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Macroeconomics, 6e (Blanchard/Johnson) Appendix 1: An Introduction to National Income and Product Accounts 26.1 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 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 the above 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 the above 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 1 Copyright © 2013 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 the above 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 the above 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 the above 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 2 Copyright © 2013 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 3 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) 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 the above E) none of the above 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 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 the above E) none of the above Answer: A Diff: 1 1 Copyright © 2013 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 2 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 1: A Tour of the World 1.1 Multiple Choice Questions 1) In 2010, output per capita in the United States was approximately equal to A) $15,500. B) $25,800. C) $43,800. D) $47,300. Answer: D Diff: 2 2) The most recent financial crisis started in A) stock market. B) bond market. C) foreign exchange market. D) housing market. Answer: D Diff: 2 3) The standard of living typically refers to A) the rate of unemployment. B) output per capita. C) wealth per capita. D) all of the above Answer: B Diff: 1 4) In 2010 , the U.S. budget deficit as a percentage of U.S. output was approximately equal to A) 1.7%. B) 9%. C) 6%. D) 16.2%. Answer: B Diff: 1 5) In 2010, the unemployment in the U.S. was A) 5%. B) 11%. C) 9.6%. D) 4.6%. Answer: C Diff: 2 1 Copyright © 2013 Pearson Education, Inc. 6) 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 the above Answer: E Diff: 2 7) Which of the following countries had the lowest level of output per capita in 2010? A) Spain B) France C) Italy D) German Answer: A Diff: 2 8) At what point could the Euro be used as currency? A) January 1, 1998 B) January 1, 1999 C) January 1, 2000 D) January 1, 2002 Answer: D Diff: 2 9) In 2010, output per capita in China was approximately equal to A) $2,100. B) $4,300. C) $22,100. D) $32,100. Answer: B Diff: 2 10) 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 2 Copyright © 2013 Pearson Education, Inc. 11) Between 2000 and 2010, the annual rate of output growth in China was approximately equal to A) 2%. B) 5%. C) 10%. D) 20%. Answer: C Diff: 2 12) 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 the above Answer: C Diff: 2 13) How many countries are in the European Union? A) 27 B) 6 C) 21 D) 17 Answer: A Diff: 2 14) How many countries are in the Euro area? A) 17 B) 27 C) 21 D) 11 Answer: A Diff: 2 15) Most economists believe that the source of European high unemployment in the past two decades is A) labor market institutions. B) tight monetary policy. C) tight fiscal policy. D) financial crisis. Answer: A Diff: 2 3 Copyright © 2013 Pearson Education, Inc. 1.2 Essay Questions 1) Briefly explain the disagreement among economists about how and when to reduce U.S. budget deficit. Answer: Some economists argue that deficit reduction should start now and proceed rapidly. Other economists argue that too fast a reduction in deficit would be dangerous. The disagreement on how deficit reduction should be achieved is along political lines. Republicans believe that it should be done primarily through decreases in spending. Democrats are more inclined to do the adjustment through an increase in taxes. 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. 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. 4) 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 inadequate macroeconomic policies. 5) 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. 4 Copyright © 2013 Pearson Education, Inc. 6) 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. 7) 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 accumulation and technological progress. 8) 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. 9) 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 de crease fell on imports f 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. 10) 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 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. 5 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 2: A Tour of the Book 2.1 Multiple Choice Questions 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 the above E) none of the above 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 the above 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 1 Copyright © 2013 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 the above Answer: D Diff: 2 2 Copyright © 2013 Pearson Education, Inc. 9) 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 10) 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 the above Answer: E Diff: 1 11) 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 12) 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 the above E) none of the above Answer: A Diff: 1 3 Copyright © 2013 Pearson Education, Inc. 13) Labor income's share in an advanced country is likely to be A) 70%. B) 45%. C) 29%. D) 10%. E) none of the above Answer: A Diff: 2 14) 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 the above Answer: B Diff: 1 Use the information provided below to answer the following questions. 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. 15) 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 16) 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 4 Copyright © 2013 Pearson Education, Inc. 17) Refer to the information above. The official unemployment rate is A) .1. B) .2. C) .33. D) .4. E) .66. Answer: C Diff: 2 18) 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 19) 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 the above Answer: E Diff: 2 20) 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 the above Answer: A Diff: 2 21) 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 the above Answer: E Diff: 2 5 Copyright © 2013 Pearson Education, Inc. 22) 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 the above Answer: C Diff: 2 23) 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 the above Answer: E Diff: 1 24) 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 the above Answer: A Diff: 2 25) Changes in GDP in the medium run are determined primarily by A) demand factors. B) supply factors. C) monetary policy. D) all of the above Answer: B Diff: 2 26) Changes in GDP in the long run are determined primarily by A) monetary policy. B) fiscal policy. C) demand. D) all of the above E) none of the above Answer: E Diff: 2 6 Copyright © 2013 Pearson Education, Inc. 27) 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 28) 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 29) 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 30) 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 31) 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 7 Copyright © 2013 Pearson Education, Inc. 32) 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 the above D) both A and B Answer: D Diff: 1 33) 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 34) 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 35) 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 36) 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 8 Copyright © 2013 Pearson Education, Inc. 37) 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 38) 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 the above Answer: E Diff: 1 39) 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 the above Answer: E Diff: 1 40) 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 41) 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 above Answer: A Diff: 1 9 Copyright © 2013 Pearson Education, Inc. 42) 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 43) 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 44) 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 45) 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 46) 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 10 Copyright © 2013 Pearson Education, Inc. 2.2 Essay Questions 1) 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. 2) 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. 3) 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. 4) 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. 5) 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. 11 Copyright © 2013 Pearson Education, Inc. 6) 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 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). 7) 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. 8) 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. 9) 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. 10) 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). 11) 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. 12) Explain Okun's Law. Answer: It shows the relationship between GDP growth and unemployment rate. If output growth is high, unemployment will decrease. 13) 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. 12 Copyright © 2013 Pearson Education, Inc. 14) 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. 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. 16) 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. 13 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 3: The Goods Market 3.1 Multiple Choice Questions 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 the above 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 the above E) only A and B Answer: D Diff: 1 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 the above 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 1 Copyright © 2013 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 the above 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 the above Answer: E Diff: 2 7) 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 the above Answer: D Diff: 1 8) 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 9) 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 the above Answer: E Diff: 1 2 Copyright © 2013 Pearson Education, Inc. 10) 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 11) 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 the above Answer: A Diff: 2 12) 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 the above Answer: E Diff: 2 13) 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 14) 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 the above Answer: D Diff: 1 3 Copyright © 2013 Pearson Education, Inc. 15) 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 the above Answer: D Diff: 2 16) 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 the above Answer: D Diff: 2 17) 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 the above Answer: B Diff: 2 18) 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 4 Copyright © 2013 Pearson Education, Inc. 19) 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 the above Answer: B Diff: 2 20) 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 the above Answer: E Diff: 1 21) 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 22) 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 the above E) none of the above Answer: D Diff: 2 23) 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 5 Copyright © 2013 Pearson Education, Inc. 24) 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 the above E) none of the above Answer: D Diff: 2 25) 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 26) 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 27) 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 the above Answer: D Diff: 1 28) 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 6 Copyright © 2013 Pearson Education, Inc. 29) 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 the above Answer: D Diff: 2 30) 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 31) 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 32) 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 7 Copyright © 2013 Pearson Education, Inc. 33) 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 34) 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 35) 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 36) 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 the above Answer: D Diff: 1 8 Copyright © 2013 Pearson Education, Inc. 37) 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 38) 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 39) 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 40) 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 41) 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 9 Copyright © 2013 Pearson Education, Inc. 42) 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 43) 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) both B and D Answer: D Diff: 2 44) 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 45) 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) both A and B Answer: A Diff: 3 46) 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 10 Copyright © 2013 Pearson Education, Inc. 47) 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 48) 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 49) 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 11 Copyright © 2013 Pearson Education, Inc. 3.2 Essay Questions 1) 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). 2) Suppose the United States economy is represented by the following equations: Z = C + I + G C = 500 + .5YD YD = Y - T G = 2000 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. 