Unit 3 · 17 to 27% of the exam

Unit 3 practice test: National Income and Price Determination

twelve questions, every option explained

12 exam-style questions from the unit, free, with an explanation for every option. Most are multiple choice, as on the real exam; a few ask for a number or have you shift a curve on a graph, and sets share one data table, graph or scenario. Covers: Aggregate Demand (AD); Multipliers; Short-Run Aggregate Supply (SRAS); Long-Run Aggregate Supply (LRAS); Equilibrium in the Aggregate Demand-Aggregate Supply (AD-AS) Model; Changes in the AD-AS Model in the Short Run; Long-Run Self-Adjustment; Fiscal Policy; Automatic Stabilizers.

Start at question 1

Data

Output and unemployment in three countries

Real GDP, full-employment real GDP and unemployment in three invented countries this year (invented data for practice)
CountryReal GDP (billions of dollars)Full-employment real GDP (billions of dollars)Unemployment rate (%)Natural rate of unemployment (%)
Alta9401,0007.55
Bora1,0001,00055
Cresh1,0601,0003.55

1. Based on the table, which country has a recessionary gap?

  1. Alta
  2. Bora
  3. Cresh
  4. Alta and Cresh
Show the answer

A recessionary gap means real GDP is below full-employment output, with unemployment above the natural rate: Alta.

  • Correct: Alta: Right: Alta's real GDP (940) is below full-employment output (1,000), and its unemployment is above the natural rate.
  • Bora: Bora produces exactly its full-employment output: it is in long-run equilibrium.
  • Cresh: Cresh produces more than full-employment output, an inflationary gap.
  • Alta and Cresh: Cresh's output is above full employment, which is the opposite kind of gap.

2. Based on the table, how does Cresh's short-run equilibrium compare with its LRAS?

  1. It lies on LRAS, because the economy is growing
  2. It lies to the right of LRAS, with unemployment below the natural rate
  3. It lies to the left of LRAS, with unemployment above the natural rate
  4. It lies to the right of LRAS, with unemployment above the natural rate
Show the answer

Cresh produces above full employment: its AD and SRAS cross to the right of LRAS, and unemployment (3.5%) is below the natural rate (5%).

  • It lies on LRAS, because the economy is growing: On LRAS, output would equal 1,000. Cresh produces 1,060.
  • Correct: It lies to the right of LRAS, with unemployment below the natural rate: Right: output of 1,060 exceeds full-employment output, an inflationary gap.
  • It lies to the left of LRAS, with unemployment above the natural rate: That describes Alta, not Cresh.
  • It lies to the right of LRAS, with unemployment above the natural rate: When output is above potential, firms hire more, so unemployment is below the natural rate.

3. Based on the table, which country is in long-run equilibrium?

  1. Alta, because unemployment is high enough to keep prices from rising
  2. Cresh, because it produces the most real GDP of the three
  3. Bora, because AD and SRAS cross on LRAS at full-employment output
  4. No country, because each one has some unemployment
Show the answer

Long-run equilibrium: AD, SRAS and LRAS meet at one point, with output at full employment. Bora fits.

  • Alta, because unemployment is high enough to keep prices from rising: High unemployment means output is below potential, so Alta is not in long-run equilibrium.
  • Cresh, because it produces the most real GDP of the three: Producing above potential is an inflationary gap, not long-run equilibrium.
  • Correct: Bora, because AD and SRAS cross on LRAS at full-employment output: Right: output equals full-employment output and unemployment equals the natural rate.
  • No country, because each one has some unemployment: Full employment allows natural unemployment. Bora's 5% is its natural rate.

Data

Country G after a fall in spending, with no policy response

Country G, four years after a fall in aggregate demand, with no policy response; full-employment real GDP is 1,000 billion dollars and the natural rate of unemployment is 5% (invented data for practice)
YearReal GDP (billions of dollars)Unemployment rate (%)Nominal wage indexPrice level (index)
19008100100
294079898
397069697
41,00059596

4. Based on the table, what brings Country G's real GDP back to 1,000 billion dollars?

  1. Falling nominal wages lower costs, so SRAS shifts right
  2. Rising spending shifts AD back to the right
  3. A rise in the price level makes production more profitable
  4. LRAS shifts right as the economy grows
Show the answer

High unemployment pushes nominal wages down (100 to 95). Lower costs shift SRAS right, so output rises back to 1,000 while the price level falls.

  • Correct: Falling nominal wages lower costs, so SRAS shifts right: Right: with unemployment above the natural rate, wages fall, costs fall and SRAS shifts right until output reaches full employment.
  • Rising spending shifts AD back to the right: Nothing in the table shows spending recovering. The wage index falls, which works through SRAS.
  • A rise in the price level makes production more profitable: The price level falls in the table, from 100 to 96.
  • LRAS shifts right as the economy grows: Full-employment output stays at 1,000 throughout, so LRAS did not move.

