Practice Final 1

Section I
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
1) In which market structure do firms exist in very large numbers, each firm produces an identical product, and there is freedom of entry and exit?
A) only monopolistic competition
B) oligopoly
C) monopoly
D) only perfect competition
E) both perfect competition and monopolistic competition
Figure 1

2) Refer to Figure 1. Ceteris paribus, a decrease in productivity would be represented by a movement from
A) SRAS1 to SRAS2.
B) SRAS2 to SRAS1.
C) point A to point B.
D) point B to point A.
E) none of the above.
3) An indifference curve shows
A) preferred combinations of goods.
B) an increasing marginal rate of substitution for a good as more of it is consumed.
C) combinations of goods among which a person is indifferent.
D) a diminishing marginal rate of substitution as more of both goods are consumed.
E) utility maximizing levels of consumption.
4) One of the components of the balance of payments is
A) the income account.
B) the national debt account.
C) the financial account.
D) the commercial account.
E) the trade account.
5) If real GDP is greater than potential GDP, eventually ________ and the price level ________.
A) the aggregate demand curve shifts leftward; rises
B) the aggregate demand curve shifts rightward; falls
C) the aggregate supply curve shifts leftward; rises
D) the aggregate supply curve shifts rightward; falls
E) potential GDP increases; falls
6) At the grocery store, Bob can buy yogurt (Y) for $2 per jar and milk (M) for $3 per quart. If he has $20 to spend, Bob's budget constraint is
A) 20 = 2Y + 3M
B) 2Y = 3M
C) 20Y + 20M = 2+3
D) (Y+2) + (3+M) = 20
E) Y+M = 20 - 3 - 2
7) A cross-price elasticity of -0.90 indicates that two goods are
A) normal
B) Veblen
C) complements
D) inferior
E) substitutes

8) The unemployment rate tends to understate the true extent of joblessness because
A) persons who collect unemployment benefits report themselves to be searching for a job.
B) discouraged workers are not counted as unemployed.
C) many full time workers really want to be part time workers.
D) discouraged workers are counted as unemployed.
E) drug dealers report themselves as unemployed.
9) Caroline is an artist. She purchases canvas, paints, brushes, and accessories for $75. She sells one of her original paintings to an art gallery for
$1,500, which, in turn, sells it to an art lover for $4,500. What is the contribution to GDP of Caroline's original painting?
A) $1,425
B) $1,500
C) $3,000
D) $4,425
E) 4,500
10) In the AE model, an increase in the interest rate shifts the aggregate expenditure line __________ and short-run equilibrium output _________.
A) downward; increases
B) upward; increases
C) upward; stays the same
D) upward decreases
E) downward; decreases
11) Which of the following variables is fixed in the aggregate expenditure model?
A) real GDP
B) consumption
C) induced aggregate expenditure
D) output
E) price level
12) When actual real GDP is below potential GDP, the economy presents a(n) __________ gap
A) discretionary
B) recessionary
C) fiscal
D) stationary
E) inflationary
13) Joanne rents a TV production studio to produce an extra hour of a TV show. The rent is
A) an external cost and not a private cost.
B) a private cost and not an external cost.
C) both a private cost and an external cost.
D) neither a private cost nor an external cost.
E) a private benefit because viewers will benefit from watching the extra hour of the show.
Table 1
2008
2011
Product
Quantity
Price
Quantity
Price
Camera
100
$10
120
$12
Legal services
50
15
45
20
Books
200
40
210
45
A very simple economy produces three goods: cameras, legal services, and books. The quantities produced and their corresponding prices for 2008 and
2011 are shown in the table above.
14) Refer to Table 1. What is real GDP in 2008, using 2011 as the base year?
A) $28,885
B) $11,790
C) $11,200
D) $10,275
E) $9,750
15) Refer to Table 1. What is the CPI in 2011 if 2011 is the base year?
A) 120
B) 118
C) 100
D) 77
E) 65
16) Tax incidence is the
A) division of a tax burden between the buyer and seller.
B) dollar amount of a tax per unit sold.
C) deadweight loss from the tax.
D) dollar amount of a tax, expressed as a percentage of the purchase price.
E) amount of revenue collected by government on a specific good.

