Macroeconomics of Behaviour - Practice midterm with answers. Shows step by step solutions to most common problems involving Solow growth model, Aggregate demand, long run and short run interest rates, etc.

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Macroeconomics of Behaviour - Practice midterm with answers. Shows step by step solutions to most common problems involving Solow growth model, Aggregate demand, long run and short run interest rates, etc.

© All Rights Reserved

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1. Assume that two countries both have the per-worker production function y =

k1/2, neither has population growth or technological progress, depreciation is

5 percent of capital in both countries, and country A saves 10 percent of

output whereas country B saves 20 percent. If A starts out with a capitallabour ratio of 4 and B starts out with a capital-labour ratio of 2, in the long

run:

A) both A and B will have capital-labour ratios of 4.

B) both A and B will have capital-labour ratios of 16.

C) A's capital-labour ratio will be 4 whereas B's will be 16.

D) A's capital-labour ratio will be 16 whereas B's will be 4.

2. If y = k1/2, there is no population growth or technological progress, 5 percent

of capital depreciates each year, and a country saves 20 percent of output

each year, then the steady-state level of capital per worker is:

A) 2.

B) 4.

C) 8.

D) 16.

3. In the Solow growth model of Chapter 7, where s is the saving rate, y is

output per worker, and i is investment per worker, consumption per worker

(c) equals:

A) sy.

B) (1 s)y.

C) (1 + s)y.

D) (1 s)y i.

4. The formula for the steady-state ratio of capital to labour (k*), with no

population growth or technological change, is s:

A) divided by the depreciation rate.

B) multiplied by the depreciation rate.

C) divided by the product of f(k*) and the depreciation rate.

D) multiplied by f(k*) divided by the depreciation rate.

Page 1

5. Assume that a war reduces a country's labour force but does not directly

affect its capital stock. If the economy was in a steady state before the war

and the saving rate does not change after the war, then, over time, capital

per worker will ______ and output per worker will grow ______ than it did

before the war.

A) decline; faster

B) increase; faster

C) decline; more slowly

D) increase; more slowly

6. The production function y = f(k) means:

A) labour is not a factor of production.

B) output per worker is a function of labour productivity.

C) output per worker is a function of capital per worker.

D) the production function exhibits increasing returns to scale.

7. In an economy with population growth at rate n, the change in capital stock

per worker is given by the equation:

A) k = sf(k) + k.

B) k = sf(k) k.

C) k = sf(k) + (+ n)k.

D) k = sf(k) ( + n)k.

8. (Exhibit: Steady-State Capital-Labour Ratio) In this graph, the capital-labour

ratio that represents the steady-state capital-labour ratio is:

A) k0.

Page 2

B) k1.

C) k2.

D) k3.

capital-labour ratio is OA, AB represents:

B) consumption per worker, and AC represents investment per worker.

C) investment per worker, and BC represents consumption per worker.

D) consumption per worker, and BC represents investment per worker.

10. When f(k) is drawn on a graph with increases in k noted along the horizontal

axis, the:

A) graph is a straight line.

B) slope of the line eventually gets flatter and flatter.

C) slope of the line eventually becomes negative.

D) slope of the line eventually becomes steeper and steeper.

11. If productivity growth in Canada had remained at its level before the recent

productivity slowdown, real income today would be more than ______

percent higher.

A) 15

B) 25

C) 35

D) 45

Page 3

12. The benefits of the computer revolution had a lagged impact on productivity

growth because:

A) it took time for firms to figure out the best use of computer technology.

B) the government restricted which new computer technologies could be

implemented.

C) it was difficult to overcome the inertia generated by the large initial size

of the computer industry.

D) military computer applications took precedence over commercial

applications.

13. If the production function is Y = AK2/3L1/3 in the land of Solovia, and the

labour force increases by 5 percent while capital is constant, labour

productivity will:

A) increase by 3.33 percent.

B) increase by 1.67 percent.

C) decrease by 1.67 percent.

D) decrease by 3.33 percent.

14. In a steady-state economy with population growth n and labour-augmenting

technological progress g, persistent increases in standard of living are

possible because the:

A) capital stock grows faster than does the labour force.

B) capital stock grows faster than does the number of effective workers.

C) capital stock grows faster than does depreciation.

D) saving rate constantly increases.

15. In the Solow growth model, technological change is ______, whereas in

endogenous growth theories, technological change is ______.

A) assumed; explained

B) explained; assumed

C) persistent; constant

D) constant; persistent

16. In a steady state with population growth and technological progress:

A) the real rental price of capital is constant, and the real wage grows at

the rate of technological progress.

B) the real rental price of capital grows at the rate of technological

progress, and the real wage is constant.

Page 4

C) both the real rental price of capital and the real wage grow at the rate of

technological progress.

