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BSc II Section B
Macroeconomics Winter 2010
Quiz 1 (A)
Lahore School of Economics
Macroeconomics I
Winter Term 2010
Quiz 1: BSc. 2, Section B
Instructions: Answer all questions in the spaces provided below. For full marks, make sure to
show all calculations. Calculators, pencils, pens, rulers, etc. cannot be shared and cell phones
cannot be used as calculators. Total points: 94
MCQs
1. Which of the following is a positive statement?
A. An unemployment rate of 7 percent is a national disgrace.
B. Unemployment is a less important problem than inflation.
C. When the national unemployment rate is 7 percent, the unemployment rate for
inner-city youth is often close to 40 percent.
D. Unemployment and inflation are equally important problems.
E. An inflation rate of 7 percent is too high.
2. Which of the following is an example of a normative statement?
A. The moon is made of green cheese.
B. Women should earn the same income as men.
C. When the price of the good rises, people will buy more of it.
D. The more time you spend studying, the higher your economics test scores will be.
E. The more time you spend studying for chemistry, the higher your economics test scores
will be
3. Theory seeks to
A. simplify a complex reality
B. confront reality in all its complexity by focusing on the uniqueness of each phenomenon
C. explain phenomena without predicting them
D. predict phenomena without explaining them
E. distort reality to improve its forecasting ability
4. The basic purpose of economic models is to
A. construct simplifying assumptions about the real world
B. explain reality in all its complexity
C. collect empirical data to support the facts
D. construct situations where controlled experiments can be carried out
E. provide explanations for, and predictions of, economic events
5. An increase in the price of compact disks, other things equal, is likely to cause which of the
following effects in the market for audio cassettes?
A. a decrease in demand for cassettes
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BSc II Section B
B.
C.
D.
E.
Macroeconomics Winter 2010
Quiz 1 (A)
an increase in demand for cassettes
an increase in quantity demanded of cassettes
a decrease in quantity demanded of cassettes
a decrease in the quantity supplied of cassettes
6. The market for bubble gum is competitive with a current price of 50 cents and quantity of
100,000 units. Which of the following events would lead to a new equilibrium price of 75 cents
and a new equilibrium quantity of 125,000?
A. an increase in the price of other kinds of gum and candy
B. an increase in the price of the ingredients used to make bubble gum
C. an agreement by workers in the bubble gum industry to work for lower wages
D. a decrease in the number of young people in the population
E. a decrease in income
7. Which of the following best defines foreign exchange?
A. a trade between two countries
B. the market where exporting and importing activities take place
C. the price of currency relative to another currency
D. the currency of another currency used for trading
E. the dollars that the United States uses to buy goods from other countries
8. One explanation of why the aggregate demand curve is downward sloping is that
A. as prices fall, nominal income rises and so does the demand for real goods and services
B. rising prices reduce people’s wealth and thereby reduce spending
C. with falling prices, government decides to spend less to increase price level
D. businesses increase investment spending in response to higher interest rates caused by
inflation
E. as prices fall, domestically produced goods become more expensive relative to foreignproduced products, which increase production
9. An increase in government spending, other things constant, would cause a
A. leftward shift of the aggregate supply curve
B. rightward shift of the aggregate supply curve
C. leftward shift of the aggregate demand curve
D. rightward shift of the aggregate demand curve
E. movement toward equilibrium, along curves that do not shift
10. Inflation is
A. a rise in the value of money
B. a decline in nominal income
C. sustained increase in the price level
D. a general reduction in prices
E. an economic problem only for the retired population
11. In economics, money refers to
A. income
B. wealth
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BSc II Section B
Macroeconomics Winter 2010
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C. assets used and accepted as payment
D. currency
12. Suppose velocity is 6, real output is 6000, and the price level is 200. What is the level of real
money demand in this economy?
A. 1000
B. 2000
C. 20000
D. 200000
13. Higher interest rates lower the real quantity of money demanded
A. by making alternative, nonmonetary assets look relatively more attractive to
wealth holders.
