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Chapter 11
Business Cycles
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1. What is the basic idea behind Keynesian Economics?
a. If we let the natural adjustments to take place the
economy will repair itself.
b. Because the economy is always tending toward a
full employment equilibrium we should let the
economy correct any malfunctions itself without
government intervention.
c. When the economy is tending toward a less than
full employment equilibrium we should use our
discretionary fiscal policies to push the economy
to a full employment equilibrium.
C. Fiscal policies can shift the aggregate
demand curve to the right and thus shift
the equilibrium to full employment.
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2. The idea behind Keynesian Economics
is that if we can manage demand we
can manage the economy.
True
By managing demand using our discretionary
fiscal policies it was thought that we could
manage the economy and guide it to a full
employment equilibrium.
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3. Because of the Keynesian successes during the
1930s and the 1960s we know now that we can
control the economy by controlling demand.
False
When stagflation hit us in the 1970s we learned that
because the problem was a supply problem we
could not solve it with demand remedies.
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4. Which of the following is an example of a leakage?
a. Banks lend money out a business owner.
b. Foreigners buy U.S. products.
c. People put their savings in a bank.
C. When money leaves the income stream, that
is it no longer circulates, we call it a leakage.
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5. Which of the following is an example of an injection?
a. Foreigners buy U.S. products.
b. People put their savings into a bank.
c. People pay their taxes.
A. When foreigners buy U.S. products
money flows into our income
stream, we thus call it an injection.
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6. Gross Domestic Product (GDP) is defined as the
market value of all
a. resources produced in one year by U.S. firms.
b. final goods and services produced in one year
by all resources located in the U.S., regardless
of who owns these resources.
c. final goods and services produced in one year
in the U.S. by resources owned by U.S. citizens.
B. This is the official definition of GDP.
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7. What makes the investment sector so unstable?
a. It is the largest sector of GDP.
b. It takes time to decide what to do about an
investment.
c. Decisions are based on expectations of what
investors think is going to happen in the
future.
d. all of the above.
C. Because decisions are based on expectations and
because so many things can influence expectations,
the investment sector tends to be unstable.
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8. Fear and uncertainty are the twin killers of investment.
True
Because investments are based partly on future
expectations doubt and fear of what might
happen will put a tamper on investments.
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9. A decrease in interest rates will lead
to an increase in investments.
False
The answer is false because it is not true all of the time. If
expectations are very negative, then a decline in interest
rates may not be sufficient to spur on investments, but
we say that everything else is equal, then a decline in
interest rates should lead to an increase in investments.
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10. Which of the following is an example of the
acceleration principle?
a. The bank lends out money and the borrower
buys something with the money.
b. Apple invents a new product and Best Buy
increases its’ sales volume.
c. The state builds a new highway and as a result
several gas stations are built along the highway.
C. The acceleration affect takes place due to induced
investments. The gas stations were induced from
the investment of building the highway.
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11. Conditions during the Great Depression of the
1930s were fertile ground for the ideas of John
Maynard Keynes, and the age of demand
management economics was born.
True
During the 1930s the economy was in a deep
depression and President Franklin Roosevelt
supported the ideas of deficit spending and an
enlargement of government programs, both of
which supported the ideas of Keynesian economics.
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12. The Employment Act of 1946 committed the
federal government to ensure maximum
employment, production, and purchasing power.
True
The Employment Act of 1946 represented the first
time that the federal government codified into law
its responsibility to achieve full employment by
way of active fiscal policies.
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13. By the 1960s most economists embraced the
ideas of Keynes and believed in demand
management economics.
True
The 1960s was a decade when the ideas of demand
management economics favored by Keynes
became widely accepted by academia and
Washington DC.
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14. Because of the unusually long economic
expansion from 1961 to 1969, fine tuning of the
economy was widely accepted.
True
Nothing succeeds like success, or so it appears. The
expanding economy during the 1960s helped
solidify the dominance of Keynesian economics
both in Washington DC and at most of the mature
universities in the nation. Harvard University
became the leading university supporting the
Keynesian philosophy with the University of
Chicago being one of the few universities
supporting Austrian economics.
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15. Consumer demand for durable goods tend to be
more stable than the demand for nondurable goods.