17) Monetary policy is anti-cyclical only if the Federal Reserve

A) is quick to recognize a recession has started and conducts a contractionary monetary policy.
B) is late recognizing a recession has started and conducts an expansionary monetary policy.
C) is late recognizing a recession has started and does not change its stand of monetary policy.
D) is quick to recognize a recession has started and conducts an expansionary monetary policy.
E) none of the above is true.
18) The PPP theory would be most useful in predicting:
A) long run changes in the exchange rate for a country that mainly produces heavily traded standardized goods.
B) short run changes in the exchange rate for a country that mainly produces heavily traded standardized goods.
C) short run changes in the exchange rate for a country that mainly produces lightly traded non-standardized goods.
D) short run changes in the exchange rate for a country that mainly produces lightly traded standardized goods.
E) long run changes in the exchange rate for a country that mainly produces lightly traded non-standardized goods.
Table 2

19) Refer to Table 2.The above table has data from the nation of Atlantica. Based on these data, autonomous consumption is
A) $3.2 trillion.
B) $1.8 trillion.
C) $2.6 trillion.
D) $5.8 trillion.
E) $4.0 trillion.
20) The practical implication of the long run Phillips curve is that
A) the short run Phillips curve never reaches the natural rate of unemployment.
B) the economy never reaches potential output, not even in the long run.
C) monetary policy is ineffective in the short run.
D) any attempt to lower the unemployment rate below the natural rate of unemployment will lead to accelerating inflation.
E) in the long run, the economy is in disequilibrium.
Figure 2

21) Refer to Figure 2. Based on the graph of the labor market above, if a minimum wage of $8 per hour is imposed, which of the following will result?
A) The quantity of labor demanded by firms will rise.
B) The quantity of labor demanded by firms will fall.
C) The unemployment rate will fall.
D) The labor force participation rate will fall.
E) The quantity of labor supplied by workers will fall.
22) Which of the following does NOT happens after the Federal Reserve Bank lowers the federal funds rate target?
A) Money supply drops and banks find it harder to extend new loans .
B) Asset prices increase raising household wealth and consumption expenditures.
C) Market interest rates drop and investment expenditures increase.
D) The dollar depreciates and domestic goods become more competitive in the global economy.
E) Asset prices increase, firms' balance sheets improve and firms find it easier to raise funds to finance new investment projects.
23) During the past 60 years, unemployment rates in the United States
A) have fallen steadily from approximately 11 percent 40 years ago to near 4 percent today.
B) have risen and fallen in a range between 4 and 11 percent.
C) have remained between 4 and 6 percent.
D) have risen and fallen in a range between approximately 11 and 19 percent.
E) have risen steadily and today are near all-time highs.

24) Because Don has health insurance, he is more likely to see the doctor when he has a cold. This is an example of
A) both moral hazard and adverse selection.
B) private information.
C) adverse selection.
D) the lemons problem.
E) moral hazard.
25) When computing the CPI, the term "commodity substitution bias" refers to changes in
A) prices that lead business to change the items they buy.
B) stores so that consumers switch from one store to another.
C) income that lead households to change the items they buy.
D) quantities that lead households to change the items they buy.
E) prices that lead households to change the items they buy.
26) To maximize its profit, a perfectly competitive firm produces so that ________ and a single-price monopoly produces so that ________.
A) MR = MC; MR > MC
B) MR > MC; MR > MC
C) MR > MC; MR = MC
D) MR = MC; MR = MC
E) P = ATC; P = ATC
Figure 3

27) Refer to Figure 3. In the figure above, if real GDP is $12 trillion, aggregate planned expenditure is ________ $12 trillion and unplanned inventory
changes are ________.
A) equal to; positive
B) less than; positive
C) less than; negative
D) equal to; equals to zero
E) equal to; negative
28) Which of the following countries had the lowest GDP per capita in 2012?
A) Canada
B) France
C) China
D) Japan
E) The USA
29) Potential output is also referred to as
A) full-employment GDP.
B) realized GDP.
C) inflation neutral GDP.
D) politico-economic GDP.
E) balanced-budget GDP.
30) Which of the following is an example of an implicit cost?
A) liability insurance payments made only once a year
B) wages paid to employees
C) the cost of using capital the business already owns.
D) dollars paid to a supplier for materials used in production
E) interest paid to a bank on a building loan
31) The government has a budget surplus if
A) there is no national debt.
B) tax revenues are greater than government outlays.
C) a fiscal stimulus is being used to combat a recession.
D) transfer to firms and families are greater than tax revenues.
E) Congress passes balanced budget regulations.

