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ECON102

Spring 2014
Study Guide 8
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
Figure 27-3

1) Refer to Figure 27-3. In the dynamic model of AD-AS in the figure above, if the economy is at point A in
year 1 and is expected to go to point B in year 2, the government would most likely pursue
A) expansionary fiscal policy.
B) expansionary monetary policy.
C) expansionary automatic stabilizers.
D) contractionary monetary policy.
E) contractionary fiscal policy.
2) Refer to Figure 27-3. In the dynamic model of AD-AS in the figure above, if the economy is at point A in
year 1 and is expected to go to point B in year 2, Congress and the president would most likely
A) raise interest rates.
B) increase the money supply and decrease the interest rate.
C) increase taxes.
D) increase government spending.
E) increase oil prices.
3) Expansionary fiscal policy involves
A) increasing taxes or decreasing government purchases.
B) increasing government purchases or decreasing taxes.
C) increasing the money supply and decreasing interest rates.
D) decreasing the money supply and increasing interest rates.

4) A recession tends to cause the budget deficit to ________ because tax revenues ________ and government
spending on transfer payments ________.
A) increase; fall; rises
B) decrease; fall; rises
C) increase; rise; falls
D) decrease; rise; falls
5) Expansionary fiscal policy to prevent real GDP from falling below potential real GDP would cause the
inflation rate to be ________ and real GDP to be ________.
A) lower; lower
B) higher; lower
C) higher; higher
D) lower; higher
Figure 27-1

6) Refer to Figure 27-1. Suppose the economy is in short-run equilibrium above potential GDP and no policy is
pursued. Using the static AD-AS model in the figure above, this would be depicted as a movement from
A) C to B.
B) C to D.
C) D to C.
D) E to A.
E) A to E.
7) Refer to Figure 27-1. Suppose the economy is in short-run equilibrium below potential GDP and no fiscal or
monetary policy is pursued. Using the static AD-AS model in the figure above, this would be depicted as a
movement from
A) B to A.
B) A to B.
C) A to E.
D) C to B.
E) B to C.
8) Refer to Figure 27-1. An increase in taxes would be depicted as a movement from ________, using the static
AD-AS model in the figure above.
A) B to C
B) B to A
C) C to D
D) E to B
E) A to B
9) Suppose real GDP is $12.6 trillion and potential GDP is $12.4 trillion. To move the economy back to potential
GDP, the government should
A) lower government purchases by an amount less than $200 billion.
B) lower taxes by $200 billion.
C) lower government purchases by $200 billion.
D) raise taxes by an amount more than $200 billion.
E) raise taxes by $200 billion.

Figure 27-2

10) Refer to Figure 27-2. In the dynamic model of AD-AS in the figure above, if the economy is at point A in
year 1 and is expected to go to point B in year 2, and no fiscal or monetary policy is pursued, then at point B
A) the unemployment rate is very low.
B) the economy is above full employment.
C) income and profits are rising.
D) firms are operating below capacity.
E) there is pressure on wages and prices to rise.
11) Refer to Figure 27-2. In the dynamic model of AD-AS in the figure above, if the economy is at point A in
year 1 and is expected to go to point B in year 2, Congress and the president would most likely pursue
A) expansionary monetary policy.
B) expansionary fiscal policy.
C) contractionary monetary policy.
D) contractionary fiscal policy.
E) contractionary automatic stabilizers.

Figure 27-4

12) Refer to Figure 27-4. In the graph above, the shift from AD1 to AD2 represents the total change in aggregate
demand. If government purchases increased by $50 billion, then the distance from point A to point B
________ $50 billion.
A) would be less than
B) may be greater than or less than
C) would be greater than
D) would be equal to
13) Suppose Congress increased spending by $100 billion and raised taxes by $100 billion to keep the budget
balanced. What will happen to real equilibrium GDP?
A) Real equilibrium GDP will rise.
B) There will be no change in real equilibrium GDP.
C) Real equilibrium GDP will initially rise, but then fall below its previous equilibrium value.
D) Real equilibrium GDP will fall.
14) If the tax multiplier is -1.5 and a $200 billion tax increase is implemented, what is the change in GDP,
holding everything else constant? (Assume the price level stays constant.)
A) a $133.33 billion decrease in GDP
B) a $300 billion decrease in GDP
C) a $300 billion increase in GDP
D) a $133.33 billion increase in GDP
E) a $30 billion increase in GDP
15) Contractionary fiscal policy to prevent real GDP from rising above potential real GDP would cause the
inflation rate to be ________ and real GDP to be ________.
A) lower; lower
B) higher; lower
C) higher; higher
D) lower; higher
16) The increase in government spending on unemployment insurance payments to workers who lose their jobs
during a recession and the decrease in government spending on unemployment insurance payments to
workers during an expansion is an example of
A) automatic monetary policy.
B) discretionary monetary policy.
C) automatic stabilizers.
D) discretionary fiscal policy.

