Name: __________________________ Date: _____________

1.The circular flow model shows that households use income for:
A) consumption, saving, and factor payments.
B) consumption, taxes, and factor payments.
C) taxes, saving, and factor payments.
D) consumption, taxes, and saving.

2.In the circular flow diagram, firms receive revenue from the _____ market, which is used
to purchase inputs in the _____ market.
A) goods; financial
B) factor; financial
C) goods; factor
D) factor; goods

3.In the circular flow model, households receive income from the _____ market and save
through the _____ market.
A) goods; financial
B) factor; financial
C) goods; factor
D) factor; goods

4.In the long run, the level of national income in an economy is determined by its:
A) factors of production and production function.
B) real and nominal interest rate.
C) government budget surplus or deficit.
D) rate of economic and accounting profit.

5.An economy's factors of production and its production function determine the economy's:
A) labor force participation rate.
B) budget surplus or deficit.
C) population growth rate.
D) output of goods and services.

6.In the long run, what determines the level of total production of goods and services in an
economy?
A) the interest rate and the amount of national saving
B) the quantity of capital, quantity of labor, and production technology
C) consumption, investment, and government spending
D) the marginal products of capital and labor, constant returns to scale, and competition

Page 1
 7.The two most important factors of production are:
A) goods and services.
B) labor and energy.
C) capital and labor.
D) saving and investment.

8.Unlike the real world, the classical model with fixed output assumes that:
A) all factors of production are fully utilized.
B) all capital is fully utilized but some labor is unemployed.
C) all labor is fully employed but some capital lies idle.
D) some capital lies idle and some labor is unemployed.

9.A production function is a technological relationship between:

A) factor prices and the marginal product of factors.
B) factors of production and factor prices.
C) factors of production and the quantity of output produced.
D) factor prices and the quantity of output produced.

10.The production function feature called constant returns to scale means that if we:
A) multiply capital by z1 and labor by z2, we multiply output by z3.
B) increase capital and labor by 10 percent each, we increase output by 10 percent.
C) increase capital and labor by 5 percent each, we increase output by 10 percent.
D) increase capital by 10 percent and increase labor by 5 percent, we increase output by
7.5 percent.

11.If an increase of an equal percentage in all factors of production results in an increase in

output of the same percentage, then a production function has the property called:
A) constant marginal product of labor.
B) increasing marginal product of labor.
C) constant returns to scale.
D) increasing returns to scale.

12.If bread is produced by using a constant returns to scale production function, then if the:
A) number of workers is doubled, twice as much bread will be produced.
B) amount of equipment is doubled, twice as much bread will be produced.
C) amounts of equipment and workers are both doubled, twice as much bread will be
produced.
D) amounts of equipment and workers are both doubled, four times as much bread will
be produced.

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 13.At any particular point in time, the output of the economy:
A) is fixed because the supplies of capital and labor and the technology are fixed.
B) is fixed because the demand for goods and services is fixed.
C) varies because the supplies of capital and labor vary.
D) varies because the technology for turning capital and labor into goods and services
varies.

14.The neoclassical theory of distribution:

A) was developed by Karl Marx.
B) is rejected by most economists today.
C) shows that the national income of an economy is not equal to total output.
D) is a theory of how national income is divided among the factors of production.

15.The price received by each factor of production for its services is determined by:
A) demand for output and supply of factors.
B) demand for factors and supply of output.
C) demand and supply of output.
D) demand and supply of factors.

16.When factor supply is fixed and quantity of the factor is graphed on the horizontal axis
while factor price is graphed on the vertical axis, the factor:
A) supply curve is horizontal.
B) supply curve is vertical.
C) supply curve slopes up to the right.
D) demand curve slopes up to the right.

17.A competitive firm:

A) is small relative to the market in which it trades.
B) has to charge a lower price when it wants to sell more goods.
C) has several large competitors with whom it engages in fierce competition.
D) can set the wage at which it hires workers.

18.A firm's economic profit is:

A) the price of output minus the wage minus the rental price of capital.
B) revenue minus costs.
C) revenue plus capital costs.
D) the price of output minus labor costs.

19.A competitive firm chooses the:

A) price at which to sell the product produced.

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B) wage to pay labor.
C) quantity of labor and capital to employ.
D) rental price to pay capital.

20.The marginal product of labor is:

A) output divided by labor input.
B) additional output produced when one additional unit of labor is added.
C) additional output produced when one additional unit of labor and one additional unit
of capital are added.
D) value of additional output when one dollar's worth of additional labor is added.

21.The property of diminishing marginal product means that, after a point, when additional
quantities of:
A) a factor are added, output diminishes.
B) both labor and capital are added, output diminishes.
C) both labor and capital are added, the marginal product of labor diminishes.
D) a factor is added when another factor remains fixed, the marginal product of that
factor diminishes.

22.A competitive, profit-maximizing firm hires labor until the:

A) marginal product of labor equals the wage.
B) price of output multiplied by the marginal product of labor equals the wage.
C) real wage equals the real rental price of capital.
D) wage equals the rental price of capital.

23.The real wage is the return to labor measured in:

A) dollars.
B) units of output.
C) units of labor.
D) units of capital.

24.The marginal product of capital is:

A) output divided by capital input.
B) additional output produced when one additional unit of capital is added.
C) additional output produced when one additional unit of capital and one additional
unit of labor are added.
D) value of additional output when one dollar's worth of additional capital is added.

25.The real rental price of capital is the price per unit of capital measured in:
A) dollars.

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B) units of output.
C) units of labor.
D) units of capital.

26.The real wage will increase if:

A) the supply of labor increases.
B) the productivity of labor increases.
C) the price of output increases.
D) the supply of capital decreases.

27.An increase in the supply of capital will:

A) increase the real rental price of capital.
B) decrease the real rental price of capital.
C) increase the productivity of capital.
D) decrease the real interest rate.

28.In the classical model, what adjusts to eliminate any unemployment of labor in the
economy?
A) the average price level
B) the interest rate
C) the real rental price of capital
D) the real wage

29.The neoclassical theory of distribution explains the allocation of:

A) output between goods and services.
B) output among consumption, investment, and government spending.
C) income among factors of production.
D) income between saving and investment.

30.Economic profit is zero if:

A) all factors are paid their marginal products and the law of diminishing returns is
valid.
B) all factors are paid their marginal products and there are constant returns to scale.
C) all firms maximize profits and none are competitive.
D) all firms maximize profits and all factors are paid their marginal products.

31.According to Euler's theorem, if competitive firms pay each factor its marginal product
and the production function has constant returns to scale, the sum of all factor payments
will equal:
A) total investment.

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B) total saving.
C) total profits.
D) total output.

32.Accounting profit is:

A) economic profit minus the return to capital.
B) equal to economic profit.
C) economic profit plus the return to capital.
D) equal to the economic return to capital.

