Which of the following is not a reason for the slope of the aggregate demand AD curve?

PART I: Multiple Choice. 10 points (each question worth � point)

1.      At every point along the aggregate demand curve,

(a)    Y = C + I + G

(b)   Y = C

(c)    G = T

(d)   none of the above

2.      The Aggregate Demand curve in the following graph will shift from AD1 to AD0 if

(a)    the output level decreased

(b)   the price level increased

(c)    net taxes decreased

(d)   the money supply decreased

Ans. (d)

3.      In the same graph above the economy would move from point A to B along the AD0 curve if

(a)    the money supply increased

(b)   the price level fell

(c)    taxes increased

(d)   both a and b

Ans. (b)

4.      The aggregate supply curve is likely to be nearly vertical for output levels close to capacity because

(a)    interest rates are very high and therefore investment will be decreasing

(b)   aggregate demand is high

(c)    at output levels close to capacity the additional cost of producing more output is likely to be very high

(d)   prices and wages are above their equilibrium levels

Ans. (c)

5.      If the Phillips Curve is vertical in the long run, then an increase in the money supply from year to year will _______ the unemployment rate and will _________inflation rate.

(a)    increase; increase

(b)   increase; not change

(c)    not change; increase

(d)   not change; not change

Ans. (c)

6.      Those holding the classical view of the labor market are likely to believe that

(a)    monetary and fiscal policy have a substantial effect on output and employment in both the short run and the long run

(b)   monetary and fiscal policy have some effect on output and employment in both the short run and the long run

(c)    monetary and fiscal policy have little or no effect on output and employment in both the short run and the long run

(d)   monetary and fiscal policy have some effect on output and employment in the short run, but not in the long run

Ans. (c)

7.      What sequence of events results from a decrease in aggregate demand?

(a)    P ↓, inventories ↓, firms respond by output�, and employment �

(b)   P �, inventories ↓, firms respond by output�, and employment �

(c)    P �, inventories� �, firms respond by output�, and employment �

(d)   P ↓, inventories �, firms respond by output↓, and employment ↓

Ans. (d)

8.      If the AS curve shifts from year to year, but the AD does not then the Phillips curve would show

(a)    a negative relationship between the inflation and unemployment rates

(b)   a positive relationship between the inflation and unemployment rates

(c)    a constant trade-off between the inflation and unemployment rates

(d)   no particular relationship between the inflation and unemployment rates

Ans. (b)

9.      If the government attempts to use stabilization policy, it becomes a �fool in the shower,�� because of:

(a)    implementation lags

(b)   recognition lags

(c)    response lags

(d)   all of the above

Ans. (d)�

10.  In the long run, deficit targeting will

(a)    decrease unemployment

(b)   increase unemployment

(c)    depends on whether the economy is experiencing a boom or a recession

(d)   have no effect on the unemployment rate

Ans. (d)

11.  The Fed policy to �lean against the wind� means that

(a)    interest rates are increased as the economy contracts

(b)   reserve requirements are increased as the economy contracts

(c)    interest rates are decreased gradually as the economy contracts

(d)   reserve requirements are increased significantly during an economic slowdown

Ans. (c)

12.  An examples of an automatic stabilizers within the economy are

(a)    tariffs on imports

(b)   a tax cut approved by Congress

(c)    defense spending changes

(d)   changes in spending for unemployment compensation

Ans. (d)

13.  The payment on a bond is known as the

(a)    maturity payment

(b)   dividend payment

(c)    yield

(d)   coupon

Ans. (d)

14.  If you buy a stock from a firm, you are

(a)    borrowing money from the firm

(b)   a partial owner form the firm and have a claim on the firm�s profits

(c)    suffering a capital loss

(d)   sacrificing future consumption for current consumption

Ans. (b)

15.  On the stock page, the column titled �yield percent� is found by taking the dividend as a percentage of the stock�s

(a)    highest price during the year

(b)   lowest price during the year

(c)    average price during the year

(d)   closing price for the day

Ans. (d)

16.  In response to an increase in the wage rate, the substitution effect _____ hours worked and the income effect ______ hours, if leisure is a normal good.

(a)    Increases, increases

(b)   Increases, decreases

(c)    Decreases, increases

(d)   Decreases, decreases

Ans. (b)

17.  The life-cycle theory of consumption can be summarized by saying that consumption decisions are based

(a)    on permanent income rather than current income

(b)   on current income rather than permanent income

(c)    on an individual�s highest expected annual income

(d)   only on current income

Ans. (a)

18.  An increase in the interest rate

(a)    increases the opportunity cost of future consumption, but has no effect on the opportunity cost of present consumption

(b)   decreases the opportunity cost of future consumption, but has no effect on the opportunity cost of present consumption

(c)    lowers the opportunity cost of present consumption

(d)   reduces the opportunity cost of future consumption

Ans. (d)

19.  Monetarists consider the velocity of money is ( constant )

20.  According to the Laffer curve, a cut in tax rates

(a)    will always increase tax revenue

(b)   will always decrease tax revenues

(c)    will increase tax revenues if the economy is on the positively sloped portion of the Laffer curve, and reduce tax revenues if the economy is on the negatively sloped portion of the Laffer curve

(d)   will decrease tax revenues if the economy is on the positively sloped portion of the Laffer curve, and increase tax revenues if the economy is on the negatively sloped portion of the Laffer curve

Ans (d)

PART II: Short Answer Questions. 10 points (each question worth 2 points)

1.      Suppose the budget deficit is $100 million. If the government wants to balance the budget by cutting government spending, by how much should government spending be reduced? Assume the marginal propensity to consume is 0.5 and that the amount by which the deficit changes with a $1 change in GDP is 50 cents.

