other years.

D) none of these Answer: C Diff: 1

309 Copyright © 2021 Pearson Education, Inc.

5) During which of the following decades was the debt-to-GDP ratio generally highest in the United States?

A) 1930s B) 1940s C) 1960s D) 1980s E) 1990s Answer: B Diff: 1 6) Suppose we compare the average growth rates of output for Republican and Democratic administrations. In which year, on average, is the difference in growth rates for Republican and Democratic administrations greatest?

A) first B) second C) third D) fourth E) the growth rates are nearly identical for both parties Answer: B Diff: 1 7) Analysis of macro policy and theory has resulted in of the following views?

A) There should be no constraints imposed on fiscal or monetary policy.

B) A constitutional amendment is the most appropriate method to constrain fiscal policy.

C) The heads of the central bank should be chosen by popular elections.

D) all of these E) none of these Answer: E Diff: 1 8) Suppose an elected official wishes to introduce a new government program. Under a PAYGO rule, this new program would be adopted only if A) the budget deficit is reduced by the same amount as the costs of the new program.

B) the budget deficit is reduced by half the amount of the costs of the new program.

C) the new program does not result in an increase in the current or future budget deficit.

D) none of these Answer: C Diff: 2 9) Which of the following was one of the main rules in the 1990 "Budget Enforcement Act"?

A) flat tax rate B) spending caps C) indexation of income tax brackets D) consumption tax E) none of these Answer: B Diff: 1 310 Copyright © 2021 Pearson Education, Inc.

10) Which of the following was one of the main rules in the 1990 "Budget Enforcement Act"?

A) flat tax rate B) PAYGO rule C) indexation of income tax brackets D) consumption tax E) none of these Answer: B Diff: 1 11) The PAYGO rule was allowed to expire in which year?

A) 1990 B) 1991 C) 2002 D) the PAYGO rule still exists Answer: D Diff: 1 12) Arguments for placing restraints on policy makers fall into which of the following?

A) policy makers understand completely how the economy operates B) policy makers have good intentions, but end up doing more harm than good C) policy makers do what is best for them, not necessarily what is best for the country D) all of these E) none of these Answer: C Diff: 1 13) Fine tuning represents which of the following?

A) policy makers' attempts to minimize the deviations of actual output from the natural level of output B) policy makers' attempts to achieve zero inflation C) policy makers' attempts to minimize fluctuations in interest rates D) policy makers' attempts to maintain a given rate of growth in the nominal money supply E) policy makers' attempts to minimize variations in the real exchange rate Answer: A Diff: 1 14) Who is best known for arguing about the long and variable lags of monetary policy?

A) Friedman B) Keynes C) Phillips D) Greenspan E) Bernanke Answer: A Diff: 1

311 Copyright © 2021 Pearson Education, Inc.

15) Based on an analysis of macroeconomic outcomes under Republican and Democratic administrations, we would expect which of the following to occur?

A) Growth rates to be generally higher under Republican administrations.

B) Macroeconomic policy to be relatively contractionary under Democratic administrations.

C) Unemployment rates to be generally higher under Democratic administrations.

D) Inflation rates to be generally lower under Democratic administrations.

E) none of these Answer: E Diff: 1 16) Analysis of U.S. growth rates shows that growth rate of output tends to be highest in which year of a presidential administration?

A) the first B) the second C) the third D) the fourth Answer: D Diff: 1 17) Analysis of U.S. budget deficits in the United States between 1990 and 2000 indicates that which of the following is primarily responsible for the reduction in the budget deficit?

A) decrease in spending B) increase in tax revenues C) decrease in spending and increase in tax revenues D) lower interest rates E) increases in tax rates Answer: C Diff: 1 18) Assume that political business cycles do not exist. Given this assumption, we would expect, all else fixed, the output growth to be highest in which period?

A) just prior to an election B) just after an election C) in the first year of an administration D) in the second year of an administration E) none of these Answer: E Diff: 1 19) Which of the following policies toward kidnappings would you recommend to authorities?

A) State policy of NO negotiations. If a kidnapping occurs, authorities should negotiate.

B) State policy of negotiations. If a kidnapping occurs, authorities should NOT negotiate.

C) State policy of negotiations. If a kidnapping occurs, authorities should negotiate.

D) none of these Answer: D Diff: 1 312 Copyright © 2021 Pearson Education, Inc.

20) Those who are concerned about balanced budget amendments typically argue that balanced budget amendments A) cause interest rates to be higher than they otherwise would be.

B) would make fluctuations in output around the natural level of output greater.

C) would increase spending in a recession.

D) would reduce national saving.

Answer: B Diff: 1 21) Democratic administrations generally are relatively more concerned about which of the following?

A) reducing government expenditures B) reducing the rate of inflation C) reducing the unemployment rate D) balancing budget deficits E) balancing trade deficits Answer: C Diff: 1 22) Republican administrations generally are relatively more concerned about which of the following?

A) increasing expenditures B) reducing the rate of inflation C) reducing unemployment D) raising taxes E) none of these Answer: B Diff: 1 23) During democratic presidential administration since 1948, economic growth was highest in ________ year of the administration?

A) first B) second C) third D) fourth Answer: B Diff: 1 24) During republican presidential administration since 1948, economic growth was highest in ________ year of the administration?

A) first B) second C) third D) fourth Answer: D Diff: 1 313 Copyright © 2021 Pearson Education, Inc.

25) In ________, would-be members of the Euro area signed the Stability and Growth Pact (SPG).

A) 1997 B) 1998 C) 1999 D) 2000 Answer: A Diff: 1 26) The Maastricht treaty set the budget ratio to GDP to be ________ in order for countries to qualify to join the Euro area.

A) below 3% B) below 4% C) below 5% D) below 6% Answer: A Diff: 1 27) The Maastricht treaty set the budget ratio to GDP to be ________ in order for countries to qualify to join the Euro area.

A) below 60% B) below 70% C) below 80% D) below 90% Answer: A Diff: 1 28) Assume a country has presidential elections every three years. If a political business cycle exists in this country, explain any differences in the average annual growth rates of output for each year of a typical administration.

Answer: Political business cycles represent the outcomes of politically motivated policies that increase the chances of an incumbent's reelection. Specifically, policies that are implemented to increase the probability of reelection will cause, in theory, output growth to be higher in an election year. Such a cycle where output growth is highest just before an election is called a political business cycle. Because of the inflationary consequences of such a policy, it is more likely that contractionary policies would be implemented in the first year of any administration. So, we would expect output growth to be highest in the election year and lowest, depending on lags, in either the first or second year.

Diff: 2 29) Balanced budget amendments are believed to be destabilizing. Explain why this is so.

Answer: When an economy enters a recession, tax revenues automatically fall. A balanced budget amendment would require that either taxes be increased or spending cut — both of which would cause Y to fall even further.

Diff: 2

314 Copyright © 2021 Pearson Education, Inc.

30) Suppose a government implements rules that result in a more independent central bank. What effect do you think this more independent central bank will eventually have on money growth and inflation in that country? Explain.

Answer: Research suggests as central bank independence increases, average inflation rates decrease (which implies that money growth must be lower as well). The possible explanation for this deals with political manipulation of monetary policy. We would expect to see at some point both slower money growth and lower inflation.

Diff: 2 31) Research by Alberto Alesina has documented differences and similarities in the average annual rates of growth in output during each year of Democratic and Republican administrations.

Briefly explain what the pattern of these differences and similarities is.

Answer: The growth rates are similar in the first year. While there are some differences in years 3 and 4, the differences are small. Where there are sizable differences in growth rates is in year 2.

Here, we observe that GDP growth is about two times greater during Democratic administrations.

The reason for this is that Democratic administrations presumably prefer more expansionary policies and that the effects of these policies kick in with a lag.

Diff: 2 32) Explain what a PAYGO rule is.

Answer: A PAYGO rule requires that any newly proposed government program will have no effect on either the current or future budget deficits. This implies that proponents of a new program must either propose tax increases to pay for the program or cuts in other programs.

Diff: 2 33) Use "wars of attrition" to explain the debate about deficit reduction.

Answer: When country is facing large budget deficits, both parties in congress want to reduce the deficit, but they disagree about the way to do it: One party wants to reduce deficits primarily through an increase in taxes; the other wants to reduce deficits primarily through a decrease in spending. Both parties may hold out on the hope that the other side will give in first. Only when debt has increased sufficiently, and it becomes urgent to reduce deficits, will one party give up.

These situations are reffed as wars of attrition. The fights between Congress and the Obama administration on how to reduce the large deficits triggered by the crisis are mostly driven by disagreements on whether deficit reduction should be achieved mainly through spending cuts or mainly through tax increases.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 22: Fiscal Policy: A Summing Up 22.1

What We Have Learned

1) When the economy is in a liquidity trap, which of the following is not correct?

A) A reduction in the interest rate can be used to increase output.

B) Fiscal policy is more important.

C) Interest rate is zero.

D) Large increases in spending and cuts in taxes were not enough to avoid the recession.

Answer: A 315 Copyright © 2021 Pearson Education, Inc.

Diff: 2 22.2

The Government Budget Constraint: Deficits, Debt, Spending, and Taxes

1) The government budget constraint tells us that the budget deficit is equal to A) interest on the debt.

B) the primary deficit.

C) the primary deficit plus interest on the debt.

D) imports minus exports.

E) the primary deficit plus the trade deficit plus interest on the debt.

Answer: C Diff: 1 2) The primary deficit is A) government spending minus interest on the debt.

B) government spending minus net tax revenues.

C) government spending plus interest on the debt minus net tax revenues.

D) government spending plus net tax revenues minus interest on the debt.

E) interest on the debt minus net tax revenues.