33.According to the neoclassical theory of distribution, if firms are competitive and subject
to constant returns to scale, total income in the economy is distributed:
A) only to the labor used in production.
B) partly between labor and capital used in production, with the surplus going to the
owners of the firm as profits.
C) equally between the labor and capital used in production.
D) between the labor and capital used in production, according to their marginal
productivities.

34.According to the neoclassical theory of distribution, total output is divided between

payments to capital and payments to labor depending on their:
A) supply.
B) equilibrium growth rates.
C) relative political power.
D) marginal productivities.

35.What determines the distribution of national income between labor and capital in a
competitive, profit-maximizing economy with constant returns to scale?
A) the relative quantity of labor to capital
B) the interest rate
C) the ratio of public saving to private saving
D) the marginal productivity of labor relative to the marginal productivity of capital

36.In fourteenth-century Europe, the bubonic plague:

A) reduced the population of Europe by about one-half.
B) substantially increased economic output in Europe.
C) substantially increased real rentals on land in Europe.
D) substantially increased real wages in Europe.

37.With a CobbDouglas production function, the share of output going to labor:

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A) decreases as the amount of labor increases.
B) increases as the amount of labor increases.
C) increases as the amount of capital increases.
D) is independent of the amount of labor.

38.If output is described by the production function Y = AK 0.2L0.8, then the production
function has:
A) constant returns to scale.
B) diminishing returns to scale.
C) increasing returns to scale.
D) a degree of returns to scale that cannot be determined from the information given.

39.If Y = AK0.5L0.5 and A, K, and L are all 100, the marginal product of capital is:
A) 50.
B) 100.
C) 200.
D) 1000.

40.Since 1960, the U.S. ratio of labor income to total income has:
A) been about 2.5 to 1.
B) been about 0.7.
C) increased steadily.
D) decreased steadily.

41.If the production function describing an economy is Y = 100 K.25L.75, then the share of
output going to labor:
A) is 25 percent.
B) is 75 percent.
C) depends on the quantities of labor and capital.
D) depends on the state of technology.

42.In a CobbDouglas production function the marginal product of labor will increase if:
A) the quantity of labor increases.
B) the quantity of capital increases.
C) capital's share of output increases.
D) average labor productivity decreases.

43.In a CobbDouglas production function the marginal product of capital will increase if:
A) the quantity of labor increases.
B) the quantity of capital increases.

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C) labor's share of output increases.
D) average capital productivity decreases.

44.According to Goldin and Katz, the increasing income inequality of recent decades is the
result of:
A) increases in the rates of technological advance and educational attainment.
B) decreases in the rates of technological advance and educational attainment.
C) a steady pace of technological advance and a slowdown in educational advance.
D) a decrease in the rate of technological advance and an increase in the rate of
educational advance.

45.Skill-biased technological change ______ the demand for high-skilled workers, while the
slowdown in the pace of educational advancement reduces the supply of skilled workers,
resulting in relatively _____ wages for skilled workers.
A) increases; higher
B) increases; lower
C) decreases; higher
D) decreases; lower

46.The public policy implication of Goldin and Katz's analysis of growing income inequality
is that reversing this trend will require that more of society's resources be put into:
A) space exploration.
B) capital expenditures.
C) education.
D) transfer payments.

47.Estimates by Goldin and Katz indicate that the financial returns of a year of college
_____ between 1980 and 2005.
A) increased.
B) decreased.
C) did not change.
D) were negative.

48.According to the neoclassical theory of distribution, in an economy described by a Cobb

Douglas production function, workers should experience high rates of real wage growth
when:
A) real interest rates are high.
B) real interest rates are low.
C) average labor productivity is growing rapidly.
D) capital's share of income is growing rapidly.

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 49.According to the neoclassical theory of distribution, in an economy described by a Cobb
Douglas production function, when average labor productivity is growing rapidly:
A) labor's share of total income will be increasing.
B) labor's share of income will be decreasing.
C) workers will experience high rates of real wage growth.
D) economic profits will be positive.

50.In a closed economy, the components of GDP are:

A) consumption, investment, government purchases, and exports.
B) consumption, investment, government purchases, and net exports.
C) consumption, investment, and government purchases.
D) consumption and investment.

51.The demand for output in a closed economy is the sum of:

A) public saving and private saving.
B) the quantity of capital and labor and production technology.
C) consumption, investment, and government spending.
D) government purchases and transfer payments minus tax receipts.

52.Disposable personal income is defined as income after the payment of all:

A) taxes.
B) interest.
C) loans.
D) social insurance contributions.

53.A consumption function shows the relationship between consumption and:

A) income.
B) personal income.
C) disposable income.
D) taxes.

54.Consumption depends ______ on disposable income, and investment depends ______ on

the real interest rate.
A) positively; positively
B) positively; negatively
C) negatively; negatively
D) negatively; positively

55.The marginal propensity to consume is:

Page 9
A) normally expected to be between zero and one.
B) equal to consumption divided by disposable income.
C) normally assumed to decrease as disposable income increases.
D) normally assumed to increase as disposable income increases.

56.If the consumption function is given by C = 500 + 0.5(Y T), and Y is 6,000 and T is
given by T = 200 + 0.2Y, then C equals:
A) 2,500.
B) 2,800.
C) 3,500.
D) 4,200.

57.If the consumption function is given by the equation C = 500 + 0.5Y, the production
function is Y = 50K0.5L0.5, where K = 100 and L = 100, then C equals:
A) 1,000.
B) 2,500.
C) 3,000.
D) 5,000.

58.If the consumption function is given by C = 150 + 0.85Y and Y increases by 1 unit, then
C increases by:
A) 0.15 units.
B) 0.5 units.
C) 0.85 units.
D) 1 unit.

59.If the consumption function is given by C = 150 + 0.85Y and Y increases by 1 unit, then
savings:
A) decreases by 0.85 units.
B) decreases by 0.15 units.
C) increases by 0.15 units.
D) increases by 0.85 units.

60.If the consumption function is given by C = 150 + 0.85(Y T) and T increases by 1 unit,
then savings:
A) decreases by 0.85 units.
B) decreases by 0.15 units.
C) increases by 0.15 units.
D) increases by 0.85 units.

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 61.Assume that the consumption function is given by C = 150 + 0.85(Y T) and the tax
function is given by T = t0 + t1Y. If t0 increases by 1 unit, then consumption:
A) decreases by 0.85 units.
B) decreases by 0.15 units.
C) increases by 0.15 units.
D) increases by 0.85 units.

62.Assume that the consumption function is given by C = 150 + 0.85(Y T), the tax function
is given by T = t0 + t1Y, and Y is 5,000. If t1 decreases from 0.3 to 0.2, then consumption
increases by:
A) 85.
B) 425.
C) 500.
D) 525.

