Macroeconomics 4th Australian Edition by Olivier Blanchard – Test Bank

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ExamName___________________________________MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.1)Suppose there is a simultaneous RBA sale of bonds and increase in government spending. Weknow with certainty that this combination of policies must cause:1)A)a decrease ini.B)a decrease inY.C)an increase inY.D)an increase ini.E)an increase inM.Answer:DExplanation:A)B)C)D)E)2)Suppose the economy is currently operating on both the IS curve and the LM curve. Which of thefollowing is true for this economy?2)A)Financial markets are in equilibrium.B)The money supply equals money demand.C)Production equals demand.D)The quantity supplied of bonds equals the quantity demanded for bonds.E)All of the above.Answer:EExplanation:A)B)C)D)E)3)Suppose there is an RBA purchase of bonds and simultaneous tax cut. We know with certainty thatthis combination of policies must cause:3)A)an increase inY.B)a decrease inM.C)a decrease ini.D)an increase ini.E)a decrease inY.Answer:AExplanation:A)B)C)D)E)1
4)An increase in the budget deficit increasing the level of investment is known as:4)A)the crowding out of investment.B)the crowding out of budget deficit.C)the crowding in of budget deficit.D)the crowding out of output.E)the crowding in of investment.Answer:EExplanation:A)B)C)D)E)5)Suppose there is a simultaneous tax decrease and open market sale of bonds. Which of thefollowing must occur as a result of this policy mix?5)A)Output increases.B)The interest rate decreases.C)Output decreases.D)The interest rate increases.E)Both output and the interest rate decrease.Answer:DExplanation:A)B)C)D)E)6)Suppose the economy is operating on the LM curve but not on the IS curve. Given this information,we know that:6)A)the money market and goods market are in equilibrium and the bond market is not inequilibrium.B)the money market and bond markets are in equilibrium and the goods market is not inequilibrium.C)the goods market is in equilibrium and the money market is not in equilibrium.D)the money, bond and goods markets are all in equilibrium.E)neither the money, bond, nor goods markets are in equilibrium.Answer:BExplanation:A)B)C)D)E)2
7)Which of the following will occur if there is an increase in consumer confidence?7)A)The IS curve will shift rightward.B)The LM curve will shift down.C)The LM curve will shift up.D)The IS curve will shift leftward, and the LM curve will shift down.E)The IS curve will shift leftward.Answer:AExplanation:A)B)C)D)E)8)Suppose there is a tax cut and the central bank controls the money supply. Which of the followingis a complete list of the variables that must increase as a result of the tax cut?8)A)Consumption and output.B)Consumption.C)Consumption, output and investment.D)Consumption and investment.E)Consumption, output and the interest rate.Answer:EExplanation:A)B)C)D)E)9)An increase in the money supply must cause which of the following?9)A)An upward shift in the LM curve.B)A decrease in the interest rate and ambiguous effects on investment.C)An increase in investment and a rightward shift in the IS curve.D)No change in output if investment is independent of the interest rate.E)No change in the interest rate if investment is independent of the interest rate.Answer:DExplanation:A)B)C)D)E)10)An increase in the budget deficit decreasing the level of investment is known as:10)A)the crowding out of investment.B)the crowding out of the budget deficit.C)the crowding in of investment.D)the crowding out of output.E)the crowding in of the budget deficit.Answer:AExplanation:A)B)C)D)E)3
11)Suppose there is a decrease in consumer confidence and the central bank controls the interest rate.Which of the following represents the complete list of variables that must decrease in response tothis consumer pessimism?11)A)Consumption.B)Consumption and output.C)Consumption and investment.D)Consumption, output and the interest rate.E)Consumption, investment and output.Answer:EExplanation:A)B)C)D)E)12)Which of the following will cause a shift in the LM curve?12)A)An increase in money supply.B)An increase in firm confidence.C)An increase in the interest rate.D)An increase in taxes.E)An increase in output.Answer:AExplanation:A)B)C)D)E)13)An increase in consumer confidence will likely have which of the following effects?13)A)A rightward shift in the IS curve.B)A leftward shift in the IS curve.C)An upward shift in the LM curve.D)A downward shift in the LM curve.E)A rightward shift in the IS curve and an upward shift in the LM curve.Answer:AExplanation:A)B)C)D)E)4
14)Suppose there is a simultaneous tax increase and open market purchase of bonds. Which of thefollowing must occur as a result of this policy mix?14)A)Output decreases.B)Output increases.C)The interest rate increases.D)The interest rate decreases.E)Both output and the interest rate increase.Answer:DExplanation:A)B)C)D)E)15)A decrease in government spending will cause:15)A)a rightward shift in the IS curve.B)a leftward shift in the IS curve.C)an upward shift in the LM curve.D)a downward shift in the LM curve.E)a rightward shift in the IS curve and a downward shift in the LM curve.Answer:BExplanation:A)B)C)D)E)16)We know with certainty that a decrease in tax must cause which of the following?16)A)A decrease in output if the central bank simultaneously pursues a contractionary monetarypolicy.B)An increase in the interest rate and an increase in investment.C)An increase in the interest rate and a decrease in investment.D)An increase in the interest rate and an upward shift in the LM curve.E)An increase in the interest rate and an ambiguous effect on investment.Answer:EExplanation:A)B)C)D)E)5
17)A decrease in the aggregate price level,P, will most likely have which of the following effects?17)A)A rightward shift in the IS curve.B)A leftward shift in the IS curve.C)An upward shift in the LM curve.D)A downward shift in the LM curve.E)A downward shift in the IS curve and an upward shift in the LM curve.Answer:DExplanation:A)B)C)D)E)18)An increase in the reserve deposit ratio,Ό, will most likely have which of the following effects?18)A)A rightward shift in the IS curve.B)A leftward shift in the IS curve.C)An upward shift in the LM curve.D)A downward shift in the LM curve.E)A downward shift in the IS curve and an upward shift in the LM curve.Answer:CExplanation:A)B)C)D)E)19)Assume that investment spending depends only on the interest rate and no longer depends onoutput. Given this information, a decrease in money supply:19)A)will cause investment to increase.B)may cause investment to increase or to decrease.C)will have no effect on output.D)will cause a reduction in output and have no effect on the interest rate.E)will cause investment to decrease.Answer:EExplanation:A)B)C)D)E)6
20)Suppose there is a simultaneous tax increase and open market sale of bonds. Which of thefollowing must occur as a result of this?20)A)Output increases.B)Output decreases.C)The interest rate increases.D)The interest rate decreases.E)Both output and the interest rate increase.Answer:BExplanation:A)B)C)D)E)21)Assume that investment spending depends only on the interest rate and no longer depends onoutput. Given this information, a decrease in government spending:21)A)causes an increase in output and has no effect on the interest rate.B)has no effect on output.C)has no effect on investment.D)causes investment to increase.E)causes investment to decrease.Answer:DExplanation:A)B)C)D)E)22)Which of the following best defines the IS curve?22)A)Illustrates the effects of changes inion desired money holdings by individuals.B)The combinations ofiandYthat maintain equilibrium in the goods market.C)The combinations ofiandYthat maintain equilibrium in the financial markets.D)Illustrates the effects of changes inYon investment.E)Illustrates the effects of changes inion investment.Answer:BExplanation:A)B)C)D)E)7
23)A RBA sale of securities will most likely have which of the following effects?23)A)A rightward shift in the IS curve.B)A leftward shift in the IS curve.C)An upward shift in the LM curve.D)A downward shift in the LM curve.E)A downward shift in the IS curve and an upward shift in the LM curve.Answer:CExplanation:A)B)C)D)E)24)Assume that investment spending depends only on output and no longer depends on the interestrate. Given this information, an increase in government spending:24)A)will cause investment to increase.B)may cause investment to increase or to decrease.C)will have no effect on investment.D)will cause an increase in investment if the interest rate decreases.E)will cause investment to decrease.Answer:AExplanation:A)B)C)D)E)25)We know with certainty that a tax cut must cause which of the following?25)A)An increase in output.B)An increase in investment.C)A decrease in output.D)A decrease in the interest rate.E)No change in output.Answer:AExplanation:A)B)C)D)E)8
26)Suppose fiscal policy makers implement a policy to increase the size of a budget deficit. Based onthe IS-LM model, we know with certainty that the following will occur as a result of this fiscalpolicy action:26)A)The price level increases.B)Output increases.C)Investment spending decreases.D)Output decreases.E)Investment spending increases.Answer:BExplanation:A)B)C)D)E)27)Based on our understanding of the IS-LM model, we know with certainty that the policy mix inAustralia in response to the global crisis would have resulted in:27)A)an increase in the interest rate.B)an increase in output.C)no change in output.D)a decrease in the interest rate.E)a decrease in output.Answer:BExplanation:A)B)C)D)E)28)Suppose there is a decrease in consumer confidence and the central bank controls the moneysupply. Which of the following represents the complete list of variables that must decrease inresponse to this consumer pessimism?28)A)Consumption and investment.B)Consumption and output.C)Consumption, investment and output.D)Consumption.E)Consumption, output and the interest rate.Answer:EExplanation:A)B)C)D)E)9
