Download Solutions to MC – Practice Test 4 1) B 2) E 3) A 4) A 5) C 6) B 7) D 8

Solutions to MC – Practice Test 4
1) B
2) E
3) A
4) A
5) C
6) B
7) D
8) D
9) E
10) D
11) E
12) C
13) B
14) C
15) D
16) B
17) B
18) B
19) C
20) D
21) D
22) B
23) D
24) C
25) B
26) C
27) D
28) D
29) B
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Short Answer: Answer all the following questions. Use graphs and equations when they are
asked for.
Question 1:
a. Explain and illustrate the shape of the AD curve and what each point on the curve entails?
b. What does the AS curve show you? Explain and illustrate. Why is it upward sloping?
c. Using both graphs illustrate equilibrium and explain what it means when the AS and AD curve
meet.
(a) The AD curve is downward sloping and relates Price Level (CPI) to the overall level of
Output (GDP). Every point on the AD curve represents a possible SR equilibrium. The
downward slope is a result of 3 things:
1-As the value of the dollar goes up (i.e. overall p-level drops) people will spend more
2-The value of domestic goods becomes more expensive at higher prices and people purchase
more foreign goods.
3- As the p-level drops there is a smaller r which makes it cheaper to finance purchases.
Aggregate Demand Curve:
Price Level
(CPI)
We can see as price level goes up
that GDP goes down: This is
exactly like law of demand in a
regular demand curve
AD
GDP
GDP changes in output and the price level does so from
(b) The AS curve illustrates the relationship between
a firms or production point of view. Measures the relative relationship of real GDP and what producers
are willing and able to supply at different price level. As the price level of goods goes up producers want
to supply more output.
Aggregate Supply Curve:
Price Level
(CPI)
AS
We can see as price level goes up
that GDP goes up: This is exactly
like law of supply in a regular
supply curve
GDP
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(c) Equilibrium is where AD = AS. The price at which all suppliers want to supply at corresponds to the
price level that demands are demanding at. It is equilibrium in price level and output in the economy. At
this point we have all that is supplied is purchased (net) inGDP
the economy.
Price Level
(CPI)
AS
E
P-Level - Eq
AD
GDPE
GD
P
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Question 2
a. Given that there is a recessionary GAP of 500 Billion dollars and we have an MPC=.8, calculate the
amount of spending that would be necessary to achieve FE-GDP?
b. Using the calculations above show the results on the AE and AD/AS graphs. Make sure to use your
calculations when labeling the graphs.
c. How would your answer change if instead of a spending change the gov’t wanted to implement a tax
cut to achieve the same result?
d. What could the FED do in order to alleviate this? Explain and illustrate your answer in the money
market.
(a) Recall that we have Δ GDP = Δ spending * exp multiplier
So if we sub in the appropriate numbers we have:
500 Billion = 1/ (1 - 0.8) * Δ spending  Δ spending = 100 Billion
*so we need an increase of 100 Billion in spending to get rid of the recessionary gap.
AE2
AE
(b)AE-Line:
AE1
The increase in the AE line
is by 100 Billion
500 Billion
GDP
GDP1 GDP2
AD/AS:
P-level
LRAS = Potential GDP
AS
P2
P1
GDP
500 Billion
GD
P
AD2
AD1
GDP1 GDP2
GD
P
GDP
(c) The answer is different if the government decided to engage in a tax cut since a tax cut reduces taxes
GDP as opposed to increasing spending. To see the desired result we
by putting money back in people’s hands
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can show what would happen if taxes were cut by 100 Billion and see the result. This would increase
spending initially by 100 Billion*MPC = 80 Billion
So, plugging this back into our equation of Δ GDP = Δ spending * exp multiplier = 80 Billion ( 1 / 10.80) = 400 Billion, which would not cover the Gap. So to fill the gap we would need a greater tax cut
than the change in spending required in a.
**specifically we would need 100 / MPC = 125 Billion tax cut to get the 500 Billion change in GDP.
d. If the FED were to do this they would have the exact same changes and graphs as in (a) and (b), but for
them to get an increase in spending they would need to increase money supply through the increasing of
reserves. To do this they buy US securities which will reduce the overall interest rate.