3) 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. 4) 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. 12 Copyright © 2013 Pearson Education, Inc. 5) 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. 6) 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. 7) 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. 8) 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. 9) 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. 10) 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. 11) 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. 13 Copyright © 2013 Pearson Education, Inc. 12) 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. 13) Suppose the United States economy is represented by the following equations: Z = C + I + G C = 500 + .5YD YD = Y - T G = 2000 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. 14) Suppose the United States economy is represented by the following equations: Z = C + I + G C = 500 + .5YD YD = Y - T G = 2000 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. 15) 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. 14 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 4: Financial Markets 4.1 Multiple Choice Questions 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 the above E) none of the above Answer: C Diff: 1 2) Which of the following is a flow variable? A) income B) money C) financial wealth D) all of the above E) none of the above 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 the above 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 the above Answer: D Diff: 1 1 Copyright © 2013 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 the above 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 the above E) none of the above 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 the above 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 the above E) none of the above 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 the above Answer: D Diff: 2 2 Copyright © 2013 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) 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 12) 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 the above E) none of the above Answer: A Diff: 2 13) Which of the following is NOT an asset on a bank's balance sheet? A) reserves B) loans C) checkable deposits D) all of the above E) none of the above Answer: C Diff: 1 14) Which of the following is a liability on a bank's balance sheet? A) checkable deposits B) reserves C) loans D) all of the above E) none of the above Answer: A Diff: 1 3 Copyright © 2013 Pearson Education, Inc. 15) 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 16) 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 17) 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 the above Answer: A Diff: 2 18) 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 19) 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 4 Copyright © 2013 Pearson Education, Inc. 20) 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 21) 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 the above Answer: E Diff: 2 22) 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 23) 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 24) 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 the above Answer: E Diff: 3 5 Copyright © 2013 Pearson Education, Inc. 25) 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 the above E) none of the above Answer: B Diff: 3 26) 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 the above Answer: D Diff: 2 27) 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 the above Answer: E Diff: 1 28) 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 the above Answer: E Diff: 2 29) 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 the above Answer: D Diff: 2 6 Copyright © 2013 Pearson Education, Inc. 30) 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 31) 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 the above Answer: C Diff: 2 32) 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 the above Answer: B Diff: 2 33) 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 the above Answer: C Diff: 2 7 Copyright © 2013 Pearson Education, Inc. 34) 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) both C and D Answer: A Diff: 2 35) 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 36) 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 37) 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 the above Answer: D Diff: 2 38) 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 8 Copyright © 2013 Pearson Education, Inc. 39) 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 40) 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 41) 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 the above Answer: C Diff: 2 42) 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 the above Answer: D Diff: 2 43) 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 the above Answer: D Diff: 2 9 Copyright © 2013 Pearson Education, Inc. 44) 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 the above E) both B and C Answer: E Diff: 2 45) 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 the above E) both B and C Answer: D Diff: 2 46) 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 the above Answer: C Diff: 2 47) 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 the above Answer: A Diff: 2 48) 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 10 Copyright © 2013 Pearson Education, Inc. 49) Which of the following is an asset of a central bank? A) currency B) bonds C) reserves D) none of the above Answer: B Diff: 2 50) Which of the following is an asset for both a bank and a central bank? A) currency B) deposits C) bonds D) all of the above E) none of the above Answer: C Diff: 2 51) Which of the following affects demand for money? A) prices B) nominal income C) interest rate D) all of the above E) none of the above Answer: D Diff: 2 11 Copyright © 2013 Pearson Education, Inc. 4.2 Essay Questions 1) 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. 2) 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. 3) 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. 4) 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. 5) 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. 6) 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. 12 Copyright © 2013 Pearson Education, Inc. 7) 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. 8) 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. 9) 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. 10) 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). 11) 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. 12) 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. 13 Copyright © 2013 Pearson Education, Inc. 13) 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. 14) 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. 15) 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%. 14 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 5: Goods and Financial Markets. The IS-LM Model 5.1 Multiple Choice Questions 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 the above 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 the above E) none of the above 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) 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 the above E) none of the above Answer: C Diff: 2 1 Copyright © 2013 Pearson Education, Inc. 5) 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 the above Answer: E Diff: 2 6) 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 7) 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 the above Answer: E Diff: 1 8) 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 2 Copyright © 2013 Pearson Education, Inc. 9) 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 the above Answer: E Diff: 2 10) 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 Diff: 2 11) 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 12) 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 the above Answer: A Diff: 2 3 Copyright © 2013 Pearson Education, Inc. 13) 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 the above Answer: D Diff: 3 14) 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 15) 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 16) 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 4 Copyright © 2013 Pearson Education, Inc. 17) 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 18) 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 the above E) none of the above Answer: D Diff: 2 19) 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 20) 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 21) 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 5 Copyright © 2013 Pearson Education, Inc. 22) 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 23) 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 24) 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 25) 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 Copyright © 2013 Pearson Education, Inc. 26) 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 27) 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 28) 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 29) 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 30) 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 7 Copyright © 2013 Pearson Education, Inc. 31) 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 the above Answer: D Diff: 2 32) 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 33) 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 34) 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 35) 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 the above Answer: E Diff: 3 8 Copyright © 2013 Pearson Education, Inc. 36) 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 37) 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 38) 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 39) 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 40) 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 9 Copyright © 2013 Pearson Education, Inc. 41) 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 42) 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 43) 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 the above E) none of the above Answer: B Diff: 1 44) 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 45) 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 10 Copyright © 2013 Pearson Education, Inc. 46) 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 the above Answer: B Diff: 2 47) 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 48) 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 the above Answer: B Diff: 2 49) 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 50) 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 11 Copyright © 2013 Pearson Education, Inc. 51) 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 52) 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 53) 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 54) 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 55) 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 the above E) none of the above Answer: B Diff: 2 12 Copyright © 2013 Pearson Education, Inc. 56) 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 5.2 Essay Questions 1) 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. 2) 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. 3) 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. 4) 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. 13 Copyright © 2013 Pearson Education, Inc. 5) 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. 6) 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). 7) 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. 8) 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. 9) 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. 10) 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. 14 Copyright © 2013 Pearson Education, Inc. 11) 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. 12) 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. 13) 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. 14) 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. 15) 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. 16) 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). 15 Copyright © 2013 Pearson Education, Inc. 17) 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. 16 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 6: The Labor Market 6.1 Multiple Choice Questions 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 the above Answer: E Diff: 1 Use the information provided below to answer the following questions. 