29)Assume that investment does not depend on the interest rate. A decrease in government spendingwill cause which of the following for this economy?29)A)An increase in the interest rate.B)An increase in output.C)No change in investment.D)An increase in investment.E)A decrease in investment.Answer:EExplanation:A)B)C)D)E)30)The IS curve will not shift when which of the following occurs?30)A)A decrease in government spending.B)A decrease in firm confidence.C)A decrease in consumer confidence.D)A decrease in taxes.E)A decrease in the interest rate.Answer:EExplanation:A)B)C)D)E)31)Based on our understanding of the IS-LM model that takes into account dynamics, we know that adecrease in the money supply will cause:31)A)a gradual increase inYand a gradual decrease ini.B)an immediate decrease iniand an immediate increase inY.C)a gradual increase iniand a gradual decrease inY.D)an immediate increase iniand no initial change inY.E)an immediate decrease inYand an immediate increase ini.Answer:CExplanation:A)B)C)D)E)10
32)Based on our understanding of the IS-LM model that takes into account dynamics, we know that adecrease in government spending will cause:32)A)an immediate decrease iniand no initial change inY.B)a gradual increase iniand a gradual decrease inY.C)a gradual decrease iniand a gradual decrease inY.D)a gradual decrease iniand a gradual increase inY.E)an immediate decrease inYand immediate increase ini.Answer:CExplanation:A)B)C)D)E)33)Under the reasonable dynamic assumptions, a temporary monetary contraction should result in:33)A)an immediate rise in the interest rate, and then a further rise over time.B)an immediate rise in the interest rate, and no further interest rate changes.C)an immediate rise in the interest rate, and then a fall in the interest rate over time.D)no change in the interest rate initially, and then a sudden rise to its new equilibrium value.E)a very gradual but steady rise in the interest rate to its new equilibrium level.Answer:CExplanation:A)B)C)D)E)34)Assume that investment does not depend on the interest rate. An increase in the money supply willcause which of the following for this economy?34)A)A decrease in output.B)An increase in the interest rate.C)An increase in investment.D)No change in investment.E)A decrease in investment.Answer:DExplanation:A)B)C)D)E)11
35)Suppose there is a simultaneous tax increase and open market purchase of bonds. Which of thefollowing must occur as a result of this?35)A)Output increases.B)Output decreases.C)The interest rate increases.D)The interest rate decreases.E)Both output and the interest rate increase.Answer:DExplanation:A)B)C)D)E)36)Suppose the current level of output and the interest rate are such that the economy is operating onneither the IS nor LM curve. Which of the following is true for this economy?36)A)Financial markets are not in equilibrium.B)The money supply does not equal money demand.C)Production does not equal demand.D)The quantity supplied of bonds does not equal the quantity demanded for bonds.E)All of the above.Answer:EExplanation:A)B)C)D)E)37)In the IS-LM model,an increase in the money supply will cause an increase in which of thefollowing variables?37)A)Output.B)Consumption.C)Investment.D)All of the above.E)None of the above.Answer:DExplanation:A)B)C)D)E)12
38)A decrease in consumer confidence will likely have which of the following effects?38)A)A rightward shift in the IS curve.B)A leftward shift in the IS curve.C)An upward shift in the LM curve.D)A downward shift in the LM curve.E)A rightward shift in the IS curve and an upward shift in the LM curve.Answer:BExplanation:A)B)C)D)E)39)A reasonable dynamic assumption for the IS-LM model is that:39)A)the economy is always on the LM curve, but moves only slowly to the IS curve.B)the output market is quick to adjust, but the money market adjusts more slowly.C)the economy is always on both the IS and LM curves.D)adjustment to the new IS-LM equilibrium is instantaneous after an LM shift, but not after anIS shift.E)the economy is always on the IS curve, but moves only slowly to the LM curve.Answer:AExplanation:A)B)C)D)E)40)Which of the following statements is consistent with a given LM curve?40)A)An increase in output causes an increase in demand for goods.B)An increase in the interest rate causes investment spending to decrease.C)An increase in the interest rate causes money demand to decrease.D)An increase in output causes an increase in money demand.E)An increase in the interest rate causes a decrease in the money supply.Answer:DExplanation:A)B)C)D)E)13
41)Assume that investment spending depends only on output and no longer depends on the interestrate. Given this information, a decrease in government spending:41)A)will cause investment to increase.B)may cause investment to increase or to decrease.C)will have no effect on investment.D)will cause an increase in investment if the interest rate decreases.E)will cause investment to decrease.Answer:EExplanation:A)B)C)D)E)42)Suppose there is a fiscal expansion and the central bank controls the interest rate. Which of thefollowing is a complete list of the variables that must increase as a result of the fiscal expansion?42)A)Consumption and output.B)Consumption, output and the interest rate.C)Consumption, output and investment.D)Consumption and investment.E)Consumption.Answer:CExplanation:A)B)C)D)E)43)Which of the following best defines the LM curve?43)A)Illustrates the effects of changes inMon investment.B)Illustrates the effects of changes inYon money supply.C)The combinations ofiandYthat maintain equilibrium in the financial markets.D)The combinations ofiandYthat maintain equilibrium in the goods market.E)Illustrates the effects of changes inion desired money holdings by individuals.Answer:CExplanation:A)B)C)D)E)14
44)Which of the following statements is consistent with a given IS curve?44)A)An increase in the interest rate causes money demand to decrease.B)An increase in taxes causes an increase in demand for goods.C)An increase in government spending causes a decrease in demand for goods.D)An increase in the interest rate causes investment spending to decrease.E)An increase in the interest rate causes a decrease in the money supply.Answer:DExplanation:A)B)C)D)E)45)A decrease in the money supply must cause which of the following?45)A)An increase in the interest rate and ambiguous effects on investment.B)A downward shift in the LM curve.C)A decrease in investment and a leftward shift in the IS curve.D)No change in output if investment is independent of the interest rate.E)No change in the interest rate if investment is independent of the interest rate.Answer:DExplanation:A)B)C)D)E)46)Which of the following describes the Australian policy mix in response to the global crisis in2008-09?46)A)Fiscal expansion and tax contraction.B)Fiscal expansion and monetary contraction.C)Fiscal expansion and monetary expansion.D)Fiscal contraction and monetary expansion.E)Fiscal contraction and monetary contraction.Answer:CExplanation:A)B)C)D)E)15
47)Suppose there is a simultaneous tax cut and open market purchase of bonds. Which of thefollowing must occur as a result of this?47)A)Output increases.B)Output decreases.C)The interest rate increases.D)The interest rate decreases.E)Both output and the interest rate increase.Answer:AExplanation:A)B)C)D)E)48)Which of the following describes the US policy mix during the 2001 recession?48)A)Expansionary fiscal policy and expansionary monetary policy.B)Contractionary fiscal policy and contractionary monetary policy.C)Contractionary fiscal policy and expansionary monetary policy.D)Expansionary fiscal and contractionary tax policy.E)Expansionary fiscal policy and contractionary monetary policy.Answer:AExplanation:A)B)C)D)E)49)Which of the following will cause a shift in the IS curve?49)A)An increase in taxes.B)An increase in government spending.C)An increase in consumer confidence.D)An increase in firm confidence.E)All of the above.Answer:EExplanation:A)B)C)D)E)16
50)Suppose there is a simultaneous central bank purchase of bonds and increase in taxes. We knowwith certainty that this combination of policies must cause:50)A)an increase ini.B)a decrease inY.C)a decrease inM.D)a decrease ini.E)an increase inY.Answer:DExplanation:A)B)C)D)E)51)Suppose there is a simultaneous tax cut and open market sale of bonds. Which of the followingmust occur as a result of this?51)A)Output increases.B)Output decreases.C)The interest rate increases.D)The interest rate decreases.E)Both output and the interest rate increase.Answer:CExplanation:A)B)C)D)E)52)A RBA purchase of securities will most likely have which of the following effects?52)A)A rightward shift in the IS curve.B)A leftward shift in the IS curve.C)An upward shift in the LM curve.D)A downward shift in the LM curve.E)A downward shift in the IS curve and an upward shift in the LM curve.Answer:DExplanation:A)B)C)D)E)17
