In Keynesian analysis, what determines the level of real GDP in the short run?
The level of aggregate demand
✓
The quantity of physical capital
The size of the labor force
The state of technology
Correct Answer
The level of aggregate demand
Keynesian analysis holds that firms produce only what they expect to sell, so in the short run real GDP depends on aggregate demand. The quantity of physical capital helps set potential GDP, the most the economy could produce, not how much actually sells. The size of the labor force is also a determinant of potential GDP. The state of technology likewise shapes potential output rather than short-run production.
Category: Aggregate Demand
Question 2
Which change would increase consumption spending, according to Keynesian analysis?
An increase in income taxes
A rise in expected future income
✓
A rise in interest rates
A decrease in household wealth
Correct Answer
A rise in expected future income
When households expect higher income in the future, they feel more secure and spend more now, raising consumption and shifting aggregate demand to the right. An increase in income taxes lowers disposable income and reduces consumption. A rise in interest rates makes borrowing more costly and reduces consumption. A decrease in household wealth leads people to save more and consume less.
Category: Consumption and Investment
Question 3
For most people, which factor did Keynes see as the single most powerful determinant of consumption?
Interest rates
Expected inflation
Disposable income
✓
Population growth
Correct Answer
Disposable income
Disposable income, which is income after taxes, is the strongest influence on how much most households spend, so higher income brings higher consumption. Interest rates do affect consumption, but they are not the leading factor. Expected inflation is not one of the main consumption factors Keynes identified. Population growth affects total spending over long periods but is not what drives a household's consumption.
Category: Consumption and Investment
Question 4
When U.S. stock prices fell sharply from March 2008 to March 2009, how did households respond?
Saving rates fell and consumption rose
Saving rates and consumption both rose
Saving rates and consumption both fell
Saving rates rose and consumption fell
✓
Correct Answer
Saving rates rose and consumption fell
The fall in stock prices reduced household wealth and left people far more uncertain about their economic future, so saving rates rose and consumption fell, which reduced aggregate demand. Saving rates fell and consumption rose describes the late 1990s, when rising stock prices increased wealth. Saving rates and consumption both rose is wrong, because the loss of wealth led households to cut their spending. Saving rates and consumption both fell is wrong, because households responded to the loss of wealth by saving a larger share of their income.
Category: Consumption and Investment
Question 5
Which category of investment spending is made by households rather than by businesses?
Residential structures
✓
Nonresidential structures
Changes in inventories
Equipment and software
Correct Answer
Residential structures
Investment has four categories, and residential structures, meaning new homes, are the one made by households. Nonresidential structures such as factories, offices, and stores are built by businesses. Changes in inventories are the goods that businesses produce or buy and hold before selling. Equipment and software are capital goods that businesses buy for production.
Category: Consumption and Investment
Question 6
How does a rise in interest rates affect investment spending by firms, according to Keynesian analysis?
It rises, because saving earns a higher return
It falls, because borrowing and using funds cost more
✓
It is unaffected when firms use their own funds
It rises, because expected profits increase
Correct Answer
It falls, because borrowing and using funds cost more
Interest rates are the cost of borrowing for investment and also the opportunity cost of using a firm's own funds, so higher rates make projects less attractive and investment falls. It rises, because saving earns a higher return gets the direction wrong for investment spending. It is unaffected when firms use their own funds is wrong, because those funds could have earned interest elsewhere. It rises, because expected profits increase is wrong, since higher interest rates raise costs rather than expected profits.
Category: Consumption and Investment
Question 7
Canada, Japan, and Germany are major buyers of U.S. goods. If all three enter recessions, what is the likely effect on the U.S. economy?
U.S. exports rise and U.S. aggregate demand shifts right
U.S. imports fall and U.S. potential GDP rises
U.S. exports fall and U.S. aggregate demand shifts left
✓
U.S. aggregate demand is unaffected
Correct Answer
U.S. exports fall and U.S. aggregate demand shifts left
When incomes fall in countries that buy U.S. goods, they buy fewer of them, so U.S. exports fall and U.S. aggregate demand shifts left. U.S. exports rise and U.S. aggregate demand shifts right reverses the effect of lower foreign income. U.S. imports fall and U.S. potential GDP rises is wrong because foreign recessions do not expand U.S. productive capacity. U.S. aggregate demand is unaffected ignores that exports are a component of aggregate demand.
Category: Aggregate Demand
Question 8
What is a recessionary gap?
An equilibrium with output above potential GDP
A decline in potential GDP during a recession
The difference between exports and imports
An equilibrium with output below potential GDP
✓
Correct Answer
An equilibrium with output below potential GDP
A recessionary gap exists when the economy settles at an equilibrium level of output below potential GDP, leaving cyclical unemployment. An equilibrium with output above potential GDP is an inflationary gap. A decline in potential GDP during a recession is a change in capacity, not a gap between actual and potential output. The difference between exports and imports is net exports.