Answer: B Diff: 1 3) A higher deficit in the current year will lead to increased debt in the future only if A) the deficit is greater than the previous year's deficit.

B) the deficit-to-GDP ratio is greater than the debt-to-GDP ratio.

C) it causes a drop in private saving.

D) it causes an increase in private saving.

E) none of these Answer: E Diff: 2

316 Copyright © 2021 Pearson Education, Inc.

4) The "official measure" of the deficit (the one reported by the government) A) tells us the change in government nominal debt.

B) is equal to nominal interest payments on the debt plus the primary deficit.

C) overestimates the real budget deficit whenever the inflation rate is positive.

D) all of these E) none of these Answer: D Diff: 1 5) The official measure of the deficit A) always underestimates the correct measure of the deficit when inflation is positive.

B) differs from the correct measure by the inflation rate times taxes.

C) depends on the nominal interest rate.

D) depends on the real interest rate.

E) none of these Answer: C Diff: 1 6) The official measure of the deficit becomes more inaccurate as A) the inflation rate rises.

B) the total debt falls.

C) taxes rise.

D) all of these E) none of these Answer: A Diff: 1 7) All else equal, a rise in the debt-to-GDP ratio implies A) a greater ratio of interest payments to GDP. B) a greater difference between the official and correct measures of the deficit as a fraction of GDP. C) a greater surplus is needed to prevent further rises in the debt-to-GDP ratio.

D) all of these E) none of these Answer: D Diff: 2 8) If the government runs a primary deficit in year zero of B0, and decides to repay it in year t (i.e., bring the debt back down to its pre-existing level), then in year t it must run a primary surplus equal to A) zero.

B) one.

C) B0.

D) B0(1 + r).

E) none of these Answer: E Diff: 2 317 Copyright © 2021 Pearson Education, Inc.

9) If the government runs a primary deficit in year zero of B0, and, in year 1, decides to stabilize the debt (i.e., prevent the deficit from rising any further), then in year 1 and beyond, it must run a primary surplus equal to A) zero.

B) B0.

C) (1 + r)B0.

D) r.

E) none of these Answer: D Diff: 2 10) The debt-ratio is the ratio of the debt to A) government spending.

B) saving.

C) taxes.

D) personal disposable income.

E) GDP. Answer: E Diff: 1 11) The debt ratio will increase by more in any given year when A) the real interest rate is lower.

B) the growth rate of GDP is higher.

C) the initial debt ratio is greater.

D) all of these E) none of these Answer: C Diff: 1 12) Since the early 1980s, debt ratios for the OECD countries have A) increased.

B) remained constant.

C) decreased slightly.

D) decreased dramatically, and are now close to zero.

E) become impossible to define.

Answer: A Diff: 1 13) In 2010, the deficit-to-GDP ratio for the United States was approximately equal to A) 10%.

B) 17%.

C) 37%.

D) 67%.

Answer: A Diff: 1 318 Copyright © 2021 Pearson Education, Inc.

14) A major reason to be concerned about any U.S. budget deficit is that A) if it were maintained, it would lead to an ever-increasing debt-to-GDP ratio.

B) it would exacerbate the problem of the low U.S. saving rate.

C) under current legislation, it would lead to budget surpluses in the future.

D) if it were to increase, Ricardian equivalence will no longer hold.

E) since large deficits are associated with wars, the deficit might encourage the U.S. to become more adventuristic in its foreign policy.

Answer: B Diff: 1 15) The deficit (as a fraction of GDP) is anticipated to rise over the next several decades due to projections of A) increased defense spending.

B) increased spending on entitlements.

C) increased inflation.

D) decreased corporate tax revenues.

E) decreased income tax revenues.

Answer: B Diff: 1 16) In the short run, an increase in government spending that causes an increase in the budget deficit A) affects the level of output but not its composition.

B) affects both the level and composition of output.

C) affects only the price level.

D) is neutral.

E) none of these Answer: E Diff: 1 17) In the medium run, an increase in government spending that causes an increase in the budget deficit A) affects the level of output but not its composition.

B) affects both the level and composition of output.

C) will not affect the composition of output but will affect the price level.

D) is neutral.

E) none of these Answer: E Diff: 1

319 Copyright © 2021 Pearson Education, Inc.

18) In the medium run, a tax cut that causes an increase in the budget deficit will affect which of the following?

A) the level of output but not its composition B) both the level and composition of output C) only the composition of output D) only the price level E) none of these Answer: C Diff: 1 19) In the medium run, a tax increase that causes a reduction in the budget deficit will A) affect only the price level.

B) not affect the price level but will alter the composition of output.

C) not affect the level of output, but will affect the composition of output.

D) affect both the level and composition of output.

Answer: C Diff: 1 20) The correct measure of the deficit is also called A) the cyclically-adjusted deficit.

B) the structural deficit.

C) the full-employment deficit.

D) the inflation-adjusted deficit.

E) all of these Answer: D Diff: 1 21) The official measure of the deficit is equal to A) iB + G - T. B) iB + T - G. C) rB - G + T. D) (i - π)B + G - T. E) none of these Answer: A Diff: 1 22) The correct measure of the deficit is represented by which of the following expressions?

A) iB - G + T. B) iB + T - G. C) rB - G + T. D) (i - π)B + G - T. E) none of these Answer: D Diff: 1

320 Copyright © 2021 Pearson Education, Inc.

23) The difference between the official and correct measures of the deficit will be greater, A) the lower is inflation.

B) the lower is the level of debt, B. C) the higher is growth of output.

D) all of these E) none of these Answer: E Diff: 1 24) The difference between the official and correct measures of the deficit will be greater, A) the lower is government spending.

B) the lower is the level of debt, B. C) the higher is inflation.

D) none of these Answer: C Diff: 1 25) The primary deficit is represented by which of the following?

A) G - T B) iB - G + T C) iB + G - T D) rB - G + T E) rB + G - T Answer: A Diff: 1 26) The debt-to-GDP ratio will tend to decline over time when A) r > g.

B) r < g.

C) the primary deficit increases.

D) the initial level of debt increases.

Answer: B Diff: 1 27) The debt-to-GDP ratio is higher, A) the lower the real interest rate.

B) the lower is the ratio of the primary deficit to GDP. C) the higher is the growth rate of output.

D) all of these E) none of these Answer: E Diff: 1

321 Copyright © 2021 Pearson Education, Inc.

28) Which of the following will cause a reduction in the debt-to-GDP ratio?

A) an increase in the real interest rate B) an increase in the ratio of the primary deficit to GDP C) an increase in the growth rate of output D) all of these Answer: C Diff: 1 29) The difference between the official and correct measures of the deficit will be smaller, A) the higher is government spending.

B) the higher is the level of debt, B. C) the smaller is inflation.

D) none of these Answer: C Diff: 1 30) Which of the following will cause an increase in the debt-to-GDP ratio?

A) a reduction in the real interest rate B) a reduction in the ratio of the primary deficit to GDP C) a reduction in the growth rate of output D) all of these Answer: C Diff: 1 31) In 2010, the debt-to-GDP ratio for the United States was approximately equal to A) 90%.

B) 17%.

C) 37%.

D) 67%.

Answer: A Diff: 1 32) The deficit at natural level of output is called A) full-employment deficit.

B) mid-cycle deficit.

C) structural deficit.

D) cyclically adjusted deficit.

E) all of these Answer: E Diff: 1

322 Copyright © 2021 Pearson Education, Inc.

33) Which of the following is an entitlement program?

A) Social Security B) Medicare C) Medicaid D) all of these E) none of these Answer: D Diff: 1 34) Which of the following would decrease the cyclically adjusted deficit?

A) an increase in income B) a decrease in income C) an increase in the primary deficit D) a decrease in the primary deficit E) none of these Answer: C Diff: 1 35) Under what conditions will the official measure of the budget deficit be greater than, less than, or equal to the correct measure of the budget deficit.

Answer: The official measure of the deficit is: iB + G - T. The correct measure of the deficit is: rB + G - T. The difference between the two measures equals πB; that is, the official measure overstates the correct measure by that amount. The official measure will be greater when inflation is positive.

The two measures will be equal when inflation is zero. And finally, the correct measure will be greater when inflation is negative.

Diff: 2 36) Explain what can occur to cause an increase in the debt ratio.

Answer: The debt ratio is simply the ratio of the stock of debt to GDP. So, the debt ratio will rise whenever the increase in debt is greater than the increase in GDP. Even if the primary deficit is zero, the debt ratio will increase if the interest payments on the existing debt are such that they more than offset the fact that the economy is growing. So, a comparison of the real interest rate and growth rate of GDP will be important. Also, the debt ratio will rise if the primary deficit exists (or increases).

Diff: 2 37) What are the factors that will determine the size of some future required tax increase to pay off all debt?

Answer: The factors will include: the size of the debt at that time, how long it will take to pay off the debt, and the interest rate on the existing debt.

Diff: 2

323 Copyright © 2021 Pearson Education, Inc.

22.3

Ricardian Equivalence, Cyclical Adjusted Deficits, and War Finance

1) The Ricardian equivalence proposition states that an increase in the deficit causes A) consumption to decrease.

B) savings to decrease.

C) investment to decrease.

D) all of these E) none of these Answer: E Diff: 1 2) If the Ricardian equivalence proposition is correct, then an increase in the deficit will lead to A) an increase in private saving.

B) a decrease in investment spending.

C) a lower standard of living in the future.

D) all of these E) none of these Answer: A Diff: 2 3) If the Ricardian equivalence proposition is correct, then A) deficits harm future generations.

B) deficits reduce investment spending.

C) deficits stimulate the economy in the short run.