53)The IS curve will not shift when which of the following occurs?53)A)An increase in firm confidence.B)An increase in taxes.C)An increase in consumer confidence.D)An increase in the money supply.E)An increase in government spending.Answer:DExplanation:A)B)C)D)E)54)An increase in government spending will cause:54)A)a rightward shift in the IS curve.B)a leftward shift in the IS curve.C)an upward shift in the LM curve.D)a downward shift in the LM curve.E)a rightward shift in the IS curve and a downward shift in the LM curve.Answer:AExplanation:A)B)C)D)E)55)Suppose the central bank decides to conduct an open market sale of bonds. Which of the followingwill occur as a result of this monetary policy action?55)A)The LM curve shifts up.B)The LM curve shifts down.C)The IS curve shifts leftward as the interest rate decreases.D)The IS curve shifts rightward as the interest rate increases.E)The LM curve shifts up and the IS curve shifts leftward.Answer:AExplanation:A)B)C)D)E)56)Which of the following is the definition for the real supply of money?56)A)The ratio of real GDP to the nominal money supply.B)The actual quantity of money, rather than the officially reported quantity.C)The real value of currency in circulation only.D)The stock of money measured in terms of dollars.E)The stock of money measured in terms of goods, not dollars.Answer:EExplanation:A)B)C)D)E)18
57)Which of the following describes the policy mix of the Gillard Labor government in Australia andthe Reserve Bank of Australia in 2012?57)A)Fiscal expansion and monetary expansion.B)Fiscal expansion and monetary contraction.C)Fiscal expansion and tax contraction.D)Fiscal contraction and monetary expansion.E)Fiscal contraction and monetary contraction.Answer:DExplanation:A)B)C)D)E)58)Which of the following is the correct definition of the IS curve?58)A)The IS curve represents the single level of output where financial markets are in equilibrium.B)The IS curve represents the combinations of output and the interest rate where the financialmarkets are in equilibrium.C)The IS curve represents the single level of output where the goods market is in equilibrium.D)The IS curve represents the combinations of output and the interest rate where the moneymarket is in equilibrium.E)The IS curve represents the combinations of output and the interest rate where the goodsmarket is in equilibrium.Answer:EExplanation:A)B)C)D)E)59)Which of the following is true for a given point on the LM curve?59)A)Inventory investment equals zero.B)The bond market is in equilibrium.C)The goods market is in equilibrium.D)Production is equal to demand.E)The financial markets are in equilibrium.Answer:EExplanation:A)B)C)D)E)19
60)An increase in the aggregate price level,P, will most likely have which of the following effects?60)A)A rightward shift in the IS curve.B)A leftward shift in the IS curve.C)An upward shift in the LM curve.D)A downward shift in the LM curve.E)A downward shift in the IS curve and an upward shift in the LM curve.Answer:CExplanation:A)B)C)D)E)61)A decrease in the reserve deposit ratio,Ό, will most likely have which of the following effects?61)A)A rightward shift in the IS curve.B)A leftward shift in the IS curve.C)An upward shift in the LM curve.D)A downward shift in the LM curve.E)A downward shift in the IS curve and an upward shift in the LM curve.Answer:DExplanation:A)B)C)D)E)62)We know with certainty that a tax hike must cause which of the following?62)A)An increase in output.B)A decrease in investment.C)No change in output.D)A decrease in output.E)An increase in the interest rate.Answer:DExplanation:A)B)C)D)E)63)Assume that investment spending depends only on the interest rate and no longer depends onoutput. Given this information, an increase in money supply:63)A)will cause investment to increase.B)may cause investment to increase or to decrease.C)will have no effect on output.D)will cause a reduction in output and have no effect on the interest rate.E)will cause investment to decrease.Answer:AExplanation:A)B)C)D)E)20
64)Which of the following will occur if there is a decrease in taxes?64)A)Neither the IS nor the LM curve shifts.B)The IS curve shifts and the economy moves along the LM curve.C)Both the IS and LM curves shift.D)Output will change causing a change in money demand and a shift of the LM curve.E)The LM curve shifts and the economy moves along the IS curve.Answer:BExplanation:A)B)C)D)E)65)Suppose there is a simultaneous central bank sale of bonds and tax increase. We know withcertainty that this combination of policies must cause:65)A)a decrease inY.B)an increase ini.C)an increase inM.D)a decrease ini.E)an increase inY.Answer:AExplanation:A)B)C)D)E)66)We know with certainty that an increase in tax must cause which of the following?66)A)A decrease in the interest rate and an ambiguous effect on investment.B)No change in output if the central bank simultaneously pursues a contractionary monetarypolicy.C)A decrease in the interest rate and an upward shift in the LM curve.D)A decrease in the interest rate and an increase in investment.E)A decrease in the interest rate and a decrease in investment.Answer:AExplanation:A)B)C)D)E)ESSAY. Write your answer in the space provided or on a separate sheet of paper.67)Explain in detail what effect a central bank purchase of bonds will have on: (1) the LM curve and (2) the IScurve.Answer:A central bank purchase of bonds causes an increase inhigh-powered moneyand an increase in themoney supply. This leads to an excess supply of money and the interest rate must fall to restore moneymarket equilibrium. The LM curve shifts down as a result to reflect the lower interest rate. The IS curvedoes not shift, it is a movement along the IS curve as the LM curve shifts downwards.21
68)Explain: (1) what happens to income, money demand, the interest rate, and output when an increase ingovernment spending is implemented and (2) what happens to the position of the LM curve as a result of thefiscal expansion if the central bank controls the interest rate.Answer:(1) A fiscal expansion such as an increase in government spending results in an increase in income, anincrease in money demand, and an increase in the equilibrium interest rate in the financial markets. Thefiscal expansion causes an increase in output. (2) If the central bank controls the interest rate, an increasein government spending leads to open market purchases of bonds by the central bank to increase themoney supply so as to keep the interest rate constant.69)Explain (1) what happens to the interest rate, investment, demand, and output when the central bank pursuescontractionary monetary policy and (2) what happens to the position of the IS curve as the central bank pursuescontraction monetary policy.Answer:(1)When the central bank pursues contractionary monetary policy, this policy measure leads to anincrease in the interest rate, a decrease in investment, a decrease in demand, and a lower level ofequilibrium output. (2) Changes in the interest rate do not, however, cause shifts in the IS curve. Insteadthey lead to movements along the IS curve.70)First, define the LM curve. Second, explain why it has its particular shape.Answer:The LM curve illustrates the combinations of the interest rate and output that maintain financial marketequilibrium. The curve is upward sloping because as income increases, money demand will rise. Thisincrease in money demand will cause an excess demand for money and an excess supply of bonds. Bondprices will fall and the interest rate will increase until equilibrium is restored.71)Based on your understanding of the IS-LM model, graphically illustrate and explain what effect a decrease inconsumer confidence will have on output, the interest rate, and investment.Answer:A decrease in consumer confidence (orc0in the consumption function) decreases demand and leads to aleftward shift in the IS curve. If the central bank controls the level of money supply, as output decreases,money demand decreases causing the interest rate to fall. However, the effects on investment areambiguous. Lower output decreases investment while the lower interest rate increases investment.If the central bank instead controls the interest rate and its current policy stance is to keep itconstant, the decrease in output as a result of the fall in consumer confidence triggers open market salesof bonds by the central bank to keep the interest rate constant. Hence the effect on investment workssolely through output and investment unambiguously decreases.72)Explain in detail what effect a decrease in government spending will have on: (1) the LM curve and (2) the IScurve.Answer:A decrease in government spending causes a decrease in disposable income and consumption. The fall inconsumption causes a decrease in demand and the equilibrium level of output in the goods marketbecomes lower. This is reflected in a leftward shift in the IS curve. If the central bank controls the moneysupply, goods market events such as lower government spending does not shift the LM curve (only amovement along it). However, if the central bank controls the interest rate, in response to the decrease inthe interest rate as a result of the fiscal contraction, the central bank conducts open market sales of bondsto decrease the money stock to keep the interest rate constant. This has the effect of shifting the LM curveupwards until the same interest rate is attained.22