D) both the real rental price of capital and the real wage are constant.

17. In the Solow model with technological progress, the steady-state growth rate

of output per effective worker is:

A) 0.

B) g.

C) n.

D) n + g.

18. The number of effective workers takes into account the number of workers

and the:

A) amount of capital available to each worker.

B) rate of growth of the number of workers.

C) efficiency of each worker.

D) saving rate of each worker.

19. Other things being equal, all of the following government policies are likely

to increase national saving except:

A) decreasing taxes on savings accounts.

B) running a budget deficit.

C) running a budget surplus.

D) retiring part of the national debt.

20. If the short-run aggregate supply curve is horizontal, an increase in union

aggressiveness that pushes wages and prices up will result in ______ prices

and ______ output in the short run.

A) higher; lower

B) lower; higher

C) higher; higher

D) lower; lower

21. Short-run fluctuations in output and employment are called:

A) sectoral shifts.

Page 5

C) business cycles.

D) productivity slowdowns.

(Exhibit: Supply Shock)

22. (Exhibit: Supply Shock) In this graph, assume that the economy starts at

point A and there is a favourable supply shock that does not last forever. In

this situation, point ______ represents short-run equilibrium and point ______

represents long-run equilibrium.

A) B; C

B) B; A

C) E; D

D) E; A

23. Long-run growth in real GDP is determined primarily by ______, while shortrun movements in real GDP are associated with ______.

A) variations in labour-market utilization; technological progress

B) technological progress; variations in labour-market utilization

C) money supply growth rates; changes in velocity

D) changes in velocity; money supply growth rates

Page 6

24. If the long-run aggregate supply curve is vertical, then changes in aggregate

demand affect:

A) neither prices nor level of output.

B) both prices and level of output.

C) level of output but not prices.

D) prices but not level of output.

25. When a long-term aggregate supply curve is drawn with real GDP (Y) along

the horizontal axis and the price level (P) along the vertical axis, this curve:

A) slopes upward and to the right.

B) slopes downward and to the right.

C) is horizontal.

D) is vertical.

26. When the Bank of Canada reduces the money supply, at a given price level

the amount of output demanded is ______ and the aggregate demand curve

shifts ______.

A) greater; inward

B) greater; outward

C) lower; inward

D) lower; outward

27. Throughout much of the 1990s, North America experienced declining energy

prices. Assume that the Canadian economy was in long-run equilibrium

before these declines began.

a.

b.

illustrate graphically the short-run and long-run impact of this

decline on output and prices.

If the Bank of Canada attempted to offset this deviation from

the natural rate in the short run, should the money supply be

increased or decreased?

Page 7

electronic payments system dramatically reduces the demand for money in

the economy.

a.

b.

c.

system?

What can the central bank do, if anything, to counteract the short-run

changes in output and prices?

If the central bank does not take any policy actions, what will be the

long-run impact of the electronic payments system on prices and

output?

29. The theory of liquidity preference implies that the quantity of real money

balances demanded is:

A) negatively related to both the interest rate and income.

B) positively related to both the interest rate and income.

C) positively related to the interest rate and negatively related to income.

D) negatively related to the interest rate and positively related to income.

30. According to the Keynesian-cross analysis, if the marginal propensity to

consume is 0.6, and government expenditures and autonomous taxes are

both increased by 100, equilibrium income will rise by:

A) 0.

B) 100.

C) 150.

D) 250.

31. a.

b.

equilibrium levels of saving, investment, and the interest rate in

the loanable funds model.

Be sure to label:

i. the axes

ii. the curves

iii. the initial equilibrium values

iv. the direction the curve shifts to

v. the terminal equilibrium values.

Explain in words what happens to the equilibrium levels of

saving, investment, and the interest rates as a result of the

increase in income.

Page 8

32. Tax cuts stimulate ______ by improving worker's incentive and expand ______

by raising households' disposable income.

A) velocity; demand for loanable funds

B) demand for loanable funds; velocity

C) aggregate demand; aggregate supply

D) aggregate supply; aggregate demand

33. The simple investment function shows that investment ______ as ______

increases.

A) decreases; the interest rate

B) increases; the interest rate

C) decreases; government spending

D) increases; government spending

34. The IS curve shows combinations of ______ that are consistent with

equilibrium in the market for goods and services:

A) inflation and unemployment

B) the price level and real output

C) the interest rate and the level of income

D) the interest rate and real money balances

35. In the Keynesian-cross analysis, if the consumption function is given by C =

100 + 0.6(Y T), and planned investment is 100, G is 100, and T is 100,

then equilibrium Y is:

A) 350.

B) 400.

C) 600.

D) 750.