D) all of these E) none of these Answer: E Diff: 1 4) The large increases in the deficit during the 1980s in the United States were associated with A) large increases in public saving.

B) no change in public saving.

C) large increases in private saving.

D) all of these E) none of these Answer: E Diff: 2 5) Which of the following would increase the cyclically adjusted deficit?

A) an increase in income.

B) a decrease in income.

C) an increase in the primary deficit.

D) a decrease in the primary deficit.

E) none of these Answer: D Diff: 1 324 Copyright © 2021 Pearson Education, Inc.

6) If the government thinks the natural unemployment rate is 5%, when it is really 6%, then the government will A) overestimate the actual deficit.

B) underestimate the actual deficit.

C) overestimate the cyclically adjusted deficit.

D) underestimate the cyclically adjusted deficit.

E) none of these Answer: C Diff: 2 7) Using taxes to finance a war, rather than deficits, A) leads to a greater future capital stock.

B) is generally not proposed by economists.

C) shares less of the burden of the war with future generations.

D) all of these E) none of these Answer: D Diff: 1 8) The United States financed the additional government spending during World War II through A) an increase in the deficit.

B) an increase in taxes.

C) an increase in imports.

D) increases in both the deficit and taxes.

E) increases in both the deficit and imports.

Answer: D Diff: 1 9) To reduce distortions in the economy, it is probably better to finance temporary large government spending with A) deficits.

B) taxes.

C) exports.

D) all of these E) none of these Answer: A Diff: 1 10) "Debt repudiation" occurs when A) a government announces it will no longer run nominal deficits.

B) a government announces it will no longer run real deficits.

C) a government announces it will no longer honor its debt obligations.

D) a central bank will no longer monetize the debt.

Answer: D Diff: 1

325 Copyright © 2021 Pearson Education, Inc.

11) The Ricardian Equivalence proposition suggests that a tax increase that causes a budget surplus will A) cause an increase in output.

B) cause no change in output.

C) cause a reduction in output.

D) a reduction in consumption.

Answer: B Diff: 2 12) A rule of thumb is that a 1% increase in output leads automatically to a reduction in the deficit of what percentage of GDP? A) 0.5% B) 1% C) 1.5% D) 2% Answer: A Diff: 2 13) The effect of changes in economic activity on the budget deficit is called A) fine tuning.

B) debt monetization.

C) the structural deficit.

D) tax smoothing.

E) none of these Answer: E Diff: 1 14) Explain the macroeconomic effects of a tax cut according to the Ricardian Equivalence proposition. Include in your answer the IS-LM graph that shows the effects of this tax cut.

Answer: The Ricardian Equivalence proposition describes the effects of, for example, tax cuts. A tax cut will have no effect on the demand for goods according to the Ricardian Equivalence proposition. A tax cut in the current period will cause an increase in the budget deficit. At some point in the future, say one year, taxes will have to increase to pay off this debt. Individuals will realize this. Once they do, they will realize that the current period tax cut is equivalent to a future period tax increase of the same present value. Hence, they realize that their wealth does not increase as a result of this tax cut. So, they do not increase consumption. In fact, they simply save all of the tax cut. In terms of the IS-LM model, the tax cut does not increase consumption or demand. So, the IS curve does not shift and there is no change in output or the interest rate.

Diff: 2

326 Copyright © 2021 Pearson Education, Inc.

15) Suppose the Ricardian Equivalence proposition holds (i.e., it is correct). What does this imply about the ability of fiscal policy to affect GDP? Explain.

Answer: The Ricardian Equivalence proposition describes the effects of, for example, tax cuts.

A tax cut will have no effect on the demand for goods according to the Ricardian Equivalence proposition. A tax cut in the current period will cause an increase in the budget deficit. At some point in the future, say one year, taxes will have to increase to pay off this debt. Individuals will realize this. Once they do, they will realize that the current period tax cut is equivalent to a future period tax increase of the same present value. Hence, they realize that their wealth does not increase as a result of this tax cut. So, they do not increase consumption. In fact, they simply save all of the tax cut. In terms of the IS-LM model, the tax cut does not increase consumption or demand. So, the IS curve does not shift and there is no change in output or the interest rate.

Simply put, the tax cut will have no effect on household consumption. So, all we would observe is an increase in private saving, no change in consumption, no change in demand, and no change in output.

Diff: 2 16) For this question, assume that Ricardian Equivalence proposition does not hold. Briefly discuss the short-run, medium-run and long-run effects of a fiscal expansion (e.g. tax cut).

Answer: Answers could be quite long. In the short run, fiscal policy can affect the level of output, the composition of output, the price level, and financial market variables. In the medium run, changes in fiscal policy will not affect the level of output; however, they will affect the composition of GDP and financial market variables. So, a fiscal expansion would have no effect on output in the medium run. In the long run, fiscal policy will affect output. It will do so by affecting the level of national saving.

Diff: 2 17) Explain what is meant by automatic stabilizers and how they work to minimize fluctuations in economic activity.

Answer: Automatic stabilizers refer to the effect that changes in economic activity have on the size of the actual deficit. The fact that T will automatically fall as Y falls, will dampen the effects of any negative shock on the economy.

Diff: 2 18) First, define and explain the cyclically adjusted deficit. Second, explain what effect a recession caused, for example, by a reduction in consumer confidence will have on the size of the cyclically adjusted deficit.

Answer: The cyclically adjusted deficit is the deficit that would occur if the economy were operating at the natural level of output. In terms of notation, it would be represented as G - T0 tYN where T0 is autonomous taxes, YN is the natural level of output, and t is the average income tax rate. Deviations in output from YN will not cause changes in the cyclically adjusted deficit. So, a consumption-led recession will have no effect on this particular measure of the budget.

Diff: 2

327 Copyright © 2021 Pearson Education, Inc.

22.4

The Dangers of High Debt

1) Very high debt burdens can result in A) fine tuning.

B) automatic stabilizer.

C) the structural deficit.

D) tax smoothing.

E) debt repudiation.

Answer: E Diff: 2 2) Based on our understanding of the U.S. budget, we know that A) government accounts treat asset sales as revenues.

B) government accounts do not treat asset sales as revenues.

C) the NIPA accounts treat asset sales as revenues.

D) neither the government accounts nor the NIPA accounts treat asset sales as revenues.

Answer: A Diff: 2 3) When a government partially defaults its debt, a "haircut" of 20% means that A) creditors receive 20% of what they owed.

B) creditors receive 80% of what they owed.

C) creditors receive 40% of what they owed.

D) creditors receive 10% of what they owed.

Answer: B Diff: 1 4) Government default is also called A) debt restructuring.

B) debt rescheduling.

C) private sector involvement.

D) all of these Answer: D Diff: 1 5) Hyperinflation refers to inflation in excess of ________ per month.

A) 30% B) 10% C) 20% D) 25% Answer: A Diff: 1

328 Copyright © 2021 Pearson Education, Inc.

6) In virtually all hyperinflations, rapid money growth begins to occur because of A) a war.

B) a change of government.

C) union demands for higher wages.

D) large and/or growing budget deficits.

E) the introduction of wage indexation in labor contracts.

Answer: D Diff: 1 7) Which of the following represents debt monetization?

A) an increase in the budget deficit that is financed by money creation B) an increase in the budget deficit that is financed by foreigner investors' purchases of domestic bonds C) an increase in the budget deficit that coincides with a central bank sale of bonds D) an open market purchase of bonds that results in inflation E) none of these Answer: A Diff: 1 8) When the budget deficit is financed entirely through money creation, the real budget deficit is equal to which of the following?

A) ΔH B) ΔH - ΔP C) (ΔH)/P D) (ΔH)/H E) P[(ΔH)/H] Answer: C Diff: 2 9) Seignorage is defined as which of the following?

A) the part of a budget deficit financed by the issuance of bonds sold to the private sector B) revenue from money creation C) the increase in income tax revenues that occurs during a hyperinflation D) the increase in income tax revenues that occurs as a result nominal income tax brackets not being adjusted to changes in E) the part of a budget deficit financed with foreign lending Answer: B Diff: 1 10) Seignorage is equal to A) the rate of inflation.

B) one divided by the rate of inflation.

C) real money balances.

D) the percentage growth rate of nominal money.

E) the percentage growth rate of nominal money times real money balances.

Answer: E Diff: 1 329 Copyright © 2021 Pearson Education, Inc.

11) Given nominal money growth, the amount of seignorage will be greater when A) tax revenues are higher.

B) real money balances are larger.

C) the inflation rate is higher.

D) foreign lending is higher.

E) none of these Answer: B Diff: 2 12) During most episodes of hyperinflation, A) the inflation rate is high but constant.

B) the inflation rate decreases over time.

C) the inflation rate increases over time.

D) the inflation rate first increases, and then remains constant.

E) the inflation rate increases over time, but then rapidly decreases on its own.

Answer: C Diff: 1 13) Hyperinflation typically leads to A) a reduction in barter.

B) a reduction in real money balances.

C) a preference for domestic over foreign currency.

D) an increase in real tax revenues collected by the government.

E) all of these Answer: B Diff: 2 14) An increase in money growth, holding all other factors constant, will cause A) a reduction in seignorage.

B) an increase in seignorage.

C) no change in seignorage.

D) an ambiguous effect on seignorage.

Answer: B Diff: 1 15) A reduction in money growth, holding all other factors constant, will cause A) a reduction in seignorage.

B) an increase in seignorage.

C) no change in seignorage.

D) an ambiguous effect on seignorage.

Answer: A Diff: 1

330 Copyright © 2021 Pearson Education, Inc.

16) Explain fiscal dominance.