63.Assume that the consumption function is given by C = 200 + 0.7(Y T), the tax function
is given by T = 100 + t1Y, and Y = 50K0.5L0.5, where K = 100 and L = 100. If t1 increases
from 0.2 to 0.25, then consumption decreases by:
A) 70.
B) 140.
C) 175.
D) 250.

64.Assume that the consumption function is given by C = 200 + 0.7(Y T), the tax function
is given by T = 100 + 0.2Y, and Y = 50K0.5L0.5, where K = 100. If L increases from 100 to
144, then consumption increases by:
A) 560.
B) 840.
C) 1,120.
D) 2,120.

65.Investment goods as measured in the GDP are purchased by:

A) business firms alone.
B) households alone.
C) business firms and households.
D) business firms, households, and governments.

66.Total investment in the United States averages about ______ percent of GDP.
A) 10
B) 15
C) 20

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D) 25

67.Other things equal, an increase in the interest rate leads to:

A) a decrease in the quantity of investment goods demanded.
B) no change in the quantity of investment goods demanded.
C) an increase in the quantity of investment goods demanded.
D) sometimes an increase and sometimes a decrease in the quantity of investment goods
demanded.

68.When economists speak of the interest rate, they mean:

A) the rate on 90-day Treasury bills.
B) the rate on 30-year government bonds.
C) the prime rate on loans.
D) no particular interest rate, since it is assumed that various interest rates tend to move
up and down together.

69.Assume that a firm wants to build a factory that will cost $5 million. It believes that it can
get a return of $600,000 in one year and then can sell the used factory for its original cost.
The rate of return on this investment would be:
A) 6 percent.
B) 12 percent.
C) 18 percent.
D) 30 percent.

70.Assume that a firm is considering building a factory that will cost $5 million. It believes
that it can get a profit from this factory of $600,000 per year for many years. The interest
rate at which the firm can borrow money is 15 percent. After evaluating whether it should
build the factory, the firm decides that it should:
A) not build because the rate of return on the factory is only 6 percent.
B) not build because the rate of return on the factory is only 12 percent.
C) build because the rate of return on the factory is 30 percent.
D) build because the rate of return on the factory is 35 percent.

71.The home that would have the highest mortgage payment on a 30-year fixed-rate
mortgage would be a home with a mortgage of:
A) $200,000 at 8 percent.
B) $100,000 at 12 percent.
C) $100,000 at 8 percent.
D) $200,000 at 12 percent.

Page 12
 72.The nominal interest rate is the:
A) rate of interest that investors pay to borrow money.
B) same as the real interest rate.
C) rate of inflation minus the real rate of interest.
D) real rate of interest minus the rate of inflation.

73.The real interest rate is the:

A) rate of interest actually paid by consumers.
B) rate of interest actually paid by banks.
C) rate of inflation minus the nominal interest rate.
D) nominal interest rate minus the rate of inflation.

74.Assume that the investment function is given by I = 1,000 30r, where r is the real rate
of interest (in percent). Assume further that the nominal rate of interest is 10 percent and
the inflation rate is 2 percent. According to the investment function, investment will be:
A) 240.
B) 700.
C) 760.
D) 970.

75.The investment function slopes ______ because there are ______ investment projects that
are profitable as the interest rate decreases.
A) upward; fewer
B) upward; more
C) downward; fewer
D) downward; more

76.Consumption depends positively on ______ and investment depends negatively on

______.
A) disposable income; the real interest rate
B) the real interest rate; disposable income
C) private saving; public saving
D) public saving; private saving

77.The government spending component of GDP includes all of the following except:
A) federal spending on goods.
B) state and local spending on goods.
C) federal spending on transfer payments.
D) federal spending on services.

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 78.If government purchases exceed taxes minus transfer payments, then the government
budget is:
A) balanced.
B) in deficit.
C) in surplus.
D) endogenous.

79.All of the following actions increase government purchases of goods and services except
the:
A) federal government's sending a Social Security check to Betty Jones.
B) federal governments sending a paycheck to the president of the United States.
C) federal government's buying a Patriot missile.
D) city of Boston's buying a library book.

80.Government transfer payments:

A) are included as part of government purchases, G.
B) can be viewed as negative tax payments, T.
C) are received as payment for inputs in the factor market.
D) do not affect the level of public or private saving.

81.In examining the impact of fiscal policy, it is assumed that:

A) consumption, investment, and the interest rate are endogenous variables.
B) consumption, investment, and the interest rate are exogenous variables.
C) government purchases, taxes, and interest rates are endogenous variables.
D) government purchases, taxes, and interest rates are exogenous variables.

82.In a classical model with fixed factors of production and flexible prices, the amount of
consumption spending depends on _____ , the amount of investment spending depends
on _____, and the amount of government spending is determined _____.
A) the interest rate; disposable income; by tax revenue
B) the real wage; the real rental price of capital; by factor prices
C) labor's share of output; capital's share of output; by the interest rate
D) disposable income; the interest rate; exogenously

83.In the classical model with fixed output, the supply and demand for goods and services
are balanced by:
A) government spending.
B) taxes.
C) fiscal policy.
D) the interest rate.

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 84.
The equation

Y C Y T I r G
may be solved for the equilibrium level of:
A) income.
B) consumption.
C) government purchases.
D) the interest rate.

85.The demand for the economy's output:

A) is always equal to the supply, regardless of the interest rate.
B) may be computed provided that we know disposable income.
C) is equal to consumption, investment, and government purchases.
D) is determined by government purchases and taxes.

86.In the classical model with fixed income, if the demand for goods and services is less
than the supply, the interest rate will:
A) increase.
B) decrease.
C) remain unchanged.
D) either increase or decrease, depending on whether consumption is greater or less
than investment.

87.In the classical model with fixed income, if the demand for goods and services is greater
than the supply, the interest rate will:
A) increase.
B) decrease.
C) remain unchanged.
D) either increase or decrease, depending on whether consumption is greater or less
than investment.

88.In the classical model with fixed income, if the interest rate is too low, then investment is
too ______ and the demand for output ______ the supply.
A) high; exceeds
B) high; falls short of
C) low; exceeds
D) low; falls short of

89.In the classical model with fixed income, if the interest rate is too high, then investment is
too ______ and the demand for output ______ the supply.
A) high; exceeds
B) high; falls short of
C) low; exceeds

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D) low; falls short of

90.National saving refers to:

A) disposable income minus consumption.
B) taxes minus government spending.
C) income minus consumption minus government spending.
D) income minus investment.

91.Public saving is:

A) always positive.
B) always negative.
C) always zero.
D) either positive, negative, or zero.

92.In a closed economy, Y C G equals:

A) national saving.
B) private saving.
C) public saving.
D) financial saving.

93.In a closed economy, private saving equals:

A) Y C G.
B) Y T C.
C) Y I C.
D) Y T.

