Chapter 7

Unemployment and the Labor Market

1. The labor force participation rate is defined as

a) the ratio of employment to the labor force
b) the ratio of the working-age population to the total population
c) the ratio of employment to the total population
d) the ratio of the labor force to the civilian, non-institutionalized, working-age population
e) the number of hours worked per week divided by 40

2. Suppose that 30% of a country’s population is institutionalized in schools, hospitals,

or prisons; 10% are full-time homemakers; another 10% are retired; 45% of the population is employed
either full-time or part-time; and 5% of the population is unemployed and seeking work. Then the
unemployment rate is
a) 5%
b) 10%
c) 15%
d) 25%
e) 55%

3. The most accurate measurement of unemployment

a) is an extrapolation based on a random survey of households
b) counts the number of workers collecting unemployment insurance benefits
c) uses payroll data by subtracting the number of workers employed at firms from the number of
citizens of working age
d) uses the number of layoffs reported to the government by employers
e) none of the above

4. The marginal product of labour is defined as

a) the amount of output produced by a given labour force
b) the minimum amount of workers required to produce a given level of output
c) the increase in productivity of the marginal worker if capital is increased
d) the amount of output one more worker could produce given other factors of production are
fixed
e) the cost of employing another worker

5. If the stock of physical capital remains constant while employment rises, output
a) initially declines, then eventually rises
b) increases at an increasing rate
c) remains constant in real terms
d) increases at a decreasing rate
e) fluctuates with the price level

6. Suppose that production at a firm occurs according to the following schedule.

Labor: 0 1 2 3 4 5 6
Output: 0 175 340 495 640 765 880

If the wage per unit of labor is $765 and the price of output is $5 per unit, then the optimal amount of
labor to hire is
a) zero
b) at least one but less than two
c) between three and four
d) five
e) six or more
7. If a firm’s marginal product of labor is currently 75 units of output, the wage is $15
per unit of labor, and output sells for $0.80 per unit, the firm should
a) shut down production
b) hire fewer workers
c) maintain its current workforce, but at fewer hours per worker
d) keep the current number of employees and hours worked
e) hire more labor

8. Suppose that production at a firm occurs according to the following schedule.

Labor: 0 1 2 3 4 5 6
Output: 0 85 160 225 280 325 360

If output sells for $6 per unit, then for 5 units of labor the firm should be willing to pay a wage rate (per
unit of labor) of up to
a) $30
b) $45
c) $180
d) $270
e) $1950

9. The labor supply curve

a) slopes upward if the income and substitution effects of a wage increase exactly offset each other
b) is vertical if the income effect of a wage increase is dominant
c) is downward-sloping if the income effect of a wage increase is dominant
d) is vertical if the substitution effect of a wage increase is dominant
e) is horizontal in the long run

10. Increases in labor productivity from improved technology

a) increase the long run supply of labor
b) reduce the demand for labor
c) reduce real wages
d) induce firms to substitute capital for labor
e) have no long run effect on total hours worked

11. The natural rate of unemployment is a measure of

a) human capital
b) long run equilibrium in the labor market
c) the rate at which natural resources are extracted and depleted
d) the size of the private sector relative to the public sector
e) the rate at which marginal returns to labor are diminishing according to the economy’s long run
production function

12. Among developed economies, the natural rate of unemployment

a) is a fixed number
b) tends to follow a steady upward trend
c) varies, but less the actual unemployment
d) varies more the actual unemployment
e) tends to follow a steady downward trend

13. The rate of unemployment will be higher (for a given level of labour market coordination)
a) if firms have less monopoly power
b) if workers have less monopoly power
c) if firms have monopoly power but workers have none
 d) if both firms and workers have monopoly power
e) if there is no monopoly power

14. Which of the following would not give workers some degree of monopoly power?
a) learning by doing
b) labor unions
c) highly specialized human capital
d) high rates of short term unemployment
e) high costs of job turnover and training incurred by employers

15. If firms seek an average markup of 25% over labor costs, and this is consistent with
labor demands at the natural rate, then in the long run
a) real wages will be 25% of the price level
b) prices will be 4 times greater than wages
c) wages will rise 80 cents for every $1 increase in prices
d) wages will fall 25 cents for every $1 increase in prices
e) prices will rise 25 cents for every $1 increase in wages

16. When the unemployment rate is below the natural rate,

a) wages and prices will begin to rise and employment will fall
b) real wages will fall and employment will increase
c) prices will fall, and unemployment will rise
d) the natural rate will increase to restore equilibrium
e) the unemployment rate will rise, but neither prices not wages will change

17. If firms seek an average markup of 25% over labor costs and workers demand real
hourly wages equal to $10 – 100u where u is the unemployment rate, then the equilibrium rate of
unemployment will be
a) 4.6%
b) 8%
c) 9.2%
d) 10%
e) 25%

18. Which of the following is the least likely to influence the natural rate of
unemployment?
a) monopolies in the goods market
b) labor unions
c) payroll taxes
d) unemployment insurance benefits
e) monetary policy

19. The replacement ratio is defined as

a) The cost of replacing a worker
b) The cost of employing a new worker relative to the value of output they could produce
c) The cost of replacing capital relative to the book value of existing capital
d) Unemployment benefit as a share of previous earnings
e) None of the above

20. In most developed economies, unemployment insurance benefits

a) are nonexistent
b) paid for by insurance companies
c) initially replace 100% of lost wages
d) replace an increasing percentage of lost earnings as the duration of unemployment becomes
prolonged
 e) become less generous as the duration of unemployment is prolonged

21. Unemployment insurance benefits increase productivity most by

a) shortening the duration of unemployment
b) providing replacement rates that are lower than real wages
c) shifting government funds away from less productive ventures
d) helping to improve the match-up between jobs and workers
e) weakening monopoly power

22. Long term unemployment causes all of the following except

a) depreciation of human capital
b) reduced probability of reemployment
c) reduced intensity of job search
d) increased unemployment insurance replacement rates
e) discouraged worker effects and labor market withdrawal

23. The Beveridge Curve is the relationship between

a) Unemployment and unemployment benefits
b) Unemployment and regional mismatch
c) Unemployment and the output gap
d) Unemployment and vacancies
e) Unemployment and Union membership

24. Which of the following taxes has the greatest effect on the natural rate of
unemployment?
a) income taxes
b) retail sales taxes
c) Social Security taxes
d) real estate taxes
e) inheritance taxes

25. Which of the following government policies is not likely to reduce unemployment?
a) increasing payroll taxes
b) making loans to the unemployed who wish to start businesses of their own
c) providing retraining subsidies
d) offering relocation assistance to the unemployed who find work out of town
e) providing publicly funded job placement agencies

26. If 4% of employed workers lose their jobs each period while 76% of the unemployed
find work, then the natural rate of unemployment is
a) 4%
b) 5%
c) about 3%
d) 20%
e) 19%

27. If the rate at which workers flow from employment into unemployment each period is
6% and the flow out of unemployment occurs at a rate of 69%, then the natural rate of unemployment is
a) 4.14%
b) 6%
c) 8%
d) 6.9%
e) 11.5%

28. If the natural rate of unemployment is 10% and 6% of employed workers become
 unemployed each period, then
a) the natural rate is declining
b) 4% of the unemployed remain unemployed each period
c) the labor force is expanding at a rate of 16%
d) the outflow from unemployment occurs at a rate of 54%
e) 60% of the unemployed find employment each period

29. In general, high unemployment is associated with

a) High levels of labour market co-ordination
b) Low levels of labour market co-ordination
c) Both high and low levels of labour market co-ordination
d) Neither high nor low levels of labour market coordination
e) Other factors and is unrelated to labour market co-ordination

30. Which of the following is not typically true of Employment Protection Legislation
(EPL)?
a) countries with strong EPL have low unemployment rates
b) EPL reduces part-time work and labor force participation rates
c) EPL reduces the layoff rate
d) EPL reduces the duration of unemployment
e) EPL benefits the employed at the expense of the unemployed

17. Which of the following is not a valid argument against labor market deregulation?
a) deregulation produces income inequality
b) deregulation reduces wages
c) deregulation leads to crime
d) active labor market spending may be equally or more effective at reducing unemployment than
deregulation
e) deregulation restricts employer choices