32) A Nash equilibrium is defined as

A) relying on other game players to realize the benefit of cooperation.
B) forming a cartel with strong penalties for cheaters.
C) each player taking the action that is best for all the players.
D) making zero economic profit in the long run.
E) each player taking the best possible action given the action of the other player.
33) Which of the following would increase gross private domestic investment?
A) an increase in the number of workers Apple hires
B) an increase in the shares of Apple stock households own
C) an increase in the number of iPads Apple sells to a public high school
D) an increase in the level of Apple's inventory
E) an increase in the number of highway construction projects the government is funding
34) Potential output is affected by all of the following except
A) changes in the capital stock.
B) accumulation of human capital.
C) the size of the labor force.
D) changes in the price level.
E) technological change.

35) M1 includes
A) currency in circulation, savings account balances, checking account deposits in banks, and holdings of traveler's checks.
B) currency in circulation, checking account deposits in banks, and holdings of traveler's checks.
C) currency in circulation, savings account balances, and checking account deposits in banks.
D) monetary base, checking account deposits in banks and money market deposits in banks.
E) coins, savings account balances, traveler's checks.
36) If the number employed is 190 million, the number unemployed is 10 million, and the working-age population is 250 million, then the labor force
participation rate is
A) 4%.
B) 5.2%.
C) 60%.
D) 76%.
E) 80%.
Figure 4

37) Refer to Figure 4. An economy moves from a point like A to a point like B in response to
A) an increase in capital per hour worked
B) an increase in human capital
C) a technological regression
D) an improvement in technology
E) a decrease in capital per hour worked

38) If productivity at German firms rises more quickly than at French firms, which of the following would you expect to see?
A) a decrease in the value of the French currency relative to the German currency.
B) an increase in the prices of German products.
C) an increase in the dollar value of the Euro.
D) All of the above are correct.
E) a worsening of the French trade balance with Germany.

39) As an economy nears the end of an expansion, we typically see

A) rising profit rates.
B) rising private investment.
C) falling real wages.
D) rising inflation.
E) falling employment.
Figure 5

Fancy Footwear manufactures shoes. Figure 5 shows Fancy Footwear's marginal product of labor and average product of labor curves in the short run.
40) Refer to Figure 5. For what quantity of labor does production display diminishing returns?
A) for more than 1 units of labor
B) for more than 4 unit of labor
C) for more than 5 units of labor
D) for less than 4 units of labor
E) for more than 8 units of labor
41) When tax revenues depend on income, a formula for the autonomous expenditure multiplier is

A)

B)

C)

D)

E)

42) The unemployment rate is 5%. Under what circumstance would you expect the Fed to use contractionary monetary policy?
A) if the inflation rate is below 5%
B) if the natural rate of unemployment is above 5%
C) if the inflation rate is above 5%
D) if the natural rate of unemployment is below 5%
E) in none of the circumstances above
43) Which statement is true?
A) In response to the great recession, the United States relied more heavily on automatic stabilizers than Germany.
B) States' balanced budget rules act as powerful automatic stabilizers.
C) Unlike stimulus packages, unemployment insurance and food stamps are not effective automatic stabilizers.
D) Automatic stabilizers do not cure the business cycle but they help even the cycle out.
E) Because of the long debates in Congress before automatic stabilizers can be implemented, they play a small role in the U. S. economy.
44) Commodity money is an asset
A) used as money that also has value independent of its use as money.
B) used as money that has no intrinsic value.
C) that is designated as money by law.
D) that is traded only in commodity markets
E) used as money that has no secondary use.

45) Which of the following transactions is included in the current account with a negative sign?
A) the sale of domestically grown apples to a foreign fruit distributor.
B) the sale of newly issued stock to a foreign citizen.
C) the sale of a patent to a foreign company.
D) the purchase of corporate bonds from a foreign bank
E) interest payments to foreign investors.
Table 3