94.The factor that makes national saving equal investment, in equilibrium, is:
A) the interest rate.
B) private saving.
C) public saving.
D) fiscal policy.

95.Private saving is:

A) income minus consumption minus government spending.
B) disposable income minus consumption.
C) disposable income minus government spending.
D) taxes minus government spending.

96.Public saving is:

Page 16
A) income minus consumption minus government spending.
B) disposable income minus consumption.
C) disposable income minus government spending.
D) government revenue minus government spending.

97.National saving is:

A) private saving.
B) public saving.
C) private saving plus public saving.
D) private saving minus public saving.

98.If disposable income is 4,000, consumption is 3,500, government spending is 1,000, and
taxes minus transfers are 800, national saving is equal to:
A) 300.
B) 500.
C) 700.
D) 1,000.

99.If income is 4,800, consumption is 3,500, government spending is 1,000, and taxes minus
transfers are 800, private saving is:
A) 300.
B) 500.
C) 1,000.
D) 1,300.

100.If income is 4,800, consumption is 3,500, government spending is 1,000, and taxes minus
transfers are 800, public saving is:
A) 200.
B) 200.
C) 500.
D) 1,800.

101.In equilibrium, total investment equals:

A) private saving.
B) public saving.
C) national saving.
D) household saving.

102.The demand for loanable funds is equivalent to:

A) national saving.

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B) private saving.
C) public saving.
D) investment.

103.The supply of loanable funds is equivalent to:

A) national saving.
B) private saving.
C) public saving.
D) investment.

104.The supply and demand for loanable funds determines the:

A) real wage.
B) real rental price of capital.
C) real interest rate.
D) nominal interest rate.

105.If saving exceeds investment demand, and consumption is not a function of the interest
rate:
A) the demand for loans exceeds the supply of loans.
B) the interest rate will fall.
C) the interest rate will rise.
D) saving will fall.

106.In the classical model with fixed income, if households want to save more than firms
want to invest, then:
A) the interest rate rises.
B) the interest rate falls.
C) output increases.
D) output falls.

107.When the demand for loanable funds exceeds the supply of loanable funds, households
want to save ______ than firms want to invest and the interest rate ______.
A) more; rises
B) more; falls
C) less; rises
D) less; falls

108.Assume that equilibrium GDP (Y) is 5,000. Consumption (C). is given by the equation C
= 500 + 0.6Y. No government exists. In this case, equilibrium investment is:
A) 1,500.

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B) 2,000.
C) 2,500.
D) 3,000.

109.Assume that equilibrium GDP (Y) is 5,000. Consumption (C) is given by the equation C =
500 + 0.6(Y T). Taxes (T) are equal to 1,000. Government spending is 600. In this case,
equilibrium investment is:
A) 600.
B) 1,100.
C) 1,500.
D) 2,200.

110.Assume that equilibrium GDP (Y) is 5,000. Consumption (C) is given by the equation C =
500 + 0.6Y. Investment (I) is given by the equation I = 2,000 100r, where r is the real
interest rate in percent. No government exists. In this case, the equilibrium real interest
rate is:
A) 2 percent.
B) 5 percent.
C) 10 percent.
D) 20 percent.

111.Assume that equilibrium GDP (Y) is 5,000. Consumption (C) is given by the equation C =
500 + 0.6(Y T). Taxes (T) are equal to 600. Government spending is equal to 1,000.
Investment is given by the equation I = 2,160 100r, where r is the real interest rate in
percent. In this case, the equilibrium real interest rate is:
A) 5 percent.
B) 8 percent.
C) 10 percent.
D) 13 percent.

112.According to the model developed in Chapter 3, when government spending increases

without a change in taxes:
A) consumption increases.
B) consumption decreases.
C) investment increases.
D) investment decreases.

113.According to the model developed in Chapter 3, when taxes decrease without a change in
government spending:
A) consumption and investment both increase.
B) consumption and investment both decrease.

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C) consumption increases and investment decreases.
D) consumption decreases and investment increases.

114.According to the model developed in Chapter 3, when government spending increases

and taxes increase by an equal amount:
A) consumption and investment both increase.
B) consumption and investment both decrease.
C) consumption increases and investment decreases.
D) consumption decreases and investment increases.

115.According to the model developed in Chapter 3, when government spending increases

but taxes are not raised, interest rates:
A) increase.
B) are unchanged.
C) decrease.
D) can vary.

116.According to the model developed in Chapter 3, when taxes are increased but
government spending is unchanged, interest rates:
A) increase.
B) are unchanged.
C) decrease.
D) can vary wildly.

117.In a closed economy with fixed output, when government spending increases:
A) private saving decreases.
B) private saving increases.
C) public saving decreases.
D) public saving increases.

118.In the neoclassical model with fixed income, if there is a decrease in government
spending with no change in taxes, then public saving ______ and private saving ______.
A) increases; increases.
B) increases; does not change
C) decreases; increases
D) decreases; does not change

119.Crowding out occurs when an increase in government spending ______ the interest rate
and investment ______.
A) increases; increases

Page 20
B) increases; decreases
C) decreases; increases
D) decreases; decreases

120.The reduction in investment brought about by the increase in the interest rate caused by
increased government spending is called:
A) a budget deficit.
B) fiscal policy.
C) the identification problem.
D) crowding out.

121.In the United Kingdom between 1730 and 1920, during wartime, government spending
tended to increase:
A) but the interest rate did not increase.
B) and the interest rate also increased.
C) but the interest rate decreased.
D) and the interest rate remained constant.

122.In the classical model with fixed income, an increase in the real interest rate could be the
result of a(n):
A) increase in government spending.
B) decrease in government spending.
C) decrease in desired investment.
D) increase in taxes.

123.In the classical model with fixed income a decrease in the real interest rate could be the
result of a(n):
A) increase in government spending.
B) increase in desired investment.
C) increase in taxes.
D) decrease in taxes.

124.In the classical model with fixed income, a reduction in the government budget deficit
will lead to a:
A) higher real interest rate.
B) lower real interest rate.
C) higher level of output.
D) lower level of output.

125.When government spending increases and taxes are increased by an equal amount,

Page 21
 interest rates:
A) increase.
B) remain the same.
C) decrease.
D) can vary wildly.