18. In the 1990s the Netherlands reduced its unemployment rate by

a) reducing union density and coverage
b) cutting payroll taxes
c) reducing the unemployment insurance replacement rate
d) using active labor market expenditures and coordination
e) all of the above
 Chapter 8
International Trade

1. On average, over the last 50 years or so world trade has

a) increased faster than world output
b) been primarily concentrated in agriculture
c) been dominated by Middle East oil exports
d) declined as nations closed their borders to imports
e) been conducted almost exclusively over the internet

2. Which of the following industries accounts for the largest share of world trade?
a) agriculture
b) mining
c) manufacturing
d) construction
e) services

3. As a general rule,
a) large economies tend to be more open than small economies
b) small economies tend to be more open than large economies
c) small economies tend to export more services than goods
d) small economies tend to have greater diversity of exports than large economies
e) small economies tend only to trade with each other, and large economies tend to do the same

4. The largest exporter of goods and services in the world is

a) China
b) European Union
c) Japan
d) Mexico
e) Saudi Arabia

5. The idea that efficient producers can benefit from trading with inefficient producers is known as
a) the theory of competitive advantage
b) the Hecksher-Ohlin theorem
c) the Stolper-Samuelson theorem
d) New Trade Theory
e) comparative advantage

6. Suppose there are three nations (North, South, and East) and three goods (A, B, and
C). Given resources and technology, North can produce 5 units of A, or 2 units of B,
or 10 units of C, or any linear combination thereof. South can produce 5 units of A,
or 2 units of B, or 5 units of C, or any linear combination thereof. East can produce
either 1 unit of A, or 5 units of B, or 10 units of C, or any linear combination thereof.
The most efficient pattern of specialization is to have
a) North produce A, South produce B, and East produce C
b) North produce A, South produce C, and East produce B
c) South produce A, North produce B, and East produce C
d) South produce A, North produce C, and East produce B
e) East produce A, South produce B, and North produce C

The next four questions refer to the following.

Suppose Canada can produce either 120 units of goods, 80 units of services, or any linear combination
thereof. Mexico can produce 90 units of goods, 50 units of services, or any linear combination thereof.

7. Then in terms of production,

 a) Mexico has an absolute advantage in producing goods
b) Canada should produce both goods and services, but mostly goods
c) neither country should produce services
d) the opportunity cost of producing goods is higher in Canada than in Mexico
e) Mexico is relatively more efficient at producing services than goods

8. International trade under these conditions

a) cannot benefit either country
b) can only benefit Mexico
c) can only benefit Canada
d) can benefit both countries if Canada exports goods and imports services
e) can benefit both countries if Canada exports services and imports goods

9. Under these conditions, the ratio of the international price of services relative to the price of goods
should fall into what range?
a) less than 9/8
b) 9/8 to 2.4
c) 4/3 to 1.6
d) 1.5 to 1.8
e) more than 2.4

10. If by international treaty the ratio of the price of services to the price of goods was held at 1.5, then
a) neither country would benefit from trade
b) both countries will benefit from trade
c) only Canada would benefit from trade; Mexico would lose
d) only Mexico would benefit from trade; Canada would lose
e) Mexico would benefit from trade; Canada would neither gain nor lose

11. The price of a country’s exports relative to the price of its imports is called
a) the export price ratio
b) the comparative advantage
c) the tariff barrier
d) the terms of trade
e) the mercantile factor

12. An increase in a country’s terms of trade means that

a) export-import contracts are of longer duration
b) imports have become relatively more expensive
c) the exchange rate is rising
d) the benefits from trade are increasing
e) the country is becoming less open to foreign trade

13. Applied to trade in two goods between two countries, the principle of comparative advantage does not
suggest that
a) a nation with an absolute disadvantage in producing both goods will have a comparative advantage
in producing one of them
b) the two nations will specialize in the production of different goods
c) both nations will equally benefit from trade
d) consumption possibilities will exceed production possibilities after trade
e) each nation will import the good whose opportunity cost of production is higher at home than abroad

14. According to the Hotelling Rule, the price of an exhaustible natural resource will
a) be very volatile
b) rise at the rate of interest
c) be too low and result in to being exploited too quickly
 d) rise to ensure that the resource never runs out.
e) Always be at the backstop price where rival sources are economic

15. In the Hotelling Rule, which of the following will not cause the price of an exhaustable natural resource
to rise
a) An unanticipated fall in interest rates
b) An unanticipated rise in demand
c) An unanticipated fall in supply
d) An unanticipated rise in the backstop price
e) An unanticipated rise in interest rates

16. The central prediction of the Hecksher-Ohlin theorem is that

a) international goods prices equalize under foreign trade
b) comparative advantages depend on the abundance of factor inputs
c) international trade disperses technology, speeding convergence
d) all nations move beyond their production possibilities sets with free trade
e) exchange rates adjust to ensure purchasing power parity

17. Which of the following would not be predicted by the Hecksher-Ohlin theorem?
a) the US should export capital-intensive and technology-intensive goods
b) India should export labor-intensive goods
c) Canada should have a comparative advantage in forestry
d) Kuwait should specialize in the production of oil
e) Central African Republic should have a comparative advantage in fisheries

18. Which of the following does not help to explain why the US imports capital-intensive goods?
a) preference differences between nations
b) the imposition of tariffs
c) differences in technology across countries
d) the relatively recent development of the US capital-goods industry
e) imperfect competition

19. Which of the following is not an example of intra-industry trade?

a) England exports beef to Ireland, and imports Irish potatoes
b) the Dutch export elm trees and import lumber products
c) Canadians touring the US side of Niagara Falls stay in US motels while Americans touring the
Canadian side stay in Canadian hotels
d) Russia exports oil and imports capital equipment
e) Norwegians deposit funds in Swiss banks while the Swiss buy insurance from Norway

20. If a country exports $1 billion worth of fish each year and imports $4 billion worth of fish, then the
measure of intra-industry trade among its fisheries is
a) .6
b) .4
c) 2/3
d) 1/3
e) .25

21. If production is characterized by increasing returns to scale, then

a) the economy is self-sufficient and will not engage in foreign trade
b) intra-industry trade is likely to occur
c) the nation is more likely to be a net importer than a net exporter
d) the production possibilities set is limitless
e) smaller production runs are more economical than large ones
22. Given the following sectoral trade data, in which case is the level of intra-industry trade in country A
different from that in country B?
a) In A, X = 10, M = 5; in B, X = 20, M = 10
b) In A, X = 7, M = 3; in B, X = 3, M = 7
c) In A, X = 3, M = 2; in B, X = 6, M = 9
d) In A, X = 6, M = 8; in B, X = 4, M = 3
e) In A, X = 12, M = 9; in B, X = 12, M = 15

23. If country A is well-endowed with natural resources but a small population while B is endowed with
much labor but little land and few natural resources, then trade theory predicts that
a) A and B will not trade with each other, as neither can produce enough goods to export
b) A will gain more from trade than B
c) The price of labor-intensive goods will fall in country B after trade
d) Trade will occur, but wages will fall in country A
e) Wages and land values will rise in both countries if they trade

24. The Stopler-Samuelson Theory suggests that

a) Owners of capital tend to gain from trade
b) Countries will have a comparative advantage in goods produced using factors in which the country is
abundant
c) Trade increase the real incomes of owners of the abundant factor of production relative to
those of the owners of the scarce factor
d) Commodity prices tend to fall relative to the price of manufactured goods
e) Tariff protection can benefit a country which is large enough to influence the world price of traded
goods
f) Mexico

25. Differences between trade partners in real hourly wage rates for unskilled labor illustrate
a) the fallacy of the factor-price equalization theorem
b) the importance of different capital endowments
c) discrepancies between nations in accounting procedures
d) the principle of comparative advantage
e) the disequilibria created by international trade