Answer: Most of the time, fiscal and monetary policies proceed independently. The government finances its deficit through borrowing. The central bank chooses the supply of money so as to achieve its objective (for example, low inflation). But, when the fiscal situation is bad, either because deficits are large or debt is high, and the interest rate faced by the government is high, it becomes increasingly tempting for the government to want to finance itself through money finance. Fiscal policy then determines the behavior of the money supply, a case known as fiscal dominance.

Diff: 1 17) Explain seignorage.

Answer: The real revenue from money creation is called seignorage. It is equal to the money creation divided by the price level.

Diff: 1 18) Explain the economic costs of hyperinflation.

Answer: The transaction system works less and less well. Price signals become less and less useful. Swings in the inflation rate become larger.

Diff: 1 19) Suppose the central bank decreases the rate of growth of the money supply. What effect will this decrease in money growth have on seignorage in: (1) the short run; and (2) the medium run?

Explain.

Answer: Seignorage equals the rate of growth of H times real money balances. In the short run, the decrease in money growth will likely cause a reduction in seignorage as long as H/P does not change or does not fall significantly. H/P is a function of real income and the nominal interest rate.

In the short run, Y will fall and i will likely rise so H/P will decrease. In the medium run, Y will not change. The decreased money growth will cause a reduction in inflation and a reduction in the nominal interest rate causing H/P to increase. Therefore, the effects of a decrease in money growth on seignorage are ambiguous.

Diff: 2 20) Explain "haircuts" when a government defaults its debt.

Answer: Default is often partial and creditors take is what is known as a haircut. A haircut of 40%, for example, means that creditors receive 60% of they were owed.

Diff: 2 21) What are the primary causes of hyperinflations? Explain.

Answer: A hyperinflation simply means a very high inflation. For one to occur, money growth must also be very high. Money growth is usually very high when the government is using debt monetization to finance a large and growing budget deficit.

Diff: 2

331 Copyright © 2021 Pearson Education, Inc.

22) First, explain what seignorage is. Second, write out and explain the expression that represents seignorage. And finally, what policies can a central bank implement to increase seignorage?

Answer: Seignorage is the revenue from money creation measured in real terms, seignorage equals ΔH/P. This expression can be rearranged to yield: (ΔH/H)(H/P). The first term is simply the rate of growth of nominal money and the second term is real money balances. To increase seignorage, the central bank can increase the rate of growth of H, assuming H/P does not change.

Diff: 2 23) Suppose the central bank increases the rate of growth of the money supply. What effect will this increase in money growth have on seignorage in: (1) the short run; and (2) the medium run?

Explain.

Answer: Seignorage equals the rate of growth of H times real money balances. In the short run, the increase in money growth will likely cause an increase in seignorage as long as H/P does not change or does not fall significantly. H/P is a function of real income and the nominal interest rate.

In the short run, Y will rise and i will likely fall so H/P will increase. In the medium run, Y will not change. The increased money growth will cause an increase in inflation and an increase in the nominal interest rate causing H/P to fall. Therefore, the effects of an increase in money growth on seignorage are ambiguous.

Diff: 2 22.5

The Challenages Facing US Fiscal Policy Today

1) In 2018, the debt issued by the federal government stood at ________ of GDP. A) 104% B) 120% C) 140% D) 110% Answer: A Diff: 2 2) In 2018, the real interest rate was A) -0.3%.

B) 7%.

C) 0.4%.

D) 3%.

Answer: A Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 23: Monetary Policy: A Summing Up 23.1

What We Have Learned

1) Monetary policy affects which of the following variables in the long run?

A) the level of output B) the rate of unemployment C) the rate of inflation D) the real interest rate 332 Copyright © 2021 Pearson Education, Inc.

E) all of these Answer: C Diff: 1 2) Which of the following is a function of money?

A) medium of exchange B) provides protection from inflation C) it is a flow variable D) all of these E) none of these Answer: A Diff: 1 23.2

From Money Targeting to Inflation Targeting

1) Suppose the annual inflation rate is 10%, and an asset bought at the beginning of the year for $100,000 is sold for $115,000. If the capital-gains tax rate is 30%, what is the (approximate) effective tax rate on the sale of this asset?

A) 10% B) 20% C) 25% D) 30% E) 4% Answer: E Diff: 1 2) Which of the following would serve to reduce the costs caused by the variability of inflation?

A) seignorage B) bracket creep C) a higher capital gains tax D) indexed wages E) none of these Answer: D Diff: 1

333 Copyright © 2021 Pearson Education, Inc.

3) The nominal interest A) will never be negative.

B) can be negative if inflation is unexpected.

C) can be negative if the inflation rate is greater than the nominal interest rate.

D) can be negative if deflation occurs.

E) can be negative when the real interest rate is negative.

Answer: A Diff: 1 4) Which of the following is part of "M2" but not "M1"?

A) money market mutual fund shares B) saving deposits C) time deposits (under $100,000) D) all of these E) none of these Answer: D Diff: 1 5) M1 consists of A) currency only.

B) currency plus travelers checks only.

C) currency plus checkable deposits only.

D) checkable deposits only.

E) none of these Answer: E Diff: 1 6) Which of the following is part of M1 and part of M2?

A) currency B) travelers checks C) checkable deposits D) all of these E) none of these Answer: D Diff: 1 7) An asset is considered liquid if it A) can be used as a store of value.

B) has a guaranteed rate of return.

C) is indexed to the rate of inflation.

D) acts as a medium of exchange.

E) none of these Answer: E Diff: 1

334 Copyright © 2021 Pearson Education, Inc.

8) M2 is also referred to as which of the following?

A) currency B) narrow money C) near money D) high powered money E) none of these Answer: E Diff: 1 9) Since the 1980s, "NOW" accounts have been included in A) M1, but not M2.

B) M2, but not M1.

C) both M1 and M2.

D) the monetary base and M1, but not M2.

E) neither M1 nor M2.

Answer: C Diff: 1 10) Suppose individuals decide to reduce their holdings of money market funds. Further assume that these decisions put funds into checkable deposits. Given this information, we know that A) the demand for M1 would increase and the demand for M2 would decrease.

B) the demand for M1 would decrease and the demand for M2 would decrease.

C) the demand for M1 would increase and the demand for M2 would increase.

D) the demand for M1 would decrease and the demand for M2 would increase.

E) none of these Answer: A Diff: 1 11) The maximum number of individuals a U.S. president can appoint to the Board of governors is A) 15.

B) 12.

C) 7.

D) 4 .

E) none of these Answer: C Diff: 1 12) There are how many members of the Board of Governors in the Federal Reserve system?

A) 15 B) 12 C) 7 D) 4 E) none of these Answer: C Diff: 1 13) There are how many members of the Federal Open Market Committee?

335 Copyright © 2021 Pearson Education, Inc.

A) 15 B) 14 C) 12 D) 7 E) 5 Answer: C Diff: 1 14) The Humphrey-Hawkins Act requires the Fed to promote A) stable prices.

B) maximum employment.

C) moderate long-term interest rates.

D) all of these E) none of these Answer: D Diff: 1 15) Each governor of the Federal Reserve is A) appointed by the President to a 4-year term.

B) appointed by the President to a 14-year term.

C) appointed by the President for life.

D) elected by the Presidents of banks and savings institutions.

Answer: B Diff: 1 16) In the United States, day-to-day decisions about monetary policy are carried out by A) the Board of Governors.

B) the Chairman of the Board of Governors.

C) the Federal Open Market Committee.

D) the Open Market desk in New York.

E) none of these Answer: D Diff: 1 17) When the Fed wants to signal the public about the direction of monetary policy, it will likely use A) a change in the discount rate.

B) open market operations.

C) a change in the reserve requirement.

D) a public announcement about a change in the targeted federal funds rate.

E) all of these Answer: D Diff: 1

336 Copyright © 2021 Pearson Education, Inc.

18) Chairmen of the Federal Reserve Board A) serve 14-year terms as chairmen.

B) serve 4-year renewable terms as chairmen.

C) also serve as members of the administration.

D) serve 4-year non-renewable terms as chairmen.

E) none of these Answer: B Diff: 1 19) A change in the reserve requirement changes A) the monetary base.

B) the money multiplier.

C) the discount rate.

D) all of these E) none of these Answer: B Diff: 2 20) Which of the following statements about Fed management of the money supply is correct?

A) Over the past thirty years, the Fed has always stayed within its pre-announced target rates for growth in M2.

B) The most common tool used by the Fed is a change in the required ratio of reserves to deposits.

C) The rate at which the Fed lends money to banks is called the "Federal Funds rate."

D) The Fed must report each week to Congress on the conduct of monetary policy.

E) none of these Answer: E Diff: 1 21) Which of the following would cause a reduction in M1?

A) an increase in the required ratio of reserves to deposits B) a reduction in the discount rate C) an open market operation where the Fed sells bonds D) all of these E) none of these Answer: C Diff: 1 22) Monetary policy has short-run effects on which of the following?

A) the level of output but not its composition B) both the level and composition of output C) only the price level D) only the nominal interest rate, not the real interest rate E) none of these Answer: B Diff: 1 23) Monetary policy has medium-run effects on which of the following?

337 Copyright © 2021 Pearson Education, Inc.

A) the level of output but not its composition B) both the level and composition of output C) the nominal interest rate D) the real interest rate E) none of these Answer: C Diff: 1 24) Monetary policy has medium-run effects on which of the following?

A) the level of output but not its composition B) both the level and composition of output C) only the price level D) the level of output AND the price level E) none of these Answer: C Diff: 1 25) In the medium run, an increase in the rate of growth of nominal money will cause A) lower nominal and lower real interest rates.

B) lower nominal interest rates and no change in the real interest rate.

C) an increase in inflation and an increase in output growth.