126.In the neoclassical model with fixed income, if there is a decrease in taxes with no
change in government spending, then public saving ______ and private saving ______.
A) increases; increases
B) increases; decreases
C) decreases; increases
D) decreases; does not change

Use the following to answer questions 127-130:

Exhibit: Saving, Investment, and the Interest Rate 1

127.(Exhibit: Saving, Investment, and the Interest Rate 1) The economy begins in equilibrium
at Point E, representing the real interest rate, r1, at which saving, S1, equals desired
investment, I1. What will be the new equilibrium combination of real interest rate, saving,
and investment if the government cuts spending, holding other factors constant?
A) Point A
B) Point B
C) Point C
D) Point D

Page 22
 128.(Exhibit: Saving, Investment, and the Interest Rate 1) The economy begins in equilibrium
at Point E, representing the real interest rate, r1, at which saving, S1, equals desired
investment, I1. What will be the new equilibrium combination of real interest rate, saving,
and investment if the government cuts taxes, holding other factors constant?
A) Point A
B) Point B
C) Point C
D) Point D

129.(Exhibit: Saving, Investment, and the Interest Rate 1) The economy begins in equilibrium
at Point E, representing the real interest rate, r1, at which saving, S1, equals desired
investment, I1. What will be the new equilibrium combination of real interest rate, saving,
and investment if the government increases spending, holding other factors constant?
A) Point A
B) Point B
C) Point C
D) Point D

130.(Exhibit: Saving, Investment, and the Interest Rate 1) The economy begins in equilibrium
at Point E, representing the real interest rate, r1, at which saving, S1, equals desired
investment, I1. What will be the new equilibrium combination of real interest rate, saving,
and investment if the government raises taxes, holding other factors constant?
A) Point A
B) Point B
C) Point C
D) Point D

131.Use the model developed in Chapter 3 and assume that consumption does not depend on
the interest rate. In this case, when there is a technological advance that leads to an
increase in investment demand:
A) investment increases and the interest rate rises.
B) investment is unchanged and the interest rate rises.
C) investment and the interest rate are both unchanged.
D) investment increases and the interest rate falls.

132.Use the model developed in Chapter 3 and assume that consumption does not depend on
the interest rate. In this case, when the government lowers taxes on business investment,
thus increasing desired investment, but does not change government spending or change
any taxes that affect disposable income, then the quantity of investment:
A) increases and the interest rate rises.
B) is unchanged and the interest rate rises.

Page 23
C) and the interest rate are both unchanged.
D) decreases and the interest rate rises.

133.Use the model developed in Chapter 3, but assume that consumption decreases, other
things being equal, when the interest rate rises. If there is a technological advance that
leads to an increase in investment demand:
A) investment increases and the interest rate rises.
B) investment is unchanged and the interest rate rises.
C) investment and the interest rate are both unchanged.
D) investment decreases and the interest rate rises.

134.When there is a fixed supply of loanable funds, an increase in investment demand results
in a(n):
A) higher interest rate.
B) lower interest rate.
C) increase in investment.
D) decrease in investment.

135.When saving (the supply of loanable funds) increases as the interest rate increases, an
increase in investment demand results in a ______ interest rate and ______ in the
quantity of investment.
A) higher; no change
B) higher; an increase
C) lower; no change
D) lower; an increase

136.Suppose that GDP (Y) is 5,000. Consumption (C) is given by the equation C = 500 +
0.5(Y T). Investment (I) is given by the equation I = 2,000 100r, where r is the real
interest rate in percent. Government spending (G) is 1,000 and taxes (T) is also 1,000.
When a technological innovation changes the investment function to I = 3,000 100r:
A) I rises by 1,000 and r rises by 10 percentage points.
B) I rises by 1,000 and r is unchanged.
C) I is unchanged and r rises by 10 percentage points.
D) I is unchanged and r rises by 15 percentage points.

Page 24
Use the following to answer questions 137-138:

Exhibit: Saving, Investment, and the Interest Rate 2

137.(Exhibit: Saving, Investment, and the Interest Rate 2) The economy begins in equilibrium
at Point E, representing the real interest rate, r1, at which saving, S1, equals desired
investment, I1. What will be the new equilibrium combination of real interest rate, saving,
and investment if there is a technological innovation that increases the demand for
investment goods?
A) Point A
B) Point B
C) Point C
D) Point D

138.(Exhibit: Saving, Investment, and the Interest Rate 2) The economy begins in equilibrium
at Point E, representing the real interest rate, r1, at which saving, S1, equals desired
investment, I1. What will be the new equilibrium combination of real interest rate, saving,
and investment if there is a tax law change that makes investment projects less profitable
and decreases the demand for investment goods (but does not change the amount of taxes
collected in the economy)?
A) Point A
B) Point B
C) Point C
D) Point D

139.If increased immigration raises the labor force, the neoclassical theory of distribution
predicts:
A) the real wage will rise and the real rental price of capital will fall.
B) both the real wage and the real rental price of capital will fall.
C) both the real wage and the real rental price of capital will rise.
D) the real wage will fall and the real rental price of capital will rise.

Page 25
 140.If an earthquake destroys some of the capital stock, the neoclassical theory of distribution
predicts:
A) the real wage will rise and the real rental price of capital will fall.
B) both the real wage and the real rental price of capital will fall.
C) both the real wage and the real rental price of capital will rise.
D) the real wage will fall and the real rental price of capital will rise.

141.If a neutral technological advance improves the production function, the neoclassical
theory of distribution predicts:
A) the real wage will rise and the real rental price of capital will fall.
B) both the real wage and the real rental price of capital will fall.
C) both the real wage and the real rental price of capital will rise.
D) the real wage will fall and the real rental price of capital will rise.

142.An example of decreasing returns to scale is when capital and labor inputs:
A) both increase 10 percent and output increases 5 percent.
B) both increase 10 percent and output increases 10 percent.
C) both increase 5 percent and output increases 10 percent.
D) do not change and output increases 5 percent.

143.An example of increasing returns to scale is when capital and labor inputs:
A) both increase 10 percent and output increases 5 percent.
B) both increase 10 percent and output increases 10 percent.
C) both increase 5 percent and output increases 10 percent.
D) do not change and output decreases 5 percent.

144.If the productivity of farmers has risen substantially over time because of technological
progress, and workers can move freely between being farmers and barbers, the
neoclassical theory of distribution predicts that the real wage(s) of:
A) both barbers and farmers should have remained constant over time.
B) both barbers and farmers should have risen over time.
C) farmers should have risen while the real wage of barbers should have remained
constant.
D) barbers should have risen while the real wage of farmers should have remained
constant.

145.The government raises lump-sum taxes on income by $100 billion, and the neoclassical
economy adjusts so that output does not change. If the marginal propensity to consume is
0.6, private saving:

Page 26
A) rises by $40 billion.
B) rises by $60 billion.
C) falls by $60 billion.
D) falls by $40 billion.

146.The government raises lump-sum taxes on income by $100 billion, and the neoclassical
economy adjusts so that output does not change. If the marginal propensity to consume is
0.6, public saving:
A) rises by $100 billion.
B) rises by $60 billion.
C) falls by $60 billion.
D) falls by $100 billion.

147.The government raises lump-sum taxes on income by $100 billion, and the neoclassical
economy adjusts so that output does not change. If the marginal propensity to consume is
0.6, national saving:
A) rises by $100 billion.
B) rises by $60 billion.
C) falls by $60 billion.
D) falls by $100 billion.