46) Refer to Table 3. Using the data in the table above, at the price of $80 a phone,
A) a surplus of 25,000 cellular telephones occurs.
B) a shortage of 55,000 cellular telephones occurs.
C) the market is in equilibrium.
D) a shortage of 25,000 cellular telephones occurs.
E) a surplus of 80,000 cellular telephones occurs.
47) If GDP is currently $13 trillion and is growing at a rate of 2.3% per year, how long will it take GDP to reach $26 trillion?
A) about 15 years
B) about 17 years
C) about 25 years
D) about 30 years
E) two generations
48) Crowding out, following an increase in government spending, results from
A) lower interest rates and higher profit rates.
B) higher interest rates and a higher exchange rate.
C) lower interest rates and a higher marginal propensity to consume.
D) lower interest rates and lower moral hazard.
E) higher interest rates and stronger exports.
49) An example of a transfer payment is
A) the home mortgage interest deduction.
B) a teacher's paycheck.
C) the purchase of a new bridge in Alaska.
D) unemployment insurance benefits.
E) a paycheck for a member of the National Guard.
50) Hurricane Katrina destroyed oil and natural gas refining capacity in the Gulf of Mexico. This subsequently drove up natural gas, gasoline, and
heating oil prices. As a result, this should
A) move the economy up along a stationary short-run aggregate supply curve.
B) move the economy down along a stationary short-run aggregate supply curve.
C) shift the long-run aggregate supply curve to the right.
D) shift the short-run aggregate supply curve to the left.
E) shift the short-run aggregate supply curve to the right.
51) Suppose a transaction changes a bank's balance sheet as indicated in the following T-account, and the required reserve ratio is 10 percent.
Assets
Reserves + $2,000

Liabilities
Deposits + $2,000

As a result of the transaction, the bank can make a maximum loan of

A) $0.
B) $200.
C) $1,800.
D) $2,000.
E) $4,000
52) The international trade effect states that a(n) ________ in the price level will ________ net exports.
A) increase; increase
B) increase; not affect
C) increase; decrease
D) decrease; not affect
E) decrease; decrease

Table 4
Year
2009
2010
2011

Nominal Average
Hourly Earnings
$10
10
12

CPI
(1982-1984 =100)
100
105
110

53) Refer to Table 4. Looking at the table above, real wages ________ from 2009 to 2010, and real wages ________ from 2010 to 2011.
A) rose; fell
B) fell; rose
C) rose; rose
D) fell; fell
E) stayed the same; rose
54) When disposable income increases from $9 trillion to $10 trillion, consumption expenditure increases from $6 trillion to $6.8 trillion. The MPC is
A) 0.80.
B) $6.8 trillion.
C) 0.60.
D) 0.68.
E) 1.00.
Figure 6

55) Refer to Figure 6. The change in the budget constraint from BC1 to BC2 implies
A) the price of DVDs has increased and the price of CDs has decreased.
B) income and the prices of DVDs and CDs have increased.
C) the prices of DVDs and CDs have increased.
D) the price of DVD has increased and income has dropped.
E) the price of DVDs has decreased and the price of CDs has increased.
56) Inflation is
A) an increase in the general level of prices.
B) an increase in value of a currency
C) an increase in household debt.
D) an increase in the price of oil.
E) an increase in public debt.
Table 5

57) Refer to Table 5. Paulette owns a pizza parlor. Her total cost schedule is in the above table. Her variable cost of producing four pizzas per hour is
A) $49.
B) $71.
C) $20.
D) $51.
E) Some amount, but more information is needed to determine this total variable cost.
58) The demand curve is also the
A) total cost curve.
B) marginal deadweight cost curve.
C) marginal benefit curve.
D) marginal cost curve.
E) total benefit curve.

Real GDP per Capita

(in 1996 dollars)
$958
1,091
4,544
2,344

Country
Botswana
Thailand
Japan
Guatemala

Table 6
Growth in Real GDP per Capita,
1960-2000
5.29%
4.70%
4.32%
1.29%

59) Refer to Table 6. In the table above, which countries are consistent with the predictions of the economic growth model?
A) all four countries
B) Japan and Guatemala
C) only Guatemala.
D) only Japan
E) Botswana and Thailand
Table 7

The table above gives a nation's government outlays and tax revenues for 2008 through 2012.
60) Refer to Table 7. During which years public saving was negative?
A) all except 2011
B) 2008 and 2009
C) 2010 and 2012
D) 2012 only
E) 2011 only
Table 8
Lawns Mowed
Gardens Cultivated

