Macroeconomics Questions and Answers

Answer: A

A.W. Phillips's trade off between wage inflation and unemployment was based on the static expectations hypothesis: inflation expectations are taken as fixed, so a lower unemployment rate leads to higher wage inflation along a stable curve.

The adaptive expectations hypothesis came with Friedman and Phelps, who argued that the trade off is only temporary, and the rational expectations hypothesis came later, so options B and D are wrong; the extrapolative one is a different kind of expectation.

Answer: D

If the demand for money is perfectly interest inelastic, the LM schedule is a vertical line. The LM curve is the set of income and interest rate pairs at which money demand equals the fixed money supply. When the demand for money does not respond to the interest rate at all, money market equilibrium fixes a single level of income whatever the interest rate, so the curve is vertical. An upward sloping LM comes from a demand that responds to the interest rate, and a horizontal LM comes from perfectly elastic demand in the liquidity trap. A downward sloping LM does not arise. So option D is right.

Answer: B

In the Keynesian system the speculative demand for money arises because of the uncertainty of future interest rates and the relationship between changes in the interest rates and bond prices, statements I and IV, option B. A person who expects the interest rate to rise expects bond prices to fall, and so holds cash and not bonds. Unexpected expenditures belong to the precautionary motive, and bridging the gap between income and expenditure belongs to the transactions motive, so options A, C and D, which include II or III, are wrong.

Answer: D

According to Milton Friedman, the permanent component of consumption expenditure depends on permanent income alone, which is statement III, option D. In the permanent income hypothesis, permanent consumption is a stable proportion of permanent income, and transitory income, such as windfall gains, goes mainly into saving, so it has no effect on the permanent component. Statements I, II and IV bring transitory income or windfall gains into the determination of permanent consumption, which the theory denies, so options A, B and C are wrong.

Answer: D

Both statements are correct and the reason explains the assertion. In the life cycle theory of consumption, an individual's consumption does not depend only on current income but also on the long run expected earnings, because people plan a pattern of consumption over their whole lifetime and spread their expected earnings over it. The reason states exactly how the assertion comes about, so option D is right. Option A calls the reason false, option B calls both false, and option C calls the assertion not correct, none of which agrees with the theory.

Answer: B

Both statements are correct and the reason does explain the assertion, according to the key. A more equitable distribution of wealth raises effective demand, because people with small incomes spend a larger part of their income than a rich person. The reason gives that illustration: thirty or forty persons with incomes of one to five lakh would create much more effective demand than one person with ten lakh. So option B is the keyed answer. Option A says the reason is not the explanation, option C calls the reason incorrect, and option D calls the assertion incorrect.

Answer: C

The matching is: new classical economics with Robert Lucas (2), the permanent income hypothesis with Milton Friedman (4), the multiplier of a balanced budget with T. Haavelmo (1), and new Keynesian economics with N. Gregory Mankiw (3), giving 2 4 1 3, option C. Haavelmo showed that a balanced budget has a multiplier effect of one. Options A, B and D give new classical economics to Mankiw or Haavelmo, or the permanent income hypothesis to another person, so they are wrong.

Answer: A

The matching is: the IS-LM theory with Hicks and Hansen (3), the consumption ratchet with James Duesenberry (4), the life cycle hypothesis with Franco Modigliani and Richard Brumberg (1), and the critics of Keynesian economics with Lucas and Sargent (2), giving 3 4 1 2, option A. Hicks and Hansen developed the IS-LM framework, Duesenberry put forward the ratchet effect in consumption, and Lucas and Sargent are the leading critics from the rational expectations school. Options B, C and D mispair at least two of the items.

Answer: D

The statement that does not hold in Keynesian economics is that the aggregate supply schedule is vertical, with output and employment completely supply determined. That is the classical case, where full employment output is fixed by factor supplies and demand affects only the price level. Keynes held that supply is flat at levels of output well below full employment and turns steeper as capacity is approached, which is option C. Option A is consistent with Keynes because the velocity of money varies with the interest rate and expectations. Option B is consistent because Keynesian labour supply responds to money wages, which is money illusion.

Answer: B

Tobin's q is the ratio of the market value of a firm's capital to its replacement cost. When q is above one, a unit of installed capital is worth more than it costs to build, so firms add to their capital stock. The keyed option is that the market value of their financial assets, meaning the firm's equity and debt claims on its real capital, exceeds the replacement value of their real assets. Option A reverses the inequality, which would make investment unprofitable. Options C and D compare the market value with a book value, but the theory concerns replacement cost, not accounting book value.