148.The government raises lump-sum taxes on income by $100 billion, and the neoclassical
economy adjusts so that output does not change. If the marginal propensity to consume is
0.6, investment:
A) rises by $100 billion.
B) rises by $60 billion.
C) falls by $60 billion.
D) falls by $100 billion.

149.Assume that an increase in consumer confidence raises consumers' expectations of future

income and thus the amount they want to consume today for any given income. This
shift, in a neoclassical economy, will:
A) lower investment and raise the interest rate.
B) raise investment and lower the interest rate.
C) lower both investment and the interest rate.
D) raise both investment and the interest rate.

150.In a neoclassical economy, assume that the government lowers both government spending
and taxes by the same amount. By doing so:
A) investment falls and the interest rate rises.
B) investment rises and the interest rate falls.

Page 27
 C) investment and the interest rate both fall.
D) investment and the interest rate both rise.

151.In a neoclassical economy, assume that the government lowers both government spending
and taxes by $100 billion. If the marginal propensity to consume is 0.6, investment will:
A) rise $100 billion.
B) rise $60 billion.
C) rise $40 billion.
D) not change.

152.In a neoclassical economy, if consumption increases as the interest rate decreases, then a
$10 billion rise in government spending would:
A) still crowd out exactly $10 billion of investment.
B) crowd out between zero and $10 billion of investment.
C) not crowd out any investment.
D) crowd out more than $10 billion of investment.

153.Assume that the production function is CobbDouglas with parameter = 0.3. If factors
are paid their marginal products, capital and labor, respectively, receive the shares of
income:
A) 0.3 and 0.3.
B) 0.7 and 0.7.
C) 0.3 and 0.7.
D) 0.7 and 0.3.

154.Assume that the production function is CobbDouglas with parameter = 0.3. In the
neoclassical model, if the labor force increases by 10 percent, then output:
A) increases by about 10 percent.
B) increases by about 7 percent.
C) increases by about 3 percent.
D) does not increase since the new workers are unemployed.

155.In an economy with flexible prices, competitive factor markets and fixed supplies of the
factors of production, graphically illustrate the impact of a change in immigration policy
in a country that permits a huge influx of foreign workers into the labor market, ceteris
paribus. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv.
the direction the curve's shift; and v. the terminal equilibrium values. Explain in words
how the equilibrium values of labor, the real wage, saving, investment, and the real
interest rate change.

Page 28
156.In an economy with flexible prices, competitive factor markets, and fixed supplies of the
factors of production, graphically illustrate the impact of an advance in technology that
greatly improves the productivity of capital, ceteris paribus. Be sure to label: i. the axes;
ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v.
the terminal equilibrium values. Explain in words how the equilibrium values change.

157.In an economy with flexible prices, competitive factor markets, and fixed supplies of the
factors of production, graphically illustrate the impact of a deadly virus that kills a large
part of the labor force, but leaves the other factors of production untouched, ceteris
paribus. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv.
the direction the curves shift; and v. the terminal equilibrium values. Explain in words
how the equilibrium values change.

158.Assume that the production function is given by Y = AK0.5L0.5, where Y is GDP, K is

capital stock, and L is labor. The parameter A is equal to 10. Assume also that capital is
100, labor is 400, and both capital and labor are paid for their marginal products.
a. What is Y?
b. What is the real wage of labor?
c. What is the real rental price of capital (the amount of output paid per unit of capital)?

159.Assume that GDP (Y) is 6,000. Consumption (C). is given by the equation C = 600 +
0.6(Y T). Investment (I) is given by the equation I = 2,000 100r, where r is the real
rate of interest in percent. Taxes (T) are 500 and government spending (G) is also 500.
a. What are the equilibrium values of C, I, and r?
b. What are the values of private saving, public saving, and national saving?
c. If government spending rises to 1,000, what are the new equilibrium values of C, I, and
d. What are the new equilibrium values of private saving, public saving, and national saving?

160.Assume that GDP (Y) is 5,000. Consumption (C). is given by the equation C = 1,000 +
0.3(Y T). Investment (I) is given by the equation I = 1,500 50r, where r is the real
interest rate in percent. Taxes (T) are 1,000 and government spending (G) is 1,500.
a. What are the equilibrium values of C, I, and r?
b. What are the values of private saving, public saving, and national saving?
c. Now assume there is a technological innovation that makes business want to invest more. It
raises the investment equation to I = 2,000 50r. What are the new equilibrium values of
I, and r?
d. What are the new values of private saving, public saving, and national saving?

161.Assume that GDP (Y) is 5,000. Consumption (C). is given by the equation C = 1,200 +
0.3(Y T) 50r, where r is the real interest rate. Investment (I) is given by the equation I
= 1,500 50r. Taxes (T) are 1,000 and government spending (G) is 1,500.

Page 29
 a. What are the equilibrium values of C, I, and r?
b. What are the values of private saving, public saving, and national saving?
c. Now assume there is a technological innovation that makes business want to invest more. It
raises the investment equation to I = 2,000 50r. What are the new equilibrium values of
I, and r?
d. What are the new values of private saving, public saving, and national saving?

162.a. Suppose a government moves to reduce a budget deficit. Using the long-run model of the
economy developed in Chapter 3, graphically illustrate the impact of reducing a
government's budget deficit by reducing government purchases. Be sure to label: i. the axes;
ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and v. the
terminal equilibrium values.
b. State in words what happens to: i. the real interest rate; ii. national saving; iii. investment; iv.
consumption; and v. output.

163.a. Suppose a government moves to reduce a budget deficit. Using the long-run model of the
economy developed in Chapter 3, graphically illustrate the impact of reducing a
government's budget deficit by increasing (lump-sum) taxes on household income. Be sure
to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction curves
shift; and v. the terminal equilibrium values.
b. State in words what happens to: i. the real interest rate; ii. national saving; iii. investment; iv.
consumption; and v. output.

164.a. Suppose a government education program succeeds in getting households to save more (you
may interpret this as a downward shift in the consumption function). Using the long-run
model of the economy developed in Chapter 3, graphically illustrate the impact of the higher
saving rate by households. Be sure to label: i. the axes; ii. the curves; iii. the initial
equilibrium values; iv. the direction curves shift; and v. the terminal equilibrium values.
b. State in words what happens to: i. the real interest rate; ii. national saving; iii. investment; iv.
consumption; and v. output.

165.a. Suppose there is a technological breakthrough that increases the productivity of all capital
and, consequently, increases the demand for investment. Using the long-run model of the
economy developed in Chapter 3, graphically illustrate the impact of the increased
investment demand. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium
values; iv. the direction curves shift; and v. the terminal equilibrium values.
b. State in words what happens to: i. the real interest rate; ii. national saving; iii. investment; iv.
consumption; and v. output.