D) a proportionate increase in inflation.

Answer: D Diff: 1 26) In the medium run, an increase in inflation causes A) an increase in the opportunity cost of holding money.

B) a reduction in the opportunity cost of holding money.

C) no change in the opportunity cost of holding money.

D) individuals to switch from holding bonds to money and increase their real money balances.

Answer: A Diff: 1 27) Bracket creep would less likely occur in which of the following?

A) a progressive income tax system B) a regressive income tax system C) a flat income tax system D) none of these Answer: B Diff: 1

338 Copyright © 2021 Pearson Education, Inc.

28) Broad money is represented by A) H. B) M1.

C) M2.

D) higher powered money.

E) the monetary base.

Answer: C Diff: 1 29) Which of the following has the tightest relation with inflation?

A) H, the monetary base B) M1 C) M2 D) M3 Answer: C Diff: 1 30) The Taylor rule (where a and b are positive parameters) is represented by A) i = i* + a(π* - π) - b(un - u).

B) i = i* + a(π - π *) + b(u - un).

C) i = i* + a(π* - π) - b(u - un).

D) none of these Answer: D Diff: 1 31) Which of the following is not a tool of the Fed? A) the discount rate B) reserve requirements C) open market operations D) the proportion of money held as currency Answer: D Diff: 1 32) The discount rate represents the interest rate on A) overnight loans between banks.

B) three-month U.S. securities.

C) municipal bonds.

D) one-year discount bonds.

E) none of these Answer: D Diff: 1

339 Copyright © 2021 Pearson Education, Inc.

33) For this question, assume that the Fed sets monetary policy according to the Taylor rule.

Suppose current U.S. macroeconomic conditions are represented by the following: π > π?* and u = un. Given this information, we would expect that the Fed will A) implement a monetary contraction.

B) implement a monetary expansion.

C) maintain its current stance of monetary policy.

D) more information is need to answer this question.

Answer: A Diff: 1 34) For this question, assume that the Fed sets monetary policy according to the Taylor rule.

Suppose current U.S. macroeconomic conditions are represented by the following: π < π?* and u = un. Given this information, we would expect that the Fed will A) implement a monetary contraction.

B) implement a monetary expansion.

C) maintain its current stance of monetary policy.

D) more information is need to answer this question.

Answer: B Diff: 1 35) For this question, assume that the Fed sets monetary policy according to the Taylor rule.

Suppose current U.S. macroeconomic conditions are represented by the following: π = π?* and u > un. Given this information, we would expect that the Fed will A) implement a monetary contraction.

B) implement a monetary expansion.

C) maintain its current stance of monetary policy.

D) more information is need to answer this question.

Answer: B Diff: 1 36) For this question, assume that the Fed sets monetary policy according to the Taylor rule.

Suppose current U.S. macroeconomic conditions are represented by the following: π = π?* and u < un. Given this information, we would expect that the Fed will A) implement a monetary contraction.

B) implement a monetary expansion.

C) maintain its current stance of monetary policy.

D) more information is need to answer this question.

Answer: A Diff: 1

340 Copyright © 2021 Pearson Education, Inc.

37) For this question, assume that the Fed sets monetary policy according to the Taylor rule.

Suppose current U.S. macroeconomic conditions are represented by the following: π > π?* and u < un. Given this information, we would expect that the Fed will A) implement a monetary contraction.

B) implement a monetary expansion.

C) maintain its current stance of monetary policy.

D) more information is need to answer this question.

Answer: A Diff: 1 38) For this question, assume that the Fed sets monetary policy according to the Taylor rule.

Suppose current U.S. macroeconomic conditions are represented by the following: π < π?* and u > un. Given this information, we would expect that the Fed will A) implement a monetary contraction.

B) implement a monetary expansion.

C) maintain its current stance of monetary policy.

D) more information is need to answer this question.

Answer: B Diff: 1 39) Which of the following would cause an increase in M1?

A) a reduction in the required ratio of reserves to deposits B) an increase in the discount rate C) an open market operation where the Fed buys bonds D) all of these E) none of these Answer: C Diff: 1 40) Explain the macroeconomic effects of changes in monetary policy in: (1) the short run; and (2) the medium run.

Answer: The answers can vary (not to mention be very long!). In the short run, we learned that changes in the money supply can affect financial market variables and economic activity (in addition to the composition of GDP). Monetary policy can also be used to affect the price level/inflation rate in the short run. In the medium run, monetary policy only affects nominal variables and, therefore, is said to be neutral.

Diff: 2 41) First, write out the equation that represents the Taylor rule. Second, discuss how the Taylor rule is used to explain the implementation of monetary policy.

Answer: The Taylor rule is represented as the following: i = i* + a(π - π*) - b(u - un). i* is the target interest rate and π* is the desired inflation rate. Two quick cases can be examined. If actual inflation is greater than π*, the central bank should raise the interest rate above the target rate. This will reduce economic activity and reduce the actual inflation rate over time. If the unemployment rate is above the natural rate, the central bank should set the interest rate below the target rate in order to stimulate economic activity.

Diff: 2 341 Copyright © 2021 Pearson Education, Inc.

42) Briefly discuss the organization of the Federal Reserve. Include in your answer a discussion of the individuals/groups who make decisions about monetary policy.

Answer: In terms of the structure of the Fed, answers should mention the 12 district banks (and their presidents), the Board of Governors, the FOMC, and, possibly, the open market desk in New York. In terms of the individuals, answers should include a discussion of the 7 governors (with 14-year terms) and the chair with a renewable 4-year term. The role that district presidents play on the FOMC should also be noted.

Diff: 2 43) Discuss and explain each of the instruments of monetary policy.

Answer: The instruments are: the discount rate, open market operations, and reserve requirements.

Diff: 2 44) Discuss the relationships among the various monetary aggregates.

Answer: Answers will include a discussion of the monetary base (H), M1, M2, and M3.

Diff: 2 45) Discuss the current debate on the optimal inflation target.

Answer: At this stage, most central banks in richer countries have an inflation target of about 2%.

They are being challenged on two fronts. Some economists want to achieve price stability — that is, 0% inflation. Others want, instead, a higher target rate of inflation, say 4%, to help prevent from falling in the liquidity trap in the future.

Diff: 2 23.3

The Optimal Inflation Rate

1) Which of the following is considered a benefit of inflation?

A) the option of a negative real interest rate B) money illusion C) seignorage D) all of these E) none of these Answer: D Diff: 1 2) Which of the following is an example of the "shoe-leather costs" of inflation?

A) a rise in the cost of primary raw materials, like leather for shoes B) an artificial rise in the capital gains tax C) the need to take more trips to the bank D) miscalculations due to money illusion E) All of these Answer: C Diff: 1

342 Copyright © 2021 Pearson Education, Inc.

3) The existence of inflation does which of the following?

A) reduces tax distortions B) allows governments to benefit from seignorage C) reduces shoe-leather costs D) reduces the costs associated with money illusion Answer: B Diff: 1 4) The existence of inflation does which of the following?

A) reduces tax distortions B) reduces shoe-leather costs C) allows for the possibility of negative real interest rates D) reduces the costs associated with money illusion Answer: C Diff: 1 5) The existence of inflation does which of the following?

A) facilitates the downward adjustment of real wages B) reduces shoe-leather costs C) reduces tax distortions D) reduces the costs associated with money illusion Answer: A Diff: 1 6) In 2018, the average inflation rate in the OECD countries was A) 1.7%.

B) 2.3%.

C) 5.2%.

D) 3.8%.

E) 10.5%.

Answer: B Diff: 1 7) Explain the costs imposed by an increase in inflation.

Answer: The answers to this question should include a discussion of: shoe-leather costs, tax distortions, money illusion, and inflation variability.

Diff: 1 8) Suppose an economy experiences an increase in inflation. Explain the possible macroeconomic benefits of this increase in inflation.

Answer: Answers should include discussions of: seignorage, the option of a negative real interest rate, and money illusion.

Diff: 1

343 Copyright © 2021 Pearson Education, Inc.

9) Explain what role money illusion plays in determining the Fed's ability to affect output in the short run.

Answer: Money illusion refers to a situation where individuals make mistakes about the distinction between nominal and real magnitudes. For example, individuals might be reluctant to accept a reduction in the nominal wage (that would cause a reduction in the real wage) while at the same time would "accept" a reduction in the real wage when inflation exists and the nominal wage does not change. Money illusion, therefore, might allow a central bank to inflate an economy and, therefore, cause output to rise temporarily.

Diff: 1 10) Explain what is meant by shoe-leather costs.

Answer: In the medium run, an increase in inflation will cause an increase in nominal interest rates. When the nominal interest rate rises, the opportunity cost of holding money increases causing individuals to reduce their money balances. Individuals, therefore, make more trips to the bank. The costs associated with this are called shoe-leather costs.

Diff: 2 11) What are the factors that will determine the optimal inflation rate?

Answer: In short, the factors that will determine the optimal inflation rate are the relative magnitudes of the costs and benefits of inflation. Therefore, on the cost side, individuals would consider: shoe-leather costs, tax distortions, money illusion, and inflation variability. On the benefit side, one would consider: seignorage, the option of a negative real interest rate, and money illusion. So, an individual would compare the costs and benefits of inflation and choose some optimal inflation rate.

Diff: 2 23.4

Unconventional Monetary Policy

1) Which of the following is not correct about quantitative easing?

A) It is one of the conventional monetary policy tools.

B) It refers to the Fed's asset purchasing program.

C) It helped reduce term premium on long-term government bonds.

D) As a result, the balance sheet of the Fed is much larger than it was before the crisis.

Answer: A Diff: 1 2) Which of the flowing is an unconventional monetary policy tool?