17) Assume a closed economy with fixed taxes and the marginal propensity to consume is equal to 0.9. What is
the government spending multiplier?
A) 10
B) 9
C) 5
D) 1
18) If the economy is falling below potential real GDP, which of the following would be an appropriate fiscal
policy to bring the economy back to long-run aggregate supply? An increase in
A) government purchases.
B) taxes.
C) oil prices.
D) the money supply and a decrease in interest rates.
19) Crowding out refers to a decline in ________ as a result of an increase in ________.
A) government purchases; private expenditures
B) tax revenues; unemployment
C) private expenditures; government purchases
D) government purchases; tax rates
20) The government purchases multiplier equals the change in ________ divided by the change in ________.
A) consumption spending; government purchases
B) equilibrium real GDP; government purchases
C) government purchases; equilibrium real GDP
D) government purchases; consumption spending
SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.
21) What is expansionary fiscal policy? What is contractionary fiscal policy?
22) Calculate the value of the government purchases multiplier if the marginal propensity to consume equals
0.9, the tax rate equals 0.25, and the marginal propensity to import equals 0.15.
23) What are the key differences between how we illustrate an expansionary fiscal policy in the basic aggregate
demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?
24) If real GDP is $300 billion below potential GDP and the tax multiplier equals -1.5, then how much would the
government need to change taxes to bring the economy to equilibrium at potential?
25) The problem typically during a recession is not that there is too little money, but too little spending. If the
problem was too little money, what would be its cause? If the problem was too little spending, what could
be its cause?
26) How can tax simplification be beneficial to the economy?
27) What is the difference between fiscal policy and monetary policy?
28) If the federal budget goes from a budget deficit in Year 1 to a budget surplus in Year 2, does it follow that the
federal government acted to raise taxes or cut government spending in Year 2?

Table 27-1
Year
1
2

Potential Real GDP


$11.0 trillion
11.5 trillion

Real GDP
$11.0 trillion
11.7 trillion

Price Level
100
109

29) Refer to Table 27-1. Suppose the economy is in the state described by the table above. What problem will
occur in the economy if no policy is pursued? What fiscal policy tools could be used to combat the problem?
Draw a dynamic aggregate demand and aggregate supply diagram to illustrate the appropriate fiscal policy
to use in this situation.

Answer Key
Testname: STUDY GUIDE 8 S2014

1) E
2) C
3) B
4) A
5) C
6) B
7) C
8) B
9) A
10) D
11) B
12) C
13) A
14) B
15) A
16) C
17) A
18) A
19) C
20) B
21) An expansionary fiscal policy is a decrease in taxes or an increase in government purchases intended to increase
aggregate demand. A contractionary fiscal policy is an increase in taxes or a decrease in government purchases
intended to decrease aggregate demand.
22) Government purchases multiplier = 1 / 1 - (0.9(1 - 0.25) - 0.15) = 2.11
23) In the basic aggregate demand and aggregate supply model, expansionary fiscal policy is illustrated by a rightward
shift of the aggregate demand curve, with the short-run aggregate supply curve and long-run aggregate supply
curve remaining stationary. The dynamic aggregate demand and aggregate supply model takes into account the
economy experiencing continuing inflation from year to year and the economy experiencing long-run growth. In
the dynamic model, expansionary fiscal policy is illustrated by a rightward shift of the aggregate demand curve, a
rightward shift of the short run aggregate supply curve, and a rightward shift of the long run aggregate supply
curve.
24) The government would need to cut taxes by $200 billion. Plugging the values into the tax multiplier equation
yields: -1.5 = $300 billion . The change in taxes equals $300 billion , or -$200 billion.
Change in taxes
-1.5
25) Too little money would be caused by too small of a money supply by the Federal Reserve. Too little spending could
be caused by a variety of reasons such as a decrease in consumption spending by households because they become
pessimistic about the future, a decrease in investment spending by firms because they lower their estimates of the
future profitability of new factories and machinery, or a decrease in U.S. exports because a major trading partner is
in a recession.
26) Tax simplification would free up resources in the economy. The complexity of the tax code has created an entire
industry to assist taxpayers in preparing their tax forms. If tax simplification reduces the need for tax preparation
assistance, the resources used in this industry could be allocated to some other productive endeavor. This is
beneficial, as it would reduce wasted resources.
Simplifying the tax code would increase economic efficiency by reducing the time and trouble firms and households
spend solely to reduce their tax payments.
27) Fiscal policy involves changes in federal taxes and purchases and is implemented by Congress and the President.
Monetary policy involves changes in the money supply and interest rates and is implemented by the Federal
Reserve. Both are intended to achieve macroeconomic objectives.
7

Answer Key
Testname: STUDY GUIDE 8 S2014

28) No, the economy could have been in an expansion in Year 2 with GDP growing faster than anticipated. The faster
growth in GDP would raise tax revenues and decrease government spending on transfer payments, decreasing the
budget deficit (in this case, moving it to a budget surplus).
29)

The economy begins in equilibrium at point A, at potential real GDP of $11 trillion and a price level of 100. Without
government policy, aggregate demand will shift from AD1 to AD2 (without policy). Because long-run aggregate
supply shifted from LRAS1 to LRAS2, the economy is pushed above potential real GDP. The economy will be at a
short-run equilibrium at point B, with real GDP of $11.7 trillion and a price level of 109.
The government should pursue contractionary fiscal policy by decreasing government purchases or raising taxes to
shift aggregate demand to AD2 (without policy). The economy will be in equilibrium at point C with real GDP of
$11.5 trillion and a price level of 105. The price level is lower than it would have been if expansionary fiscal policy
had not been used.