166.a. Suppose a government decides to reduce spending and (lump-sum) income taxes by the
same amount. Using the long-run model of the economy developed in Chapter 3, graphically
illustrate the impact of the equal reductions in spending and taxes. Be sure to label: i. the

Page 30
 b. State in words what happens to: i. the real interest rate; ii. national saving; iii. investment; iv.
consumption; and v. output.

167.Consider two competitive economies that have the same quantities of labor (L = 400) and
capital (K = 400), and the same technology (A = 100). The economies of the countries are
described by the following CobbDouglas production functions:
North Economy: Y = A L.3K.7
South Economy: Y = A L.7K.3
a. Which economy has the larger total production? Explain.
b. In which economy is the marginal product of labor larger? Explain.
c. In which economy is the real wage larger? Explain.
d. In which economy is labor's share of income larger? Explain.

168.Assume that a competitive economy can be described by a constant returns to scale

(CobbDouglas) production function and all factors of production are fully employed.
Holding other factors constant, including the quantity of capital and technology, carefully
explain how a one-time, 10-percent increase in the quantity of labor (perhaps the result of
a special immigration policy) will change each of the following:
a. the level of output produced;
b. the real wage of labor;
c. the real rental price of capital;
d. labor's share of total income.

169.Assume that a competitive economy can be described by a constant returns to scale

(CobbDouglas) production function and all factors of production are fully employed.
Holding other factors constant, including the quantity of labor and technology, carefully
explain how a one-time, 50-percent decrease in the quantity of capital (perhaps the result
of war damage) will change each of the following:
a. the level of output produced;
b. the real wage of labor;
c. the real rental price of capital;
d. capital's share of total income.

170.Consider a competitive economy in which factor prices adjust to keep the factors of
production fully employed and the interest rate adjusts to keep the supply and demand for
goods and services in equilibrium. The economy can be described by the following set of
equations:
L L, K K , G G , T T ,
Y = AK L(1 )
Y=C+I+G
C = C (Y T)
I = I(r)

Page 31
 Suggest at least two policies that a government could use to increase the equilibrium
quantity of investment in the economy, and carefully explain how these policies produce
this result.

171.Consider a competitive economy in which factor prices adjust to keep the factors of
production fully employed, and the interest rate adjusts to keep the supply and demand
for goods and services in equilibrium. The economy can be described by the following set
of equations:
L L, K K , G G , T T ,
Y = AKL(1 )
Y=C+I+G
C = C(Y T)
I = I(r)
How does an increase in government spending, holding other factors constant, affect the
level of:
a. public saving?
b. private saving?
c. national saving?
d. the equilibrium interest rate?
e. the equilibrium quantity of investment?

172.Price flexibility plays a key role in the classical model by ensuring that the markets reach
equilibrium.
a. Explain which price adjusts to bring equilibrium in the labor market. Describe how the price
adjusts when demand exceeds supply in this market.
b. Explain which price adjusts to bring equilibrium in the loanable funds market. Describe how
the price adjusts when supply exceeds demand in this market.

173.Consider a production function for an economy:

Y = 20(L.5K.4N.1)
where L is labor, K is capital, and N is land. In this economy the factors of production are
in fixed supply with L = 100, K = 100, and N = 100.
a. What is the level of output in this country?
b. Does this production function exhibit constant returns to scale. Demonstrate by example.
c. If the economy is competitive so that factors of production are paid the value of their
marginal products, what is the share of total income will go to land?

174.The economy of Miniland has an income of $400, consumption is $200, government

expenditure is $200, and the tax earnings of government is $150.
a. Calculate private saving.

Page 32
 b. Calculate public saving.
c. Calculate national saving.

175.The closed economy of Moneyland has total income of $5000, consumption function is C
= 2000 30r, investment function I = 1500 20r, government spending is $2000, r is
nominal interest rate. Inflation is 6 percent. Find the real rate of interest.

176.The production of an economy is explained by a function: Y = 20 (L.5K.5) where L is labor

and K is capital with L = 400 and K = 400. Does this economy support constant
returns to scale?

177.After studying the circular flow of dollars in the economy, explain with an example how
saving done by households goes back into the circular flow. In reality, does all saving go
back as an investment?

178.Suppose people in an economy reduce their saving. What will be the effect on real
interest rate and investment?

179.The total output of the closed economy Moneyland is 10,000. Consumption is explained
by the function C = 3,800 + 0.7T 150r, where r is the real interest rate. Investment (I) is
given by the equation, I = 1,500 + 50r. Taxes (T) are 1,000 and government spending (G)
is 3,500. What are the values of consumption, investment, and real interest rate?

180.What effect does advancement in technology have upon the equilibrium between real
rental price and capital (assuming supply of capital is fixed)?

181.The government of an economy has increased its spending and taxes by the same amount.
What is the effect on investment?

182.What is the effect of an increase in interest rate on keeping government spending constant
on consumption and investment?

Page 33
Answer Key

1.D
2.C
3.B
4.A
5.D
6.B
7.C
8.A
9.C
10.B
11.C
12.C
13.A
14.D
15.D
16.B
17.A
18.B
19.C
20.B
21.D
22.B
23.B
24.B
25.B
26.B
27.B
28.D
29.C
30.B
31.D
32.C
33.D
34.D
35.D
36.D
37.D
38.A
39.A
40.B
41.B
42.B
43.A
44.C

Page 34
45.A
46.C
47.A
48.C
49.C
50.C
51.C
52.A
53.C
54.B
55.A
56.B
57.C
58.C
59.C
60.B
61.A
62.B
63.C
64.A
65.C
66.B
67.A
68.D
69.B
70.B
71.D
72.A
73.D
74.C
75.D
76.A
77.C
78.B
79.A
80.B
81.A
82.D
83.D
84.D
85.C
86.B
87.A
88.A
89.D
90.C

Page 35
 91.D
92.A
93.B
94.A
95.B
96.D
97.C
98.A
99.B
100.A
101.C
102.D
103.A
104.C
105.B
106.B
107.C
108.A
109.C
110.B
111.D
112.D
113.C
114.B
115.A
116.C
117.C
118.B
119.B
120.D
121.B
122.A
123.C
124.B
125.A
126.C
127.B
128.A
129.A
130.B
131.B
132.D
133.A
134.A
135.B
136.C

Page 36
137.B
138.A
139.D
140.D
141.C
142.A
143.C
144.B
145.D
146.A
147.B
148.B
149.A
150.B
151.C
152.B
153.C
154.B
155.

The supply of labor force increases, which forces the real wage lower and increases the
quantity of labor employed, since there is no unemployment in this model. Output (Y)
increases as labor increases, national saving (Y C G) increases, which makes the
equilibrium rate of interest fall to bring national saving and investment into equilibrium.
156.