A) quantitative easing B) open market operation C) changing discount rate D) changing required reserve ratio Answer: A Diff: 1

344 Copyright © 2021 Pearson Education, Inc.

3) Quantitative easing has led to A) increase in monetary base.

B) decrease in monetary base.

C) increase in risk premia.

D) decrease in bank reserves at the Fed. Answer: A Diff: 1 23.5

Monetary Policy and Financial Stability

1) In the medium run, a reduction in inflation causes A) a reduction in the opportunity cost of holding money.

B) an increase in the opportunity cost of holding money.

C) no change in the opportunity cost of holding money.

D) individuals to switch from holding money to bonds and reduce their real money balances.

Answer: A Diff: 1 2) Bracket creep would be more likely occur in which of the following?

A) a progressive income tax system B) a regressive income tax system C) a flat income tax system D) none of these Answer: A Diff: 1 3) LTV ratio appears to be positively related to A) bond price.

B) stock price.

C) housing price.

D) none of these E) all of these Answer: C Diff: 1 4) An economy is said to be in the liquidity trap when the short-term ________ is down to zero.

A) real interest rate on corporate bonds B) nominal interest rate on government bonds C) nominal interest rate on corporate bonds D) real interest rate on government bonds Answer: B Diff: 1

345 Copyright © 2021 Pearson Education, Inc.

5) To deal with dangerous behavior in the financial system, macro prudential tools can be used to aim directly at A) borrowers.

B) lenders.

C) banks and other financial institutions.

D) none of these E) all of these Answer: E Diff: 1 6) Reducing the maximum LTV is likely to ________ demand and thus ________ the housing price increase.

A) decrease; slow down B) increase; slow down C) decrease; speed up D) increase; speed up Answer: A Diff: 1 7) From 2000 to 2007, which country had the highest nominal house price increase?

A) Spain B) Portugal C) Greece D) Italy Answer: A Diff: 1 8) From 2000 to 2007, which country had the maximum LTV allowed?

A) United Kingdom B) Australia C) Netherlands D) Canada E) United States Answer: C Diff: 1 9) What are the lessons from the crisis for monetary policy?

Answer: Liquidity trap has led a number of countries to explore unconventional monetary policy tools, such as QE. The crisis has shown that stable inflation is not a sufficient condition for macroeconomic stability. This is leading central banks to explore the use of macro prudential tools.

Diff: 1

346 Copyright © 2021 Pearson Education, Inc.

10) What are some of the questions about the macro prudential tools?

Answer: 1) In many cases we do not know how well these tools work; 2) there are likely to be complex interaction between the traditional monetary policy tools and these macro prudential tools. 3) Whether macro prudential tools should be under the control of the central bank or under the control of a separate authority.

Diff: 2 11) Until the 1990s, how was monetary policy typically conducted in advanced countries?

Answer: 1) The central bank chose a target rate for nominal money growth corresponding to the inflation rate it wanted to achieve in the medium run. 2) In the short run, the central bank allowed for deviations of nominal money growth from the target. 3) To communicate to the public both what it wanted to achieve in the medium run and what it intended to do in the short run, the central bank announced a range for the rate of nominal money growth it intended to achieve.

Diff: 2 12) Discuss the change of the design of monetary policy over time.

Answer: Traditionally, the design of monetary policy was focused on nominal money growth.

But, because of the poor relation between inflation and nominal money growth, this approach was abandoned by most central banks. Central banks now typically focus on an inflation rate target rather than a nominal money growth rate target. And they think about monetary policy in terms of determining the nominal interest rate rather than determining the rate of nominal money growth.

The Taylor rule gives a useful way of thinking about the choice of the nominal interest rate. The rule states that the central bank should move its interest rate in response to two main factors: the deviation of the inflation rate from the target rate of inflation, and the deviation of the unemployment rate from the natural rate of unemployment. A central bank that follows this rule will stabilize activity and achieve its target inflation rate in the medium run.

Diff: 2 Macroeconomics, 8e (Blanchard) Chapter 24: Epilogue: The Story of Macroeconomics 24.1

Keynes and the Great Depression

1) Which of the following statements about Keynes' contribution to macroeconomics is correct?

A) Although he published his most important ideas about the economy long before the 1930s, few economists paid attention to Keynes until the Great Depression proved him correct.

B) Keynes argued that depressions and recessions were almost always caused by changes in the money supply.

C) Keynes argued that balancing the budget could be an effective way to cure a recession or depression.

D) all of these E) none of these Answer: E Diff: 1 2) According to Keynes, A) the Great Depression was caused by ill-considered expansionary fiscal policy.

B) balancing the budget in the midst of a depression would be a serious mistake.

347 Copyright © 2021 Pearson Education, Inc.

C) inflation is always and everywhere a monetary phenomenon.

D) the Phillips curve is stable.

E) none of these Answer: B Diff: 1 3) Liquidity preference refers to A) Keynes' name for the demand for money.

B) the "random walk" behavior of consumption spending.

C) monetarists explanations for stagflation.

D) real business cycle theorists' explanations for stagflation.

E) the controversy sparked by the Lucas critique.

Answer: A Diff: 1 4) "In the long run, we're all dead" was Keynes' way of saying that A) intellectual pursuits, like understanding the economy, are unimportant in the scheme of things.

B) no one would appreciate his theories during his lifetime.

C) there is no point in saving for retirement.

D) it is very important to save for one's retirement.

E) none of these Answer: E Diff: 1

348 Copyright © 2021 Pearson Education, Inc.

5) "Effective demand" represents which of the following?

A) money demand B) demand for exports C) domestic demand D) the demand for labor E) aggregate demand Answer: E Diff: 1 6) Liquidity preference refers to the theory of A) money demand.

B) consumption.

C) investment.

D) expectations.

Answer: A Diff: 1 24.2

The Neoclassical Synthesis

1) The neoclassical synthesis A) was a name coined by Keynes himself for his new theories.

B) rejected virtually all of Keynes' insights.

C) held that econometric models of the economy could not be used to predict the future.

D) held that economy always operated at or very near the natural rate of unemployment.

E) was the dominant school of thought among economists in the 1950s and 1960s.

Answer: E Diff: 1 2) Which of the following was not part of the neoclassical synthesis?

A) the IS curve B) the LM curve C) the Phillips curve D) aggregate demand E) rational expectations Answer: E Diff: 1 3) Which of the following schools of thought advised against fine-tuning, due to our limited understanding of the economy?

A) Monetarist B) Keynesian C) New Keynesianism D) New growth E) Neoclassical Answer: E Diff: 1 349 Copyright © 2021 Pearson Education, Inc.

4) The intellectual leader of the monetarists was A) Robert Lucas.

B) Milton Friedman.

C) John Maynard Keynes.

D) Paul Romer.

E) John Taylor.

Answer: B Diff: 1 5) In the 1960s, the monetarist school of thought held that A) monetary and fiscal policy could explain most of the output fluctuations in U.S. history.

B) there is a long-run tradeoff between inflation and unemployment.

C) efforts to fine-tune the economy are likely to do more harm than good.

D) all of these E) none of these Answer: C Diff: 1 6) If the IS curve is relatively steep, then A) there can be no long-run tradeoff between inflation and unemployment.

B) monetary policy cannot be very effective in changing GDP. C) rational expectations theory is probably correct.

D) Ricardian equivalence most likely holds.

E) budget deficits will not affect future capital accumulation.

Answer: B Diff: 1 7) During the 1970s and 1980s, macroeconomists were busy integrating the insights of which of the following into their ideas about the economy?

A) real business cycle theory B) Keynesian theory C) supply side economics D) classical macroeconomics E) none of these Answer: E Diff: 1 8) The neoclassical synthesis had emerged by what decade?

A) 1930s B) 1940s C) 1950s D) 1960s E) 1990s Answer: C Diff: 1

350 Copyright © 2021 Pearson Education, Inc.

9) The IS-LM model was developed by A) Friedman and Phelps.

B) Hicks and Hansen.

C) Modigliani and Friedman.

D) Lucas and Sargent.

E) none of these Answer: E Diff: 1 10) The theories of consumption were developed by A) Friedman and Phelps.

B) Hicks and Hansen.

C) Modigliani and Friedman.

D) Lucas and Sargent.

Answer: C Diff: 1 11) The theories of investment were developed by A) Friedman and Phelps.

B) Hicks and Hansen.

C) Modigliani and Friedman.

D) Lucas and Sargent.

E) Tobin and Jorgenson.

Answer: E Diff: 1 12) Which of the following argued that the Great Depression was caused by monetary factors?

A) Friedman and Schwartz B) Hicks and Hansen C) Modigliani and Friedman D) Lucas and Sargent E) Tobin and Jorgenson Answer: A Diff: 1 13) Explain several of the key contributions of Keynes.

Answer: Obviously, answers to this question could be quite long. Answers should include topics like: the importance of expectations, business cycle theory, the importance of aggregate demand in causing fluctuations, liquidity preference, and the concept of the multiplier.

Diff: 1 14) Explain what is meant by liquidity preference.

Answer: Liquidity preference is the phrase Keynes gave to money demand.

Diff: 1

351 Copyright © 2021 Pearson Education, Inc.

15) Discuss what is meant by the neoclassical synthesis and explain how it emerged.

Answer: This is the title given to what was believed to be the emerging consensus in economics.

Diff: 1 16) In the 1960s, there was significant debate between Keynesians and monetarists. Explain several aspects of this debate.

Answer: There were three key areas of this debate: (1) the relative importance of monetary and fiscal policy; (2) the perceived stability of the Phillips curve; and (3) the role of policy to stabilize the economy.