36. The IS curve provides combinations of interest rates and income that satisfy

equilibrium in the market for ______, and the LM curve provides combinations

of interest rates and income that satisfy equilibrium in the market for ______.

A) saving and investment; planned spending

B) real-money balances; loanable funds

Page 9

D) real-money balances; goods and services

37. In the Keynesian-cross model, if the MPC equals .75, then a $1 billion

decrease in taxes increases planned expenditures by ______ and increases

the equilibrium level of income by ______.

A) $1 billion; more than $1 billion

B) $.75 billion; more than $.75 billion

C) $.75 billion; $.75 billion

D) $1 billion; $1 billion

38. An increase in government spending raises income:

A) and the interest rate in the short run, but leaves both unchanged in the

long run.

B) in the short run, but leaves it unchanged in the long run, while lowering

investment.

C) in the short run, but leaves it unchanged in the long run, while lowering

consumption.

D) and the interest rate in both the short and long runs.

39. A tax cut shifts the ______ to the right, and the aggregate demand curve

______.

A) IS; shifts to the right

B) IS; does not shift

C) LM: shifts to the right

D) LM; does not shift

40. If MPC = 0.75 (and there are no income taxes but only lump-sum taxes),

when T decreases by 100, then the IS curve for any given interest rate shifts

to the right by:

A) 100.

B) 200.

C) 300.

D) 400.

41. If MPC = 0.75 (and there are no income taxes) when G increases by 100,

then the IS curve for any given interest rate shifts to the right by:

A) 100.

Page 10

B) 200.

C) 300.

D) 400.

42. Two identical countries, Alpha and Beta, can be described by the IS-LM

model in the short run. The governments of both countries cut taxes by the

same amount. The Central Bank of Alpha follows a policy of holding a

constant money supply. The Central Bank of Beta follows a policy of holding

a constant interest rate. Compare the impact of the tax cut on income and

interest rates in the two countries.

43. In the IS-LM model when M remains constant but P rises, in short-run

equilibrium, in the usual case, the interest rate ______ and output ______.

A) rises; falls

B) rises; rises

C) falls; rises

D) falls; falls

44. Other things equal, a given change in money supply has a larger effect on

demand, the:

A) larger the income sensitivity of money demand.

B) smaller the income sensitivity of money demand.

C) flatter the LM curve.

D) steeper the IS curve.

45. If the IS curve is given by Y = 1,700 100r and the LM curve is given by Y =

500 + 100r, then equilibrium income and interest rate are given by:

A) Y = 1,100, r = 6 percent.

B) Y = 1,200, r = 5 percent.

C) Y = 1,000, r = 5 percent.

D) Y = 1,100, r = 5 percent.

46. A change in income in the IS-LM model for a fixed price

A) represents a shift in the aggregate demand curve.

B) represents a movement along the aggregate demand curve.

Page 11

income in the IS-LM model resulting from a change in the price level.

D) does not represent a change in the aggregate demand curve.

47. Compare the impact of a tax cut on consumption, investment, output, and

interest rates in the classical model of Chapter 3 versus the IS-LM model.

48. Two identical countries, Country A and Country B, can each be described by

a Keynesian-cross model. The MPC is .9 in each country. Country A decides

to increase spending by $2 billion, while Country B decides to cut taxes by

$2 billion. In which country will the new equilibrium level of income be

greater?

49. Suppose you are an economist working for the Bank of Canada when

droughts in the Prairies and floods in Ontario substantially reduce food

production in Canada. Use the aggregate demandaggregate supply model

to illustrate graphically your policy recommendation to accommodate this

adverse supply shock, assuming that your top priority is maintaining full

employment in the economy.

Be sure to label:

i. the axes

ii. the curves

iii. the initial equilibrium values

iv. the direction the curves shift

v. the terminal equilibrium values.

State in words what happens to prices and output as a combined result of

the supply shock and the recommended Bank of Canada accommodation.

50. Assume that a country's per-worker production is y = k1/2, where y is output

per worker and k is capital per worker. Assume also that 10 percent of

capital depreciates per year (= 0.10).

a.

b.

c.

d.

If the saving rate (s) is 0.4, what are capital per worker, production

per worker, and consumption per worker in the steady state? (Hint:

Use sy = k and y = k1/2 to get an equation in s, , k, and k1/2, and

then solve for k.)

Solve for steady-state capital per worker, production per worker,

and consumption per worker with s = 0.6.

Solve for steady-state capital per worker, production per worker,

and consumption per worker with s = 0.8.

Is it possible to save too much? Why?

Page 12

51. The economies of two countries, North and South, have the same production

functions, depreciation rates, and saving rates. The economies of each

country can be described by the Solow growth model. Population growth is

faster in South than in North.

a.

b.

c.

larger? Explain.