Page 37
 The demand for capital increases, which increases the real rental price of capital, but the
quantity of capital employed is unchanged at the level of the fixed supply.
157.

The supply of labor decreases, which increases the real wage. All of the reduced labor
force is employed.
158.a. 2,000
b. 2.5
c. 10
159.a. 3,900; 1,600; 4 percent
b. 1,600; 0; 1,600
c. 3,900; 1,100; 9 percent
d. 1,600; 500; 1,100
160.a. 2,200; 1,300; 4 percent
b. 1,800; 500; 1,300
c. 2,200; 1,300; 14 percent
d. 1,800; 500; 1,300
161.a. 2,200; 1,300; 4 percent
b. 1,800; 500; 1,300
c. 1,950; 1,550; 9 percent
d. 2,050; 500; 1,550
162.a.

Page 38
 b. i. real interest rate decreases
ii. national saving increases
iii. investment increases
iv. consumption is unchanged
v. output is unchanged, fixed because it is determined by the factors of production
163.a.

b. i. real interest rate decreases

ii. national saving increases
iii. investment increases
iv. consumption decreases
v. output is unchanged, fixed because it is determined by the factors of production
164.a.

Page 39
 b. i. real interest rate decreases
ii. national saving increases
iii. investment increases
iv. consumption decreases
v. output is unchanged, fixed because it is determined by the factors of production
165.a.

b. i. real interest rate increases

ii. national saving is unchanged
iii.amount of investment is unchanged
iv. consumption is unchanged
v. output is unchanged, fixed because it is determined by the factors of production
166.a.

Page 40
 b. i. real interest rate decreases
ii. national saving increases
iii. investment increases
iv. consumption increases
v. output is unchanged, fixed because it is determined by the factors of production
167.a. Output is the same in both economies, given the symmetry of the parameters of the
productions function and the equal quantities of labor and capital.
b. The MPL is larger in the South Economy. The MPL depends on the value of (1 ) and the
average productivity of labor (Y/L). Since the average productivity of labor is the same in
both countries, differences in the MPL depend on the value of (1 ), which is larger in
South Economy (.7) than in North Economy (.3).
c. Since factors are paid according to the values of their marginal products, the real wage is
larger in South Economy, because the MPL is larger in South Economy than in North
Economy (from part b).
d. Labor's share of income equals (1 ), which is larger in South Economy (.7) than in North
Economy (.3).
168.a. Output increases by less than 10 percent because of diminishing returns to labor.
b. The real wage decreases because the average productivity of labor decreases (Y/L decreases,
as Y increases less in proportion than the increase in L), so the MPL, which equals (1
)Y/L, decreases.
c. The real rental price of capital increases because the average productivity of capital increases
(Y/K increases, as Y increases and K is constant), so the MPK, Y/K, increases.
d. Labor's share of income is unchanged, since it depends only on the parameter (1 ) from
the production function, which does not change.
169.a. Output decreases by less than 50 percent because of diminishing returns to capital.
b. The real wage decreases because the average productivity of labor decreases (Y/L decreases,
as Y decreases and L is constant), so the MPL, which equals (1 )Y/L, decreases.
c. The real rental price of capital increases because the average productivity of capital increases
(Y/K increases, as Y decreases proportionally less than K decreases), so the MPK, Y/K
increases.
d. Capital's share of income is unchanged since it depends only on the parameter () from the
production function, which does not change.
170.The government could cut spending (G), which would increase national saving (Y C

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 G), lower the equilibrium interest rate, and produce an increase in the equilibrium
quantity of investment. The government could increase taxes (T), which would increase
national saving (Y C G) by reducing consumption, lower the equilibrium interest rates
and produce an increase in the equilibrium quantity of investment.
171.a. Public saving equals T G. An increase in government spending, G, reduces public saving.
b. Private saving equals Y T C. An increase in government spending does not affect private
saving.
c. National saving equals Y C G. An increase in government spending reduces national
saving by an amount equal to the increase in government spending.
d. The equilibrium interest rate increases to bring desired investment into equilibrium with the
reduced quantity of national saving.
e. The equilibrium quantity of investment is reduced via the increase in the interest rate by an
amount equal to the increase in government spending.
172.a. The real wage adjusts to make labor demand equal to labor supply. If labor demand is greater
than labor supply, the real wage rises, decreasing the quantity of labor demanded until the
quantity demanded equals the fixed supply of labor.
b. The real interest rate adjusts to make the supply of loanable funds equal to the demand for
loanable funds. If the supply of loanable funds is greater than the demand for loanable funds
the interest rate will decrease, increasing the desired quantity of investment spending, which
is the demand for loanable funds, until the demand and supply are equal.
173.a. 2,000
b. Yes, the production function exhibits constant returns to scale. Doubling each factor of
production to 200 will double output to 4,000.
c. 10 percent
174. Y = $400
C = $200
T = $150
G = $200
a. Private saving = Y C T = 400 200 150 = $50
b. Public Saving = T G = 150 200 = - $50
c. National Saving = Private saving + public saving = 50 + -50 = $0
175. Y = C + I + G ; 5000 = 2000 30r + 1500 20r +2000 ; r = 10 percent
Real interest rate = r inflation = 10 6 = 4 percent
176.When increase in percentage of output equals the increased percentage of all factors of
production it is called constant returns to scale. Here output is 8000 units, so if we double
the factors of production, i.e., L = 800 and K = 800, we see that the output becomes
16000 units, double of 8000 units supporting the constant returns to scale.
177.According to the circular flow of dollars diagram, households save their money in
financial markets and then financial markets lend this money to markets of goods and
service for investment. In reality, not all saving is done in the financial markets, some of

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 the money is kept by people to themselves as cash, which does not get converted to
investment.
178.If households develop a tendency of saving less, there will be less money to lend, so the
supply of loanable funds will be less. This will increase the real interest rates r, and due
to the increase in r investors will find it more costly to take a loan, so investment will
decrease.
179.Y = 10,000
C = 3,800 + 0.7T -150r
I = 1,500 + 50r
T = 1,000
G = 4,500
Y=C+I+G
By plugging in values of Y, C, I, T and G, we get: r = 5 percent.
By by plugging in the value of r in C and G we get: C = 3,750 and I=1,750.
180.Provided that the supply of capital is fixed, advancement in technology will increase the
demand for capital. But as the supply is fixed, the real rental price will increase. So the
new equilibrium will be in same supply amount of capital with increased real rental price.
181.With increased taxes, people will have less money to consume and save, so there will be
reduction in private saving. With increased government spending, public saving will also
be reduced. Reduction in both private saving and public saving will lead to a reduction in
national saving, and as national saving is equal to investment, this implies a decrease in
investment.
182.With increase in interest rates, firms find taking loans for investments to be more costly,
so they will decrease investments. And households start looking to saving as a better
option than consuming, so consumption will decrease

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