73)Explain: (1) what happens to income, money demand, the interest rate, and output when an increase in tax isimplemented and (2) what happens to the position of the LM curve as a result of the fiscal contraction if thecentral bank controls the money supply.Answer:(1) A fiscal contraction such as an increase in tax results in a decrease in income, a decrease in moneydemand, and a decrease in the equilibrium interest rate in the financial markets. The fiscal contractioncauses a decrease in output. (2) If the central bank controls the money supply, changes in output onlycause movements along the LM curve as the IS curve shifts leftwards.74)Use the IS-LM model that incorporates dynamics andexplain the effect on output, the interest rate, andinvestment when the government increases taxes. Assume that the central bank controls the interest rate.Answer:Let’s consider first the response of the IS-LM model without dynamics. When there is an increase in taxthe IS curve shifts to the left and output decreases. If the central bank allows the interest rate to fall, the neteffect on investment is ambiguous. On the other hand, if the central bank keeps the interest rate constant,investment clearly decreases because of lower output/sales.When dynamics are added to the analysis, it takes some time for consumption spending to respondto the decrease in disposable income, some more time for production to decrease in response to thedecrease in consumption spending, yet more time for investment to decrease in response to lower sales,for consumption to decrease in response to decrease in income, and so on. All the while, the central bankmonitors the economic situation and would take some time to decide between keeping the interest rateconstant and decreasing the interest rate (presumably depending the central bank’s assessment of thedownward pressure on prices or inflation). In other words, when dynamics are part of the analyticalpicture, the adjustments coming from the macroeconomic variables take time to complete.75)First, briefly explain what is meant by the policy mix. Second, explain what effect different policy mixes mighthave on the level of output, investment, and the interest rate.Answer:The policy mix refers to the possible combinations of monetary (expansionary or contractionary) andfiscal (expansionary or contractionary) policies that can be simultaneously implemented. Sometimes apolicy mix is designed to achieve a common goal. For example, in response to the negative impactbrought on by the global crisis, the Australian government (more precisely the Commonwealth Treasuryin Australia) pursued expansionary fiscal policy to increase the budget deficit. At the same time theReserve Bank of Australia cut the cash rate to implement expansionary monetary policy. Most economiststhink that this expansionary policy mix helped to maintain output growth in Australia during the periodof the global crisis. Generally, the effects on output, the interest rate, and investment depend on the typeof mix.The chapter also discusses that a policy mix may occur when the central bank in the IS-LM modelis assumed to control the interest rate instead of controlling the money supply. Given an IS shock, e.g.changes in consumer or firm confidence or changes in fiscal policy, the effects on output, the interest rate,and investment depend on whether the central bank decides to hold or to change the interest rate.76)Explain: (1) what happens to income, money demand, the interest rate, and output when an increase in tax isimplemented and (2) what happens to the position of the LM curve as a result of the fiscal contraction.Answer:(1) A fiscal contraction such as an increase in tax results in a decrease in income, a decrease in moneydemand, and a decrease in the equilibrium interest rate in the financial markets. The fiscal contractioncauses a decrease in output. Provided the central bank controls the money supply, however, changes inoutput only cause movements along the LM curve. If the central bank controls the interest rate, anincrease in tax leads to open market sales of bonds by the central bank to decrease the money supply soas to keep the interest rate constant.23
77)Use the IS-LM model to answer this question and assume the central bank controls the money supply. Supposethere is a simultaneous decrease in government spending and increase in the money supply. Explain what effectthis particular policy mix will have on output and the interest rate. Based on your analysis, do we know withcertainty what effect this policy mix will have on investment? Explain.Answer:In this case, the LM curve shifts down and the IS curve shifts to the left. The interest rate will clearly belower. The effect on output depends on the relative magnitude of the two policies. If output decreases,the net effect on investment is ambiguous. It is possible for output to increase, in this case, investmentwill be higher.78)Use the IS-LM model to answer this question and assume that the central bank controls the interest rate.Suppose there is a simultaneous increase in taxes and interest rate cut. Explain what effect this particular policymix will have on output and the money supply. Based on your analysis, do we know with certainty what effectthis policy mix will have on investment? Explain.Answer:In this case, the LM curve shifts down as the central bank purchases bonds to release more liquidity intothe economy. The IS curve shifts to the left. The interest rate will clearly be lower. The effect on outputdepends on the relative magnitude of the two policies. If output falls, the net effect on investment isambiguous. It is possible for output to rise, in this case, investment will be higher.79)Explain the determinants of investment and how a change in each determinant affects investment.Answer:Investment depends on the level of sales/output and on the interest rate. As output changes, the demandfor goods changes and firms changes investment so that their capacity changes with the level of economicactivity (and demand). Investment also depends on the interest rate. As the interest rate rises, the cost ofborrowing rises (if firms use own funds, the higher interest rate raises the opportunity cost of loaning thefunds out). Firms cut back on investment as borrowing costs (or the opportunity costs) rise.80)Use the IS-LM model that incorporates dynamics andexplain the effect on output, the interest rate, andinvestment when the central bank cuts the interest rate.Answer:Let’s consider first the response of the IS-LM model without dynamics. When the central bank conductsopen market purchases of bonds to decrease the interest rate the LM curve shifts downwards and outputincreases. Investment unambiguously increases.When dynamics are added to the analysis, it takes some time for investment spending to respond tothe decrease in the interest rate, some more time for production to increase in response to the increase indemand, yet more time for consumption and investment to increase in response to the induced change inoutput, and so on. In other words, when dynamics are part of the analytical picture, the adjustmentscoming from the macroeconomic variables take time to complete.81)Define the IS curve and explain why it has its particular shape.Answer:The IS curve illustrates the different combinations of the interest rate and output that maintainequilibrium in the goods market. The IS curve is downward sloping because as the interest rate falls,firms increase investment. This increase in investment causes an increase in demand and a correspondingincrease in equilibrium output in the goods market.24
82)Based on your understanding of the IS-LM model, graphically illustrate and explain what effect a monetaryexpansion will have on output, the interest rate, and investment.Answer:If the central bank controls the level of money supply, an increase in the money supply shifts the LMcurve down and the interest rate decreases. As the interest rate decreases, firms increase investmentcausing a rise in demand and subsequent expansion in output (i.e., the multiplier effect). Investment ishigher due to the increase inoutput and the decrease in the interest rate. The interest rate endogenouslyadjusts to policy changes in the money supply.If the central bank controls the interest rate, monetary expansion is represented by an interest ratecut. The central bank conducts open market purchases of bonds which increase the money supply in themoney market. In this case, the level of money supply is endogenous to the policy setting of the interestrate. The expansionary effect on output and investment is identical as above.83)Increasing the budget deficit is believed to cause decreases in investment. Based on your understanding of theIS-LM model, will a fiscal policy action that causes an increase in the budget deficit cause a decrease ininvestment? Explain.Answer:The short-run effect on investment of a fiscal policy measure that increases the budget deficit, either anincrease inGor a decrease inTor a combination of both, will depend on the response of an interest-ratesetting central bank. If the central bank decides to hold the interest rate fixed at the current level,investment would rise due to the increase in output or sales (if inventory is assumed to be zero). If thecentral bank decides to raise the interest rate, investment could either increase or decrease dependingwhether the output effect or the interest rate effect is the stronger effect of the two, or remain unchanged.25
Answer KeyTestname: C51)D2)E3)A4)E5)D6)B7)A8)E9)D10)A11)E12)A13)A14)D15)B16)E17)D18)C19)E20)B21)D22)B23)C24)A25)A26)B27)B28)E29)E30)E31)C32)C33)C34)D35)D36)E37)D38)B39)A40)D41)E42)C43)C44)D45)D46)C47)A48)A49)E50)D26