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 1 Copyright © 2013 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 the above E) none of the above Answer: E Diff: 2 6) 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 the above Answer: E Diff: 2 7) 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 8) 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 the above E) none of the above Answer: B Diff: 1 9) 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 the above Answer: E Diff: 1 2 Copyright © 2013 Pearson Education, Inc. 10) When the Current Population Survey (CPS) was introduced in 1940, it was based on a survey of approximately 8000 households. The CPS survey is now based on a survey of how many households? A) 8,000 B) 10,000 C) 12,0000 D) 20,000 E) 60,000 Answer: E Diff: 2 11) As the unemployment rate falls, A) the proportion of the unemployed finding a job increases. B) the separation rate increases. C) the young and unskilled experience larger-than-average decreases in unemployment. D) both A and C. E) all of the above Answer: D Diff: 2 12) 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 the above Answer: B Diff: 1 13) 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 the above Answer: E Diff: 1 14) 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 3 Copyright © 2013 Pearson Education, Inc. 15) 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 the above Answer: C Diff: 2 16) 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 17) 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 the above Answer: C Diff: 1 18) 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 the above E) none of the above Answer: C Diff: 1 19) 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 4 Copyright © 2013 Pearson Education, Inc. 20) 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 the above Answer: C Diff: 2 21) 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 the above Answer: E Diff: 2 22) 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 23) 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 5 Copyright © 2013 Pearson Education, Inc. 24) 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 25) 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 the above E) none of the above Answer: B Diff: 2 26) 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 27) 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 28) The participation rate in the United States in 2010 was approximately equal to A) 96%. B) 90%. C) 65%. D) 26%. E) 5%. Answer: C Diff: 1 6 Copyright © 2013 Pearson Education, Inc. 29) 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 30) The average amount of time people spend unemployed is approximately A) 1 month. B) 6 months . C) 12 months. D) none of the above Answer: D Diff: 2 31) The Current Population Survey interviews approximately how many households each month? A) 5000 B) 10,000 C) 60,000 D) 100,000 Answer: C Diff: 1 32) 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 33) 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 7 Copyright © 2013 Pearson Education, Inc. 34) 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 the above Answer: C Diff: 2 35) 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 36) 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 37) 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 the above Answer: E Diff: 2 38) 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 the above Answer: D Diff: 2 8 Copyright © 2013 Pearson Education, Inc. 39) 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 40) 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 41) 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 42) Suppose the aggregate production function is given by the following: Y = AN. Given this information, we know that labor productivity is represented by the following: A) 1/A B) A C) 1/N D) N/Y Answer: B Diff: 2 43) Suppose the aggregate production function is given by the following: Y = N. Given this information, we know that labor productivity is represented by the following: A) 1/N B) N C) N/Y D) 1 Answer: D Diff: 2 9 Copyright © 2013 Pearson Education, Inc. 44) 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 the above Answer: B Diff: 2 45) 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 the above Answer: A Diff: 2 46) 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 the above Answer: C Diff: 2 47) 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 48) Based on our understanding of the labor market model presented in Chapter 6, 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) both B and C Answer: A Diff: 2 10 Copyright © 2013 Pearson Education, Inc. 49) Based on our understanding of the labor market model presented in Chapter 6, 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) both B and C Answer: B Diff: 2 50) Based on our understanding of the labor market model presented in Chapter 6, 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 51) For this question, assume that Y = N. Based on our understanding of the labor market model presented in Chapter 6, 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 52) For this question, assume that Y = N. Based on our understanding of the labor market model presented in Chapter 6, 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 53) 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 11 Copyright © 2013 Pearson Education, Inc. 54) 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 55) 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 the above Answer: C Diff: 2 56) 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 the above Answer: B Diff: 2 57) 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 12 Copyright © 2013 Pearson Education, Inc. 6.2 Essay Questions 1) 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. 2) 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. 3) 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. 4) 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. 5) 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. 13 Copyright © 2013 Pearson Education, Inc. 6) 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. 7) 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. 8) 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. 9) 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. 10) 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. 11) 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. 14 Copyright © 2013 Pearson Education, Inc. 12) 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. 13) 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. 14) 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. 15) Graphically illustrate (using the WS and PS relations) and explain the effects of a reduction 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: 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. 16) 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. 15 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 7: Putting All Markets Together. The AS-AD Model 7.1 Multiple Choice Questions 1) In the aggregate supply relation, the current price level depends upon A) expected price level. B) monetary policy. C) fiscal policy. D) consumer confidence. E) all of the above Answer: A Diff: 2 2) Based on the aggregate supply relation, an increase in current output will cause A) a shift of the aggregate supply curve. B) an increase in the current price level. C) a change in the expected price level this year. D) an increase in the expected price level and an upward shift of the AS curve. E) an increase in the markup over labor costs. Answer: B Diff: 2 3) Which of the following will cause the aggregate supply curve to shift down? A) an increase in firms' markup over labor costs B) an increase in the expected price level C) an increase in unemployment benefits D) all of the above E) none of the above Answer: E Diff: 2 4) When the current price level is equal to the expected price level, we know that A) the unemployment rate is zero. B) the goods market and financial markets are in equilibrium. C) the output is equal to the natural level of output. D) the money market is in equilibrium. E) none of the above Answer: C Diff: 2 1 Copyright © 2013 Pearson Education, Inc. 5) When the economy is operating at a point where output is greater than the natural level of output, which of the following occurs? A) the unemployment rate is less than the natural unemployment rate. B) the price level is greater than the expected price level. C) the price level will be higher next period than it is this period. D) all of the above E) none of the above Answer: D Diff: 2 6) In the aggregate demand relation, an increase in the price level causes output to decrease because of its effect on A) government spending. B) the money market and, subsequently, investment. C) the nominal wage. D) firms' markup over labor costs. E) the expected price level. Answer: B Diff: 1 7) The aggregate demand curve will shift to the right when which of the following occurs? A) a reduction in the money supply B) a reduction in consumer confidence C) a rise in the price level D) a reduction in taxes E) a decrease in the price level Answer: D Diff: 2 8) Based on your understanding of the AS/AD model, which of the following is an INCORRECT statement about the short-run adjustment process for the macroeconomy? A) output in excess of the natural level leads to higher prices. B) a reduction in employment leads to lower prices. C) an increase in demand increases output. D) an increase in output above the natural level leads to higher nominal wages. E) none of the above Answer: E Diff: 2 9) Which of the following represents a short-run effect of a monetary expansion? A) an increase in output B) a reduction in the interest rate C) an increase in the price level D) all of the above E) none of the above Answer: D Diff: 2 2 Copyright © 2013 Pearson Education, Inc. 10) Suppose a central bank implements a monetary contraction. Which of the following would we expect to occur in the short run? A) a reduction in the nominal wage B) the AD curve to shift to the right C) the price setting curve to shift down D) the wage setting curve to shift upward E) the wage setting curve to shift downward Answer: A Diff: 2 11) Suppose a central bank implements a monetary contraction. Which of the following would we expect to occur in the medium run? A) a decline in output B) an increase in the interest rate C) a decrease in the nominal wage D) all of the above E) none of the above Answer: C Diff: 2 12) Assume the economy is initially operating at the natural level of output. Which of the following events will initially cause a shift of the aggregate supply curve? A) an increase in the money supply B) an increase in government spending C) an increase in consumer confidence D) all of the above E) none of the above Answer: E Diff: 2 13) Which of the following would increase the short-run output effects of a monetary expansion? A) an increase in the marginal propensity to consume B) an increase in the interest rate sensitivity of investment C) the IS curve is very flat D) all of the above E) none of the above Answer: D Diff: 3 14) The neutrality of money is consistent with which of the following statements? A) changes in the money supply will not affect employment in the short run. B) changes in the money supply will not affect employment in the medium. C) changes in the money supply will not affect the price level in the short run D) changes in the money supply will not affect the price level in the medium run Answer: C Diff: 1 3 Copyright © 2013 Pearson Education, Inc. 15) Results obtained from the Taylor model suggest that it takes roughly how long for the effects of money to become neutral? A) one month B) three months C) one year D) four years E) ten years Answer: D Diff: 2 16) Results obtained from the Taylor model suggest that the output effects of a change in the money supply are greatest after approximately how long? A) one month B) one quarter C) three quarters D) four years E) ten years Answer: C Diff: 2 17) Assume the economy is initially operating at the natural level of output. Now suppose a budget is passed that calls for an increase in government spending. This increase in government spending will, in the short run, cause an increase in A) the interest rate. B) the price level. C) the nominal wage. D) all of the above E) none of the above Answer: D Diff: 2 18) Assume the economy is initially operating at the natural level of output. Now suppose a budget is passed that calls for an increase in government spending. This increase in government spending will, in the medium run, have NO effect on which of the following? A) employment B) the interest rate C) the price level D) all of the above E) none of the above Answer: A Diff: 2 4 Copyright © 2013 Pearson Education, Inc. 19) Assume the economy is initially operating at the natural level of output. Which of the following events will NOT change the composition of output (i.e., the percentage of GDP composed of consumption, investment, ... etc.) in the medium run? A) a reduction in government spending B) a cut in taxes C) a reduction in the desire to save D) an increase in consumer confidence E) an increase in the money supply Answer: E Diff: 2 20) Assume the economy is initially operating at the natural level of output. Now suppose that individuals decide to reduce their desire to save. We know with certainty that which of the following will occur in the short run as a result of decreased desire to save? A) greater investment B) less investment C) an increase in the nominal wage D) higher output and lower investment E) no change in the economy at all Answer: C Diff: 3 21) Assume the economy is initially operating at the natural level of output. Suppose that individuals decide to decrease their saving. We know that this decreased desire to save will be "neutral" in A) the short run, but not the medium run. B) the medium run, but not the long run. C) neither the medium run nor the short run. D) both the short run and the medium run. E) none of the above Answer: C Diff: 2 22) 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 5 Copyright © 2013 Pearson Education, Inc. 23) 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 the above E) none of the above Answer: C Diff: 2 24) 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 the above Answer: C Diff: 2 25) Answer this question using the AS/AD model presented in the textbook. Which of the following would cause a reduction in the natural level of output in the medium run? A) a decrease in government spending B) a decrease in the money supply C) an increase in taxes D) both A and C E) none of the above Answer: E Diff: 2 26) The aggregate demand (AD) curve presented in the textbook has its particular shape because of which of the following explanations? A) an increase in the money supply (M) will cause a reduction in the interest rate, an increase in investment, and an increase in output . B) an increase in the aggregate price level (P) will cause an increase in the interest rate and a reduction in output. C) an increase in P will cause a reduction in the real wage, an increase in employment, and an increase in output. D) as P decreases in a closed economy, goods and services become relatively cheaper and individuals respond by increasing the quantity demanded of goods and services. Answer: B Diff: 2 6 Copyright © 2013 Pearson Education, Inc. 27) The short-run aggregate supply curve (AS) presented in the textbook has its particular shape because of which of the following explanations? A) a reduction in the aggregate price level will cause a reduction in the interest rate and an increase in output. B) an increase in the aggregate price level causes an increase in nominal money demand and an increase in the interest rate. C) a drop in the nominal wage causes an increase in the amount of output that firms are willing to produce. D) a reduction in output causes a reduction in employment, an increase in unemployment, a reduction in the nominal wage and a reduction in the price level. Answer: D Diff: 2 28) Which of the following events will NOT cause an increase in the aggregate price level? A) an increase in unemployment benefits B) an increase in the markup C) an increase in Pe D) a reduction in output E) none of the above Answer: D Diff: 2 29) Which of the following events will cause an increase in the aggregate price level? A) an increase in the unemployment benefits B) a reduction in the markup C) a reduction in Pe D) an increase in the unemployment rate E) none of the above Answer: A Diff: 2 30) If u < un, we know with certainty that A) P > Pe. B) P < Pe. C) P = Pe. D) Y < Yn. Answer: A Diff: 2 31) If Y < Yn, we know with certainty that A) P > Pe. B) P < Pe. C) P = Pe. D) u < un. Answer: B Diff: 2 7 Copyright © 2013 Pearson Education, Inc. 32) At the current level of output, suppose the actual price level is greater than the price level that individuals expect (i.e., Pt > Pet). We know that A) output is currently below the natural level of output. B) the interest rate will tend to rise as the economy adjusts to this situation. C) the nominal wage will tend to decrease as individuals revise their expectations of the price level. D) the AS curve will tend to shift down over time. E) none of the above Answer: A Diff: 2 33) A reduction in the aggregate price level will cause A) an increase in the interest rate and a leftward shift in the IS curve. B) a downward shift in the LM curve and a reduction in the interest rate. C) a reduction in investment and a reduction in output . D) an ambiguous effect on investment. Answer: B Diff: 2 34) Which of the following events will cause the largest rightward shift (as measured horizontally) of the AD curve? A) a tax increase B) a 15% reduction in the aggregate price level C) a 10% increase in the nominal money supply D) a 15% reduction in the nominal wage E) none of the above Answer: C Diff: 1 35) For this question, assume that the economy is initially operating at the natural level of output. An increase in taxes will cause which of the following? A) a reduction in output and no change in the aggregate price level in the short run B) a reduction in employment and no change in the nominal wage in the short run C) an increase in investment in the medium run D) an increase in the aggregate price level, no change in output and no change in the interest rate in the medium run Answer: C Diff: 2 8 Copyright © 2013 Pearson Education, Inc. 36) 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 37) 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 38) 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 the above Answer: E Diff: 2 39) 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 40) 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 9 Copyright © 2013 Pearson Education, Inc. 41) For this question, assume that the economy is initially operating at the natural level of output. A one- time 5% reduction in the nominal money supply will cause A) a 5% reduction in the price level in the medium run. B) a 5% increase in the interest rate (i) in the medium run. C) a 5% reduction in the real money supply in the medium run. D) all of the above Answer: A Diff: 2 42) For this question, assume that the economy is initially operating at the natural level of output. A fiscal contraction must cause A) an increase in investment in the medium run. B) a reduction in investment in the short run. C) no change in investment in the medium run. D) an increase in investment in the short run. E) none of the above Answer: E Diff: 2 43) Results obtained from the Taylor model suggest that the effects of changes in the nominal money supply are neutral after A) 2 years. B) 4 years. C) 6 years. D) 8 years. Answer: B Diff: 1 44) 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 investment in the short run. B) a reduction in the real wage in the medium run. C) an increase in the interest rate in the medium run. D) ambiguous effects on investment in the medium run. E) none of the above Answer: E Diff: 2 10 Copyright © 2013 Pearson Education, Inc. 45) For this question, assume that the economy is initially operating at the natural level of output. A simultaneous reduction in taxes and reduction in the money supply will cause which of the following? A) an increase in output and an increase in the aggregate price level in the short run B) a reduction in output and a reduction in the nominal wage in the short run C) a reduction in investment in the medium run D) a reduction in the interest rate in the medium run E) an increase in the aggregate price level, no change in output, and no change in the interest rate in the medium run Answer: C Diff: 3 46) An increase in the price of oil will tend to cause which of the following? A) an increase in the natural rate of unemployment B) an increase in the price level C) an increase in the interest rate D) all of the above Answer: D Diff: 2 47) A reduction in the price of oil will tend to cause which of the following? A) no change in the real wage in the medium run B) an increase in the aggregate price level as output increases C) an increase in investment in the medium run D) no change in the interest rate in the medium run Answer: C Diff: 2 48) As product markets become more competitive and the markup decreases, we would expect which of the following to occur? A) no change in the real wage in the medium run. B) an increase in the aggregate price level and an increase in output in the medium run. C) an increase in the interest rate in the medium run. D) no change in output in the medium run. E) an increase in the real wage in the medium run. Answer: E Diff: 2 49) Suppose the minimum wage decreases. Given this event, we would expect which of the following to occur? A) a reduction in the price level and an increase in output in the medium run B) an increase in the aggregate price level as output increases C) an increase in the interest rate in the medium run D) none of the above Answer: A Diff: 2 11 Copyright © 2013 Pearson Education, Inc. 50) When the economy is operating at a point where output is less than the natural level of output, which of the following occurs? A) the unemployment rate is greater than the natural unemployment rate. B) the price level is less than the expected price level. C) the price level will be lower next period than it is this period. D) all of the above E) none of the above Answer: D Diff: 2 51) The aggregate demand curve will shift to the left when which of the following occurs? A) an increase in the money supply. B) an increase in consumer confidence. C) a reduction in the price level. D) an increase in taxes. E) a rise in the price level. Answer: D Diff: 2 52) Which of the following represents a short-run effect of a monetary contraction? A) a reduction in output B) an increase in the interest rate C) a reduction in the price level D) all of the above E) none of the above Answer: D Diff: 2 53) Suppose a central bank implements a monetary expansion. Which of the following would we expect to occur in the short run? A) an increase in the nominal wage B) the AD curve to shift to the left C) the price setting curve to shift up D) the wage setting curve to shift downward E) the wage setting curve to shift upward Answer: A Diff: 2 54) Suppose a central bank implements a monetary expansion. Which of the following would we expect to occur in the medium run? A) an increase in output B) a decrease in the interest rate C) a decline in the nominal wage D) all of the above E) none of the above Answer: C Diff: 2 12 Copyright © 2013 Pearson Education, Inc. 55) 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 the above E) none of the above Answer: C Diff: 2 56) An increase in the aggregate price level will cause A) a reduction in the interest rate and a rightward shift in the IS curve. B) a upward shift in the LM curve and an increase in the interest rate. C) an increase in investment and an increase in output. D) an ambiguous effect on investment. Answer: B Diff: 2 57) 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 58) For this question, assume that the economy is initially operating at the natural level of output. A simultaneous increase in taxes and increase in the money supply will cause which of the following? A) a reduction in output and a reduction in the aggregate price level in the short run. B) an increase in output and an increase in the nominal wage in the short run. C) an increase in investment in the medium run. D) an increase in the interest rate in the medium run. E) a reduction in the aggregate price level, no change in output, and no change in the interest rate in the medium run. Answer: C Diff: 3 59) The current crisis and the sharp decrease in output in 2010 had its origins in A) housing market. B) stock market. C) bond market. D) foreign exchange market. Answer: A Diff: 3 13 Copyright © 2013 Pearson Education, Inc. 7.2 Essay Questions 1) Explain what the aggregate supply curve represents and why it is upward sloping. Answer: The AS curve illustrates the effects of output on the price level and is derived from the behavior of wages and prices as determined by wage setting and price setting behavior. An increase in output requires firms to increase employment. An increase in N causes a reduction in the unemployment rate. As the unemployment rate decreases, workers have more bargaining power so the nominal wage will rise. The increase in the nominal wage will cause an increase in firms' costs. As firms' costs rise, they will increase the prices as determined by price setting behavior. So, an increase in Y causes an increase in P. 2) Explain what the aggregate demand curve represents and why it is downward sloping. Answer: The AD captures the effects of the price level on output. Alternatively, the AD curve represents the combinations of P and Y that maintain equilibrium in the goods and financial markets. As P falls, the real money supply increases causing a reduction in the interest rate. The drop in the interest rate causes an increase in investment, an increase in demand, and an increase in production. So, the drop in P causes an increase in Y and the AD curve is upward sloping. 3) Explain what effect a reduction in the money supply has on the aggregate demand curve. Answer: A reduction in M causes the LM curve to shift up and the interest rate to rise. As the interest rate rises, investment and demand will decrease. Firms will respond to the drop in demand by decreasing production. This implies that the drop in M will cause the AD curve to shift to the left. 4) Explain how a reduction in each of the following variables affects the aggregate price level (P): (1) the expected price level; (2) employment; (3) the markup; and (4) unemployment benefits. Answer: A drop in the expected price level will cause wage setters to seek a lower nominal wage. As W falls, firms' costs fall. As firms' costs fall, they will set their price lower (as a markup over the now lower W). So, P will fall as the expected price falls. An increase in output requires firms to increase employment. An increase in N causes a reduction in the unemployment rate. As the unemployment rate decreases, workers have more bargaining power so the nominal wage will rise. The increase in the nominal wage will cause an increase in firms' costs. As firms' costs rise, they will increase the prices as determined by price setting behavior. So, an increase in Y causes an increase in P. A reduction in the markup means that firms are setting prices lower above given costs. So, the drop in the markup will cause a reduction in the price level. A reduction in unemployment benefits will cause the WS curve to shift down and cause wage setters to seek lower nominal wages. As W falls, firms' costs fall. As firms' costs fall, they will set their price lower (as a markup over the now lower W). So, P will fall as unemployment benefits fall. 14 Copyright © 2013 Pearson Education, Inc. 5) Suppose the economy is operating at a point where output is greater than the natural level of output. Given this information, is the actual price level equal to the expected price level at the current level of output? Explain. Answer: When Y exceeds the natural level, we know that Y must have risen above the natural level. When output is operating at the natural level, we know that the actual and expected price level are equal. When Y rises above the natural level, there will be pressure (as described in several of the above answers) for the price level to rise. As P rises, it rises above the expected level. 