Macroeconomics Questions and Answers

Answer: C

The hypothesis does not imply that policy makers have better information about the economy than other economic actors.

Under rational expectations everyone uses all available information, so people do not make systematic errors, and on average the economy stays close to the long-run supply curve. Only a surprise, an unanticipated policy change, can affect real output.

The government has no informational advantage over the public in the theory, so the third option is not implied. The other three options follow from it.

Answer: B

Frictional unemployment is also known as turnover unemployment. It arises because workers take time to move between jobs, as people quit, are dismissed, enter the labour force or search for better positions, and information about vacancies is imperfect. It exists even at full employment. Disguised unemployment is the presence of workers whose marginal product is zero, common in agriculture; cyclical unemployment comes from a fall in aggregate demand in a recession; and structural unemployment comes from a mismatch between workers' skills or location and the jobs available.

Answer: C

The correct order is 1, 4, 3, 2 (the hypotheses are printed as "increase" hypotheses; they are the income hypotheses). Keynes stated the absolute income hypothesis in the General Theory (1936). Duesenberry's relative income hypothesis followed in 1949. Modigliani and Brumberg set out the life cycle hypothesis in 1954, and Friedman's permanent income hypothesis appeared in 1957. Every other code puts the permanent income hypothesis before the relative income or life cycle hypothesis, which reverses the dates.

Answer: B

The tax multiplier with respect to \(T_{0}\) is \(\frac{-b}{1 - b + bt_{1}}\). Substitute disposable income and the tax function into the consumption function and then into the income identity.

\[ Y = a + b(Y - T_{0} - t_{1}Y) + \bar{I} + \bar{G} \]

\[ Y(1 - b + bt_{1}) = a - bT_{0} + \bar{I} + \bar{G} \]

\[ \frac{dY}{dT_{0}} = \frac{-b}{1 - b + bt_{1}} \]

The multiplier is negative because a lump-sum tax reduces disposable income and so consumption. Option A is the expenditure multiplier, for \(\bar{I}\) or \(\bar{G}\), and the forms with \(-bt_{1}\) in the denominator have the sign of the tax term wrong.

Answer: B

Durable consumption expenditure is the component described as self-terminating and self-financing. Spending on durables is an adjustment of a stock: once households have acquired the cars, refrigerators and similar goods they want, the purchases stop until replacement is due, so a burst of such spending ends of its own accord. It is also largely financed by households themselves, out of savings or instalment credit repaid from income. Investment expenditure can be sustained by the accelerator, non-durable consumption is a continuing flow tied to current income, and government expenditure is financed by taxes or borrowing.

Answer: A

Adaptive price expectations are not a feature of the Phillips curve. Phillips's original curve (1958) related the rate of change of money wages to unemployment with no role for expectations, which are effectively static. He found that money wages were stable when unemployment was about 5½ per cent, and the observations traced loops around the fitted curve over the trade cycle. Adaptive expectations were introduced later by Friedman and Phelps in the expectations-augmented Phillips curve, which leads to a vertical long run curve.

Answer: A

The crowding out effect is zero when there is a liquidity trap or when investment is perfectly interest inelastic. Crowding out occurs because a rise in government spending raises income, which raises the demand for money and hence the interest rate, which in turn cuts private investment. In a liquidity trap the LM curve is horizontal and the interest rate does not rise; with interest-inelastic investment the IS curve is vertical and a higher interest rate does not reduce investment. Interest-inelastic money demand or interest-elastic investment produces full crowding out instead.

Answer: A

The bandwagon effect, where a person's consumption rises because others consume more, appears in the relative income hypothesis of Duesenberry, built on the demonstration effect: people's consumption depends on the consumption and income of those around them.

The permanent income hypothesis (Friedman), the life cycle hypothesis (Modigliani) and the absolute income hypothesis (Keynes) all make consumption a function of the person's own income, permanent or lifetime or current, with no role for imitation of others.

Answer: B

The MPC in the life cycle model is \(\left(\frac{w}{w+e}\right)\left(\frac{\partial \bar{y}}{\partial y}\right)\), which is option B. Consumption is the fraction \(\frac{w}{w+e}\) of average annual lifetime income \(\bar{y}\), so the marginal propensity to consume is that fraction multiplied by the change in average income per unit change in income.

The first option, a sum of incomes over \(w+e\), is not a derivative of consumption. The third option uses the ratio \(\bar{y}/y\), which is not the change in income. Since the question asks for a derivative and the key accepts B, 'none of the above' is also wrong.

Answer: B

The correct code is 3 4 2 1. Instantaneous adjustment of income to investment is the static multiplier (3). Consumption lagging income by one period is the dynamic multiplier (4). The investment multiplier has no lasting effect (value zero) when the increase in investment expenditure is once-for-all (2). The major portion of the multiplier is realised in fewer periods when the MPC is smaller (1), because the induced rounds die out quickly.

The other codes swap the static and dynamic multipliers or mismatch the last two statements.