26. Country A has a large pool of skilled workers earning $50 per hour and a small pool of unskilled
workers earning $18 per hour. Country B has a small pool of skilled workers earning $60 per hour and a
large pool of unskilled workers earning $8 per hour. Trade theory predicts that if A and B engage in
international trade with each other,
a) real wages paid to skilled workers will fall in A
b) unskilled wages will become more unequal between A and B
c) real incomes will become more equal within B
d) the wages of unskilled workers in B will fall
e) wages to all workers in both countries will rise

27. Advocates of competitiveness as a argument for trade protection

a) apply an adversarial business model to international trade
b) confuse economic growth with comparative advantage
c) favor protection of capital-intensive industries
d) fail to appreciate the role of industrial restructuring
e) all of the above

28. According to New Trade Theory,

a) international trade is not a zero-sum game, but a win-win proposition
b) a nation can create new comparative advantages by subsidizing key industries
 c) protectionism is justified in order to allow “infant industries” to mature
d) competitiveness is an inappropriate model for countries to follow in foreign trade
e) trade wars benefit society by raising the level of competitiveness

29. Which of the following assumptions is common to both New Trade Theory and the model of intra-
industry trade?
a) trade is a zero-sum game
b) production exhibits increasing returns to scale
c) firms behave cooperatively rather than competitively
d) exchange rates adjust to offset the effects of tariffs
e) in the long run, exports equal imports

30. A government subsidy to an industry having increasing returns to scale in order to capture international
market share is an example of
a) an embargo
b) a boycott
c) strategic trade policy
d) the Prebisch-Singer hypothesis
e) import substitution

31. Governments are most likely to adopt trade restrictions because

a) of nationalistic motives and prejudice against other countries
b) protectionist policies benefit society as a whole
c) tariffs are the primary source of government revenue
d) those whom trade hurts are more cohesive and vocal than those whom trade benefits
e) trade weakens the government’s ability to conduct stabilization policy

32. Industries which receive government protection from trade pressures are likely to exhibit all of the
following except
a) high levels of employment
b) low levels of productivity
c) a high proportion of unskilled workers
d) monopoly power
e) comparative advantage
 Chapter 10
Consumption & Investment

1. In most major countries, including Japan, Canada, and the US, fluctuations in consumption are
a) countercyclical and more volatile than GDP
b) countercyclical and less volatile than GDP
c) procyclical and more volatile than GDP
d) procyclical and less volatile than GDP
e) unrelated to fluctuations in GDP

2. The marginal propensity to consume was conceived which famous economist?

a) Adam Smith
b) David Ricardo
c) Thomas Robert Malthus
d) John Maynard Keynes
e) Robert Solow

3. A graphical plot of consumption expenditures against disposable income for the US over the past 20
years shows
a) no apparent relationship between consumption and disposable income
b) consumption remaining roughly constant as disposable income rises
c) consumption falling as disposable income rises
d) consumption rising as disposable income has fallen
e) consumption rising almost proportionately as income rises

4. The marginal propensity to consume is

a) consumption divided by disposable income
b) national income divided by consumption
c) the change in national income caused by a $1 change in consumption
d) the change in consumption caused by a $1 change in disposable income
e) the percentage increase in consumption caused by a 1% decrease in savings

5. The marginal propensity to consume is

a) identical to the average propensity to consume
b) the inverse of the marginal propensity to save
c) the slope of the consumption function
d) the inverse of the expenditure multiplier
e) equal to the income tax rate

6. The expenditure multiplier

a) is defined as the inverse of the savings rate
b) is greater than zero but less than one
c) does not depend on consumption behavior
d) is larger in a country with a large MPC than in a country with a small MPC
e) determines the effect on consumption from an increase in disposable income

7. If the consumption function is C = 750 + .75Y and there are no income taxes, then the expenditure
multiplier is
a) .75
b) .25
c) 4.0
d) 3.0
e) 1,000
The next three questions refer to the following simple Keynesian model.
Suppose C = 1000 + .9Y, G = 400, I = 100, (X – IM) = 0, and there are no income taxes.

8. The equilibrium level of national income is

a) 15,000
b) 13,500
c) 1,500
d) 5,000
e) 4,500

9. If government purchases increase by 100, equilibrium GDP will

a) rise by 25%
b) rise by a factor of 10
c) rise by 90
d) rise by 100
e) rise by 1,000

10. If investment falls by 50, equilibrium GDP will

a) fall by 50
b) fall by 5
c) fall by 500
d) fall by 45
e) fall by half its previous value

11. According to the simple Keynesian model, if disposable income rises,

a) the marginal propensity to consume rises
b) savings falls
c) consumption increases
d) the expenditure multiplier rises
e) all of the above

12. The Keynesian cross model attributes differences between actual output and planned expenditure to
a) unintended inventory accumulation or depletion
b) buffer stocks resulting from risk-averse decision-making regarding production
c) taxes
d) net exports
e) the diminishing marginal product of capital

The next four questions refer to the following.

An individual is endowed with $100 of income in period 1, and will receive an income of 121 in period 2.
The interest rate is 10%, and there are only 2 periods.

13. The maximum first period consumption consistent with the intertemporal budget constraint is
a) 100
b) 110
c) 121
d) 210
e) 221

14. The maximum second period consumption is

a) 100
b) 121
c) 221
d) 231
e) 233.1
15. If first period consumption is $80, then second period consumption must be
a) 129
b) 131
c) 141
d) 143
e) 201

16. In order to have the same level of consumption in both periods, each period’s consumption must be
a) 80
b) 100
c) 110
d) 110.5
e) 121

17. An indifference curve shows

a) different combinations of income and prices at which an individual can afford equal quantities of two
goods
b) different combination of goods that all cost the same
c) different quantities of current and future consumption that are consistent with the intertemporal
budget constraint
d) different combinations of goods that yield the same level of satisfaction
e) different levels of satisfaction that can be obtained from a given budget constraint

18. The slope of an indifference curve defined over current and future consumption
a) is constant
b) is equal to the rate of interest
c) indicates the consumer’s rate of time preference, or impatience
d) is flatter when the curve is farther away from the origin than when it is near the origin
e) is undefined

The next four questions refer to the following.

Current income is 300, expected future income is 363, and the interest rate is 10%.

19. If consumption is to be the same in each period, each period’s consumption must be
a) 330
b) 300
c) 331.5
d) 333
e) 363

20. If current income rises to 363 and consumption is smoothed across periods, then consumption in each
period becomes
a) 326.7
b) 363
c) 399.3
d) 350
e) 371

21. If current income remains 300, while expected future income rises by $63, then maintaining equal
consumption across time requires consumption to be
a) 330
b) 340
c) 350
d) 360
 e) 370

22. If income rises by $63 in each period, so Y(1) = 363 and Y(2) = 426, then in each period consumption
a) also rises by $63
b) becomes 390
c) rises by $56.7, or 90% of $63
d) remains constant
e) rises by $126

23. According to the permanent income hypothesis,

a) consumption responds only to changes in current income
b) consumption responds more to expected future changes in income than to current income
c) consumption responds more to temporary changes in income than to permanent changes
d) consumption responds more to lifetime income than to current income
e) consumption is a function of previous income

24. According to the permanent income hypothesis, which of the following should raise current consumption
the most?
a) a lottery prize of $1,000
b) an unexpected year-end bonus of $1,000
c) a temporary tax cut of $1,000
d) an increase of $1,000 in annual salary
e) an inheritance of $1,000

25. Which of the following is least likely to induce precautionary saving?

a) the decision to retire from work at age 62
b) the possibility of being laid-off from work
c) the uncertainty of one’s lifetime
d) the risk of becoming ill
e) the prospect of a potentially large tax increase in the future

26. An entrepreneur with current income of $200,000 believes that her future income will either fall to
$100,000 or rise to $300,000 with equal probabilities. Her rate of time preference is exactly offset by
the interest rate. In the first of two periods, she spends $178,000 and saves $22,000 for the second
period. Her behavior illustrates
a) a marginal propensity to consume of .89
b) the permanent income hypothesis
c) precautionary saving
d) the bequest motive
e) a borrowing constraint

27. Who among the following is likely to have the highest marginal propensity to consume out of current
income?
a) a rational consumer who intends to behave strictly according to the permanent income hypothesis
b) a risk averse consumer facing a high degree of uncertainty
c) a low-income consumer facing borrowing constraints
d) a working age consumer looking forward to retirement
e) a wealthy parent who is currently accumulating funds to bequeath to his heirs