6) Suppose the economy is operating at a point where output is less than the natural level of output. Given this information, is the actual price level equal to the expected price level at the current level of output? Explain.. Answer: When Y is less than the natural level, we know that Y must have fallen below the natural level. When output is operating at the natural level, we know that the actual and expected price level are equal. When Y falls below the natural level, there will be pressure for the price level to fall. As P falls, it falls below the expected level. 7) When output exceeds the natural level of output, explain what adjustments will occur in the labor market and discuss what effect they will have on output and the price level. Answer: When Y exceeds the natural level, we know that Y must have risen above the natural level. When output is operating at the natural level, we know that the actual and expected price level are equal. When Y rises above the natural level, there will be pressure for the price level to rise. As P rises, it rises above the expected level. At some point, wage setters will realize that the actual price has increased and adjust their expectations of the price level (upward). When this occurs, the nominal wage will rise causing firms' costs to rise. When this occurs, the aggregate price level will rise. As P rises, M/P will fall causing the interest rate to increase. As the interest rate increases, investment, demand, and output will fall. 8) Based on your understanding of the aggregate supply and aggregate demand model and the IS-LM model, graphically illustrate and explain what effect an increase in the money supply will have on the economy. In your graphs, clearly illustrate the short-run and medium-run equilibria. Answer: This is an easy question. The increase in M will cause the LM curve to shift down and the AD curve to shift to the right. As demand increases, firms will hire workers and employment will rise and the unemployment will fall. W will rise causing the price level to rise. Expectations will adjust over time causing W to rise and the cycle reverses itself. As P rises, M/P will decrease and the interest rate will rise. The economy will move along the AD curve until the economy returns to the natural level at a higher price level. All real variables will return to their initial levels. Only nominal variables will be affected by this. 15 Copyright © 2013 Pearson Education, Inc. 9) Based on your understanding of the aggregate supply and aggregate demand model and the IS-LM model, graphically illustrate and explain what effect a tax increase will have on the economy. In your graphs, clearly illustrate the short-run and medium-run equilibria. Answer: A tax increase will cause a reduction in consumption and a leftward shift in both the IS and AD curves. As demand falls, firms will reduce employment to cut production. This will cause an increase in u and a reduction in W. As W falls, firms' costs fall and they cut prices. Once expectations adjust to the higher price level, the adjustment will be similar to that described in the textbook. The economy will return to the natural level of output at a lower price. The interest rate will be lower causing all of the decreased consumption to be offset by the increase in investment. 10) Explain what is meant by the neutrality of money. Answer: The neutrality of money refers to the medium run effects of changes in the nominal money supply. Specifically, changes in M have no medium run effects on any real variables. In the medium run, only nominal variables (W and P) change as a result of changes in M. Because changes in M have no effects on real variables in the medium, money is said to be neutral. 11) Analysis of the macroeconomic effects of changes in the money supply indicates that money is "neutral" in the medium run. Suppose there is a reduction in government spending. Will this fiscal policy action also be neutral in the medium run? Explain. Answer: Changes in G are not neutral in the medium. Despite the fact that Y returns to its original level, two other real variables are affected by G in the medium run: the interest rate and investment. Specifically, the interest rate will be permanently lower causing I to rise. So, changes in government spending, while causing some real variables to return to their original levels, does cause changes in some other real variables. 12) Based on your understanding of the aggregate supply and aggregate demand model and the IS-LM model, graphically illustrate and explain what effect a reduction in the price of oil will have on the economy. In your graphs, clearly illustrate the short-run and medium-run equilibria. Also include in your answer an explanation of the effects of this change in the price of oil on the labor market and the equilibrium real wage. Answer: The graph is easy. The drop in the price of oil is represented as a reduction in the markup. This drop in the markup will cause the PS curve to shift up as firms cut prices and cause the real wage to rise. This will also cause the natural rate of unemployment to fall and the natural levels of N and Y to increase. In the AS-AD graph, we observe a reduction in P and a downward shift in the AS curve. As P falls, M/P increases causing a drop in the interest rate and increase in investment. Demand increases and firms increase production. The standard adjustment process occurs until Y reaches the now higher natural level of output at a lower price level. The real wage is higher, the unemployment rate is lower, the interest rate is lower, and output higher. 16 Copyright © 2013 Pearson Education, Inc. 13) Based on your understanding of the aggregate supply and aggregate demand model and the IS-LM model, graphically illustrate and explain what effect an increase in the minimum wage will have on the economy. In your graphs, clearly illustrate the short-run and medium-run equilibria. Also include in your answer an explanation of the effects of this change in the minimum wage on the labor market and the equilibrium real wage. Answer: The increase in minimum wage causes the WS curve to shift up and causes an increase in the natural rate of unemployment. This will also cause the natural rate of unemployment to increase and the natural levels of N and Y to fall. In the AS-AD graph, we observe an increase in P and an upward shift in the AS curve. As P increases, M/P decreases causing an increase in the interest rate and reduction in investment. Demand falls and firms cut production. The standard adjustment process occurs until Y reaches the now lower natural level of output at a higher price level. The real wage is unchanged, the unemployment rate is higher, the interest rate is higher, and output lower. 14) Explain what effect an increase in the money supply has on the aggregate demand curve. Answer: An increase in M causes the LM curve to shift down and the interest rate to decrease. As the interest rate decreases, investment and demand will increase. Firms will respond to the rise in demand by increasing production. This implies that the increase in M will cause the AD curve to shift to the right. 15) When output is less than the natural level of output, explain what adjustments will occur in the labor market and discuss what effect they will have on output and the price level. Answer: When Y is less than the natural level, we know that Y must have fallen below the natural level. When output is operating at the natural level, we know that the actual and expected price level are equal. When Y falls below the natural level, there will be pressure for the price level to fall. As P falls, it falls below the expected level. At some point, wage setters will realize that the actual price has decreased and adjust their expectations of the price level (downward). When this occurs, the nominal wage will fall causing firms' costs to drop. When this occurs, the aggregate price level will decrease. As P falls, M/P will rise causing the interest rate to decrease. As the interest rate decreases, investment, demand, and output will increase. 16) Based on your understanding of the aggregate supply and aggregate demand model and the IS-LM model, graphically illustrate and explain what effect an decrease in the money supply will have on the economy. In your graphs, clearly illustrate the short-run and medium-run equilibria. Answer: The decrease in M will cause the LM curve to shift up and the AD curve to shift to the left. As demand decreases, firms will lay off workers and employment will drop and the unemployment will rise. W will fall causing the price level to fall. Expectations will adjust over time causing W to fall and the cycle reverses itself. As P falls, M/P will increase and the interest rate will fall. The economy will move along the AD curve until the economy returns to the natural level at a lower price level. All real variables will return to their initial levels. Only nominal variables will be affected by this. 17 Copyright © 2013 Pearson Education, Inc. 17) Based on your understanding of the aggregate supply and aggregate demand model and the IS-LM model, graphically illustrate and explain what effect a tax cut will have on the economy. In your graphs, clearly illustrate the short-run and medium-run equilibria. Answer: A tax cut will cause an increase in consumption and a rightward shift in both the IS and AD curves. As demand increases, firms will increase employment to increase production. This will cause a reduction in u and an increase in W. As W increases, firms' costs rise and they raise prices. Once expectations adjust to the higher price level, the adjustment will be similar to that described in the textbook. The economy will return to the natural level of output at a higher price. The interest rate will be higher causing all of the increased consumption to be offset by the reduction in investment. 18) Analysis of the macroeconomic effects of changes in the money supply indicates that money is "neutral" in the medium run. Suppose there is an increase in government spending. Will this fiscal policy action also be neutral in the medium run? Explain. Answer: Changes in G are not neutral in the medium. Despite the fact that Y returns to its original level, two other real variables are affected by G in the medium run: the interest rate and investment. Specifically, the interest rate will be permanently higher causing I to fall. So, changes in government spending, while causing some real variables to return to their original levels, does cause changes in some other real variables. 18 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 8: The Phillips Curve, the Natural Rate of Unemployment, and Inflation 8.1 Multiple Choice Questions 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 the above Answer: D Diff: 2 2) 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 3) 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 the above E) none of the above Answer: D Diff: 2 4) 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 1 Copyright © 2013 Pearson Education, Inc. 5) 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 the above E) none of the above Answer: D Diff: 2 6) 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 7) 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 the above Answer: A Diff: 2 8) 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 the above Answer: D Diff: 2 2 Copyright © 2013 Pearson Education, Inc. 9) 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 10) 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 the above E) none of the above Answer: B Diff: 2 11) 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 the above Answer: E Diff: 2 12) 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 the above Answer: C Diff: 2 3 Copyright © 2013 Pearson Education, Inc. 13) 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 the above Answer: E Diff: 2 14) 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 15) 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 the above Answer: E Diff: 1 16) If a country experiences persistently low inflation, which of the following tends NOT to occur? A) wage indexation will become less important B) nominal wages will be set for shorter periods of time C) the markup over labor costs will decrease D) all of the above Answer: A Diff: 2 4 Copyright © 2013 Pearson Education, Inc. 17) 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 the above Answer: D Diff: 2 18) 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 the above Answer: B Diff: 1 19) 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 20) 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 the above E) none of the above Answer: E Diff: 2 5 Copyright © 2013 Pearson Education, Inc. 21) 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 the above E) none of the above Answer: C Diff: 2 22) 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 the above E) none of the above Answer: D Diff: 2 23) 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 24) 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 6 Copyright © 2013 Pearson Education, Inc. 25) 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 26) 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 27) 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 the above Answer: D Diff: 2 28) 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 the above Answer: B Diff: 2 7 Copyright © 2013 Pearson Education, Inc. 29) 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 the above Answer: E Diff: 1 30) 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 31) 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 32) 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 the above Answer: D Diff: 1 33) 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 8 Copyright © 2013 Pearson Education, Inc. 34) 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 35) 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 36) 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 37) 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 38) 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 9 Copyright © 2013 Pearson Education, Inc. 39) 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) both A and B D) results in steadily rising inflation. Answer: D Diff: 2 40) 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 41) 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 the above Answer: A Diff: 2 42) Suppose the Phillips curve is represented by the following equation: πt - πt-1 = 20 - 2ut. Given 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 the above Answer: A Diff: 2 43) 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 10 Copyright © 2013 Pearson Education, Inc. 44) 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 the above E) none of the above Answer: D Diff: 2 45) 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 8.2 Essay Questions 1) 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. 