Diff: 1 24.3

The Rational Expectations Critique

1) Which of the following events led to the crisis in macroeconomics and to the development of rational expectations theory?

A) the Great Depression B) the stock market crash of 1987 C) the stock market speculative bubble of the late 1990s D) stagflation in the 1970s E) large budget deficits in the 1980s Answer: D Diff: 1 2) Milton Friedman attributed the Great Depression primarily to A) the government's failure to respond to an increase in the budget deficit.

B) a reduction in the money supply.

C) economists' and policy-makers' failure to acknowledge their limited knowledge.

D) the failure of wages to rise.

E) inaccurate expectations by consumers and firms.

Answer: B Diff: 1 3) Which of the following is an implication of rational expectations theory?

A) Deviations of output from the natural rate are likely to be serious and long-lived.

B) The economy is like a complex machine, that needs to be optimally controlled with the proper policy.

C) Macroeconometric models based on past behavior will not be very useful in formulating policy.

D) Wages and prices are set almost entirely at random, so it is pointless to try to model their behavior.

E) Business cycles almost always result from a shift in aggregate demand.

Answer: C Diff: 1

352 Copyright © 2021 Pearson Education, Inc.

4) Most economists would agree that, unless it incorporates rational expectations or something like it, a model cannot account for A) the Great Depression.

B) shifts in aggregate supply.

C) the relationship between consumption and income.

D) the stagflation of the 1970s.

E) the different initial impact of a permanent versus a temporary policy change.

Answer: E Diff: 1 5) According to rational expectations theory, monetary policy will affect output only if it is A) anticipated.

B) unanticipated.

C) a very large change.

D) a very small change.

E) a policy that has been tried in the past.

Answer: A Diff: 1 6) The staggering of wage and price decisions suggests that A) people do not possess rational expectations.

B) people do possess rational expectations.

C) the economy will adjust slowly to shocks even if people possess rational expectations.

D) the Lucas critique is entirely correct.

E) real business cycle theory is correct.

Answer: C Diff: 1 7) Which of the following argued that a long-run trade-off between inflation and unemployment could not exist?

A) Friedman and Phelps B) Hicks and Hansen C) Modigliani and Friedman D) Lucas and Sargent E) Tobin and Jorgenson Answer: A Diff: 1 8) The steeper is the IS curve, A) the more effective is monetary policy.

B) the less effective is monetary policy.

C) the effectiveness of monetary policy does not change.

D) a given change in the money supply will have a greater effect on output.

Answer: A Diff: 1

353 Copyright © 2021 Pearson Education, Inc.

9) As the IS curve becomes flatter, we know that A) a given change in the money supply will cause a larger change in output.

B) a given change in the money supply will cause a smaller change in output.

C) a given change in the money supply will cause the same change in output.

D) monetary policy becomes less effective.

Answer: B Diff: 1 10) Stagflation refers to A) a reduction in inflation.

B) a simultaneous reduction in inflation and reduction in unemployment.

C) a liquidity trap.

D) reduction in the price level and a reduction in the unemployment rate.

E) none of these Answer: E Diff: 1 11) Which of the following led a strong attack against mainstream macroeconomists during the 1970s?

A) Friedman and Phelps B) Hicks and Hansen C) Modigliani and Friedman D) Lucas, Barro, and Sargent Answer: D Diff: 1 12) The research by Robert Hall on the theory of consumption suggests that the best forecast of consumption for next year would be A) unpredictable.

B) random.

C) this year's consumption.

D) last year's consumption.

Answer: C Diff: 1 13) The more staggered are labor contracts, A) the more rapidly the economy will adjust to changes in aggregate demand.

B) the less rapidly the economy will adjust to changes in aggregate demand.

C) the greater the inflationary effects of a given change in money growth in the medium run.

D) the less inflationary effects of a given change in money growth in the medium run.

Answer: A Diff: 1

354 Copyright © 2021 Pearson Education, Inc.

14) The new classical interpretation of the economy suggests that A) output is always above the natural level.

B) output is always below the natural level.

C) output is always equal to the natural level.

D) recessions will not occur.

Answer: C Diff: 1 15) The flatter is the IS curve, A) the more effective is monetary policy.

B) the less effective is monetary policy.

C) the effectiveness of monetary policy does not change.

D) a given change in the money supply will have a smaller effect on output.

Answer: B Diff: 1 16) As the IS curve becomes steeper, we know that A) a given change in the money supply will cause a larger change in output.

B) a given change in the money supply will cause a smaller change in output.

C) a given change in the money supply will cause the same change in output.

D) monetary policy becomes more effective.

Answer: A Diff: 1 17) The less staggered are labor contracts, A) the more rapidly the economy will adjust to changes in aggregate demand.

B) the less rapidly the economy will adjust to changes in aggregate demand.

C) the greater the inflationary effects of a given change in money growth in the medium run.

D) the less inflationary effects of a given change in money growth in the medium run.

Answer: B Diff: 1 18) Discuss some of the implications of rational expectations.

Answer: Answers should include a discussion of the implications of rational expectations on: (1) our understanding of the behavior of consumption and financial market variables; (2) the determinants of wage and price setting behavior; and (3) the theory, implementation, and effectiveness of policy.

Diff: 1

355 Copyright © 2021 Pearson Education, Inc.

19) First, what is the Lucas critique? Second, explain how it might relate to the implementation of monetary policy.

Answer: The Lucas critique refers to the argument made by Robert Lucas that using existing macro models to make predictions about the effects of proposed policy would not be successful.

These models' predictions were based on previous relationships that, as Lucas noted, would no longer hold as new policy is implemented. When monetary policy is implemented, these models might predict, for example, increases in output. However, as we now know, expectations of the effects of these policies would change.

Diff: 1 24.4

Developments in Macroeconomics up to the 2009 Crisis

1) According to real business cycle theorists, A) fiscal policy explains most changes in output.

B) price and wage rigidity explain most changes in output.

C) efficiency wage theory explains wage rigidity.

D) changes in output primarily represent changes in the natural level of output.

E) fiscal policy explains most changes in efficiency wage theory.

Answer: D Diff: 1 2) One problem with real business cycle theory is that A) it is more successful in explaining expansions than in explaining contractions.

B) it relies almost entirely on Keynes' original ideas, ignoring much of the progress made since then.

C) it treats government officials as well-meaning public servants, despite much evidence to the contrary.

D) it defines "productivity" in a new and not very intuitive way.

E) its models downplay the importance of technological progress in the economy.

Answer: A Diff: 1 3) Those economists who attempt to explain why wages and prices do not freely adjust would most likely be A) real business cycle theorists.

B) new classical economists.

C) new Keynesian economists.

D) new growth theorists.

E) none of these Answer: C Diff: 1

356 Copyright © 2021 Pearson Education, Inc.

4) The existence of menu costs are often used to explain why A) fiscal and monetary policies should be relatively effective.

B) the price of services, like those provided by restaurants and barbers, rise at a faster rate than the price of goods, like automobiles and clothing.

C) food prices tend to rise disproportionately rapidly in the consumer price index.

D) price and wage adjustments will be relatively rapid.

E) people prefer to look backward, instead of forward, when anticipating the future.

Answer: A Diff: 1 5) If consumers are very foresighted, we would expect actual consumption spending to A) increase during recessions.

B) increase during episodes of stagflation.

C) have no relation to wealth.

D) resemble a "random walk."

E) be entirely predictable.

Answer: D Diff: 2 6) A core belief of modern macroeconomics is that in the short run, A) fiscal policy is more effective in changing output than monetary policy.

B) monetary policy is more effective in changing output than fiscal policy.

C) fluctuations in aggregate demand affect unemployment.

D) fluctuations in aggregate demand have no impact on the price level.

E) the economy always operates at or near the natural rate of unemployment.

Answer: C Diff: 1 7) A core belief of modern macroeconomics is that in the long run, A) a change in money growth will affect the level of output, but not its composition.

B) a change in money growth will affect the composition of output, but not its level.

C) output can deviate permanently from its natural level.

D) a change in fiscal policy will not affect the composition of output.

E) greater saving will result in greater output.

Answer: E Diff: 1 8) One of the most important areas of disagreement among macroeconomists today is over A) the slope of the IS curve.

B) the slope of the LM curve.

C) the definition of consumption spending.

D) the definition of government spending.

E) none of these Answer: E Diff: 1

357 Copyright © 2021 Pearson Education, Inc.

9) Both the new classical and new Keynesian models had in common the belief that A) in the medium run, output returns to its natural level.

B) output is always at its natural level.

C) in the short run, output would likely deviate from its natural level.

D) none of these Answer: A Diff: 1 10) The main debate during the 1960s was A) between Keynesians and classicals.

B) between new Keynesians and new classicals.

C) between Keynesians and monetarists.

D) between new Keynesians and monetarists.

Answer: C Diff: 1 11) The intellectual leader of new classicals is A) Edward Prescott.

B) John Taylor.

C) Stanley Fischer.

D) Ben Bernanke.

Answer: A Diff: 1 12) Discuss new classical economics and real business cycle theory.

Answer: New classical economics refers to that area of research where it is assumed that there is sufficient wage and price flexibility. It was a fairly logical extension of Lucas' work on rational expectations. Real business cycle theory attempts to explain fluctuations in output as changes in the natural level of output.

Diff: 1 13) Explain what is meant by "new Keynesians" and discuss some of the research conducted in this area.

Answer: New Keynesians focus on the implications of market imperfections such as nominal rigidities. This research has also focused on the determination of wages (e.g. efficiency wage theory). Others have focused on "menu costs" to explain why prices might not adjust as rapidly to clear product markets.

Diff: 1 14) Briefly discuss new growth theory.