In which country is the steady-state growth rate of output per

worker larger?

In which country is the growth rate of steady-state total output

greater?

52. Explain how the Solow growth model differs from models of endogenous

growth with respect to:

a.

b.

returns to capital.

53. A central bank reduces the money supply in an economy initially in long-run

equilibrium.

a.

b.

c.

What will happen to unemployment in the short run?

What will happen to output and prices in the long run?

a.

Illustrate graphically the impact of a decrease in income on the

equilibrium interest rate using the theory of liquidity preference

and the market for real money balances.

b.

Be sure to label:

i. the axes

ii. the curves

iii. the initial equilibrium values

iv. the direction the curve shifts

v. the terminal equilibrium values.

Explain in words what happens to equilibrium interest rate as a

result of the open-market purchase.

55. According to the IS-LM model, if the government raises taxes but the Bank of

Canada wants to hold the interest rate constant, then the Bank of Canada

must ______ the money supply.

A) increase

B) decrease

C) first increase and then decrease

Page 13

Answer Key

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

13.

14.

15.

16.

17.

18.

19.

20.

21.

22.

23.

24.

25.

26.

27.

C

D

B

D

C

C

D

C

C

B

C

A

D

A

A

A

A

C

B

A

C

D

B

D

D

C

a.

B. Output and prices return to their original levels at point A in

the long run.

Page 14

b.

28. a.

b.

c.

The Bank of Canada must reduce the money supply in the short

run, in order to return the economy to the natural rate, moving

the economy to point C with a permanently lower price level.

In the short run, output will increase as the reduction in money

demand (increase in velocity) shifts the aggregate demand curve out

to the right. There will be little change in prices in the short run.

The central bank could counteract the decline in money demand by

reducing the money supply, shifting the aggregate demand curve

back to the left.

In the long run, with no central bank stabilizing action, output will

return to the full-employment level with a higher price level.

29. D

30. B

31. a.

b.

32.

33.

34.

35.

36.

37.

38.

39.

40.

41.

42.

43.

44.

45.

46.

47.

interest rate falls.

D

A

C

C

C

B

B

A

C

D

The interest rate will increase in Alpha, but remain constant in Beta. The

increase in output will be larger in Beta because the Central Bank of Beta

will increase the money supply to keep the interest rate constant in the face

of the tax cut. Thus, there will be no crowding out of investment in Beta, but

there will be crowding out in Alpha because of the higher interest rate.

A

B

A

A

Output increases in the IS-LM model, but is fixed at the natural level in the

classical model because it is determined by the factors of production and

technology. In both models, consumption increases because the tax cut

Page 15

the classical model, the tax cut reduces saving, which increases the interest

rate and reduces the equilibrium quantity of investment. In a closed classical

economy, since income is fixed, the increase in consumption exactly offsets

the decrease in investment. In the IS-LM model, the increase in income

increases money demand, which results in a higher interest rate to bring

money demand into equilibrium with the constant money supply. The higher

interest rate partially crowds out investment in the IS-LM model (for the

usual interest sensitivities of investment and money demand).

48. Income in Country A will increase more. The government-spending multiplier

in Country A equals 10, so income in Country A will increase by $20 billion.

The tax multiplier in Country B equals 9, so income in Country B will only

increase by $18 billion.

49.

The accommodating policy means that the price level is permanently higher,

but output is at the full-employment level.

50. a. k = 16; y = 4; Consumption per worker is 2.4.

b. k = 36; y = 6; Consumption per worker is 2.4.

c. k = 64; y = 8; Consumption per worker is 1.6.

d. Yes. If the capital stock gets so big that the extra output produced

by more capital is less than the extra saving needed to maintain it,

extra capital reduces consumption per worker. The saving rate

exceeds the Golden Rule rate.

51. a. North will have a higher level of steady-state output per worker

because the population growth is faster in South. The same

saving in both countries means that investment in both

countries will be the same. However, capital will be spread more

thinly per worker in the South, where the population is growing

more rapidly. Given the same production functions, output per

worker will be higher in the North because it has a higher capital

per worker ratio than the South.

b. In the steady state in both countries, capital per worker is

constant, so output per worker is constant. The growth rate of

output per worker is zero in both North and South.

c. In the steady state, total output grows at the rate of population

growth. Since South has a higher rate of population growth, the

growth rate of total output will be higher in South than in North.

Page 16

52. a.

b.

53. a.

b.

c.

endogenous growth models try to explain where technological

progress comes from.

The Solow model assumes diminishing returns to capital, while

endogenous growth models assume constant returns to capital.

In the short run, output would decrease with little change in prices.

In the short run, unemployment will increase.

In the long run, output will return to the full-employment level at a

lower price level.

54. a.

b.

55. B

Page 17

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