B. by causing an increase in the issuance of corporate debt.
C. by changing the distribution of wealth toward the poor, who have a lower demand for
money.
D. by increasing government interest payments, which in turn increase taxes, lowering
disposable income.
14. M1 includes
A. demand deposits
B. savings deposits
C. time deposits
D. money-market mutual funds
15. What is the difference between gross investment and net investment?
A. net investment = gross investment minus taxes
B. net investment = gross investment minus net factor payments
C. net investment = gross investment minus inventory accumulation
D. net investment = gross investment minus depreciation
16. A major difference between the CPI and the GDP price index is that the CPI includes
A. all domestically produced goods and the price index includes only a sample of
domestically produced goods
B. all domestically produced goods and the price index includes a sample of goods
consumed, including imported goods
C. only a sample of domestically produced goods and the price index includes all
domestically produced goods
D. a sample of goods consumed, including imported goods, and the price index
includes all domestically produced goods
E. a sample of all goods consumed that are domestically produced, and the price index
includes all goods produced
17. Personal income is
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BSc II Section B
Macroeconomics Winter 2010
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A.
B.
C.
D.
NDP minus indirect business taxes
NDP minus depreciation minus taxes
national income minus taxes
national income plus income received but not earned minus income earned but
not received
E. national income minus income received but not earned plus income earned but not
received
18. The immediate effect on GDP of Ibrahim’s purchase of a government bond is
A. a decrease in consumption because Ibrahim has less money to spend
B. an increase in government spending
C. an increase in investment
D. a decrease in investment because less money is available to him for further investment
E. nonexistent, since no real goods and services have been produced.
19. The economy is in equilibrium while the government budget is in deficit and exports are greater
than imports. According to the circular flow model,
A. saving is greater than investment
B. saving equals investment
C. saving is less than investment
D. saving could be equal to or less than investment
E. it is impossible to determine given the information
20. If the CPI is 160 one year and 175 the next, the annual rate of inflation as measured by the CPI
is approximately
A. 4.5 percent
B. 8.6 percent
C. 9.4 percent
D. 15 percent
E. 175 percent
21. If future price changes were perfectly anticipated by both borrowers and lenders, what would
happen to the real interest rate in the future if the price level changed?
A. it would increase
B. it would decrease
C. it would decrease by the amount of the price increase
D. it would increase by the amount of the price decrease
E. it would not change
Short Questions
1. During World War II, both Germany and England had plans for a paper weapon: they each
printed the other’s currency, with the intention of dropping large quantities by airplane. Why
might this have been an effective weapon? (10 points)
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BSc II Section B
Macroeconomics Winter 2010
Quiz 1 (A)
Solution:
A paper weapon might have been effective for all the reasons that a hyperinflation is bad. For example, it
increases shoeleather and menu costs; it makes relative prices more variable over a period of time; it
alters tax liabilities in arbitrary ways; it increases variability in relative prices; it makes the unit of account
less useful; and finally, it increases uncertainty and causes arbitrary redistributions of wealth. If the
hyperinflation is sufficiently extreme, it can undermine the public’s confidence in the economy and
economic policy.
Note that if foreign airplanes dropped the money, the public will receive it and then the government
would not receive seigniorage revenue from the resulting inflation, so this benefit (usually associated with
inflation) is lost.
2. Suppose that consumption depends on the level of real money balances (on the grounds that
real money balances are part of wealth). Show that if real money balances depend on the
nominal interest rate, then an increase in the rate of money growth affects consumption,
investment, and the real interest rate. Does the nominal interest rate adjust more than one-forone or less than one-for-one to expected inflation? (8 + 5 = 13 points)
Solution:
An increase in the rate of money growth leads to an increase in the rate of inflation. Inflation, in turn,
causes the nominal interest rate to rise, which means that the opportunity cost of holding money
increases. As a result, real money holdings fall and savings increase. If the savings keep on increasing, the
real interest rate will fall.