Answer KeyTestname: C551)C52)D53)D54)A55)A56)E57)D58)E59)E60)C61)D62)D63)A64)B65)A66)A67)A central bank purchase of bonds causes an increase inhigh-powered moneyand an increase in the money supply.This leads to an excess supply of money and the interest rate must fall to restore money market equilibrium. The LMcurve shifts down as a result to reflect the lower interest rate. The IS curve does not shift, it is a movement along the IScurve as the LM curve shifts downwards.68)(1) A fiscal expansion such as an increase in government spending results in an increase in income, an increase inmoney demand, and an increase in the equilibrium interest rate in the financial markets. The fiscal expansion causes anincrease in output. (2) If the central bank controls the interest rate, an increase in government spending leads to openmarket purchases of bonds by the central bank to increase the money supply so as to keep the interest rate constant.69)(1)When the central bank pursues contractionary monetary policy, this policy measure leads to an increase in theinterest rate, a decrease in investment, a decrease in demand, and a lower level of equilibrium output. (2) Changes inthe interest rate do not, however, cause shifts in the IS curve. Instead they lead to movements along the IS curve.70)The LM curve illustrates the combinations of the interest rate and output that maintain financial market equilibrium.The curve is upward sloping because as income increases, money demand will rise. This increase in money demandwill cause an excess demand for money and an excess supply of bonds. Bond prices will fall and the interest rate willincrease until equilibrium is restored.71)A decrease in consumer confidence (orc0in the consumption function) decreases demand and leads to a leftward shiftin the IS curve. If the central bank controls the level of money supply, as output decreases, money demand decreasescausing the interest rate to fall. However, the effects on investment are ambiguous. Lower output decreases investmentwhile the lower interest rate increases investment.If the central bank instead controls the interest rate and its current policy stance is to keep it constant, thedecrease in output as a result of the fall in consumer confidence triggers open market sales of bonds by the central bankto keep the interest rate constant. Hence the effect on investment works solely through output and investmentunambiguously decreases.72)A decrease in government spending causes a decrease in disposable income and consumption. The fall in consumptioncauses a decrease in demand and the equilibrium level of output in the goods market becomes lower. This is reflectedin a leftward shift in the IS curve. If the central bank controls the money supply, goods market events such as lowergovernment spending does not shift the LM curve (only a movement along it). However, if the central bank controlsthe interest rate, in response to the decrease in the interest rate as a result of the fiscal contraction, the central bankconducts open market sales of bonds to decrease the money stock to keep the interest rate constant. This has the effectof shifting the LM curve upwards until the same interest rate is attained.73)(1) A fiscal contraction such as an increase in tax results in a decrease in income, a decrease in money demand, and adecrease in the equilibrium interest rate in the financial markets. The fiscal contraction causes a decrease in output. (2)If the central bank controls the money supply, changes in output only cause movements along the LM curve as the IScurve shifts leftwards.27
Answer KeyTestname: C574)Let’s consider first the response of the IS-LM model without dynamics. When there is an increase in tax the IS curveshifts to the left and output decreases. If the central bank allows the interest rate to fall, the net effect on investment isambiguous. On the other hand, if the central bank keeps the interest rate constant, investment clearly decreases becauseof lower output/sales.When dynamics are added to the analysis, it takes some time for consumption spending to respond to thedecrease in disposable income, some more time for production to decrease in response to the decrease in consumptionspending, yet more time for investment to decrease in response to lower sales, for consumption to decrease in responseto decrease in income, and so on. All the while, the central bank monitors the economic situation and would take sometime to decide between keeping the interest rate constant and decreasing the interest rate (presumably depending thecentral bank’s assessment of the downward pressure on prices or inflation). In other words, when dynamics are part ofthe analytical picture, the adjustments coming from the macroeconomic variables take time to complete.75)The policy mix refers to the possible combinations of monetary (expansionary or contractionary) and fiscal(expansionary or contractionary) policies that can be simultaneously implemented. Sometimes a policy mix is designedto achieve a common goal. For example, in response to the negative impact brought on by the global crisis, theAustralian government (more precisely the Commonwealth Treasury in Australia) pursued expansionary fiscal policyto increase the budget deficit. At the same time the Reserve Bank of Australia cut the cash rate to implementexpansionary monetary policy. Most economists think that this expansionary policy mix helped to maintain outputgrowth in Australia during the period of the global crisis. Generally, the effects on output, the interest rate, andinvestment depend on the type of mix.The chapter also discusses that a policy mix may occur when the central bank in the IS-LM model is assumed tocontrol the interest rate instead of controlling the money supply. Given an IS shock, e.g. changes in consumer or firmconfidence or changes in fiscal policy, the effects on output, the interest rate, and investment depend on whether thecentral bank decides to hold or to change the interest rate.76)(1) A fiscal contraction such as an increase in tax results in a decrease in income, a decrease in money demand, and adecrease in the equilibrium interest rate in the financial markets. The fiscal contraction causes a decrease in output.Provided the central bank controls the money supply, however, changes in output only cause movements along theLM curve. If the central bank controls the interest rate, an increase in tax leads to open market sales of bonds by thecentral bank to decrease the money supply so as to keep the interest rate constant.77)In this case, the LM curve shifts down and the IS curve shifts to the left. The interest rate will clearly be lower. Theeffect on output depends on the relative magnitude of the two policies. If output decreases, the net effect on investmentis ambiguous. It is possible for output to increase, in this case, investment will be higher.78)In this case, the LM curve shifts down as the central bank purchases bonds to release more liquidity into the economy.The IS curve shifts to the left. The interest rate will clearly be lower. The effect on output depends on the relativemagnitude of the two policies. If output falls, the net effect on investment is ambiguous. It is possible for output to rise,in this case, investment will be higher.79)Investment depends on the level of sales/output and on the interest rate. As output changes, the demand for goodschanges and firms changes investment so that their capacity changes with the level of economic activity (and demand).Investment also depends on the interest rate. As the interest rate rises, the cost of borrowing rises (if firms use ownfunds, the higher interest rate raises the opportunity cost of loaning the funds out). Firms cut back on investment asborrowing costs (or the opportunity costs) rise.80)Let’s consider first the response of the IS-LM model without dynamics. When the central bank conducts open marketpurchases of bonds to decrease the interest rate the LM curve shifts downwards and output increases. Investmentunambiguously increases.When dynamics are added to the analysis, it takes some time for investment spending to respond to the decreasein the interest rate, some more time for production to increase in response to the increase in demand, yet more time forconsumption and investment to increase in response to the induced change in output, and so on. In other words, whendynamics are part of the analytical picture, the adjustments coming from the macroeconomic variables take time tocomplete.28
Answer KeyTestname: C581)The IS curve illustrates the different combinations of the interest rate and output that maintain equilibrium in thegoods market. The IS curve is downward sloping because as the interest rate falls, firms increase investment. Thisincrease in investment causes an increase in demand and a corresponding increase in equilibrium output in the goodsmarket.82)If the central bank controls the level of money supply, an increase in the money supply shifts the LM curve down andthe interest rate decreases. As the interest rate decreases, firms increase investment causing a rise in demand andsubsequent expansion in output (i.e., the multiplier effect). Investment is higher due to the increase inoutput and thedecrease in the interest rate. The interest rate endogenously adjusts to policy changes in the money supply.If the central bank controls the interest rate, monetary expansion is represented by an interest rate cut. The centralbank conducts open market purchases of bonds which increase the money supply in the money market. In this case,the level of money supply is endogenous to the policy setting of the interest rate. The expansionary effect on output andinvestment is identical as above.83)The short-run effect on investment of a fiscal policy measure that increases the budget deficit, either an increase inGora decrease inTor a combination of both, will depend on the response of an interest-rate setting central bank. If thecentral bank decides to hold the interest rate fixed at the current level, investment would rise due to the increase inoutput or sales (if inventory is assumed to be zero). If the central bank decides to raise the interest rate, investmentcould either increase or decrease depending whether the output effect or the interest rate effect is the stronger effect ofthe two, or remain unchanged.29

 

 

 

 

