Macroeconomics Questions and Answers

Answer: A

Expansionary monetary policy increases income with a fall in the equilibrium rate of interest.

In the IS-LM model, a larger money supply shifts the LM curve to the right. The new equilibrium is at a lower interest rate, which encourages investment, and a higher level of income.

A rise in the interest rate with higher income is what expansionary fiscal policy gives (IS shifts right). Lower income goes with contractionary policy.

Answer: C

Value of output equals Total Sales + Change in Inventories.

Under the output (value-added) method, a firm's output in a year is what it sold plus what it produced but did not sell. Goods added to stock count as output; goods sold from earlier stock do not. So value of output = sales + change in inventories, and value added = value of output minus intermediate consumption.

Total sales alone misses unsold production. Wages are a factor payment, used in the income method. Inventories plus inputs mixes stocks and costs.

Answer: B

The multiplier is 4.

In \(C = 200 + 0.75Y\), the marginal propensity to consume is 0.75. The simple investment multiplier is:

\[ \begin{aligned} k &= \frac{1}{1 - MPC} = \frac{1}{1 - 0.75} \\ &= \frac{1}{0.25} = 4 \end{aligned} \]

Every extra rupee of investment raises income by 4 rupees. 3, 5 and 6 would correspond to MPCs of about 0.67, 0.8 and 0.83. The autonomous 200 affects the level of income, not the multiplier.

Answer: A

The GDP deflator covers only domestically produced goods.

The GDP deflator is nominal GDP divided by real GDP, so its 'basket' is everything counted in GDP: all final goods and services produced within the country, including capital goods and government purchases, and excluding imports.

That is the key contrast with the consumer price index, which includes imported consumer goods. 'Only capital goods' and 'only consumer goods' each leave out a large part of GDP.

Answer: A

\(k\) is determined by (i), (ii) and (iii).

In Friedman's permanent income hypothesis, permanent consumption is a proportion \(k\) of permanent income, \(C_{P} = kY_{P}\). Friedman made \(k\) depend on the rate of interest (i), the ratio of non-human wealth to human wealth (ii), and the consumer's tastes and preferences, including the desire to add to wealth (iii).

\(k\) is independent of the level of permanent income itself (v), which is the hypothesis's central claim that consumption is proportional to permanent income, and the inflation rate (iv) is not among the determinants he listed.

Answer: A

The short-run Keynesian consumption function is C = a + bY.

Here \(a \gt 0\) is autonomous consumption, spending that takes place even at zero income, and \(b\) is the marginal propensity to consume, between 0 and 1. Because of the intercept \(a\), the average propensity to consume falls as income rises, which is the short-run pattern Keynes described.

\(C = bY\) has no intercept, so APC = MPC is constant; it matches the long-run proportional consumption function found by Kuznets. \(C = a - bY\) would make consumption fall as income rises, and \(C = abY\) is not a standard form.

Answer: C

This is the Ratchet Effect.

Duesenberry's relative income hypothesis argues that consumers get used to the highest standard of living they have reached. When income falls, they protect that standard by cutting saving rather than consumption, so consumption falls less than in proportion. Like a ratchet, consumption moves up easily but resists moving down.

The demonstration effect, also Duesenberry's, is the tendency to imitate the consumption of richer neighbours. The income effect is the change in demand caused by a change in real income. 'Uprise effect' is not a standard term.

Answer: D

Both (A) and (B) are false.

The Keynesian range of the LM curve is its horizontal section at a very low rate of interest, the liquidity trap. There, any extra money supply is simply held as idle balances and the interest rate does not fall, so monetary policy is ineffective, which makes statement (A) false.

Fiscal policy, by contrast, is fully effective in this range: an increase in government spending shifts the IS curve right and raises income without raising the interest rate, so there is no crowding out. Statement (B), that fiscal policy is ineffective, is therefore also false. (Monetary policy is fully effective in the opposite, classical range, where the LM curve is vertical.)

Answer: A

The value of the balanced budget multiplier is 1.

An increase in government spending \(\Delta G\) raises income by \(\frac{1}{1 - b}\Delta G\), while an equal lump-sum tax increase \(\Delta T = \Delta G\) lowers it by \(\frac{b}{1 - b}\Delta T\), where \(b\) is the MPC.

\[ \begin{aligned} \Delta Y &= \frac{1}{1 - b}\Delta G - \frac{b}{1 - b}\Delta G \\ &= \frac{1 - b}{1 - b}\Delta G = \Delta G \end{aligned} \]

So income rises by exactly the change in government spending, and the multiplier is 1 whatever the value of the MPC. The other values would depend on a particular MPC.

Answer: B

This ratio is the Sacrifice Ratio.

The sacrifice ratio measures the cost of disinflation: the cumulative percentage of a year's GDP lost (output below potential) for each percentage point by which inflation is reduced. A ratio of 3 means bringing inflation down by one point costs about 3% of a year's output.

The inflation-unemployment trade-off is the Phillips curve relationship, and the growth-inflation and growth-price trade-offs are general relationships, not this specific ratio of output lost to inflation reduced.