The classical dichotomy states that a change in a nominal variable such as inflation does not affect real
variables. In this case, the classical dichotomy does not hold; the increase in the rate of inflation leads to
a decrease in the real interest rate. The Fisher effect states that i = r + π. In this case, since the real
interest rate r falls, a 1 percent increase in inflation increases the nominal interest rate i by less than 1
percent.
3. The country of Myrule has produced the following quantities of gauges and potatoes.
1994:
Gauges: 10000 @ Rs 4
Potatoes: 5000 @ Rs 8
1995:
Gauges: 12000 @ Rs 3
Potatoes: 4000 @ Rs 14
a. Using a ‘fixed-weight’ price index, with 1994 as base year, what are the prices indices for 1994
and 1995? What is the inflation rate using this index?
Cost of consuming basket of goods in base year: (4 x 10000) + (5000 x 8) = 80000
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BSc II Section B
Macroeconomics Winter 2010
Quiz 1 (A)
Cost of consuming the same basket of goods in current year: (3 x 10000) + (5000 x 14) =
100000
CPI = 100000/80000 = 1.25  25% increase in price level
b. Using a ‘variable-weight’ price index, with 1994 as the base year, what are the price indices for
1994 and 1995? What is the inflation rate using this index?
Nominal GDP in 1995: 3 x 12000 + 14 x 4000 = 92000
Real GDP in current year (1995, with new Q and old P) = 4 x 12000 + 8 x 4000 = 80000
GDP Deflator in base year: 100
GDP Deflator in current year: Nominal GDP/Real GDP = 92000/80000 = 1.15  15%
increase in price level
c. Analyze the differences in the inflation rate. (6 + 6 + 5 = 17 points)
Fixed weight index only updated the prices of the goods keeping relative and respective
importance of the goods at the same level as in the base year. That thus, overestimated the
increase in the cost of living.
Variable weight index kept the prices at the same level while taking into account the new
quantities or the new ‘relative imprtance’ placed by the consumers on the respective goods. This
gets us rid of the substitution bias but underestimates the increase in the cost of living.
4. Citizens of the country of Heehaw produce hay and provide entertainment services
(banjo playing). In 1993, they provided $15 million worth of hay, with $11 million
consumed domestically and the other $4 million sold to neighboring countries. They
provided $7 million worth of banjo playing services, $5 million in Heehaw and $2 million
in the neighboring countries. They purchased $6 million worth of soda pop from
neighboring countries.
Calculate: GDP, GNP, net income from abroad and net exports. (15 points)
GNP (Ouput produced by the citizens): 15 + 7 = $22 million
GDP (Ouptut produced in the country): 15 million worth of hay and 5 million worth of banjoplaying = $20 million
Net factor income: GDP – GNP = – $2 million
Net exports: Exports – Imports = 4 + 2 – 6 = $0 million
Note: Full credit should only be given to students who explained the variables and
formulae rather than just writing numerical values
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BSc II Section B
Macroeconomics Winter 2010
Quiz 1 (A)
5. Using the saving and investment identity in the national income accounting to explain what
happens to saving-investment balance in each of the following cases: (4 + 4 + 4 + 6 = 18 points)
a.
b.
c.
d.
Lower output as a result of lower productivity.
Businesses face lower taxes
The government decreases spending temporarily for a one year project
The price of an essential import such as OIL increases.
Solution:
S – I = NX + BD; saving as a function of ‘Y’
a. Lower output will decrease the production and the savings will fall as well. Lower savings will reduce
the finance available for investment. The final change in the identity can only be seen when the
magnitude of fall in the ‘savings’ and ‘investments’ is known.
b. Lower taxes increases the disposable profits of the business sector which increases the desired
investments. Higher investments will cause the income to increase and that will cause the savings to
increase too. Again, the final change depends on the magnitudes of increase.
c. In this case, the budget deficit falls leading to rise in government savings. As savings increase, more
finance is available for investment.
d. The import acts as a necessity. Therefore, higher price will not reduce the quantity demanded to a
huge extent. The import bill will increase, reducing the value of ‘NX’. The government expenditures
would increase and national savings will reduce on the other side of the equation.
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