The budget cannot be balanced.

2.      Explain the efficiency wage theory. Why would a firm be willing to pay an efficient wage?

Ans. The efficiency wage theory states that productivity increases as wages increase so firms may be willing to pay above the market clearing wage. The benefits the firms may receive include lower turnover, improved morale, and less shirking.

3.      �A balanced budget rule under which the government is required to spend
exactly what it receives in tax revenue would help control inflationary pressures faced by an economy with a positive demand shock� Is this true or false? Explain.

Ans. False. If there is a positive demand shock and income rises, tax revenues will rise and transfers will fall. To keep the budget balanced tax rates have to cut or spending must be increased. Any of this reinforces the first shock and worsens the expansion.

4.      Explain how a decrease in taxes and increase in transfer payments effect consumption and labor supply. Assume the substitution effect dominates the income effect.

Ans. A decrease in taxes increases disposable income which will increase consumption. Also an increase in transfer payments means that nonlabor income has increased which will increase consumption. The decrease in taxes will increase the labor supply, while the hither transfer payments will decrease the labor supply (by income effect).

5.      Suppose you are a New Classical economist that believes in rational expectations and in the Lucas� supply function. What type of economic policy would you recommend to reactivate an economy in a slump? Why?

Ans. The only policy �I� would recommend is one that surprises people. This is because any announced economic policy will lead the people to adjust their (rational) expectations. Hence the policy change will effect both the actual price level and the expected price level equally, leaving output unchanged.

PART III: Essay � 10 points (each question worth 5 points)

Essay # 1

NO ONE expects the Federal Reserve's open market committee, the policymaking body of America's central bank, to raise interest rates when it meets on March 16th. Indeed, a growing number of economists believe rates will remain at 1%, a 45-year-low, at least until the end of 2004. Yet the case for an increase is strengthening.

The main reason why the Fed is expected to hold rates is the feeble state of America's labour market. In February, payrolls rose by only 21,000, an unusually low figure for a briskly growing economy. Not only would it be politically provocative to raise rates--especially in an election year--but sluggish jobs growth will hold down wage pressures and hence inflation. Core consumer-price inflation (i.e., excluding food and energy) is only 1%, a bit low for comfort, so there appears to be no reason to tighten policy. That is the view of most American economists. More important, it is also thought to be the view of Alan Greenspan, the Fed's chairman.

However, some Fed officials, along with several foreign central bankers, are starting to wonder whether policy is being kept too loose for too long. The Fed was right to cut interest rates immediately after the stock market bubble burst; it saved America's economy from a deeper recession and the risk of deflation. But rates cannot stay where they are for ever. Monetary policy is the loosest for 30 years.

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1. Why would the feeble state of America�s labor market justify lower interest rates?

Lowering interest rates will cause investment (I) to rise, and hence aggregate expenditure will rise too, so for each given price level the Aggregate Demand curve will shift to the right leading to higher output and lower unemployment.

1. Why would inflation call for a tightening of interest rates?

Rising interest rates would shift in the Aggregate Demand and reduce pressures on prices.

1. What would happen to GDP, inflation and deficits if the Fed were to increase interest rate? Illustrate graphically using an AS/AD diagram.

Output falls, Prices fall, inflation falls.

Also since output fell, taxes collected will fall and if there is no adjustment in government expenditure, the deficit will rise.

Essay # 2

�It seems like only yesterday that start-up companies, preferably doing something internet-related, and the sleek-suited venture capitalists who funded them, were all the rage.� They could scarcely be less trendy now.� Since the dotcom craze collapsed, many of the firms born during the boom years have died, or else stagger on as shadows of their former selves.� Martin Pichinson, an insolvency specialist who has built a reputation as the �company undertaker� of America�s Silicon Valley, recently said that around 7,000 companies are still waiting for their investors to arrive.� Not surprisingly, the money available for investments in start-up companies slowed to a trickle after the bubble burst.�

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1.      What would you predict a household�s consumption decisions would change after the stock market crash?

Wealth goes down, hence consumption will decrease.

2.      What are the three determinants of stock prices? Given these determinants, why did internet stocks drop in value so suddenly?

Stock prices are determined by expected future dividends, the interest rate and risk.� Internet stocks were part of a speculative bubble, where expectations about the future where uncorrelated with the expected future dividends of the companies.

3.      What are the effects of the stock market boom on saving and the unemployment rate?� Explain

Saving rates and unemployment was lowered since greater wealth encouraged higher consumption. This lead to increased employment throughout the economy.�

Which of the following is not a reason for the slope of the aggregate demand curve?

Which isn't one of the reasons the aggregate demand AD curve slopes downward?

What are the 3 reasons that AD is downward sloping?

Which of the following correctly describes one reason why the aggregate demand AD curve slopes downward?