28. The effect of an increase in interest rates on current consumption is

a) positive among borrowers if the income effect is dominant
b) positive among borrowers if the substitution effect is dominant
c) positive among savers if the income effect is dominant
d) positive among savers if the substitution effect is dominant
e) strongly positive in the aggregate consumption data
29. The economy’s IS curve has a downward slope because
a) when output is too high, firms cut investment to reduce inventory
b) as income rises, consumption rises and saving falls
c) as interest rates rise, investment decreases
d) as uncertainty increases, saving rises and consumption falls
e) as government purchases rise, interest rates fall

30. If realized capital gains are counted as household savings, then the saving rate in the US over the past 2
decades has
a) fallen sharply from 10% to nearly zero
b) hovered near zero and occasionally been negative
c) remained roughly steady at 10%
d) increased sharply
e) varied dramatically as the stock market has fluctuated

31. The marginal propensity to consume is difficult to estimate because

a) it depends on expectations of future income
b) it depends on perceptions regarding the permanence of changes in income
c) it depends on credit and borrowing constraints
d) it declines as uncertainty increases
e) all of the above

The next three questions refer to the following.

Consider an individual who enters adulthood and the labor force at age 18, expects to work 5 years at a real
income of $10,000 per year, anticipates earning a real income of $40,000 per year from age 23 to 63,
expects to retire with a $10,000 annual pension, and live until age 78. Suppose the interest rate is zero, and
the individual seeks perfectly smooth consumption across his adult lifetime.

32. In the absence of borrowing constraints, then beginning at age 18, the individual should consume
a) all of his income as he receives it each year
b) $10,000 every year
c) $20,000 every year
d) $30,000 every year
e) $25,000 every year

33. If borrowing is precluded, then beginning at age 18, the individual will consume
a) $10,000 each year until age 23, then about $32,000 per year afterwards
b) $10,000 every year
c) all of his income as he receives it each year
d) $10,000 per year until age 23, then $25,000 per year afterwards
e) $25,000 every year

34. Suppose there are no borrowing constraints but the individual wishes to leave a bequest of $120,000
(after adjusting for inflation) to heirs. Then annual consumption should be
a) $12,000
b) $16,000
c) $20,000
d) $24,000
e) $28,000

35. The life cycle model explains saving primarily as

a) a desire to leave a bequest to one’s heirs
b) a response to uncertainty regarding longevity
c) a response to high real interest rates
 d) a response to employment and demographic changes over one’s lifetime
e) the result of under-estimating real wealth

36. The long run significance of investment is due to

a) its volatility
b) the importance of capital to economic growth
c) the effect of income on investment
d) the procyclical nature of investment
e) its ability to crowd-out government expenditures

37. Investment is important to the short run health of the economy because it
a) is the largest component of GDP
b) is countercyclical, and thus stabilizing
c) is highly volatile, and thus contributes largely to business cycles
d) can be easily controlled by government
e) is highly predictable, and thus useful for forecasting

38. The useful economic life of a machine depends most importantly on

a) the depreciation rate
b) the interest rate
c) the tax rate
d) risk
e) the marginal revenue produced by the machine

39. If each unit of capital lasts an average of 25 years, then for an economy with a capital stock worth 5
times the annual GDP, approximately what percentage of output must be set aside to replace
depreciation?
a) 5%
b) 10%
c) 20%
d) 25%
e) 30%

40. The measured capital stock in developed countries

a) overestimates real capital growth because capital prices have risen dramatically in recent years
b) underestimates real capital growth because machines have become more powerful and less
expensive
c) overestimates real capital growth because the manpower needed to operate new machines in greater
than in previous years
d) underestimates real capital growth because it does not include financial investments
e) overestimates real capital growth because it includes government consumption expenditures

41. In recent years, Japan, Germany, the UK, and the US have financed most investments
a) from retained earnings
b) by borrowing from banks
c) by issuing bonds
d) by issuing new equity, or shares of stock
e) by using trade credit and capital transfers

42. A firm that can afford to buy capital out of retained earnings without borrowing
a) is indifferent to interest rates
b) invests more as interest rates rise
c) invests less as interest rates rise
d) is indifferent to the marginal product of capital
e) has an increasing marginal product of capital
43. Which of the following does not directly affect the optimal stock of capital?
a) the price of output
b) the marginal product of labor
c) the depreciation rate
d) the risk premium
e) taxes

The next two questions refer to the following.

Consider the following production function for a delivery service.

Number of trucks: 0 1 2 3 4 5
Number of deliveries: 0 100 170 230 280 300

Each delivery generates $200 in gross revenue, and the tax rate is 10 percent on profits. Each truck costs
$11,000.

44. The optimal number of trucks is

a) 1
b) 2
c) 3
d) 4
e) 5

45. The net (after tax) profit will be

a) $4,500
b) $8,100
c) $10,800
d) $11,700
e) $12,400

46. A machine will generate after tax revenues of $1331 at the end of each year for 3 years, after which it
will be worthless. (Its scrap value will only cover the cost of its removal). The interest rate available to
the firm on risk-free bank accounts or bonds is 10 percent. The machine is a worthwhile investment if
its purchase price is less than
a) $3,993.00
b) $4,846.17
c) $3,310.00
d) $4,392.30
e) $3,630.00

47. Which of the following would encourage greater investment in capital?

a) an increase in the corporate profits tax
b) greater uncertainty regarding the rate of return
c) an increase in the price of capital
d) a reduction in the rate of interest
e) an increase in the rate of depreciation or obsolescence

48. Which of the following would most likely discourage investment?

a) an increase in the selling price of a firm’s output
b) a reduction in the selling price of corporate stock
c) an increase in bond prices
d) a reduction in the rate of inflation
e) an increase in the optimal capital stock
49. A firm’s net investment will be negative if
a) the actual capital stock is less than the optimal capital stock
b) the rate of return on capital exceeds the market interest rate
c) the depreciation rate is less than the gross investment rate
d) gross investment is zero
e) its workforce is growing faster than its capital stock

50. Technological advances affect the net capital stock by

a) reducing the volatility of investment
b) inducing obsolescence
c) lowering the marginal product of capital
d) shrinking the gap between gross and net investment
e) raising the aggregate gearing of firms

51. Which of the following is a definition of Tobin’s q?

a) the growth rate of the quantity of money
b) a firm’s optimal capital stock divided by its actual capital stock
c) the ratio of a firm’s stock market valuation to the value of its physical assets
d) the ratio: gross investment/net investment
e) the rate at which physical capital depreciates, plus the interest rate

52. A firm should continue to invest as long as the value of Tobin’s q is

a) negative
b) zero
c) a positive fraction
d) one
e) greater than one

53. A publicly traded firm has 2.5 million shares of stock outstanding, with a current share price of $30. The
firm’s insurance agent estimates that the replacement cost of the firm’s plant and equipment (and related
capital assets) is $70 million. Tobin’s q is
a) 0.84
b) 1.07
c) 1.20
d) 2.33
e) 2.80

54. According to Tobin’s q theory of investment,

a) when the stock market undervalues a company, the company should invest in capital expansion
b) when a firm’s bond prices rise, the firm should sell off existing assets
c) borrowing funds by issuing bonds is always a less expensive way than issuing stock to raise funds
for investment
d) a firm should buy capital when its stock market valuation exceeds the replacement cost of
capital
e) firms should invest at a constant rate each month, a practice known as dollar-cost averaging

55. Tobin’s q may be interpreted as a measure of

a) the quantity of a firm’s output
b) the optimal quantity of output for a monopolist
c) the relative importance of bond financing to equity financing
d) the rate of return on capital divided by the cost of capital
e) the useful life of physical capital

The next four questions refer to the following.

A publicly traded firm has 4 million shares of stock outstanding, with a current share price of $50. The
value of its plant and equipment is $250 million. Its profit annually is $50 million.