ExamName___________________________________MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.1)Suppose there is a decrease in profitability. This suggests that:1)A)the real interest rate has decreased.B)firms have decreased their expectations of future profits.C)the rate of depreciation has decreased.D)All of the above.E)None of the above.Answer:BExplanation:A)B)C)D)E)2)A panel dataset study of consumption behaviour by Venti and Wise for the U.S. finds that:2)A)most people are indifferent about saving sufficiently for retirement.B)most people are forward-looking with many in the top income distribution leaving bequests.C)most people are not able to save enough for retirement because of bad luck.D)most people are backward-looking about consumption.E)most people plan to a limited degree for retirement while concentrating on currentconsumption.Answer:BExplanation:A)B)C)D)E)3)A fall in sales will generally cause:3)A)initial decreases followed by increases in profit per unit of capital.B)a decrease in profit per unit of capital.C)no change in profit per unit of capital.D)ambiguous effects on profit per unit of capital.E)an increase in profit per unit of capital.Answer:BExplanation:A)B)C)D)E)1
4)Assume the following: (1) the real cost of a unit of capital is one; (2) the unit of capital is expected toincrease a firm’s real profit by $10,000 each year, and depreciate by 10% each year; and (3) the realinterest rate is 2%. What is the “user cost” or “rental cost” of this unit of capital?4)A)0.09.B)0.03.C)0.12.D)0.15.E)0.18.Answer:CExplanation:A)B)C)D)E)5)Which of the following is evidence that consumption depends on total wealth, and not just oncurrent income?5)A)A series of phased-in tax cuts announced by the government causes little change inconsumption.B)People save very little for their retirement.C)Banks will not always lend money to those who want to consume more than their income.D)The anticipation of future financial distress makes some people reluctant to borrow.E)A decrease in consumer confidence, with unchanged current income, often causes totalconsumption spending to fall.Answer:EExplanation:A)B)C)D)E)6)Which of the following will cause an increase in current consumption?6)A)An increase in financial wealth.B)An increase in current disposable income.C)An increase in human wealth.D)All of the above.E)Both A and B.Answer:DExplanation:A)B)C)D)E)7)Which of the following describes the “depreciation rate”?7)A)The difference between current and expected income.B)How much usefulness a machine loses from year to year.C)The interest rate that should be used in present discounted value calculations.D)The difference between current and expected profits.E)The rate at which consumers deplete their total wealth in retirement.Answer:BExplanation:A)B)C)D)E)2
8)The user cost of capital is represented by which of the following variables?8)A)IIt/(rt+Έ).B)1/(rt+Έ).C)rt.D)rt+Έ.E)IIt.Answer:DExplanation:A)B)C)D)E)9)An increase in which of the following variables will cause an increase in the user cost of capital?9)A)Έ.B)Yt.C)Kt.D)IIt.E)IIet.Answer:AExplanation:A)B)C)D)E)10)Which of the following will occur when the capital stock increases?10)A)There will be no change in profit per unit of capital.B)Profit per unit of capital will decrease.C)Profit per unit of capital will increase.D)Profit per unit of capital initially increases followed by decreases.E)There will be an ambiguous effect on profit per unit of capital.Answer:BExplanation:A)B)C)D)E)11)Suppose that, when the price of steel drops, steel companies tend to cut back on investment in theirnon-steel activities more than other firms in these same non-steel activities. This would supportthe idea that:11)A)business firms do not care about interest rates.B)cash flow does not matter for investment.C)business firms do not care about profit.D)business firms do not use discounting.E)cash flow matters for investment.Answer:EExplanation:A)B)C)D)E)3
12)Which of the following statements is true?12)A)A change in sales should have more impact on current investment if it is expected to bepermanent rather than temporary.B)Investment and consumption contribute equally to output fluctuations.C)On a percentage basis, investment is more volatile than consumption.D)All of the above.E)None of the above.Answer:DExplanation:A)B)C)D)E)13)As of 2007, some analysts were concerned that there was a “bubble” in the Australian housingmarket. Suppose there is a decrease in real estate prices. This fall in real estate prices would havethe most direct effect on which of the following types of wealth?13)A)Financial wealth.B)Housing wealth.C)Human wealth.D)Labour wealth.E)Investment wealth.Answer:BExplanation:A)B)C)D)E)14)The rental cost/user cost of capital will increase when:14)A)the expected profit from the machine increases.B)the rate of depreciation decreases.C)the expected profit from the machine decreases.D)the real interest rate increases.E)the expected level of sales increases.Answer:DExplanation:A)B)C)D)E)4
15)Which of the following would cause a decrease in human wealth?15)A)A decrease in the value of one’s house.B)A decrease in the value of one’s stock portfolio.C)A permanent decrease in salary.D)All of the above.E)None of the above.Answer:CExplanation:A)B)C)D)E)16)An increase in which of the following variables should cause an increase in profit per unit ofcapital?16)A)The ratio of total sales to the capital stock.B)Total sales.C)The ratio of total sales to total wages and salaries.D)The capital stock.E)Total wages and salaries.Answer:AExplanation:A)B)C)D)E)17)Which of the following is a reason that consumption depends on current income, and not just ontotal wealth?17)A)The anticipation of future financial distress makes some people reluctant to borrow.B)Low income people may prefer to postpone some consumption until later years, when theirincomes are higher.C)Banks will not always lend money to those who want to consume more than their income.D)All of the above.E)None of the above.Answer:DExplanation:A)B)C)D)E)18)A decrease in which of the following variables will cause a decrease in the user cost of capital?18)A)Kt.B)IIt.C)IIet.D)Yt.E)rt.Answer:EExplanation:A)B)C)D)E)5
19)Which of the following events would likely cause the largest decrease in current consumption?19)A)A one-time decrease in income (e.g. a bonus) of $4000.B)A permanent decrease in annual salary of $2000.C)A one-time tax increase of $4000.D)Both A and C.E)Both B and C.Answer:BExplanation:A)B)C)D)E)20)The fall in stock prices during the global crisis in 2008 would have the most direct effect on whichof the following types of wealth?20)A)Financial wealth.B)Housing wealth.C)Human wealth.D)Labour wealth.E)Investment wealth.Answer:AExplanation:A)B)C)D)E)21)The study by Venti and Wise shows that most of the wealth of people aged 65-69consists of:21)A)stocks and bonds.B)social security benefits.C)home equity.D)personal retirement assets.E)employer-provided pension.Answer:BExplanation:A)B)C)D)E)22)A change in which of the following variables would affect the cash flow for a firm?22)A)Current profit.B)Current expenditure on plant and equipment.C)Total cost.D)Total sales revenue.E)Expected future profit.Answer:AExplanation:A)B)C)D)E)6
23)Suppose current sales decrease by $150 million. Investment theory suggests that current investmentmust:23)A)decrease by more than $150 million.B)decrease by less than $150 million.C)decrease by about $150 million.D)increase, but by less than $150 million.E)More information is required.Answer:EExplanation:A)B)C)D)E)24)The data for Australia show that investment and profits:24)A)have a clear positive relationship.B)are positively related during recessions, and negatively related during expansions.C)are positively related during expansions, and negatively related during recessions.D)have a strong negative relationship.E)move independently.Answer:AExplanation:A)B)C)D)E)25)A painting is currently worth $150,000, and is expected to maintain its real value for four years. Thereal interest rate is expected to remain constant at 8%. What is the present value of the painting’sexpected price at the end of the fourth year?25)A)$100,254.B)$90,254.C)$80,254.D)$110,254.E)$70,254.Answer:DExplanation:A)B)C)D)E)26)Assume that firms experience an increase in sales. We would expect that this increase in sales willcause:26)A)ambiguous effects on profit per unit of capital.B)initial increases followed by decreases in profit per unit of capital.C)an increase in profit per unit of capital.D)no change in profit per unit of capital.E)a decrease in profit per unit of capital.Answer:CExplanation:A)B)C)D)E)7