2) 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. 3) 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. 11 Copyright © 2013 Pearson Education, Inc. 4) Explain how the original Phillips curve differs from the expectations-augmented Phillips curve (or the modified, or accelerationist Phillips curve). 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. 5) 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. 6) 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 tradeoff between inflation and unemployment. However, both argued that this trade-off could not be exploited permanently. Eventually, expectations of inflation would adjust. 7) 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. 8) 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. 9) 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. 10) 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. 12 Copyright © 2013 Pearson Education, Inc. 11) 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. 12) 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. 13) 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. 14) 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. 15) 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. 16) 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. 13 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 9: The Crisis 9.1 Multiple Choice Questions 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 the above Answer: C Diff: 1 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 1 Copyright © 2013 Pearson Education, Inc. 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 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 2 Copyright © 2013 Pearson Education, Inc. 12) AIG provide CDS against A) insolvency. B) default risk. C) illiquidity. D) none of the above 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) Collaterailzed debt obligations (CDOs) were first issued in A) 1980s. B) 1990s. C) 2000. D) 2001. Answer: A Diff: 1 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 the above 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 3 Copyright © 2013 Pearson Education, Inc. 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 20) LIBOR rate is A) interbank loan rate. B) the riskless rate. C) TED spread. D) discount rate. Answer: A Diff: 1 21) 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 4 Copyright © 2013 Pearson Education, Inc. 22) 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 the above Answer: E Diff: 1 23) 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 the above Answer: C Diff: 1 24) 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 the above Answer: B Diff: 1 25) 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 the above Answer: E Diff: 1 26) 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 5 Copyright © 2013 Pearson Education, Inc. 27) 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 the above Answer: C Diff: 1 28) 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 the above Answer: B Diff: 1 29) The reduction in Japanese stock prices in the 1990s was most likely the result of which of the following? A) contractionary monetary policy B) contractionary fiscal policy C) the end of a speculative bubble D) an increase in inflation Answer: C Diff: 1 30) One of the possible solutions for the Japanese slump is to A) implement macroeconomic policies to create inflation. B) maintain a constant aggregate price level. C) maintain the real interest rate at its original level. D) none of the above Answer: A Diff: 1 31) The Nikkei, a Japanese stock price index, reached its peak in which of the following years? A) 1980 B) 1985 C) 1989 D) 1992 E) 1995 Answer: C Diff: 1 6 Copyright © 2013 Pearson Education, Inc. 32) Which of the following has been suggested as a possible solution to the Japanese slump? A) disinflationary macroeconomic policy B) budget deficit reduction packages C) banking reform D) all of the above E) none of the above Answer: C Diff: 1 9.2 Essay Questions 1) Was the sharp house price increase from 2000 to 2006 justified? Answer: Some increase in prices was clearly justified: The 2000s were a period of unusually low interest rates. As a result, mortgage rates were also low, increasing the demand for housing and thus pushing up the price. Other factors were also at work. Mortgage lenders became increasingly willing to make loans to more risky borrowers, increasing the demand for housing. 2) Capital can help prevent banks from bankruptcy. Explain why things can still go wrong even if a banks holds some capital. Answer: First, the assets may decline in value by so much that the capital the bank holds is not enough to cover losses. Second, the bank may be still solvent but become illiquid. 3) First, explain leverage ratio. Second, discuss why banks had high leverage ratio. Answer: Leverage ratio is defined as the ratio of assets to capital. There appears to be a number of reasons why banks had high leverage ratio: First, banks probably underestimated the risk they were taking. Second, the compensation system and bonus payments also gave incentives to managers to go for high expected returns without fully taking the risk of bankruptcy into account. Third, while financial regulation required banks to keep their capital ratio above some minimum, banks found new ways of avoiding the regulation, by creating new financial structures such as SIVs 4) Explain securitization and its advantages. Answer: Securitization is the creation of securities based on a bundle of assets (for example, a bundle of loans, or a bundle of mortgages).For instance, a mortgage-based security, or MBS for short, is a title to the returns from a bundle of mortgages, with the number of underlying mortgages often in the tens of thousands. The advantage is that many investors, who would not want to hold individual mortgages, will be willing to buy and hold these securities. This increase in the supply of funds from investors is, in turn, likely to decrease the cost of borrowing. 5) What were the immediate effects of the financial crisis on the macro economy. Answer: The immediate effects of the financial crisis on the macro economy were two-fold: first, a large increase in the interest rates at which people and firms could borrow; second, a dramatic decrease in confidence. 7 Copyright © 2013 Pearson Education, Inc. 6) Discuss the initial policy responses to the financial crisis. Answer: 1) In order to prevent a run by depositors, federal deposit insurance was increased from $100,000 to $250,000 per account. 2) The Fed provided widespread liquidity to the financial system.3) The government introduced a program, called the Troubled Asset Relief Program,or TARP, aimed at cleaning up banks. 4) The Fed decreased interest rate to zero. 5) In terms of fiscal policy, US government used a combination of reductions in taxes and increases in spending: The American Recovery and Reinvestment Act, was passed in February 2009. It called for $780 billion in new measures, in the form of both tax reductions and spending increases, over 2009 and 2010. 7) Suppose a liquidity trap exists. Graphically illustrate and explain the effects of an increase in money supply using the IS-LM model. Answer: Given that the liquidity trap already exists, we know that the equilibrium in the IS-LM model occurs where the IS curve intersects the LM curve on the horizontal portion of the LM curve. When M increases,any increase in the money supply will simply be held by individuals and i will not fall. 8) Suppose a liquidity trap exists and output is below its natural level. Graphically illustrate and explain if the economy can return to its natural level using the AS-AD model. Answer: Given that the liquidity trap already exists, we know that AD curver is vertical. As output is below its natural level, the aggregate supply curve shifts down over time. The price level keeps decreasing, but this does not lead to an increase in output. 9) Explain what is meant by the liquidity trap. Also discuss the implications of a liquidity trap for the shapes of the money demand and LM curves. Answer: A liquidity trap occurs when the nominal interest rate equals zero and, therefore, can no longer fall. Usually, when there is an increase in the money supply, there would be an excess demand for bonds, an excess supply of money and the interest rate would fall. When i = 0, the return on bonds and money is the same. So, any increase in the money supply will simply be held by individuals and i will not fall. This implies that the money demand curve becomes horizontal at the zero interest rate. It also implies that LM curve becomes horizontal at the zero interest rate. 10) Suppose a liquidity trap exists. Graphically illustrate and explain the effects of an increase in government spending using the IS-LM model. Answer: Given that the liquidity trap already exists, we know that the equilibrium in the IS-LM model occurs where the IS curve intersects the LM curve on the horizontal portion of the LM curve. When G increases, demand will increase. The IS curve will shift to the right causing an increase in output. The interest rate will either not increase (because we are still operating in the presence of a liquidity trap) or increase. 8 Copyright © 2013 Pearson Education, Inc. 11) To what extent can a deflation and the presence of a liquidity trap explain the Japanese slump? Explain. Answer: Both the deflation and liquidity trap can explain the Japanese slump. We have observed sluggish or negative growth with low inflation or deflation. The destabilization effects of deflation certainly can apply to Japan. Furthermore, with nominal interest rates approaching zero, a liquidity trap may also exist where the Japanese central bank cannot increase output because it cannot push the nominal interest any lower. 12) To what extent have monetary policy and fiscal policy been able to limit the severity of the Japanese Slump? Explain. Answer: The response of monetary policy was likely too late. Once monetary policy responded, the extremely low nominal interest rates made it difficult for monetary policy to have much of an impact. Fiscal policy has also been less than successful. As noted in the chapter, the increases in government spending have been on public works type programs that have been questionable. 9 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 10: The Facts of Growth 10.1 Multiple Choice Questions 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 the above E) none of the above 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 the above Answer: B Diff: 1 1 Copyright © 2013 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) 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 the above E) none of the above Answer: D Diff: 1 7) 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 8) Between 1950 and 2004, 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 9) 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 the above Answer: A Diff: 2 2 Copyright © 2013 Pearson Education, Inc. 10) 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 11) 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 12) 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 13) 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 14) Which of the following countries experienced the lowest level of output per capita in 2009? A) United States B) France C) Japan D) United Kingdom Answer: B Diff: 1 3 Copyright © 2013 Pearson Education, Inc. 15) "Leapfrogging" refers to A) the typical irregular pattern of growth: rapid in some decades, and almost non-existent in others. B) the tendency for a country's output per capita to catch up to, and then exceed, that of another country. C) "one-upsmanship" by politicians who use growth statistics to help win elections. D) the increased likelihood that a country with very high growth will have a recession, during which some other country will have the highest growth rate. E) the interchangeability of capital and labor in the aggregate production function. Answer: B Diff: 1 16) "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 17) 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) the reduction in Y will be more than 5% but less than 10% E) none of the above Answer: C Diff: 2 18) 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 the above Answer: A Diff: 1 4 Copyright © 2013 Pearson Education, Inc. 19) 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 the above Answer: A Diff: 2 20) 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 the above Answer: C Diff: 2 21) 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 the above E) both B and C. Answer: E Diff: 2 22) 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) both A and B E) both B and C Answer: C Diff: 2 5 Copyright © 2013 Pearson Education, Inc. 23) 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 