George
10
5

Jack
6
4

Table 8 shows the output per day of two gardeners, George and Jack. They can either devote their time to mowing lawns or cultivating gardens.
61) Refer to Table 8. What is George's opportunity cost of mowing a lawn?
A) two lawns mowed
B) one and a half lawns mowed
C) five gardens cultivated
D) half a garden cultivated
E) two-thirds of a garden cultivated.
62) If a 10 percent price increase generates a 20 percent decrease in quantity demanded, then demand is
A) inelastic.
B) unit elastic.
C) perfectly inelastic .
D) elastic.
E) perfectly elastic.
64) When housing prices increase, wealth ________ and consumption ____________.
A) decreases; decreases
B) increases; decreases
C) increases; stays the same
D) decreases; increases
E) increases; increases
65) To lower money supply and raise the official interest rate, a central bank can
A) lower the required reserve ratio.
B) lower the interest paid on excess reserves.
C) raise the monetary base.
D) sell securities on the open market.
E) allow investment banks to borrow funds from the discount window as a last resort.

Figure 7

63) Refer to Figure 7. Suppose the economy is at point A. If government spending increases in the economy, where will the eventual long-run
equilibrium be?
A) A
B) B
C) C
D) D
E) none of the above
66) The real interest rate is negative if the inflation rate
A) is equal to the nominal interest rate.
B) exceeds the real interest rate.
C) is less than the nominal interest rate.
D) equals zero.
E) exceeds the nominal interest rate.
Figure 8

67) Refer to Figure 8. Carlos Vanya grows tomatoes and strawberries on his land. His land is equally suited for growing either fruit. Which of the graphs
in Figure 2-3 represents his production possibilities frontier?
A) Graph A
B) Graph B
C) Graph C
D) either Graph B or Graph C
E) either Graph A or Graph B
68) The marginal product of labor is
A) the quantity of capital one worker can produce in one day.
B) the increase in output from adding one more worker
C) the increase in output from matching each worker to one more machine.
D) the quantity of output produced by one worker or by one hour of work.
E) the quantity of output produced in one hour by one machine.
69) Lower personal income taxes
A) decrease aggregate demand.
B) decrease long-run aggregate supply.
C) increase aggregate demand.
D) increase transfer payments.
E) decrease disposable income.

Table 9

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70) Refer to Table 9. The above table presents data from the nation of Pacifica. When real GDP equals $2.0 trillion, aggregate planned expenditure
equals
A) $4.00 trillion.
B) $5.00 trillion.
C) $3.75 trillion.
D) $5.50 trillion.
E) $6.00 trillion.

Section 2 True/False (2 points each) For each of the following statements, say if it is true or false and briefly but clearly justify your
answer.

1. _________ Other things being equal, a larger budget deficit leads to a lower interest rate.

2. _________ An increase in the structural rate of unemployment will shift the long-run Phillips curve.

3. _________ If the Fed wants to close a recessionary gap it should sell securities on the open market.

4. _________ A Broadband Internet subsidy would lower Internet providers producer surplus.

5. _________ In a free market, a positive externality results in underproduction.

6. _________ Lower savings lead to slower economic growth.

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Section III: Macroeconomics.

1. (5 points) Suppose you are a famous international economic advisor. You have been asked to assess the possibilities for growth in
an African country. It is a country abundant in labor and some natural resources. The capital to labor ratio is low. It has a free market
economy. You have found that this country does not have a very strong and healthy banking system, however the political system is
stable and the government does a good job protecting property rights. Assess this country's prospects for growth. Recommend two
things that would enhance the country's growth.

___________________________________________________________________
___________________________________________________________________
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___________________________________________________________________
___________________________________________________________________
2. (4 points) If the required reserve ratio is 0%, would a $100 open market purchase of Treasury securities create an infinite amount of
money? Explain.

___________________________________________________________________

____________________________________________________________
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3. (6 points) The diagram below illustrates the aggregate demand and aggregate supply curves for a small open economy.

d)

a)

Does this economy have an inflationary gap, a recessionary gap, or neither?

b)

As it adjusts toward full employment, which curve shifts?

c)

What is the long-run equilibrium real GDP and price level?

As the economy adjusts toward full employment, what happens to the interest rate and the foreign exchange rate? Explain.

4. (4 points) Explain the basic idea of the expenditure multiplier and the role consumers play in determining its magnitude.

____________________________________________________________
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5. (6 points) The diagram below illustrates the aggregate expenditure curve in Aurora.
a) If real GDP is $3 trillion, what is the unplanned change in inventories? Explain.

b) What is equilibrium real GDP in Aurora? Explain.

c) What is the multiplier? Explain.

d) The prime minister of Aurora wants GDP to increase by $200 billion. By how much should he increase spending? Explain.