5. Based on the table, why did Country G's nominal wages fall from Year 1 to Year 4?

  1. The price level was rising, so workers needed lower wages
  2. Unemployment was above the natural rate
  3. Real GDP was above full-employment output
  4. Firms were short of workers and cut wages to hire more
Show the answer

In a recessionary gap, unemployment is above the natural rate. Over time, contracts are renegotiated at lower nominal wages.

  • The price level was rising, so workers needed lower wages: The price level fell. Wages fell because of high unemployment.
  • Correct: Unemployment was above the natural rate: Right: a surplus of workers puts downward pressure on nominal wages.
  • Real GDP was above full-employment output: Real GDP was below 1,000 until Year 4, a recessionary gap.
  • Firms were short of workers and cut wages to hire more: Shortages of workers push wages up. There were too many job seekers here.

6. Based on the table, in which year is Country G back in long-run equilibrium?

  1. Year 1
  2. Year 2
  3. Year 4
  4. Year 3
Show the answer

Long-run equilibrium returns when output equals full-employment output and unemployment equals the natural rate: Year 4.

  • Year 1: Year 1 has the largest gap: 900 against 1,000.
  • Year 2: Output (940) is still below full employment.
  • Correct: Year 4: Right: real GDP equals full-employment output (1,000) and unemployment equals the natural rate (5%).
  • Year 3: Output (970) is still below 1,000 and unemployment (6%) above the natural rate.

7. The MPC is 0.9. The government cuts taxes by 10 billion dollars and the price level does not change. By how much does real GDP rise, in billions of dollars?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

Tax multiplier =−0.90.1=−9= -\frac{0.9}{0.1} = -9. A tax cut is a change of −10-10, so ΔY=−10×−9=90\Delta Y = -10 \times -9 = 90 billion dollars.

  • Answer: 90

8. Which of the following is a transfer payment?

  1. A government contract to build a bridge
  2. Salaries the government pays to public school teachers
  3. A monthly pension paid by the government to retirees
  4. A tax on gasoline
Show the answer

Transfer payments (pensions, aid to families, unemployment benefits) move income to households without buying output, so they are not part of G.

  • A government contract to build a bridge: That is a purchase of goods and services, part of G.
  • Salaries the government pays to public school teachers: Salaries buy teachers' services, so they are government purchases.
  • Correct: A monthly pension paid by the government to retirees: Right: money paid to households with no good or service bought in return.
  • A tax on gasoline: A tax takes money from households; a transfer gives it to them.

9. During a boom, incomes and employment rise quickly. How do automatic stabilizers affect aggregate demand?

  1. They speed its rise, because the government collects more to spend
  2. They slow its rise
  3. They have no effect, as they act just in recessions
  4. They shift SRAS left, ending the boom
Show the answer

In a boom, progressive taxes take a growing share of income and fewer people qualify for transfers, so AD rises by less.

  • They speed its rise, because the government collects more to spend: Higher tax collections take income from households; with no new law, G does not rise.
  • Correct: They slow its rise: Right: disposable income rises by less, so consumption and AD rise by less.
  • They have no effect, as they act just in recessions: They work in both directions: they cushion recessions and slow booms.
  • They shift SRAS left, ending the boom: Taxes on household income and transfers work through spending, which is AD.

10. The MPC is 0.8. The government raises its spending by 50 billion dollars and raises taxes by 50 billion dollars at the same time. With the price level unchanged, by how much does real GDP change, in billions of dollars?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

Spending: 50×5=25050 \times 5 = 250. Taxes: 50×(−4)=−20050 \times (-4) = -200. Together 250−200=50250 - 200 = 50: output rises by the amount of the spending, so the balanced-budget multiplier is 1.

  • Answer: 50

11. Full-employment real GDP is 2,000 billion dollars and actual real GDP is 1,900 billion dollars. Calculate the recessionary gap as a percent of full-employment output.

Type a number (%). A four-function calculator is allowed, as on the exam.

Show the answer

2,000−1,9002,000×100\frac{2{,}000 - 1{,}900}{2{,}000} \times 100=5%= 5\%.

  • Answer: 5 %

12. In a recession, automatic stabilizers raise transfers and lower tax collections. Which statement is correct?

  1. They close the recessionary gap at once
  2. They shrink the fall in output but leave a gap
  3. They raise output above full employment
  4. They work by lowering firms' production costs
Show the answer

Automatic stabilizers dampen the business cycle: the fall in AD is smaller, but a recessionary gap can remain.

  • They close the recessionary gap at once: They respond only as much as incomes fall, which softens the fall but leaves a gap.
  • Correct: They shrink the fall in output but leave a gap: Right: they make swings smaller; closing a gap takes self-adjustment or discretionary policy.
  • They raise output above full employment: They slow the fall in AD; they do not push output past potential.
  • They work by lowering firms' production costs: They work through household disposable income and spending.