24) 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 25) 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 the above Answer: A Diff: 2 26) Which of the following countries had the highest rate of growth of output per capita between 1950 and 2009? A) United States B) France C) Japan D) United Kingdom Answer: C Diff: 2 27) By 2009, 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 6 Copyright © 2013 Pearson Education, Inc. 28) 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 29) 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 30) 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 the above Answer: E Diff: 1 31) 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 the above Answer: D Diff: 1 32) 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 7 Copyright © 2013 Pearson Education, Inc. 33) 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 34) 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 35) 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 the above Answer: D Diff: 1 36) 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 the above Answer: E Diff: 1 37) 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 8 Copyright © 2013 Pearson Education, Inc. 38) 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 39) 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 40) 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 the above Answer: C Diff: 2 41) 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 the above Answer: D Diff: 2 42) 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 the above Answer: C Diff: 2 9 Copyright © 2013 Pearson Education, Inc. 43) 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 the above Answer: D Diff: 3 44) 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 45) 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 the above Answer: C Diff: 2 46) 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 the above Answer: D Diff: 2 47) 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 10 Copyright © 2013 Pearson Education, Inc. 48) 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 the above Answer: C Diff: 2 49) 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 50) 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 10.2 Essay Questions 1) 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. 2) 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. 11 Copyright © 2013 Pearson Education, Inc. 3) 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. 4) 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. 5) 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. 6) 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. 7) 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. 8) 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. 9) 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. 12 Copyright © 2013 Pearson Education, Inc. 10) 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. 11) 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. 12) Briefly explain what effect an increase in the saving rate will have on growth. 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. 13) 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. 14) 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. 15) Consider the production function Y= K N 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. 16) Consider the production function, Y= K N , write the production function as a relation between output per worker and capital per worker. Answer: K Y = N N 13 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 11: Saving, Capital Accumulation, and Output 11.1 Multiple Choice Questions 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 the above 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 the above 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 the above 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 1 Copyright © 2013 Pearson Education, Inc. 5) Which of the following is NOT a flow variable? A) investment B) saving C) the money supply D) output E) all of the above 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 the above E) only A and B Answer: D Diff: 2 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 the above Answer: B Diff: 2 2 Copyright © 2013 Pearson Education, Inc. 9) 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 the above E) none of the above Answer: E Diff: 2 10) 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 the above Answer: C Diff: 2 11) 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 the above Answer: A Diff: 2 12) 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 3 Copyright © 2013 Pearson Education, Inc. 13) 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 14) 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 15) 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 the above Answer: E Diff: 2 16) 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 the above E) none of the above Answer: E Diff: 1 4 Copyright © 2013 Pearson Education, Inc. 17) The Social Security system in the United States was introduced in which year? A) 1915 B) 1935 C) 1945 D) 1955 E) none of the above Answer: B Diff: 1 18) 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 19) 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 the above Answer: B Diff: 2 20) 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 the above Answer: E Diff: 2 5 Copyright © 2013 Pearson Education, Inc. 21) 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 22) 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 the above Answer: B Diff: 3 23) 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 24) 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 the above E) none of the above Answer: B Diff: 1 6 Copyright © 2013 Pearson Education, Inc. 25) 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 the above Answer: A Diff: 2 26) 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 the above Answer: C Diff: 2 27) 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 28) 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 7 Copyright © 2013 Pearson Education, Inc. 29) 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 the above Answer: E Diff: 2 30) 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 the above E) none of the above Answer: E Diff: 1 31) 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 32) 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 the above E) none of the above Answer: D Diff: 2 33) 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 the above E) none of the above Answer: B Diff: 2 8 Copyright © 2013 Pearson Education, Inc. 34) 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 the above E) none of the above Answer: C Diff: 2 35) 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 36) 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 the above Answer: A Diff: 1 37) 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 the above Answer: D Diff: 1 38) 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 the above Answer: D Diff: 2 9 Copyright © 2013 Pearson Education, Inc. 39) 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 40) 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 the above Answer: D Diff: 2 41) 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 42) 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 10 Copyright © 2013 Pearson Education, Inc. 43) 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 44) 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 the above E) none of the above Answer: D Diff: 2 45) 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 the above Answer: A Diff: 2 46) 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 the above Answer: D Diff: 2 47) 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 the above E) none of the above Answer: E Diff: 2 11 Copyright © 2013 Pearson Education, Inc. 48) 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 the above Answer: B Diff: 2 49) 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 50) 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 51) 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 12 Copyright © 2013 Pearson Education, Inc. 52) 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 the above Answer: E Diff: 2 53) 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 the above Answer: B Diff: 2 54) 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 55) 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 the above E) none of the above Answer: D Diff: 2 13 Copyright © 2013 Pearson Education, Inc. 56) 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 the above Answer: D Diff: 2 57) 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 above E) none of above Answer: D Diff: 2 11.2 Essay Questions 1) 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. 2) 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. 3) 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). 4) 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. 14 Copyright © 2013 Pearson Education, Inc. 5) 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. 6) 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. 7) 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. 8) 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. 9) 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. 10) 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. 15 Copyright © 2013 Pearson Education, Inc. 11) 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). 12) 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. 13) 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. 14) 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. 15) 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. 16 Copyright © 2013 Pearson Education, Inc. 16) 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 macoeconomic 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. 17) 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. 17 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 12: Technological Progress and Growth 12.1 Multiple Choice Questions 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 the above E) none of the above Answer: A Diff: 1 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 the above E) none of the above 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 the above Answer: D Diff: 1 4) 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 the above Answer: B Diff: 2 1 Copyright © 2013 Pearson Education, Inc. 5) 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 the above E) both A and C. Answer: D Diff: 2 6) 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%. D) N and A increase by 7%. E) all of the above Answer: B Diff: 2 7) 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 Use the following information to answer the questions 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. 8) 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 2 Copyright © 2013 Pearson Education, Inc. 9) 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 10) 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 11) 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 12) 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 3 Copyright © 2013 Pearson Education, Inc. 13) 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 the above E) none of the above Answer: B Diff: 3 14) 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 the above Answer: E Diff: 2 15) 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 the above Answer: C Diff: 2 16) 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 the above E) none of the above Answer: E Diff: 2 4 Copyright © 2013 Pearson Education, Inc. 17) 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 the above Answer: B Diff: 1 18) High growth in the rich countries from 1950 to 2009 was most likely due to A) a high savings rate. B) high capital accumulation. C) technological progress. D) high consumption rates. E) monetary policy. Answer: C Diff: 1 19) Which of the following countries had the highest rate of growth of output per worker between 1950 and 2009? A) France B) Japan C) United States D) United Kingdom Answer: D Diff: 1 20) The rate of growth of output per worker in the United States between 1950 and 2009 was approximately equal to which of the following? A) 1.9% B) 3.8% C) 4.8% D) 5.8% Answer: A Diff: 1 21) From 1978 to 1995, the rate of growth of output per worker in China appears to be A) the result of capital accumulation. B) the result of technological progress. C) the result of trade barriers. D) equal to that of the United States. E) none of the above Answer: B Diff: 2 5 Copyright © 2013 Pearson Education, Inc. 22) Moore's law refers to which of the following? A) the steady state rate of growth of output per capita will equal the rate of growth of technological progress. B) the number of transistors in a chip would double approximately every 18-24 months. C) the steady state rate of growth of output per effective worker will be zero. D) the saving rate that maximizes steady state consumption is .5 (s = 0.5). E) none of the above Answer: B Diff: 2 23) The evidence shows that, over the last 25 years, spending on research and development in the rich countries has A) decreased dramatically. B) decreased slightly. C) remained constant. D) increased in absolute numbers, but decreased as a percentage of GDP. E) increased as a percentage of GDP. Answer: E Diff: 1 24) From 1995 to 2007, the rate of growth of output per worker in China has been approximately equal to A) 5% B) 9% C) 15% D) 18% E) 23% Answer: B Diff: 1 25) In 1965, Gordon Moore predicted that the number of transistors in a chip would double approximately every A) 6-12 months. B) 18-24 months. C) five years. D) 10 years. E) none of the above Answer: B Diff: 2 6 Copyright © 2013 Pearson Education, Inc. 26) 