27)Which of the following individuals is responsible for developing the permanent income theory ofconsumption?27)A)Keynes.B)Friedman.C)Lucas.D)Modigliani.E)Sargent.Answer:BExplanation:A)B)C)D)E)28)The rental cost/user cost of capital will decrease when:28)A)the expected profit from the machine decreases.B)the real interest rate increases.C)the expected level of sales decreases.D)the rate of depreciation decreases.E)the expected profit from the machine increases.Answer:DExplanation:A)B)C)D)E)29)Assume that consumption decisions are made according to the permanent income theory. Which ofthe following would lead to the largest increase in current consumption?29)A)Winning $10,000 in the lottery.B)Obtaining $10,000 by winning a lawsuit.C)Getting a one-time $10,000 bonus from your employer.D)Taking a new job with a salary that is $10,000 higher than your current salary.E)Inheriting $10,000 from a relative.Answer:DExplanation:A)B)C)D)E)8
30)The data shows that total profit in the Australian economy:30)A)tends to increase in even years, and decrease in odd years, although no one can explain why.B)tends to decrease in recessions, increase in expansions.C)is not influenced by the business cycle.D)has decreased steadily over time.E)tends to increase in recessions, decrease in expansions.Answer:BExplanation:A)B)C)D)E)31)Which of the following statements about consumption and investment is correct?31)A)A temporary change in income will have a relatively larger effect on consumption than oninvestment.B)A permanent change in income will have a relatively larger effect on consumption than oninvestment.C)Consumption is more volatile than investment.D)Investment and consumption exhibit approximately the same degree of volatility.E)Investment is more volatile than consumption.Answer:EExplanation:A)B)C)D)E)32)Which of the following individuals is responsible for developing the life cycle theory ofconsumption?32)A)Friedman.B)Keynes.C)Lucas.D)Sargent.E)Modigliani.Answer:EExplanation:A)B)C)D)E)9
33)Suppose an individual experiences a $25,000 decrease in real income and the individual believesthis decrease in income is permanent. Economic theory suggests that this individual’s currentconsumption will:33)A)decrease, remain unchanged, or increase, depending on the value of the real interest rate.B)decrease by more than $25,000.C)decrease at most by $25,000.D)decrease or remain unchanged, depending on the value of the real interest rate.E)decrease by less than $25,000.Answer:CExplanation:A)B)C)D)E)34)Which of the following represents non-human wealth?34)A)Total wealth minus housing wealth.B)Total wealth minus the present discounted value of expected future after-tax labour income.C)Financial wealth minus housing wealth.D)Wealth that cannot be taken from a person, by law.E)Total wealth minus financial wealth.Answer:BExplanation:A)B)C)D)E)35)Which of the following represents human wealth?35)A)Wealth that cannot be taken from a person, by law.B)Financial wealth minus housing wealth.C)The present discounted value of expected future after-tax labour income.D)Total wealth minus housing wealth.E)The sum of financial and housing wealth.Answer:CExplanation:A)B)C)D)E)10
36)Human wealth is a function (i.e., affected by changes in) of which of the following variables?36)A)Current interest rates.B)Future expected income.C)Future expected taxes.D)All of the above.E)None of the above.Answer:DExplanation:A)B)C)D)E)37)Consumption is most likely to respond one-for-one with changes in current income when:37)A)people are able to borrow as much as they wish, as long as they pay it back.B)the change in current income is caused by the business cycle.C)people believe the change in their current income is permanent.D)the change in current income results from a one-time government handout.E)people believe the change in their current income is temporary.Answer:CExplanation:A)B)C)D)E)38)Which of the following peopleNnone of whom has any financial or housing wealthNis most likelyto be spending all of their current income?38)A)A high income person expecting to retire soon, and live for a long time afterward.B)A low income person expecting continued low income throughout life.C)A low income person expecting a dramatic rise in income in the future.D)A high income person expecting a dramatic drop in income in the future.E)A high income person expecting continued high income throughout life.Answer:CExplanation:A)B)C)D)E)11
39)Suppose there is an income tax cut. This tax cut would have a direct effect on which of thefollowing?39)A)Financial wealth.B)Housing wealth.C)Human wealth.D)Labour wealth.E)Investment wealth.Answer:CExplanation:A)B)C)D)E)40)Suppose you are given a rare antique painting by a long-lost relative. The value of this rare antiquepainting would be included in which of the following?40)A)Financial wealth.B)Housing wealth.C)Human wealth.D)Labour wealth.E)Investment wealth.Answer:BExplanation:A)B)C)D)E)41)Suppose there is an increase in income. This increase in income would have a direct effect on whichof the following?41)A)Financial wealth.B)Housing wealth.C)Human wealth.D)Labour wealth.E)Investment wealth.Answer:CExplanation:A)B)C)D)E)12
42)A decrease in the rate of depreciation will cause the discounted present value of expected profits to:42)A)decrease.B)increase.C)remain unchanged if the real interest rate decreases by the same amount.D)All of the above.E)None of the above.Answer:BExplanation:A)B)C)D)E)43)The “life cycle” and “permanent income” theories of consumption share which of the followingfeatures?43)A)Consumption remains stable on a permanent basis.B)Consumption spending depends on income, rather than wealth.C)Consumption spending should fluctuate widely from year to year.D)Consumers look ahead to the future in making current spending decisions.E)Consumption decisions are based on how well the stock market performs.Answer:DExplanation:A)B)C)D)E)44)Which of the following best defines total wealth?44)A)Human wealth only.B)Non-human wealth only.C)Non-human wealth and human wealth.D)Financial wealth and housing wealth only.E)Financial wealth only.Answer:CExplanation:A)B)C)D)E)45)Which of the following will occur when the capital stock falls?45)A)There will be no change in profit per unit of capital.B)Profit per unit of capital will decrease.C)Profit per unit of capital will increase.D)Profit per unit of capital initially decreases followed by increases.E)There will be an ambiguous effect on profit per unit of capital.Answer:CExplanation:A)B)C)D)E)13
46)Suppose there is an increase in cash flow. This suggests that:46)A)the real interest rate has increased.B)the rate of depreciation has increased.C)current profits have increased.D)firms have decreased their expectations of future profits.E)All of the above.Answer:CExplanation:A)B)C)D)E)ESSAY. Write your answer in the space provided or on a separate sheet of paper.47)Suppose individuals expect future output to be lower and future interest rates to be lower. Given thisinformation, how will individuals alter consumption in the current period? Explain.Answer:The effects are ambiguous. The decrease in future expected output will decrease human wealth andcause consumption to fall. The decrease in future interest rates will increase the present value of futuredisposable income and increase consumption.48)Explain why current consumption is likely to respond less than one for one to changes in current income.Answer:A change in current income is not likely to be viewed with certainty as permanent. So, part of any changein temporary income will be saved and, therefore, consumption will increase by an amount less than thechange in income. If the change were permanent, the change in consumption would be greater, albeit nomore than the increase in income. Intuitively, this is driven by the desire on the part of the consumer tosmooth her consumption over her lifetime.49)Explain how a change in expected future output could change current output.Answer:There are two channels here. An increase in future expected output will increase future expected profits.When future expected profits rise, the discounted present value of profits will be higher. More projectswill now get the go ahead. As investment today rises, demand rises, and, therefore, current output willrise. An increase in future expected output will also increase human wealth and, therefore, causeconsumption to increase. The rise in consumption will increase in demand and current output.50)Suppose firms expect future output to be higher and future interest rates to be higher. Given this information,how will firms alter investment in the current period? Explain.Answer:The increase in expected future output will cause firms to revise upwards their expectations of futureprofits. This, all else fixed, will cause an increase in the present value of expected future profits and willtend to increase investment. The increase in the interest rate, however, will tend to decrease investmentbecause it will reduce the discounted present value of expected future profits. The combined effects,therefore, on investment are ambiguous.51)Explain what decisions and calculations a firm must make when it is considering the purchase of new capital(i.e., making an investment decision).Answer:A firm must form expectations of future profits (per unit of capital). This implies that they must also formexpectations of future output which are correlated with future profit. They must also form expectationsof future interest rates to calculate the present values. And finally, they must know the current price ofthe project and the rate of depreciation. Once they have all this information, they calculate the discountedpresent value of the project and compare that with its cost.14