Section IV: Microeconomics

1. Fewer than 12% of Californians smoke cigarettes. However, the state is populous and the yearly demand for cigarettes in California
is Qd = 180 20p where quantity is measured in millions of packs and price is measured in dollars per pack, so that when the price of a
pack of cigarette is $1, Californians demand 160 million packs of cigarettes in a year. The yearly supply of cigarettes is Qs = 40p.
a) What is the equilibrium price and quantity of cigarettes in California? Show your work.

b) The state of California embarks on a war on youth smoking and as a first step it imposes and successfully enforces a price floor of
$6 per pack of cigarettes. Draw a diagram for the California cigarette market after the price floor is imposed. In your diagram, illustrate
the demand for cigarettes, the supply of cigarettes, the consumer surplus, the producer surplus and the loss in total surplus due to the
price floor.

c) The price floor does not allow the price of cigarettes to reach its equilibrium level. What sort of market distortions can arise from this?

14

d) The State legislature repeals the price floor and instead introduces a $3 per pack tax on cigarettes. Clearly explain why the quantity
of cigarettes sold in California is higher under the tax than under the price floor.

e) Briefly discuss whether you think the cigarette tax increases or reduces social welfare in California.

Section V Policy Memo (8 Points)

Its 2016. The U.S. economy has fully recovered from the Great Recession and the unemployment rate is 5.8%. In the last six months,
however, the price level has been rising at increasing speed. You work as a Research Analyst at Awesome Capital, a small hedge fund.
Your boss asks you to write a short memo explaining what actions the Federal Reserve might take in the near future and their
consequences for interest rates, asset prices and the economy in general.
In your piece, dont forget to mention what tools the Fed could/would use

15

Sample Final 1 - Solutions

1) D
2) B
3) C
4) C
5) C
6) A
7) C
8) B
9) E
10) E
11) E
12) B
13) B
14) C
15) C
16) A
17) D
18) A
19) B
20) D
21) B
22) A
23) B
24) E

25) E
26) D
27) B
28) C
29) A
30) C
31) B
32) E
33) D
34) D
35) B
36) E
37) A
38) E
39) D
40) B
41) D
42) B
43) D
44) A
45) E
46) A
47) D
48) B

49) D
50) D
51) C
52) C
53) B
54) A
55) A
56) A
57) D
58) C
59) E
60) C
61) D
62) D
63) C
64) E
65) D
66) E
67) A
68) B
69) C
70) B

Section 2 True/False (2 points each) For each of the following statements, say if it is true or false and briefly but clearly justify your
answer.
1. _____F____ Other things being equal, a larger budget deficit leads to a lower interest rate.
A larger budget deficit lowers national saving and the supply of loanable funds and leads to a HIGHER real interest rate.
2. _____T____ An increase in the structural rate of unemployment will shift the long-run Phillips curve.
An increase in the structural rate of unemployment raises the natural rate of unemployment (the sum of the structural and the frictional
rate of unemployment) and shifts the long-run Phillips curve, a vertical line indicating the combinations of inflation rate and
unemployment rate that could prevail in the long run.
3. _____F____ If the Fed wants to close a recessionary gap it should sell securities on the open market.
If the Fed wants to close a recessionary gap it should take actions that place downward pressure on interest rates and upward pressure
on asset prices and it should BUY securities on the open market and lower the target for the federal funds rate.
4. ___F______ A Broadband Internet subsidy would lower Internet providers producer surplus.
A Broadband Internet subsidy would increase the number of Internet subscribers as well as Internet providers revenue per subscriber
and it would RAISE Internet providers producer surplus.
5. ____T_____ In a free market, a positive externality results in underproduction.
In a free market, the good (or service) is produced up to the quantity where the marginal buyers benefit equals the marginal sellers
cost. If the good creates a positive externality, however, at this quantity the marginal social benefit is higher than the marginal buyers
benefit and the production of more units would increase total social welfare.
6. ____T_____ Lower savings lead to slower economic growth.
Lower savings lead to higher interest rates and less investment in physical capital, human capital and research and development. The
slower pace of capital accumulation and technological change leads to slower economic growth.
Section III: Macroeconomics.

