NAME:

1 In the diagram, OP is the equilibrium level of income and OQ is the full employment level of income in a
closed economy.

What is the deflationary gap?

A PQ B RV C TV D UV

Explanation: Closed economy is without international trade. Nothing mentioned about the government,
thus G is involved. Since expenditure (C+I+G) is below what is produced (lack of demand -> imagine AD
shifting left and/or oversupply (AS shifting right)), it is deflationary gap. The distance becomes self-
explanatory.

2 In a closed economy with no government sector, when will an increase in investment spending generate
the largest increase in equilibrium national income?

A when households have a high level of autonomous consumption

B when households have a high level of compulsory saving
C when households have a high marginal propensity to consume
D when households have a high marginal propensity to save

Explanation: Option A - a high level of autonomous consumption is independent of current income and does not
amplify the effect of increased investment in the same way that the MPC does (option C). A high level of
compulsory saving (Option B) or a high marginal propensity to save (Option D) would have the opposite effect. It
would mean that more of any additional income is saved rather than spent, which dampens the multiplier effect and
leads to a smaller increase in equilibrium national income.

3 Which statement best describes demand-induced investment?

A It is spending on capital goods by firms because the rate of growth in demand for final goods and
services increases.
B It is spending on capital goods by firms because the cost of borrowing has fallen.
C It is spending on capital goods by firms because they want to access new technology to improve the
output per worker.
D It is spending on new capital goods by firms replacing old and obsolete capital goods.

Explanation: Demand-induced investment occurs when firms increase their investment in capital goods in response
to an increase in the demand for their products. When the demand for final goods and services grows, businesses
anticipate higher sales and profits in the future. To meet this increased demand and capitalize on these potential
profits, firms invest in additional capital goods, such as machinery, equipment, and factories.
D is replacement investment (depreciation). B and C are not related to increased demand.
4 An open economy has injections, J, into the circular flow of income and withdrawals, W.

If the full employment level of national income is OQ, what represents the inflationary gap?

A QE B RT C SR D ST

Explanation: Equilibrium is OE because W(leakages)=J(injections). At full employment of of national income

(which is a state where the economy is producing its maximum potential output, like LRAS) is OQ, the gap between
injections and withdrawals is SR.

5 Which condition will produce the highest value of the national income multiplier in an open economy with
a government sector?

A high average and marginal tax rates

B high marginal propensity to save
C low level of autonomous consumption
D low marginal propensity to import

Explanation: A and B are leakages/wihdrawals – the higher they are the smaller the multiplier effect. C is
not a part of a multiplier effect. D means that MPM deducts only a small fraction from the multiplier.

6 What does not change the level of withdrawals from the circular flow of income?

A households having more of their income taken in tax following a rise in the rate of income tax
B households spending more on imported cars following a currency appreciation
C households taking money from their savings to spend on a celebration
D households transferring money from an account in one bank to a different bank

7 What could be used to offset a leakage from the circular flow of income?

A a reduction in domestic consumption

B a reduction in government expenditure
C an increase in the rate of interest
D an increase in investment

8 An increase in which factor will cause a decrease in investment spending?

A business confidence
B company profits
C interest rates
D national income

Explanation: increase in interest rates -> more expensive borrowing for investments -> more returns from
saving rather than investment. All other options would encourage investment spending.
9 The table shows an individual’s planned consumption at different levels of income.

What can be concluded about changes in the marginal propensity to consume (MPC) and average
propensities to consume (APC) as income rises?

Answer B
Explanation: MPC = change in C / change in income. It is 80/100 across the table. The APC = S/Y, thus
falling.

10 What does the accelerator principle state?

A Consumption is a function of the rate of change of income.

B Income is a function of the rate of change of investment.
C Investment is a function of the rate of change of income.
D Investment is a function of the rate of interest.

11 In a closed economy with no government sector, the multiplier shows the impact of a change in

A consumption on investment.
B investment on national income.
C national income on consumption.
D national income on investment.

Explanation: The only injection in a closed economy (no net exports) without government sector (no G) is
businesses’ investment. Multiplier shows its effect.

12 In an economy, the marginal propensity to consume is 0.2, the marginal propensity to save is 0.3, the
marginal propensity to tax is 0.3 and the marginal propensity to import is 0.2 at all levels of income.

What would be the most likely consequence of an increase in government expenditure of $1000m?

A Import expenditure would increase by $200m.

B Import expenditure would increase by $1000m.
C Tax revenues would increase by $75m.
D Tax revenues would increase by $375m.

Explanation:
1) multiplier (k) = 1/1-MPC(0.2) = 1.25
2) 1.25 x 1000 = 1250m
3) 1250 x 0.3 = 375m (do the same with all given answer options and see which is correct)
13 What identifies net injections into a country’s circular flow of income?

Answer: A

14 In a closed economy with no government there is an equilibrium level of national income of $1000
billion. The households always spend 80% of the income they receive.

If full employment occurs when national income is $1200 billion, by how much must aggregate demand
initially change to close the economy’s deflationary gap?

A –$200 billion B –$40 billion C +$40 billion D +$200 billion

Explanation: The Aggregate expenditure curve is clearly below the 45 degree line because full
employment of national income occurs (OR output is higher by 200 billion). The multiplier effect would be 5
(1/1-0.8=5). Thus 40 bn is enough because 40 x 5 = 200.

15 In a closed economy with no government sector the marginal propensity to consume is 0.6 at all levels
of income. There is an increase in private sector investment of $100 million.

What will be the increase in national income?

A $60 million B $100 million C $166 million D $250 million

Explanation: easy!