52)Explain why current consumption might change even if current income does not change.Answer:Consumption also depends on wealth and confidence. If any of the determinants of wealth changes,without current disposable income changing, individuals will change current consumption. If consumersfeel more optimistic or pessimistic about the new policies to be introduced by the incoming government,the current level of consumption can change. In short, there are other determinants of currentconsumption.53)Discuss the various components of wealth.Answer:Total wealth comprises non-human wealth and human wealth. Non-human wealth consists of financialwealth and housing wealth. Financial wealth includes stocks, bonds, and bank accounts. Housing wealthis the value of the house minus the mortgage still due. Human wealth is the present value of expectedafter-tax labour income over one’s working life.54)Explain the difference between “profitability” and “cash flow”.Answer:Some firms are borrowing constrained. Their only source of funds to purchase investment is currentprofit. So, when current profit rises, those borrowing constrained firms increase investment. Thissummarises how “cash flow” can affect a firm’s investment decision. “Profitability” simply refers to howchanges in the expected present value of future profits affect investment.55)Explain why consumption and investment contribute roughly equally to output fluctuations when investmentexhibits higher volatility than consumption.Answer:Even though investment is more volatile than consumption, however, the level of investment is muchsmaller than the level of consumption (in Australia in 2011, consumption was 56% of GDP andinvestment was 24% of GDP). Hence the higher volatility combined with the smaller share in GDP ofinvestment contributes roughly equally to output fluctuations as consumption does.56)Explain what decisions and calculations a very foresighted consumer must make to determine her consumptiondecisions in any period.Answer:An individual would have to calculate her financial wealth, housing wealth, and human wealth. Ofcourse, this implies that the individual would have to form expectations of future interest rates, income,and taxes for the remainder of her working life. Once done, the individual would then calculate theamount of consumption per year she preferred given this total wealth. If in the current period, currentdisposable income is less than this level of consumption, she would borrow the difference.57)Explain why consumption is less volatile than investment.Answer:At most, we would observe a one-for-one relationship between output and consumption. This is not thecase with investment. When output increases and is viewed as permanent by firms, they may increaseinvestment to maintain a given capital-sales ratio. If this ratio is, say, 2, an increase in sales and output of100 would require that investment increase by 200. So, investment will change more than consumptionand exhibit higher volatility.58)Explain each of the determinants of the present value of expected profits from buying a new machine.Answer:The current and expected real interest rate, the depreciation rate and expected profit in future years areall determinants of the present value of expected profits from buying a new machine.15
59)First, briefly explain what the user cost or rental cost of capital represents. Second, explain what factors wouldcause an increase in user cost or rental cost of capital.Answer:The user cost of capital is the sum of the real interest rate and the rate of depreciation. If a rental agencyrented capital, it would have to charge enough to cover any depreciation that occurs plus an amountequal to what it could get if it simply bought bonds (and receive payment through the real interest rate).Therefore, either an increase in the real interest rate or an increase in depreciation will cause an increasein the user cost or rental cost of capital.16
Answer KeyTestname: C161)B2)B3)B4)C5)E6)D7)B8)D9)A10)B11)E12)D13)B14)D15)C16)A17)D18)E19)B20)A21)B22)A23)E24)A25)D26)C27)B28)D29)D30)B31)E32)E33)C34)B35)C36)D37)C38)C39)C40)B41)C42)B43)D44)C45)C46)C47)The effects are ambiguous. The decrease in future expected output will decrease human wealth and causeconsumption to fall. The decrease in future interest rates will increase the present value of future disposable incomeand increase consumption.17
Answer KeyTestname: C1648)A change in current income is not likely to be viewed with certainty as permanent. So, part of any change in temporaryincome will be saved and, therefore, consumption will increase by an amount less than the change in income. If thechange were permanent, the change in consumption would be greater, albeit no more than the increase in income.Intuitively, this is driven by the desire on the part of the consumer to smooth her consumption over her lifetime.49)There are two channels here. An increase in future expected output will increase future expected profits. When futureexpected profits rise, the discounted present value of profits will be higher. More projects will now get the go ahead.As investment today rises, demand rises, and, therefore, current output will rise. An increase in future expected outputwill also increase human wealth and, therefore, cause consumption to increase. The rise in consumption will increasein demand and current output.50)The increase in expected future output will cause firms to revise upwards their expectations of future profits. This, allelse fixed, will cause an increase in the present value of expected future profits and will tend to increase investment.The increase in the interest rate, however, will tend to decrease investment because it will reduce the discountedpresent value of expected future profits. The combined effects, therefore, on investment are ambiguous.51)A firm must form expectations of future profits (per unit of capital). This implies that they must also form expectationsof future output which are correlated with future profit. They must also form expectations of future interest rates tocalculate the present values. And finally, they must know the current price of the project and the rate of depreciation.Once they have all this information, they calculate the discounted present value of the project and compare that withits cost.52)Consumption also depends on wealth and confidence. If any of the determinants of wealth changes, without currentdisposable income changing, individuals will change current consumption. If consumers feel more optimistic orpessimistic about the new policies to be introduced by the incoming government, the current level of consumption canchange. In short, there are other determinants of current consumption.53)Total wealth comprises non-human wealth and human wealth. Non-human wealth consists of financial wealth andhousing wealth. Financial wealth includes stocks, bonds, and bank accounts. Housing wealth is the value of the houseminus the mortgage still due. Human wealth is the present value of expected after-tax labour income over one’sworking life.54)Some firms are borrowing constrained. Their only source of funds to purchase investment is current profit. So, whencurrent profit rises, those borrowing constrained firms increase investment. This summarises how “cash flow” canaffect a firm’s investment decision. “Profitability” simply refers to how changes in the expected present value of futureprofits affect investment.55)Even though investment is more volatile than consumption, however, the level of investment is much smaller than thelevel of consumption (in Australia in 2011, consumption was 56% of GDP and investment was 24% of GDP). Hence thehigher volatility combined with the smaller share in GDP of investment contributes roughly equally to outputfluctuations as consumption does.56)An individual would have to calculate her financial wealth, housing wealth, and human wealth. Of course, this impliesthat the individual would have to form expectations of future interest rates, income, and taxes for the remainder of herworking life. Once done, the individual would then calculate the amount of consumption per year she preferred giventhis total wealth. If in the current period, current disposable income is less than this level of consumption, she wouldborrow the difference.57)At most, we would observe a one-for-one relationship between output and consumption. This is not the case withinvestment. When output increases and is viewed as permanent by firms, they may increase investment to maintain agiven capital-sales ratio. If this ratio is, say, 2, an increase in sales and output of 100 would require that investmentincrease by 200. So, investment will change more than consumption and exhibit higher volatility.58)The current and expected real interest rate, the depreciation rate and expected profit in future years are alldeterminants of the present value of expected profits from buying a new machine.59)The user cost of capital is the sum of the real interest rate and the rate of depreciation. If a rental agency rented capital,it would have to charge enough to cover any depreciation that occurs plus an amount equal to what it could get if itsimply bought bonds (and receive payment through the real interest rate). Therefore, either an increase in the realinterest rate or an increase in depreciation will cause an increase in the user cost or rental cost of capital.18

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