Unit 5 · 20 to 30% of the exam

Unit 5 practice test: Long-Run Consequences of Stabilization Policies

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: Fiscal and Monetary Policy Actions in the Short Run; The Phillips Curve; Money Growth and Inflation; Government Deficits and the National Debt; Crowding Out; Economic Growth; Public Policy and Economic Growth.

Start at question 1

Graph

The production possibilities curve of Hale (invented)

Consumer goodsCapital goodsPPC1PPC2

1. The graph shows Hale's PPC for capital goods and consumer goods moving from PPC1 to PPC2. Which event could cause it?

  1. New production technology that lets each worker make more of both goods
  2. A recession that leaves many workers and factories idle
  3. A rise in the price level of consumer goods
  4. A shift of workers from making capital goods to making consumer goods
Show the answer

The PPC shifts out when resources grow or technology improves: economic growth.

  • Correct: New production technology that lets each worker make more of both goods: Right: better technology raises what the economy can produce, so the PPC shifts out.
  • A recession that leaves many workers and factories idle: Idle resources put the economy at a point inside the PPC; the curve itself does not move.
  • A rise in the price level of consumer goods: Prices are not on the PPC; it shows quantities the economy can produce.
  • A shift of workers from making capital goods to making consumer goods: That is a movement along the PPC, not a shift of it.

2. Which change on Hale's AD-AS graph shows the same event as the PPC shifting out?

  1. AD shifts right, raising real output and the price level
  2. SRAS shifts left, raising the price level
  3. LRAS shifts right, to a higher full-employment output
  4. LRAS shifts left, to a lower full-employment output
Show the answer

Growth on two graphs: the PPC shifts out and LRAS shifts right.

  • AD shifts right, raising real output and the price level: AD shows spending, not capacity; a rise in spending alone does not shift the PPC.
  • SRAS shifts left, raising the price level: A leftward SRAS shift lowers output; it is a supply shock, not growth.
  • Correct: LRAS shifts right, to a higher full-employment output: Right: the PPC and LRAS both show the economy's capacity; growth moves both.
  • LRAS shifts left, to a lower full-employment output: More capacity moves LRAS right, not left.

3. Hale and a neighbor have the same PPC this year. Hale chooses a point with more capital goods and fewer consumer goods. What is the likely result?

  1. Hale's PPC shifts in, because fewer consumer goods lower living standards
  2. Hale's PPC shifts out further in the future, at the cost of fewer consumer goods today
  3. Both PPCs shift out by the same amount, because they start equal
  4. Hale moves inside its PPC, because it gives up consumer goods
Show the answer

Investing in capital goods today is a trade-off: less consumption now, more production possibilities later.

  • Hale's PPC shifts in, because fewer consumer goods lower living standards: Producing capital goods adds to capacity; the curve does not shrink.
  • Correct: Hale's PPC shifts out further in the future, at the cost of fewer consumer goods today: Right: capital goods add to the capital stock, which raises future capacity; the opportunity cost is consumption now.
  • Both PPCs shift out by the same amount, because they start equal: The country that builds more capital gains more capacity.
  • Hale moves inside its PPC, because it gives up consumer goods: Choosing a different point on the PPC is still efficient; it is a movement along the curve.

Data

Schooling, investment and growth in four invented countries

Averages over 20 years in four invented countries
CountryAverage years of schoolingInvestment (% of GDP)Growth of real GDP per capita (% a year)
Kova12253.0
Lith8151.0
Mera12152.0
Nolo8252.0

4. Compare Mera and Lith, which have the same investment share. What do the data suggest?

  1. More investment is associated with faster growth
  2. Schooling has no link to growth
  3. More schooling goes with faster growth of real GDP per capita
  4. Lith grew faster than Mera because it spent much less on schooling
Show the answer

Holding investment fixed, the pair isolates schooling, a measure of human capital. With invented data and four countries, it is a pattern, not proof.

  • More investment is associated with faster growth: Investment is the same in Mera and Lith, so this pair cannot show its effect.
  • Schooling has no link to growth: Mera, with more schooling, grew faster than Lith.
  • Correct: More schooling goes with faster growth of real GDP per capita: Right: with investment the same, Mera's extra schooling goes with 1 point faster growth.
  • Lith grew faster than Mera because it spent much less on schooling: Lith grew more slowly: 1.0 percent against Mera's 2.0 percent.

5. Which pair of countries best shows the link between physical capital and growth?

  1. Mera and Lith
  2. Nolo and Lith
  3. Kova and Lith
  4. Mera and Nolo
Show the answer

To see one factor, compare countries that differ only in that factor.

  • Mera and Lith: They differ in schooling, not investment.
  • Correct: Nolo and Lith: Right: they have the same schooling, and Nolo's higher investment goes with faster growth.
  • Kova and Lith: They differ in both schooling and investment, so the effects are mixed together.
  • Mera and Nolo: They differ in both, and their growth rates are equal.