False
A durable good is a good that lasts for a long time, like
an automobile. A nondurable good lasts for a short
time, like food. When consumer’s expectations
change or their incomes change, purchases of
nondurables will not change very much, but the
demand for durables will change a lot.
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16. When you withdraw money from savings
economists say that you have dissaved.
True
Savings is the act of putting money into savings,
dissaving is the act of taking money out of savings.
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17. A cornerstone of Keynesian economics is the
belief that without government borrowing
money can get trapped in banks and not
circulate in the economy where the money is
needed. Keynes called this a liquidity trap.
True
The belief in the liquidity trap is a main reason why
Keynesian economics was accepted by academia.
If banks could not lend out enough money to
consumers and business, then it was up to the
federal government to borrow the money and
inject it into the income stream.
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18. The investment sector of the economy tends to
be very unstable, whereas the consumption
sector tends to be very stable.
True
The consumption sector is very stable because
consumers tend to be very habitual. When events
change, their actions do not change right away.
Because of savings and dissavings consumers will
maintain their previous spending habits, at least
for awhile.
But because investors make their decisions based on
their expectations of future events, any change
that will cause them to be more pessimistic or
optimistic will have a profound effect on the level
of investments.
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19. Along with the concept of a liquidity trap, the
Keynesian multiplier is the second biggest
reason why economists and politicians support
Keynesian economics. This is what economists
call the “balanced budget multiplier.”
True
The idea that that a dollar in the hands of the
government has a greater stimulative impact on
the economy then that dollar in the hands of
individuals garnered wide spread support for
increasing the national debt and increasing
government spending.
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20. The belief in the balanced budget multiplier
has led to huge increases in government
borrowing and spending since the 1960s.
True
The balanced budget multiplier recognizes that when
individuals have a dollar they will spend most of it,
but save some of it. But, when the government has
the money, it will spend all of it. Therefore, there is
a larger multiplier effect on the economy when the
government has the dollar instead of individuals.
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21. The concepts of the liquidity trap and the
balanced budget multiplier are debunked by
Austrian economists.
True
Because Austrian economists extoll the ideas of
savings and investing to grow the economy, they
believe that a dollar in the hands of government
will be spent on programs that may be politically
motivated, but not conducive to economic growth
over the long term.
Austrian economists also debunk the idea of the
liquidity trap because they believe that the free
market will drive down interest rates during
recessions, giving investors more incentive to
borrow and invest.
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22. Big tax breaks for the first time home buyers
have a positive impact on the economy and lead
to an increase in home ownership and more jobs
over the long run.
False
Both Austrian and Keynesian economists recognize
that consumers make most of their decisions based
on their expectations of future income, not
necessarily on their present income. If people expect
a large income tax return, they will tend to increase
their present spending in anticipation of that future
income. Likewise, if consumers are pessimistic about
the future, they will tend to curtail their spending,
regardless of their present income.
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23. Lag effects can be a cushioning effect on the
economy in the short run but can cause wider
swings in the business cycle over the long run.
True
Because it takes time to recognize there is a problem,
to make a decision of what to do about the problem,
and to put into action the agreed upon remedy,
months or even years may go by. In the short run
these lag effects may cushion any wide swings
because they temper any radical short run changes.
However, in the long run they can be a destabilizing
force because events can change radically between
the time that the problem was recognized and when
the proposed solution takes effect.
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24. Monetary and fiscal policies tend to be procyclical because of lag effects.
True
A pro-cyclical policy is a policy that accentuates the
wide swings of the business cycle. A countercyclical policy would be a policy that tempers the
wide swings of a business cycle.
In a perfect situation with perfect control and
knowledge monetary and fiscal policies would be
counter-cyclical. But because we live in a
democracy and because our knowledge is not
perfect, we experience lag effects anytime a
change occurs. These lag effects can work at cross
purposes to our intentions.
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25. Austrian economists tend to support the Fullemployment and Balanced Growth Act of 1978.
False
The idea that the government can take action to
ensure full employment and stable prices is the
antithesis of Austrian economics. Austrians tend
support policies that ensure a level playing field and
a flexible economy fueled by market forces.
Keynesians would more likely support a larger role of
the federal government in their belief that as long as
we can control demand we can control the economy.
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