56. The average rate of return on existing capital is

a) 5%
b) 10%
c) 15%
d) 20%
e) 25%

57. The average cost of capital is approximately

a) 5%
b) 10%
c) 15%
d) 20%
e) 25%

58. Tobin’s q for this firm is

a) 0.75
b) 0.80
c) 1.00
d) 1.20
e) 1.25

59. This firm should

a) divest itself of some of its capital
b) issue more stock
c) continue to operate as it is
d) invest in new plant and equipment
e) issue bonds

60. Empirical evidence suggests that the relationship between a firm’s investment and its stock prices is
a) strongly negative
b) weakly negative
c) nonexistent; the two variables are independent
d) weakly positive
e) strongly positive

61. In the 1980s, one often-heard explanation for the low levels of net investment in the US and UK was that
a) developed economies had no incentives for acquiring new capital
b) investment opportunities were limited because the already large capital stock was inducing a low
marginal product of capital
c) depreciation and obsolescence were so rapid that firms could barely keep up with demands for
replacing existing capital
d) stock market participants sought short-term capital gains from market appreciations rather
than long term dividends from investment
e) rapid price inflation was creating excessive investor uncertainty

62. A company’s gearing is

a) the ratio of debt to overall assets
b) the ratio of stock market valuation to book value
c) the share price divided by corporate earnings
d) its stockholder’s equity
e) the ratio of taxes paid to the overall wage bill
63. The link between corporate profits and investment
a) results from heavy reliance on internal financing
b) indicates that cash flow is probably the key variable driving investment
c) is the strongest empirical evidence of Tobin’s q
d) explains the persistent drop in investment that occurred throughout the 1990s
e) helps to keep investment fairly stable and countercyclical

64. To the extent that firms base investment decisions on current profits,
a) Tobin’s q theory is supported
b) investment spending tends to destabilize the economy
c) resources are efficiently allocated
d) the hypothesis that available cash flow drives investment is rejected
e) taxes, depreciation, and interest rates are irrelevant

65. Which of the following explains why investment may be procyclical?

a) high installation costs for replacing, updating, and expanding the capital stock
b) simultaneous investment by firms in various industries throughout the economy
c) the correlation between current profits and investment expenditures
d) the basing of expectations on current conditions
e) all of the above

66. In the Keynesian view, the volatility of investment is primarily due to

a) technological advancements
b) waves of productivity change
c) “creative destruction”: new industries destroying old ones
d) “animal spirits”: unpredictable episodes of optimism and pessimism
e) erratic monetary policy by the central bank

67. A firm is most likely to have a value of Tobin’s q that exceeds 1 if

a) it is privately held
b) it consistently allows depreciation to erode its stock of physical capital
c) it holds numerous copyrights
d) its optimal capital stock exceeds its actual capital stock
e) its gross investment exceeds its net investment
 Chapter 11
Business Cycles

1. Business cycles are

a) seasonal changes in output
b) quarterly profit and loss fluctuations around a company’s fiscal-year average
c) long run trends upward or downward in employment
d) medium-term fluctuations of aggregate output around its long term trend
e) gyrations of share prices on the stock market

2. The economy’s capacity to produce is defined in such a way that

a) output cannot exceed capacity
b) the growth of potential GDP corresponds to the economy’s long run trend
c) the economy is always operating at its current potential
d) there is always a degree of slack or inefficiency in production, so output is always below capacity
e) when workers work overtime, capacity expands

3. Output in excess of potential GDP

a) implies a negative output gap
b) describes a recession
c) is impossible
d) is unsustainable
e) creates deflation

4. A large negative output gap

a) represents a shortage of goods due to excessive demand for output
b) is the result of overtime work by the labor force
c) creates inflation
d) means the business cycle is at a peak
e) implies excessive unemployment

5. A traditional definition of recession is

a) any GDP gap which persists for 9 months or more
b) deflation or a slowing of the inflation rate for one year or more
c) a temporary shock to the economy resulting in the need for fiscal or monetary stimulus
d) at least two successive quarters of positive unemployment
e) negative GDP growth for half a year or more

6. A growth recession occurs when

a) there are two successive quarters of negative GDP growth
b) economic growth is so rapid that it creates inflation
c) real GDP is growing but nominal GDP is not
d) potential GDP declines
e) GDP grows at a slower rate than its long run trend

The next two questions refer to the following.

Consider the following hypothetical annual growth rates of real GDP:

Long run trend 1996 1997 1998 1999 2000 2001 2002 2003
2.5% 3.0% 2.5% 2.0% -1% 0.5% 2.0% 2.5% 3.0%

7. 1998 appears to have been a year of

a) economic expansion
b) recession
 c) depression
d) growth recession
e) stagflation

8. Economic recovery from recession appears to have begun in

a) 1999
b) 2000
c) 2001
d) 2002
e) 2003

9. Okun’s law refers to

a) The tendency for recessions in the USA to spread throughout the world
b) The generally stable negative relationship between the output gap and deviations of
unemployment from the natural rate
c) The generally stable positive relationship between the output gap and deviations of unemployment
from the natural rate
d) The tendency for business cycle volatility to fall over time
e) The negative relationship between unemployment and job vacancies

10. Over the course of the business cycle

a) the public sector is the most procyclical sector of the economy
b) manufacturing tends to be countercyclical
c) the service sector displays greater volatility than manufacturing
d) construction is the most volatile sector of the economy
e) the amplitude of fluctuations in the public sector exceeds that of GDP as a whole

11. Which of the following is characteristic of business cycles?

a) consumption displays greater volatility than GDP
b) investment remains relatively stable throughout the business cycle
c) the inflation rate is a leading indicator of recessions and expansions in GDP
d) the unemployment rate is a leading indicator of recessions and expansions in GDP
e) the growth rate of wages fluctuates less than the growth rate of GDP

12. Which of the following variables typically moves in the opposite direction from national income?
a) the inflation rate
b) the unemployment rate
c) consumption
d) investment
e) GDP

13. Comparing State economies to that of the US as a whole shows that

a) about half the States are in recession at any point in time
b) when the US enters a recession, about 20% of the States experience economic expansion, and vice
versa
c) there is very little correlation between the national and regional economies
d) there is a highly positive correlation between the national economy and most State economies
e) the 12 Federal Reserve districts experience business cycles independently of each other

14. Internationally, recessions

a) are likely to begin in the smallest economies and spread to larger ones
b) are isolated events, uncorrelated across countries
c) in one region mean that world demand has shifted elsewhere, so other countries do not fall prey to
downturns at the same time
d) are especially contagious among trade partners
 e) are most pronounced among Socialist countries

15. Comparisons of business cycles before and after World War II show that
a) there has been no significant change in the nature of business cycles
b) the amplitude of business cycles has increased in recent years
c) diminishing foreign trade has successfully reduced volatility in the post-war period
d) expansions have lengthened and contractions have shortened
e) recessions have become shorter but deeper, while expansions have become shorter with higher
growth rates

16. The Great Moderation refers to

a) Dramatic fall in business cycle volatility that occurred from the mid-1980s to the mid-2000s
b) The general fall in business cycle volatility after the second world war
c) The fall in global output that occurred after 2007
d) Improved monetary policy since the mid-1980s
e) Improved fiscal policy since the mid-1980s

17. The impact of recession

a) is, in the aggregate, a more significant factor in social welfare than long run growth
b) is more severe for professionals than for semi-skilled manual laborers
c) is more severe for skilled workers than for unskilled workers
d) causes larger declines in consumption among those aged 26 to 45 than among teenagers
e) is most severe for the poorest members of society

18. Business cycles affect long run growth because

a) uncertainty caused by business cycles deters investment
b) installation costs for new plant and equipment are lower during recessions than during periods of
expansion
c) human capital depreciates during recessions
d) the competition to survive a recession provides incentives for firms to reorganize for greater
efficiency
e) all of the above

19. The most controversial element of the Frisch-Slutsky paradigm concerns

a) the direction in which employment moves during business cycles
b) the duration of business cycles
c) which types of events can cause business cycles
d) the manner in which exogenous shocks are translated into business cycles
e) whether the business cycle creates impulses or propagation mechanisms

20. According to Real Business Cycle theory,

a) lack of consumer confidence causes most business cycles
b) price fluctuations are unimportant because they affect nominal, not real GDP
c) recessions are an optimal response to negative technology shocks
d) fiscal policy is the most appropriate way to smooth out economic fluctuations
e) labor supply curves are extremely steep