Step 1: Money Market:
MS1
r
MS2
r1
MD
r2
$
Step 2: AE Line
45-degree line
AE
AE2
AE
1
AE-Line
The increase in the AE line
GDP1 GDP2
Step 3: AD/AS:
P-level
LRAS = Potential GDP
AS
P2
P1
GDP
Δ GDP
GD
P
AD2
AD1
GDP1 GDP2
GDP
5
GDP
GD
P
So we see the final result of the FED increasing money supply by buying bonds on the open market (open
market operations by FOMC) is as follows:
1) Money Supply Increases (from MS1 to MS2)
2) Interest rate (r) decreases (from r1 to r2)
3) AE increases due the decreased cost of borrowing (from AE1 to AE2)
4) GDP increases (from GDP1 to GDP2)
5) Price level increases (from P1 to P2)
*so even though we do get to FE GDP, we get an increase in inflation/price level.
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Question 3
a. Label and explain the Consumption-Function. Make sure to illustrate the MPC and
autonomous consumption and explain each of these concepts using the graph to accompany your
discussion.
b. What would happen to the line if autonomous cons. ↓? Illustrate and explain with the CF.
Show this in a new graph. What does this change mean?
c. Using the consumption function illustrate and explain both savings and dissavings in the
graph.
Consumption Function – relationship between C and YD
mathematically: C = a + b* YD
Graphically:
C
a
CF =a+bYd
MPC =
C
Y d
YD
Important Concepts in Consumption Function
(i) The consumption function shows the ideas of the marginal propensity to consume, or MPC in
its slope. As disposable income changes we get a change in consumption. This is the concept of
the marginal propensity to consume. It tells us how much C changes with Yd (or as we labeled it
DI). We should note that it must be between [0, 1]. If you get $1 you can’t spend more than $1.
So the MPC tells how much of each new dollar that you actually spend.
-note: what is not spent is saved. So we may note that 1 = MPC + MPS, where MPS is the
marginal propensity to save.
(b) -If we have a change in autonomous consumption we get a change in the intercept. Once
again, a positive change would shift the intercept upwards and a negative change would shift it
downwards. We can see below in Graph 2 that autonomous consumption increased from a1 to
a2.
Graph:
CF2
Consumption (C)
CF1
a2 (+ ) Change in a
a1
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(c) Graph:
45o - Line
Consumption (C)
CF = a + bYd
Saving: C < Yd
Dissaving: C > Yd
Disposable Income
So we can see that we C > Yd that we are spending more than we make and there is dissaving.
When we have C = Yd that we are spending all that we make. And if we have C < Yd then we
are spending less than we make and there is savings.
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Question 4
a. Using the AE Line illustrate SR equilibrium. Make sure to label the graph fully and provide an
explanation for why it is an equilibrium.
b. Why is GDP1 not equilibrium? Make sure to compare AE and GDP and discuss what is happening
with inventories at that level of GDP.
c. If you are given that MPC is equal to 0.85, how much would you expect GDP to change if there is an
initial increase in spending of ΔAE = +100 Million? Show your calculations for full credit and illustrate
graphically your results using the graph below.
(a) The AE-Line is at SR equilibrium when it crosses the 45 degree line b/c it shows us where total
spending equals total output. This means that all the items that are being produced are sold. This is our
definition of equilibrium in the economy.
AE
45-degree line
AE-Line
AE
Eq
Here spending is greater than output
(i.e. the AE –Line > 45o which shows
us potential equilibrium points for
GDP. So we have AE > GDP-Eq and
inventories are falling. This is a signal
to increase output.
AE1
GDP1 GDPEq
(b) If the economy were at a point below the equilibrium level of spending and GDP, then we would have
a point where spending was too much for that level of GDP. This would cause inventories to go down b/c
goods that were being produced would be bought. This would cause an increase in production and bring
us back to a point where GDP and spending are at equilibrium. Also explained in the text box above.
(c) If the spending in the economy changed by 100 with an MPC of .85 would get a change in GDP of:
Δ GDP = Δ spending * exp multiplier =100 million *(1/ (1-.85)) = 667 million. This shifts the graph up
and gives us a new equilibrium assuming that the change is positive. If we had a negative change we
would get the opposite result.
45-degree line
AE
AE-Line-2
The initial increase in AE1
2
AE
to AE2 is an increase of
AE-Line- 1
100 million
AE1
The overall change in
output/GDP Increased by
667 Million
GDP1
GDP2
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