Answer: New growth theory focuses on the determinants of technological progress and on the extent to which increasing returns to scale might exist.

Diff: 1

358 Copyright © 2021 Pearson Education, Inc.

15) Explain the menu cost explanation of output fluctuations.

Answer: Each wage setter or price setter is largely indifferent as to when and how often he changes his own wage or price. Therefore, even small costs of changing prices can lead to infrequent and staggered price adjustment. This staggering leads to slow adjustment of the price level and to large aggregate output fluctuations in response to movements in aggregate demand. In short, decisions that do not matter much at the individual level (how often to change prices or wages) lead to large aggregate effects (slow adjustment of the price level, and shifts in aggregate demand that have a large effect on output).

Diff: 1 24.5

First Lessons for Macroeconomics after the Crisis

1) The crisis reflects a major intellectual failure of macroeconomics to understand the macroeconomic importance of A) financial system.

B) growth.

C) unemployment.

D) inflation.

Answer: A Diff: 1 2) Work by Doug Diamond and Philip Dybvig in the 1980s had clarified the nature of A) unemployment.

B) bank runs.

C) inflation.

D) growth.

Answer: B Diff: 1 3) Economist ________ shows the "limits of arbitrage."

A) Doug Diamond B) Andrei Shleifer C) Philip Dybvig D) Richard Thaler Answer: B Diff: 1 4) The Great Depression had led economists to suggest a larger role for A) market mechanism.

B) government intervention.

C) price mechanism.

D) international trade.

Answer: B Diff: 1

359 Copyright © 2021 Pearson Education, Inc.

5) Recent research up to the crisis proceeded mainly on three fronts. Discuss each of them.

Answer: New classical: the extent to which fluctuations in output are explained by movements in the natural level of output. New Keynesian: exploring the nature of market imperfections and nominal rigidities and the extent to which they can explain fluctuations in output. New Growth theory: examines the determinants of technological progress and the implications of increasing returns to scale for economic growth.

Diff: 1 6) Discuss the major intellectual failure on macroeconomics from the crisis.

Answer: The failure was in not realizing that such a large crisis could happen,that the characteristics of the economy were such that a relatively small shock, in this case the decrease in U.S. housing prices, could lead to a major financial and macroeconomic global crisis. The source of the failure, in turn, was a lack of focus on the role of the financial institutions in the economy.

Diff: 1 7) Discuss research on the role of banks and other financial institutions in the intermediation of funds between lenders and borrowers.

Answer: Work by Doug Diamond and Philip Dybvig in the 1980s had clarified the nature of bank runs : liquid assets and liquid liabilities created a risk of runs even for solvent banks. The problem could only be avoided by the provision of liquidity by the central bank if and when needed. Work

by Bengt Holmström and Jean Tirole had shown that liquidity issues were endemic to a modern economy. Andrei Shleifer discussed the limits of arbitrage. Behavioral economists had pointed to the way in which individuals differ from the rational individual model typically used in economics, and had drawn implications for financial markets.

Diff: 1 8) Discuss the consensus on the adjustment process after the crisis.

Answer: The crisis has raised a larger issue, about the adjustment process through which output returns to its natural level. If there is a consensus, it might be that with respect to small shocks and normal fluctuations, the adjustment process works, and policy can accelerate this return; but that, in response to large, exceptional shocks, the normal adjustment process may fail, the room for policy may be limited, and it may take a long time for the economy to repair itself.

Diff: 1 Macroeconomics, 8e (Blanchard) Appendix 1: An Introduction to National Income and Product Accounts 25.1

Multiple Choice Questions

1) If GDP exceeds GNP, we know with certainty that A) a budget deficit exists.

B) a trade surplus exists.

C) a trade deficit exists.

D) receipts of factor income from the rest of the world exceed payments of factor income to the rest of the world.

Answer: D Diff: 1 360 Copyright © 2021 Pearson Education, Inc.

2) If GDP is less than GNP, we know with certainty that A) a budget deficit exists.

B) a trade surplus exists.

C) a trade deficit exists.

D) none of these Answer: D Diff: 2 3) Net national product (NNP) is equal to A) personal income minus taxes.

B) GNP minus consumption of fixed capital.

C) GDP plus consumption of fixed capital.

D) national income plus consumption of fixed capital.

Answer: B Diff: 2 4) Which of the following is not a component of consumption?

A) nondurable goods B) purchase of a new condominium C) education expenses D) none of these Answer: B Diff: 1 5) Changes in business inventories will be positive when A) production exceeds sales.

B) production is less than sales.

C) a trade surplus exists.

D) a budget surplus exists.

Answer: A Diff: 2

361 Copyright © 2021 Pearson Education, Inc.

6) Suppose exports are greater than imports. Given this information, we know with certainty that A) a trade surplus exists.

B) GNP > GDP. C) GNP < GDP. D) the change in business inventories is positive.

Answer: A Diff: 1 7) Which of the following is not included in National Income?

A) indirect taxes B) wages and salaries C) net interest D) rental income of persons Answer: A Diff: 2 8) Which of the following is included in National Income?

A) indirect taxes B) consumption of fixed capital C) proprietors' income D) all of these Answer: C Diff: 2 9) Which of the following is not included in investment?

A) the purchase of new equipment by firms B) nondurable goods C) the purchase of a new home D) none of these Answer: B Diff: 1 10) If GDP is more than GNP, we know with certainty that A) a budget deficit exists.

B) a trade surplus exists.

C) a trade deficit exists.

D) none of these Answer: D Diff: 2 11) Changes in business inventories will be negative when A) production exceeds sales.

B) production is less than sales.

C) a trade surplus exists.

D) a budget surplus exists.

Answer: B Diff: 2 362 Copyright © 2021 Pearson Education, Inc.

12) Suppose exports are less than imports. Given this information, we know with certainty that A) a trade deficit exists.

B) GNP > GDP. C) GNP < GDP. D) the change in business inventories is positive.

Answer: A Diff: 1 Macroeconomics, 8e (Blanchard) Appendix 2: A Math Refresher 26.1

Multiple Choice Questions

1) A linear relation Y=X is represented by A) the 45 degree line.

B) X axis.

C) Y axis.

D) a ray.

Answer: A Diff: 1 2) In the linear consumption function C= c0 + c1YD, which of the following is not correct?

A) c1 is marginal propensity to consume B) YD is disposable income C) c1 is the intercept D) c1 is the slope Answer: C Diff: 1 3) Which of the following is not correct?

A) GDP grows at a constant rate every year.

B) A recession may lead to a few years of negative GDP growth.

C) The evolution of GDP would be better represented by using a logarithmic scale.

D) The Great Depression was not associated with a permanently lower level of output.

Answer: A Diff: 1 4) In the linear consumption function C= c0 + c1YD, which of the following is correct?

A) c1 is marginal propensity to consume B) YD is real GDP C) c1 is the intercept D) c0 is the slope Answer: A Diff: 1 363 Copyright © 2021 Pearson Education, Inc.

5) If the evolution of X using logarithmic scale is a straight line, then A) X is growing at a constant rate over time.

B) X is a linear function of time t.

C) X is growing at different rates over time.

D) none of these Answer: A Diff: 1 6) If the evolution of X using logarithmic scale is not a straight line, then A) X is growing at a constant rate over time.

B) X is a linear function of time t.

C) X is growing at different rates over time.

D) none of these Answer: C Diff: 1 Macroeconomics, 8e (Blanchard) Appendix 3: An Introduction to Econometrics 27.1

Multiple Choice Questions

1) "Ordinary least squares" is a technique that can be used to A) identify the best model.

B) determine which variables in a model are endogenous and which are exogenous.

C) obtain a bar graph showing successive quarterly increases in output.

D) obtain a line describing consumption behavior in the real world.

E) determine the direction of causation between consumption and income.

Answer: D Diff: 1 2) When we estimate a regression to determine the relationship between changes in consumption and changes in current income, we find that A) there are no residuals.

B) the R2 is zero.

C) the MPC is larger than one.

D) all of these E) none of these Answer: E Diff: 1 3) When we use ordinary least squares to determine the relationship between changes in consumption and changes in both current and lagged income, we find that A) only current income influences current consumption.

B) current income has no impact on current consumption.

C) consumption is not affected by income in any quarter.

D) current income, last quarter's income, and income two quarter's ago all have the same impact on 364 Copyright © 2021 Pearson Education, Inc.

current consumption.

E) current income has a greater impact on consumption than income lagged one quarter.

Answer: E Diff: 1 4) When estimating a regression line, a high R2‚ tells us we have A) a good fit.

B) large residuals.

C) correctly determined the direction of causation.

D) all of these E) none of these Answer: A Diff: 1

365 Copyright © 2021 Pearson Education, Inc.

5) A large "T-statistic" tell us that A) a tiny change in the independent variable will cause a relatively large change in the dependent variable.

B) we do not have enough data to obtain an accurate regression line.

C) we can be confident that our estimated coefficient is not zero.

D) we should have included more "lags" in our model.

E) we have incorrectly switched the dependent and independent variables in our model.

Answer: C Diff: 1 6) Which of the following problems would lead an economist to use instrument variable methods?

A) The dependent variable has an impact on the independent variable.

B) There are too few quarters of data.

C) There are too many independent variables.

D) The R2 is too high.

E) The residuals are too small.

Answer: A Diff: 1 7) A key step in using instrument variable methods is to A) find one or more exogenous variables that influence your dependent variable.

B) decrease the number of lags in the regression equation.

C) conduct interviews to determine how accurate your data really is.

D) run the regression on two different computers to see if the results differ.

E) eliminate the dependent variable.

Answer: A Diff: 1

366 Copyright © 2021 Pearson Education, Inc.