21. Which of the following plays a central role in Real Business Cycle theory?
a) monopoly pricing
b) the marginal product of labor
c) the marginal propensity to consume
d) expectations
e) monetary policy

22. Which of the following is not assumed in Real Business Cycle theory?
 a) labor supply curves are relatively flat
b) markets allocate resources efficiently
c) economic expansions are caused by technological improvements
d) recessions are caused by reductions in aggregate demand
e) the marginal product of labor changes over the course of the business cycle

23. Compared to Keynesians, Real Business Cycle theorists

a) have greater optimism regarding markets
b) give a larger role to stabilization policy
c) believe technology plays a relatively minor role in short run fluctuations
d) are more likely to claim that individuals are unresponsive to price changes
e) are relatively unconcerned with productivity shocks

24. Which of the following correctly describes a theory of wage behavior during the business cycle?
a) Real Business Cycle theory holds that workers are relatively unresponsive to wage changes
b) Classical theory holds that nominal wages are inflexible
c) Keynesian theory holds that real wages may rise during recessions, preventing labor markets
from clearing
d) Rational expectations theory holds that workers continue to anticipate wage increases during
recessions
e) Marxist theory holds that unions cause recessions by keeping wages too high

25. One of Keynes’ most profound insights was that

a) markets allocate resources efficiently, as if by an invisible hand
b) comparative advantage allows all nations to gain from trade
c) capitalists exploit workers by paying them less than the total value of what they produce
d) the same factor that drives long run growth—technological change—also causes business cycles
e) the economy can achieve an equilibrium below its capacity

26. Strategic complementarity refers to

a) two trade partners producing goods in which they have the greatest relative efficiency, and sharing
the benefits through trade
b) the increase in demand for one good when the price of another good falls
c) a market failure in which individual decisions are not coordinated
d) the relationship between capital and labor during a business cycle
e) government subsidies for investment

27. Which of the following is inconsistent with Keynesian models of business cycles?
a) wage and price stickiness
b) coordination failure
c) multiple equilibria
d) efficient market allocation
e) the need for stabilization policy

28. One of the reasons why higher prices affect the quantity of real output demanded is
a) at higher prices, business people become richer, so demand rises
b) at higher prices, real household wealth is reduced, so the quantity of output demanded falls
c) when prices are high, consumers fear that a recession is approaching
d) when pricing are rising, the central bank tends to reduce interest rates, thereby reducing demand
e) at higher prices, time becomes more valuable, so people buy now instead of later

29. The slope of the aggregate demand curve is generally believed to be

a) an increasing function of the interest rate
b) an increasing function of the price level
c) a decreasing function of the price level
 d) horizontal
e) initially upward-sloping, then eventually becoming vertical

30. Which of the following would cause an outward shift of aggregate demand?
a) an increase in interest rates
b) an increase in tax rates
c) the expectation of higher income
d) improvements in technology
e) an increase in imports

31. The shape of the short run aggregate supply curve is generally believed to be
a) a decreasing function of the price level
b) an increasing function of the interest rate
c) an increasing function of the price level
d) vertical
e) backward-bending

32. Over the course of the business cycle, most firms respond
a) to negative shocks by cutting wages
b) to positive shocks by raising prices
c) to negative shocks by cutting prices
d) to positive shocks by raising output
e) all of the above

33. Survey data suggest that most firms

a) respond to increased demand by utilizing overtime
b) respond to increased demand by sub-contracting work to other firms
c) review their pricing policies either daily or weekly
d) change the prices of output monthly
e) adjust wages and output prices with equal frequency

34. Which of the following can create a “real rigidity” in price setting?
a) constant marginal cost as output rises
b) fixed contracts to sell at a given price
c) existing advertisements which include prices
d) item prices for goods on store shelves
e) menu costs

35. If firms are producing below capacity,

a) it is not possible to increase output
b) they will charge higher prices to maintain profit levels
c) resources, especially labor, are in short supply
d) output can be expanded by hiring extra workers
e) an increase in aggregate demand will force firms into bankruptcy

36. As firms raise output in response to rising aggregate demand,

a) resources become scarce, wages eventually rise, and a point is reached beyond which output
cannot expand
b) they become increasingly efficient and are thus able to pass the cost savings on to consumers in the
form of lower prices
c) real wages fall, interest rates rise, and consumers buy less
d) they hire fewer workers and substitute capital for labor
e) the level of nominal GDP falls, though real GDP rises

37. In the long run, the shape of the aggregate supply curve is
 a) upward-sloping, because output can be increased only at higher costs
b) horizontal, because all inputs are variable
c) horizontal, because markets become perfectly competitive
d) vertical, because further expansion of output is unprofitable, regardless of prices
e) downward-sloping, because firms must ultimately charge lower prices in order to sell more output

38. The long run can be distinguished from the short run because in the long run
a) an equilibrium is reached between aggregate supply and aggregate demand
b) resources are no longer scarce
c) firms produce at capacity
d) the inflation rate is zero
e) technological advances come to an end

39. In the long run,

a) nominal wages rise more slowly than prices
b) output is independent of the price level
c) real wages are higher than money wages
d) a higher price level elicits a sustained increase in production
e) the aggregate demand curve is perfectly horizontal

40. In contrast to the long run, in the short run

a) changes in wages may lag behind changes in employment
b) the economy produces at full capacity
c) GDP follows a steady trend without fluctuations
d) the aggregate supply curve is vertical
e) the quantity of money has no effect on output

41. All other things being equal, in the absence of public policy, an economy producing more than its
sustainable capacity will eventually
a) reduce its long run capacity by wearing out its capital and depleting its natural resources
b) increase its long run capacity to meet the demand
c) experience wage and price increases and cutbacks in supply until output is at capacity
d) export the excess output to other countries
e) exhibit improved technology

42. A sudden, unexpected increase in the economy’s prevailing wage level due to a general strike threat
would
a) shift the aggregate demand curve out and push equilibrium prices down
b) shift the aggregate demand curve in and push equilibrium output down
c) shift the short run aggregate supply curve in and push equilibrium prices up
d) shift the Phillips Curve in and increase the natural rate of unemployment
e) shift the long run aggregate supply curve out and push equilibrium prices down

43. Assuming aggregate supply is upward-sloping and aggregate demand is downward-sloping, a sudden
reduction in a nation’s exports will
a) cause inflation
b) cause recession
c) cause stagflation
d) increase GDP and reduce prices
e) increase GDP and raise equilibrium prices

44. Which of the following could cause a recession?

a) An increase in consumption
b) An increase in saving
c) An increase in investment
 d) An increase in government purchases
e) An increase in exports

45. Increases in aggregate demand are likely to create

a) deflation during recessions
b) inflation when the output gap is quite negative
c) higher output when the output gap is negative, and inflation when output is at capacity
d) reductions in output if the output gap is already positive
e) both inflation and recession

46. If the price of imported inputs suddenly rises,

a) we buy less, so aggregate demand falls
b) we pay more for the same quantity, so aggregate demand rises
c) we substitute domestic sources of inputs, so aggregate demand rises
d) our ability to produce is reduced, so aggregate supply shifts inward
e) GDP in unaffected because imports are netted out of gross domestic product
 Chapter 12
Money and Prices

1. Consider the following data from the Economic Report of the President.

Year price index

1992 100.00
1993 102.64
1994 105.09
1995 107.76
1996 110.22

According to the data in the table, the inflation rate for 1996 was
a) 10.22 %
b) 2.28 %
c) 2.46 %
d) 1.1022 %
e) 11.022 %

2. The inflation rates in the 7 major industrialized countries

a) have fallen steadily since 1970
b) reached a peak in the mid-1990s
c) have been historically high in all countries except the U.S. during the 1990s
d) have been nearly zero since 1970, because prices have been stable
e) were higher in the mid- and late 1970s than at any time since

3. The stagflation of the 1970s is generally attributed to

a) the Cold War arms race
b) the introduction of large-scale computer systems into business
c) the opening of US markets to Japanese automobiles
d) increases in oil prices
e) changing cultural values regarding work and leisure