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 the above Answer: E Diff: 1 27) 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 the above Answer: D Diff: 2 28) 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 the above E) none of the above Answer: E Diff: 2 29) Which of the following is NOT constant when balanced growth is obtained? A) Y/NA B) NA C) K/NA D) all of the above E) none of the above Answer: B Diff: 2 30) 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 the above Answer: D Diff: 2 7 Copyright © 2013 Pearson Education, Inc. 31) 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 32) 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 the above Answer: A Diff: 2 33) 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 the above Answer: A Diff: 2 34) 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 8 Copyright © 2013 Pearson Education, Inc. 35) 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 36) 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 the above Answer: A Diff: 2 37) 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 the above Answer: C Diff: 2 38) 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 E) both B and C Answer: C Diff: 1 9 Copyright © 2013 Pearson Education, Inc. 39) 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 E) both B and C Answer: B Diff: 1 40) 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 41) The rate of growth of output per capita for the United States and France between 1950 and 2004 has been caused by A) the rate of technological progress. B) the saving rate. C) the accumulation of capital. D) the rate of growth of N. Answer: A Diff: 1 42) Research suggests that the relatively higher rate of growth of output per capita between in China between 1995 and 2007 was the result of which of the following? A) an increase in the rate of technological progress B) an increase in K/NA C) an increase in the rate of growth of N D) an increase in the saving rate E) both A and D Answer: E Diff: 1 43) 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 the above Answer: C Diff: 1 10 Copyright © 2013 Pearson Education, Inc. 44) 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 the above E) none of the above Answer: D Diff: 1 45) 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 the above Answer: D Diff: 1 46) 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 the above E) none of the above Answer: D Diff: 1 47) 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 48) 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 11 Copyright © 2013 Pearson Education, Inc. 49) 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 Use the information provided below to answer the following questions. δ = .11 gA = .03 gN = .02 50) 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 51) 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 52) 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 12 Copyright © 2013 Pearson Education, Inc. 53) 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 54) 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 55) 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 the above Answer: E Diff: 2 56) 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 the above Answer: E Diff: 2 13 Copyright © 2013 Pearson Education, Inc. 57) 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 the above E) none of the above Answer: E Diff: 2 58) Which country had the highest rate of technological progress from 1985 to 2009? A) Japan B) France C) United States D) United Kingdom Answer: A Diff: 2 12.2 Essay Questions 1) 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. 2) 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. 3) 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. 4) 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. 5) 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. 14 Copyright © 2013 Pearson Education, Inc. 6) 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. 7) 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. 8) 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. 9) 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. 10) 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. 15 Copyright © 2013 Pearson Education, Inc. 11) 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. 12) Discuss several of the hypotheses concerning the reduction in productivity growth in the mid-1970s. Answer: Answers can include: measurement error, the rise of the service sector, reduced R&D spending. 13) Suppose there is a decrease in the saving rate. Explain what effect this decrease in the saving rate will have on the rate of growth of output per worker. Answer: As described in answers for the previous chapter, a reduction 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. 14) 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. 15) 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. 16) Technological progress has played a very important role in China's economic growth. Where does the technological progress in China come from? Answer: There are two major channels. First, China has transferred labor from the countryside, where productivity is very low, to industry and services in the cities, where productivity is much higher. Second, China has imported the technology of more techonologically advanced countries. 17) 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. 16 Copyright © 2013 Pearson Education, Inc. Macroeconomics, 6e (Blanchard/Johnson) Chapter 13: Technological Progress: The Short, the Medium, and the Long Run 13.1 Multiple Choice Questions 1) Technological unemployment is a macroeconomic phenomenon that occurs when 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 the above E) none of the above 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 the above Answer: D Diff: 1 1 Copyright © 2013 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 the above Answer: E Diff: 2 7) An increase in productivity will likely cause A) the AS curve to shift upward, but has no effect on the AD curve. B) the AS curve to shift downward, and the AD curve to shift leftward. C) the AS curve to shift upward and the AD curve to shift rightward. D) the AS curve to shift downward and the AD curve to shift rightward. E) the AS curve to shift downward, and have an ambiguous effect on the AD curve. Answer: E Diff: 2 8) Suppose an economy experiences an increase in productivity. The AD curve will most likely shift to the left when this increase in productivity is the result of which of the following? A) a major technological breakthrough B) a reorganization of production designed to reduce costs with existing technology C) an increase in human capital D) government subsidies for higher education E) none of the above Answer: B Diff: 2 9) Employment will decrease as a result of an increase in productivity when which of the following occurs? A) the AS curve shifts downward B) output growth is less than productivity growth C) productivity growth is less than output growth D) the AD curve shifts to the right E) none of the above Answer: B Diff: 2 2 Copyright © 2013 Pearson Education, Inc. 10) 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 11) 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 the above Answer: C Diff: 2 12) 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 the above E) none of the above Answer: D Diff: 2 13) 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 the above E) none of the above Answer: D Diff: 2 3 Copyright © 2013 Pearson Education, Inc. 14) 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 the above E) none of the above Answer: E Diff: 2 15) 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 the above Answer: C Diff: 2 16) 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 the above Answer: B Diff: 2 17) 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 the above Answer: C Diff: 2 4 Copyright © 2013 Pearson Education, Inc. 18) 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 the above E) none of the above Answer: A Diff: 2 19) "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 20) 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 21) 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 the above Answer: A Diff: 2 5 Copyright © 2013 Pearson Education, Inc. 22) 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 23) 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 24) 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 25) 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 the above E) none of the above Answer: D Diff: 2 26) 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 the above Answer: E Diff: 1 6 Copyright © 2013 Pearson Education, Inc. 27) 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 the above Answer: D Diff: 1 28) 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 29) 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 30) 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 the above Answer: B Diff: 2 7 Copyright © 2013 Pearson Education, Inc. 31) 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 the above Answer: C Diff: 2 32) 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 the above Answer: A Diff: 2 33) 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 34) 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 8 Copyright © 2013 Pearson Education, Inc. 35) 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 the above Answer: A Diff: 1 36) 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 37) 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 the above Answer: E Diff: 2 38) 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 the above Answer: E Diff: 2 9 Copyright © 2013 Pearson Education, Inc. 39) 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 the above Answer: A Diff: 2 40) 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 the above E) none of the above Answer: B Diff: 1 41) 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 42) 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 43) 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 10 Copyright © 2013 Pearson Education, Inc. 44) 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 45) 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 46) 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 47) 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 the above E) none of the above Answer: D Diff: 1 11 Copyright © 2013 Pearson Education, Inc. 48) 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 the above Answer: B Diff: 1 49) 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 the above E) none of the above Answer: D Diff: 2 50) Suppose an economy experiences an increase in productivity. The AD curve will most likely shift to the right when this increase in productivity is the result of which of the following? A) a major technological breakthrough B) a reorganization of production designed to reduce costs with existing technology C) an increase in human capital D) government subsidies for higher education E) none of the above Answer: A Diff: 2 51) Employment will increase as a result of an increase in productivity when which of the following occurs? A) the AS curve shifts upward B) output growth is more than productivity growth C) productivity growth is more than output growth D) the AD curve shifts to the left E) none of the above Answer: B Diff: 2 12 Copyright © 2013 Pearson Education, Inc. 52) 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 53) 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 the above E) none of the above Answer: D Diff: 2 54) 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 the above Answer: C Diff: 2 55) 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 the above Answer: B Diff: 2 13 Copyright © 2013 Pearson Education, Inc. 13.2 Essay Questions 1) 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. 2) 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." 3) 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. 4) 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. 5) 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. 14 Copyright © 2013 Pearson Education, Inc. 6) Using the AS/AD model, graphically illustrate and explain the short-run and medium-run effects of a reduction in productivity. In your graph, clearly label all curves and equilibria. For simplicity, assume that the change in productivity has no effect on aggregate demand. Answer: The fall in A causes a new lower natural level of output. It also will cause firms to raise the price so the AS curve shifts up (horizontal distance reflects the change in the natural level of Y). So, Y falls and P increases. Expectations of P will adjust over time causing Y to reach the lower level. As P increases, M/P falls so the interest rate rises causing a reduction in investment. This is a supply shock. 7) 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. 8) 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. 9) 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. 10) Explain some of the causes of increased wage inequality. Answer: Possible causes: skill-biased technological progress and international trade. 11) 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. 15 Copyright © 2013 Pearson Education, Inc. 12) 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. 13) Using the AS/AD model, graphically illustrate and explain the short-run effect of an increase in productivity. In your graph, clearly label all curves and equilibria. Answer: An increase in A shifts the AS curve down. It has an ambiguous effect on the AD curve, which may shifts to the right or to the left. 14) 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. 15) 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. 16) 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% 16 Copyright © 2013 Pearson Education, Inc.