16

1. (5 points) Suppose you are a famous international economic advisor. You have been asked to assess the possibilities for growth in
an African country. It is a country abundant in labor and some natural resources. The capital to labor ratio is low. It has a free market
economy. You have found that this country does not have a very strong and healthy banking system, however the political system is
stable and the government does a good job protecting property rights. Assess this country's prospects for growth. Recommend two
things that would enhance the country's growth.
________________________________________________________________________ The prospects for this country's growth are fairly
good. It has a lot of labor and natural resources. Having abundant factors of production can contribute to strong growth. The free
market system is also another characteristic that should help enhance economic growth. Entrepreneurs can respond quickly and adopt
technological innovations. We know that technological change can increase labor productivity. Also the fact that the government
enforces property rights can help the free market to flourish. The political stability of the government is also a good sign. Investors
won't be afraid to risk investing in the country. Two things the country could do to increase growth would be to take actions that
would help raise the capital-to-labor ratio and develop the financial sector. The country could increase the capital-to-labor ratio by
attracting foreign investment, or perhaps giving tax breaks or direct subsidies to firms that increase the amount they invest. This is
probably one of the most effective ways to increase growth. (There are other policies students might mention: the country could pursue
to enhance growth are strengthening the education and health care sector, subsidize base research and R&D)
___________________________________________________________________
2. (4 points) If the required reserve ratio is 0%, would a $100 open market purchase of Treasury securities create an infinite amount of
money? Explain.
_______Money is created when banks loan out some of the funds deposited with them. The higher the share of deposits banks loans out the

more money is created out of an initial injection of $100 of excess reserve from an open market operation. Theoretically, if banks loan
out all excess reserves and families and firms deposit all funds at banks, from an initial injection of reserves of $M a total amount of
money $M x 1/(required reserve ratio) - $M x simplified money multiplier - could be created and with a required reserve ratio of
0%, any injection of reserves could create an infinite amount of money. In reality however, banks hold reserves in excess of reserve
requirements so that the size of the actual money multiplier is never as high as the simplified multiplier. For this reason even in
countries with no reserve requirements money supply is not infinite.

______________________________________________________
3. (6 points) The diagram below illustrates the aggregate demand and aggregate supply curves for a small open economy.
a)

Does this economy have an inflationary gap, a recessionary gap, or neither?

(1 point)
An inflationary gap as actual real GDP exceeds potential real GDP
b)

As it adjusts toward full employment, which curve shifts?

The (SR)AS curve.

c)

What is the long-run equilibrium real GDP and price level?

Eventually, the economy will move to an equilibrium with a real GDP of $13 trillion and a
price level of 120.

d)

As the economy adjusts toward full employment, what happens to the interest
rate and the foreign exchange rate? Explain.

When the price level increases, families and firms need more cash to pay for their transactions. The higher money demand leads to an
increase in interest rates and a drop in domestic asset prices. Cheaper assets and higher interest rates attract foreign capital.
Foreign investors buy more dollars and the foreign exchange rate of the dollar increases (the dollar appreciates).

4. (4 points) Explain the basic idea of the expenditure multiplier and the role consumers play in determining its magnitude.

_____ The basic idea of the expenditure multiplier is that any increase in expenditure will increase real GDP by a
larger (a multiple) amount. The magnitude of the expenditure multiplier basically depends on how strongly consumers
respond to additional income. Any initial increase in expenditure increases aggregate expenditure, which leads to more
production and an increase in real GDP and income. Thus an increase, say in investment, will generate an increase in
income and this increase, in turn, will induce an increase in consumption expenditure. The second round, the increase
in consumption expenditure, is the result of the first round, the increase in investment. But the story does not stop with
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just two rounds. The initial increase in expenditure sets off a chain of increases because the second round increase in
consumption leads to yet another increase in GDP and income. As a result of this next increase in income, consumption
expenditure increases another time and a third round of expenditure increases occurs. The final result of all the rounds
has real GDP increasing many fold compared to the initial increase in investment.

_______________________________________________________
5. (6 points) The diagram below illustrates the aggregate expenditure curve in Aurora.
a) If real GDP is $3 trillion, what is the unplanned change in inventories? Explain.