6. Lith wants to grow more like Kova. Which pair of policies fits the data?

  1. Expand schooling and give firms incentives to invest in equipment
  2. Raise taxes on investment and cut school funding to balance the budget
  3. Send each household a cash payment each year
  4. Raise the money supply faster to raise spending
Show the answer

Growth policy aims at the sources of growth: human capital, physical capital and technology.

  • Correct: Expand schooling and give firms incentives to invest in equipment: Right: Kova leads Lith in both schooling and investment.
  • Raise taxes on investment and cut school funding to balance the budget: Both would move Lith further from Kova.
  • Send each household a cash payment each year: Cash transfers raise AD; they do not build human or physical capital.
  • Raise the money supply faster to raise spending: Faster money growth raises inflation in the long run, not capacity.

7. A country's nominal GDP is 16 trillion dollars and its money supply is 2 trillion dollars. What is the velocity of money?

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

Show the answer

V=P×YM=162=8V = \frac{P \times Y}{M} = \frac{16}{2} = 8: each dollar is spent on final goods and services about 8 times a year.

  • Answer: 8

8. A government spends 4.5 trillion dollars (including transfers and interest) and collects 3.9 trillion dollars in taxes this year. How large is its budget deficit, in trillions of dollars? Give the size as a positive number.

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

Show the answer

Deficit == outlays −- revenue =4.5−3.9=0.6= 4.5 - 3.9 = 0.6 trillion dollars.

  • Answer: 0.6

9. A government runs a balanced budget this year. What happens to the national debt?

  1. It falls to zero, because a balanced budget pays off what is owed
  2. It rises by the amount of tax revenue collected
  3. It falls by the amount of government spending
  4. It stays about the same: no new borrowing, no repayment
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Deficit: debt rises. Balanced budget: debt about unchanged. Surplus: debt falls.

  • It falls to zero, because a balanced budget pays off what is owed: A balanced budget only stops the debt from growing; past debt is still owed.
  • It rises by the amount of tax revenue collected: Taxes pay for outlays; they do not add to the debt.
  • It falls by the amount of government spending: Spending is covered by taxes this year; it does not repay debt.
  • Correct: It stays about the same: no new borrowing, no repayment: Right: with revenue equal to outlays, the government neither adds to the debt nor pays it down.

10. A rise in government spending raises real GDP and the price level. On the money market graph, what happens, and why?

  1. Money supply rises because the government is spending more money, so the nominal interest rate falls
  2. Money demand rises, as more output at higher prices takes more money, so the nominal rate rises
  3. Money demand falls because higher prices make money worth less, so the nominal interest rate falls
  4. Money supply falls because the government borrows from banks, so the nominal interest rate rises
Show the answer

Expansionary fiscal policy raises money demand (more transactions at higher prices), which pushes the nominal interest rate up. That is why the interest rate effect of a policy mix can be unclear.

  • Money supply rises because the government is spending more money, so the nominal interest rate falls: The central bank sets the money supply; government spending does not shift it.
  • Correct: Money demand rises, as more output at higher prices takes more money, so the nominal rate rises: Right: more nominal spending raises the transaction demand for money; with money supply fixed, the nominal interest rate rises.
  • Money demand falls because higher prices make money worth less, so the nominal interest rate falls: Higher prices mean people need more money for the same purchases, not less.
  • Money supply falls because the government borrows from banks, so the nominal interest rate rises: Government borrowing shows up in the loanable funds market, not as a shift in the money supply.

11. A central bank permanently raises the money supply. Which of these changes in the long run?

  1. Real GDP
  2. The natural rate of unemployment
  3. The real interest rate
  4. The price level
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The long-run neutrality of money: money changes nominal variables, not real ones.

  • Real GDP: Real GDP returns to full-employment output, which depends on resources and technology.
  • The natural rate of unemployment: The natural rate depends on frictional and structural unemployment, not on the amount of money.
  • The real interest rate: In the long run the real interest rate is set by saving and investment, not by the money supply.
  • Correct: The price level: Right: in the long run the extra money raises the price level and other nominal values.

12. What is a government's budget deficit?

  1. The total amount the government owes from past borrowing
  2. The amount by which its outlays exceed its tax revenue in one year
  3. The amount by which imports exceed exports in one year
  4. The amount by which the government's tax revenue exceeds its outlays in one year
Show the answer

Deficit = outlays - tax revenue, measured over one year. The debt is the running total.

  • The total amount the government owes from past borrowing: That is the national debt, a stock built up from past deficits.
  • Correct: The amount by which its outlays exceed its tax revenue in one year: Right: a deficit is a yearly flow, outlays (spending, transfers and interest) minus revenue.
  • The amount by which imports exceed exports in one year: That is a trade gap between a country and the rest of the world, not the government budget.
  • The amount by which the government's tax revenue exceeds its outlays in one year: Revenue above outlays is a budget surplus.