4. Which of the following is not a reason that the cost of owner-occupied housing is difficult to measure?
a) Housing is both an investment and consumption good
b) Buying a house is a one-off expenditure, but the benefits of home ownership are spread over many
years
c) Owner-occupiers do not pay rent which is the most straightforward measure of the cost of housing
d) House purchase, when it occurs, is too large a share of total spending
e) Many countries do not have a well developed rental market from which to calculate imputed rents
for owner occupiers

5. Which price index is not affected by the cost of imports?

a) the consumer price index
b) the retail price index
c) the wholesale price index
d) the producer price index
e) the GDP deflator

6. Post-World War II inflation rates, as measured by the CPI

a) are overestimated due to the inability to measure quality improvements
b) are underestimated due to the exclusion of import prices
c) are not comparable across decades due to decennial changes in the base year
d) have tended to move in the opposite direction of inflation rates as measured by the GDP deflator
e) have become increasingly accurate as technology has improved
7. If incomes rose proportionately with prices, then in the absence of taxes
a) money would cease to be a veil
b) real GDP would increase
c) everyone would be worse off
d) prices would have no effect on output or well-being
e) resources would be over allocated to the present at the expense of future generations

8. Which of the following is not a likely consequence of inflation?

a) Firms incur the “menu costs” of changing advertisements
b) Some taxpayers are pushed into higher tax brackets
c) The value of currency is reduced
d) Banks reduce nominal interest rates to reflect expected inflation
e) Price signals sent by consumers to firms are distorted

9. Suppose a loan of $100 is made at a fixed nominal interest rate of 5% for one year. During the year,
there is unexpected inflation of 7%. Which of the following is true?
a) The inflation has redistributed income from the lender to the borrower
b) The real rate of interest is 12%
c) The borrower will be obligated to repay $107 instead of $105
d) The real rate of interest is 2%
e) None of the above

10. The inflation tax is

a) an additional income tax levied during periods of inflation to prevent government revenue from
losing value
b) the movement of taxpayers into higher tax brackets due to inflation
c) the reduction in the value of cash due to inflation
d) the federal sales tax on goods whose prices rise by more than the general inflation rate
e) a tax on trucking, so called because of the inflation of the tires

11. Inflation is primarily a problem

a) because even low inflation rates severely hamper GDP growth
b) for those who are heavily indebted
c) when it is volatile and thus unpredictable
d) because it is severely underestimated, especially when products are improving in quality
e) for accounting and record-keeping, but it does not affect the actual trading of goods and services

12. Japan appeared to have entered a liquidity trap at the turn of the century because
a) inflation made currency holdings virtually worthless
b) the central bank pushed nominal interest rates so high than investment stagnated
c) consumer spending rose dramatically, depleting savings
d) deflation pushed real interest rates up to levels that the central bank could not correct
e) long-term investments depleted the economy of cash

13. The widespread historical use of gold or silver in transactions is an example of

a) barter
b) commodity money
c) fiat money
d) credit
e) paper money

14. Fiat money differs from commodity money in that

a) only fiat money can be made legal tender
b) fiat money has no intrinsic value
 c) fiat money is backed by gold
d) only fiat money can serve as a unit of account
e) only commodity money can serve as a store of value

15. Which of the following is not a problem associated with barter?

a) tax rates are generally higher on barter than on monetary transactions
b) the quality of goods used in barter may differ across time and place
c) transporting goods for use in barter is inconvenient
d) goods used in barter may not be easily divisible
e) barter requires a double coincidence of wants

16. In the 1970s when US President Richard M. Nixon ended the gold standard,
a) barter became the predominant method of transacting business
b) silver took the place of gold
c) hyperinflation occurred
d) he created a pure fiat money
e) a run on banks ensued

17. In the late 13th century, Chinese money consisted of

a) stones
b) tobacco
c) beads made of sea shells
d) paper
e) gold

18. The ease with which assets can be converted to cash for transactions is called
a) convertibility
b) liquidity
c) float
d) seignorage
e) the substitution effect

19. Which of the following is not included in M2?

a) coins
b) gold
c) savings accounts
d) retail money market mutual funds
e) overnight repurchase agreements

20. When depositors transfer funds from savings accounts to checking accounts,
a) M2 falls and M1 rises, while M3 remains constant
b) M1 rises while M2 and M3 remain constant
c) both M1 and M2 increase, while M3 falls
d) M3 falls while M1 and M2 remain constant
e) M1 falls, M3 rises, and M2 remains constant

The next two questions refer to the following.

The Economic Report of the President estimated that for 1997, the US had the following money stock
components (in billions): $426 in currency; $391.7 in checking account deposits; $8.2 in travelers checks;
$242.8 in other checkable deposits; $963.7 in small denomination time deposits; $1395.4 in savings
accounts; $591.5 in retail money market mutual funds; $579.2 in large time deposits; $235.9 in term
repurchase agreements; $139.1 in Eurodollar accounts; and $359.5 in institutional money market mutual
funds.
21. The value of M1 was
a) $434.2
b) $825.9
c) $1068.7
d) $2454.1
e) $3417.8

22. The value of M2 was

a) $2454.1
b) $3417.8
c) $4019.3
d) $4958.0
e) $5333.0

23. Banks can expand the nation’s money supply by

a) issuing credit cards
b) paying interest on deposits
c) lending out excess reserves
d) cashing checks
e) selling life insurance

24. Compared with a 100% reserve system, fractional reserve banking

a) makes the economy more stable
b) creates a greater risk of bank insolvency
c) gives banks less control over the money supply
d) makes the money multiplier smaller
e) means that each dollar of currency is backed by a smaller amount of gold

25. Suppose a sunken ship containing $1000 in currency is dredged out of Lake Erie. The currency is still
legal tender, but interest rates are high so no one wants to hold onto the currency; the owners therefore
deposit it in a bank. If the reserve requirement is 20% and the banks hold no excess reserves, the
eventual result will be
a) the money supply decreases by $200
b) the money supply increases by $1000
c) the money supply increases by $2000
d) the money supply increases by $5000
e) the money supply remains unchanged

26. The government’s profit from printing currency is called

a) seignorage
b) arbitrage
c) the rate of exploitation
d) the inflation tax
e) the velocity of money

27. Seignorage is an especially important source of government revenue in countries

a) with weak credit industries
b) with low inflation rates
c) with high tariffs on imports
d) with a currency tied to the dollar
e) that still use commodity money

28. Which of the following is characteristic of a hyperinflation?

a) the government runs a large budget surplus by raising taxes
b) households increase their savings
 c) government finances expenditures by printing money
d) the real stock of money rises by more than 50% per month
e) currency is issued according to a gold standard

29. According to the quantity theory of money,

a) the quantity of money determines the long run equilibrium price level
b) the amount of money in the economy determines the long run quantity of output
c) money affects the aggregate supply curve, while the aggregate demand curve determines real output
d) the money supply only affects the economy in the long run, not in the short run
e) the full-capacity level of output determines the supply of money needed in the economy

30. The number of times a unit of currency changes hands for transactions in a given period is called
a) the transactions demand for money
b) the money multiplier
c) M1
d) GDP
e) velocity

31. The equation of exchange states that the relationship among the money supply (M), the price level (P),
the velocity of money (V) and real output (Y) is
a) MP = VY
b) M/P = YV
c) PV = MY
d) MV = PY
e) Y/V = MP

32. Which of the following is an assumption used by monetarists in establishing the quantity theory of
money?
a) real GDP is equal to the multiplicative product of the money supply and the price level
b) the velocity of money is constant
c) households exhibit rational expectations
d) households exhibit money illusion
e) all of the above

33. Consider the following (hypothetical) cash economy with no banks. The money
supply consists entirely of $1000 in currency. Output is currently at potential. The government is
currently faced with a $100 budget deficit and chooses not to raise taxes, but instead prints $100 more
currency with which to balance its budget. The long run result is likely to be
a) an interest rate of 10%
b) an inflation rate of 10%
c) a 10% increase in the velocity of money
d) a 10% growth rate of real GDP
e) a 10% increase in the national debt