If real GDP is $3 trillion, AE is $6 trillion. As more goods and services are bought than those
produced, there is an unexpected drop in inventories by $3 trillion.
b) What is equilibrium real GDP in Aurora? Explain.
Equilibrium real GDP is $9 trillion where AE = Y.
c) What is the multiplier? Explain.
In Aurora, an increase in GDP from $3 trillion to $9 trillion, raises AE by $3 trillion, hence the
MPC = $3 trillion/$6 trillion = 0.5
And the multiplier is 1/(1-MPC) = 1/(1-0.5) = 2.

d) The prime minister of Aurora wants GDP to increase by $200 billion. By how much should he increase spending? Explain.
As the spending multiplier is equal to 2, a one dollar increase in spending raises GDP by $2. To increase GDP by $200 billion, the
prime minister should increase spending by $200 billion/2 = $100 billion.

Section IV: Microeconomics

1. Fewer than 12% of Californians smoke cigarettes. However, the state is populous and the yearly demand for cigarettes in California
is Qd = 180 20p where quantity is measured in millions of packs and price is measured in dollars per pack, so that when the price of a
pack of cigarette is $1, Californians demand 160 million packs of cigarettes in a year. The yearly supply of cigarettes is Qs = 40p.
a) What is the equilibrium price and quantity of cigarettes in California? Show your work.
180 20p = 40p ! 180 = 60 p ! p = $3 ! Q = Qd(3) = 180 20 x 3 = 120 million packs (2 points)
b) The state of California embarks on a war on youth smoking and as a first step it imposes and successfully enforces a price floor of
$6 per pack of cigarettes. Draw a diagram for the California cigarette market after the price floor is imposed. In your diagram, illustrate
the demand for cigarettes, the supply of cigarettes, the consumer surplus, the producer surplus and the loss in total surplus due to the
price floor.

$9

$6
$3

S
d

Area a = consumer surplus after price floor;

Area b+c = producer surplus after price floor;
Area d = total surplus lost due to the price floor (DWL).
c) The price floor does not allow the price of cigarettes to reach its equilibrium level. What sort of market distortions can arise from this?
Black market,

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d) The State legislature repeals the price floor and instead introduces a $3 per pack tax on cigarettes. Clearly explain why the quantity
of cigarettes sold in California is higher under the tax than under the price floor.
Under the tax, buyers and sellers are free to trade at any price where the market clears. As they increase cigarette prices trying to shift
some of the tax burden onto smokers, sellers start loosing customers as the demand for cigarettes is downward sloping.
e) Briefly discuss whether you think the cigarette tax increases or reduces social welfare in California.
The tax reduces consumer and producer surplus (see above). However, cigarettes impose negative externalities and when sold in free
markets are overproduced. By reducing the quantity of cigarettes smoked, the tax reduces the external cost of cigarettes. If the
reduction in external cost is larger than the loss in total surplus, the tax increases social welfare. Otherwise, the tax reduces social
welfare.

Section V Policy Memo (8 Points)

Its 2016. The U.S. economy has fully recovered from the Great Recession and the unemployment rate is 5.8%. In the last six months,
however, the price level has been rising at increasing speed. You work as a Research Analyst at Awesome Capital, a small hedge fund.
Your boss asks you to write a short memo explaining what actions the Federal Reserve might take in the near future and their
consequences for interest rates, asset prices and the economy in general.
In your piece, dont forget to mention what tools the Fed could/would use to implement its monetary policy.

___________________________________________________________
___In the near future, the Fed is likely to implement a contractionary monetary policy to cool off the economy and
slow down price inflation. The Fed will implement the contraction with an increase in the target level for the federal
funds rate, the interest rate financial institutions charge each other on overnight unsecured loans of federal funds. To
maintain the actual rate at the new higher target, the Fed will perform a number of open market sales of securities,
and to ensure the public understands the change in monetary policy, it will also raise the discount rate.
A higher federal funds rate (and a higher discount rate) increase banks cost of money and leads to higher
interest rates on credit cards and consumer loans. Money supply drops and families and firms that need liquidity sell
some of their stocks and bonds. The higher supply of stocks and bonds will depress asset prices and lower the
interest rate on treasury and corporate bonds.
The credit crunch will make it harder and more expensive for firms to finance new investment projects and for
families to finance purchases of cars, furniture, new homes and higher education. Spending will drop and as wages
tend to be rather sticky, firms will slow production and lay off some workers. Economic activity will very likely slow
down and the unemployment rate might increase. If workers and firms trust that the contraction is credible and will
be effective, inflation will slow down with relative little damage for GDP and employment. However, if firms and workers
dont trust the efficacy of the new policy and take time to revise their inflation expectations, it will take a recession and
high levels of unemployment for the inflation rate to drop.

___________________________________________________________
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