34. The quantity theory of money is most likely to be relevant

a) when money supply growth is 2% or less
b) as a short-term policy prescription
c) for economies on the gold standard
d) as a long run explanation for inflation
e) when the velocity of money is volatile
 Chapter 13
Monetary Policy

1. Which of the following is most likely to be an ultimate target for monetary policy?
a) short term interest rates
b) reserve ratios
c) the inflation rate
d) exchange rates
e) stock market indexes, such as the S&P 500

2. Which of the following is most likely to be an intermediate target for monetary policy?
a) short term interest rates
b) the unemployment rate
c) investment expenditures
d) gross domestic product
e) the money supply

3. For central banks, short term interest rates are likely to be

a) long run policy targets
b) intermediate-term targets
c) operational instruments
d) taken as exogenously determined
e) irrelevant to policy making

4. In the Keynesian model,

a) the IS curve shows all points of informational symmetry between buyers and sellers
b) the IS curve represents international symbiosis between economies
c) the LM curve shows equilibrium positions in the goods market
d) the LM curve gives the locus of points at which imports equal exports
e) the LM curve shows where the supply and demand for money are equal

5. The horizontal and vertical axes of the LM curve diagram represent, respectively,
a) the quantity of money and the price level
b) the quantity of money and the interest rate
c) real GDP and the interest rate
d) real GDP and the price level
e) the unemployment rate and the inflation rate

6. The LM curve slopes upward because

a) as income rises, the demand for money begins to exceed its supply
b) as interest rates rise, the demand for money rises
c) as the price level rises, the velocity of money increases
d) as the money supply rises, the inflation rate increases
e) as the demand for money rises, the supply of money is increased

7. A reduction in the money supply

a) reduces both interest rates and GDP
b) pushes the LM curve down
c) pushes the LM curve inward
d) shifts the IS curve outward
 Chapter 14
Fiscal Policy and the Role of Government

1. Which of the following government functions could most easily be handled by the private sector?
a) education
b) national defense
c) the legal system
d) the police force
e) foreign policy

2. In most developed economies, government’s share of GDP

a) exceeds 60%
b) has dropped dramatically since World War II
c) is less than 30%
d) rose continually throughout the twentieth century
e) fell during the Great Depression, and is now at World War I levels

3. Which of the following is a transfer payment?

a) the wages paid to a civil servant
b) the government’s payment to a contractor building a bridge
c) an interest payment on the national debt
d) a Social Security check sent to a retiree
e) the purchase of a subway token

4. In most developed countries, the largest and fastest growing component of government expenditure has
been
a) national defense
b) transfer payments
c) interest on the national debt
d) transportation expenditures
e) the cost of maintaining the legal system

5. In most developed economies, public spending on national defense

a) is the largest component of the government’s budget
b) accounts for about 1/3 of GDP
c) is less than spending on transfer payments
d) cannot be distinguished from infrastructure expenditures in the national accounts
e) is financed by a national system of subscriptions

6. Which of the following is not a requirement for markets to be efficient?

a) perfect information
b) rational behavior by all agents
c) complete markets
d) competition in production
e) the absence of transaction costs

7. When no one can be made better off without making someone else worse off, the economy is
a) in a steady state
b) operating at full capacity
c) Pareto efficient
d) autarkic
e) operating under oligopolistic conditions

8. If markets are Pareto efficient,

a) no one benefits from redistribution
 b) redistribution is a zero-sum game
c) arbitrage opportunities exist
d) resource allocation is sub-optimal
e) resources are fully utilized but output remains unsold

9. Which of the following is not generally considered a market failure?

a) public goods
b) missing markets
c) the undesirable distribution of income
d) monopoly
e) allocation of resources based on price

10. Which of the following is a pure public good?

a) a library book
b) public transportation
c) the judicial system
d) an interstate highway
e) all of the above

11. The problem with public goods is that

a) too many people are excluded from their use and must find alternatives in the private sector
b) the opportunity to act as a free rider is a disincentive to pay for public goods
c) they compete with private goods, driving companies out of business
d) they could be provided more efficiently by private companies
e) they are distributed according to willingness to pay rather than ability to pay

12. Which of the following government functions most clearly prevents rent-seeking behavior from leading
to a socially inefficient Nash equilibrium?
a) provision of national defense
b) operation of Social Security
c) provision of public education
d) issuance of patents
e) establishing municipal rent control on urban apartments

13. Which of the following is not a valid explanation for government provision and forced consumption of
education?
a) myopic individuals make time-inconsistent decisions
b) education is a public good
c) forced education redistributes income
d) education has positive externalities, or benefits to non-consumers
e) education enhances human capital and raises GDP

14. Which of the following is a justification for transfer payments?

a) transfers can create a more ethically acceptable income distribution
b) income redistribution provides insurance against misfortune
c) poverty creates negative externalities such as crime and disease
d) myopic individuals make time-inconsistent saving decisions
e) all of the above

15. For central governments is most OECD countries,

a) business taxes are the largest source of government revenue
b) Social Security contributions are smaller than taxes for other transfer programs
c) taxes on property income are the major source of government revenue
d) direct taxes on households raise more revenue than corporate taxes
e) lotteries generate more revenue than taxes
16. Payroll taxes distort the labor market by
a) reducing gross wages
b) shifting the demand curve for labor outward
c) increasing the supply of labor
d) increasing hours of work
e) driving a wedge between wages paid and wages received

The next five questions refer to the following.

Suppose the supply of labor is W – t = 10H, where W is the gross wage, t is the tax (in dollars), and H is
labor hours. The demand for labor is W = 120 – 2H.

17. With a tax of zero dollars, equilibrium occurs at

a) H = 10, W = 100
b) H = 9, W = 90
c) H = 8, W = 80
d) H = 7, W = 70
e) H = 6, W = 60

18. With a tax of $12, hours of work become

a) H = 8
b) H = 9
c) H = 10
d) H = 11
e) H = 12

19. The dollar value of the distortion caused by a $12 tax is

a) $6
b) $12
c) $18
d) $24
e) $30

20. What fraction of this tax is borne by the workers?

a) 1/6
b) 2/6
c) 3/6
d) 4/6
e) 5/6

21. If the tax doubles to $24, the distortion

a) declines
b) remains the same
c) doubles
d) triples
e) quadruples

22. According to the Laffer Curve

a) Tax revenue always increases as tax rates rise
b) Tax revenue always falls as tax rates rise
c) Tax revenue initially rises with the tax rate but when tax rates get too high revenue begins to
fall
d) Tax revenue initially falls with the tax rate but when tax rates reach some optimal level revenue
begins to rise
e) Tax revenue is unrelated to the tax rate
23. Which of the following was not a peak period for the US debt/income ratio?
a) the Civil War
b) World War I
c) World War II
d) The War on Poverty
e) The end of the Cold War

24. When government runs a budget deficit,

a) interest rates decline
b) tax revenues exceed public expenditures
c) the national debt increases
d) inflation rates decline
e) the outstanding stock of government bonds is reduced

25. Since World War II, with the exception of the late 1990s, the governments of most developed countries
have
a) run budget surpluses
b) repaid their national debts
c) run budget deficits in times of recession
d) kept their budgets balanced
e) been net lenders in times of recession

26. By the start of the 21st century, the developed economies with the largest national debt relative to GDP
were
a) US and Spain
b) Italy and Japan
c) France and Germany
d) Australia and New Zealand
e) Norway and Ireland

27. The shortfall between tax receipts and government expenditure excluding interest on the national debt is
called the
a) structural budget deficit
b) current account deficit
c) primary deficit
d) tax gap
e) debt ceiling

28. The efficiency argument for tax smoothing is that tax-induced distortions are smallest when taxes are
a) levied on goods with highly elastic supply curves
b) levied on goods with highly elastic demand curves
c) not changed frequently
d) raised during recessions and lowered during booms
e) used to finance government consumption rather than infrastructure

29. Balancing the government’s budget each year would

a) allow tax rates to remain constant from year to year
b) reduce uncertainty over future tax rates and net income
c) exacerbate recessions
d) stabilize short run GDP
e) generate smaller economic distortions than a policy of countercyclical deficits and surpluses