Category: Output Gaps
Question 9
When aggregate demand pushes equilibrium output beyond potential GDP, which situation results?
An inflationary gap
✓
A recessionary gap
A trade deficit
A budget surplus
Correct Answer
An inflationary gap
An inflationary gap is an equilibrium at a level of output above potential GDP, where demand pushing past capacity creates upward pressure on prices. A recessionary gap is the opposite case, with output below potential. A trade deficit means imports exceed exports, which is unrelated to output relative to potential. A budget surplus means government revenue exceeds spending, which also says nothing about the output gap.
Category: Output Gaps
Question 10
Which description fits sticky wages and prices?
They are set directly by government law
They do not respond quickly to changes in demand
✓
They rise faster than the overall price level
They change every day as demand shifts
Correct Answer
They do not respond quickly to changes in demand
Sticky wages and prices fail to fall when demand drops and fail to rise when demand increases, at least for a time, so the economy adjusts slowly to demand shifts. They are set directly by government law describes price controls, not stickiness. They rise faster than the overall price level describes a change in relative prices. They change every day as demand shifts describes fully flexible prices, the opposite of sticky ones.
Category: Sticky Wages and Prices
Question 11
What was Keynes' main explanation for why wages are slow to fall during a recession?
Minimum wage laws forbid every wage cut
Workers know exactly what pay others will accept
No easy way exists to coordinate wage cuts across the economy
✓
Unions set every wage in the economy
Correct Answer
No easy way exists to coordinate wage cuts across the economy
Keynes' coordination argument says workers might accept lower pay if everyone else did too, but a market economy has no obvious way to arrange such economy-wide cuts, so wages stay sticky. Minimum wage laws forbid every wage cut is wrong, since such laws set only a floor and most wages are above it. Workers know exactly what pay others will accept is the opposite of the problem, because coordinated cuts would need that kind of perfect information. Unions set every wage in the economy is wrong, since most wages are not set by unions.
Category: Sticky Wages and Prices
Question 12
A restaurant leaves its prices unchanged for months, partly because reprinting menus and dealing with annoyed customers is costly. What are such costs of changing prices called?
Sunk costs
Opportunity costs
Fixed costs
Menu costs
✓
Correct Answer
Menu costs
Menu costs are the costs firms face in changing prices, including updating labels and records and the risk of confusing or angering customers, and they help explain why prices are sticky. Sunk costs are costs already paid that cannot be recovered. Opportunity costs are the value of the next best alternative given up. Fixed costs are costs that do not vary with the quantity a firm produces.
Category: Sticky Wages and Prices
Question 13
Each firm facing weaker demand would cut its own price, but because prices across the economy are sticky, the overall price level does not fall enough to restore aggregate demand. What term describes an economy-wide outcome that is worse than what happens at the level of individual markets?
Macroeconomic externality
✓
Expenditure multiplier
Comparative advantage
Coordination argument
Correct Answer
Macroeconomic externality
A macroeconomic externality occurs when what happens at the macro level differs from and is inferior to what happens at the micro level, such as sticky prices keeping the price level from falling to revive demand. Expenditure multiplier refers to spending changes having a larger effect on GDP. Comparative advantage is a concept from international trade about lower opportunity cost. Coordination argument is Keynes' explanation for why wages are sticky, not the name for the economy-wide outcome.
Category: Sticky Wages and Prices
Question 14
According to the expenditure multiplier, a change in autonomous spending causes what kind of change in real GDP?
An exactly equal change
A more than proportionate change
✓
A smaller, partial change
No change in the short run
Correct Answer
A more than proportionate change
Because one person's spending becomes another person's income, which is partly spent again, an initial change in spending ripples through the economy and changes real GDP by more than the original amount. An exactly equal change ignores these further rounds of spending. A smaller, partial change gets the size of the effect backward. No change in the short run contradicts the Keynesian view that demand drives output in the short run.
Category: Expenditure Multiplier
Question 15
Suppose the expenditure multiplier is 2.5 and investment spending by firms falls by 40 billion dollars, with nothing else changing. By how much does real GDP change?
It falls by 40 billion dollars
It falls by 16 billion dollars
It falls by 100 billion dollars
✓
It rises by 100 billion dollars
Correct Answer
It falls by 100 billion dollars
The change in real GDP equals the multiplier times the change in spending: 2.5 x 40 = 100, and since spending fell, GDP falls by 100 billion dollars. It falls by 40 billion dollars ignores the multiplier. It falls by 16 billion dollars comes from dividing 40 by 2.5 instead of multiplying. It rises by 100 billion dollars has the right size but the wrong direction, since the multiplier works in reverse for a spending decline.
Category: Expenditure Multiplier
Question 16
Along a downward-sloping Phillips curve, point A has 6 percent inflation and 3 percent unemployment, and point B has 2 percent inflation and 6 percent unemployment. Moving from point A to point B, how does the unemployment rate change?
It falls by 3 percentage points
It rises by 4 percentage points
It falls by 4 percentage points
It rises by 3 percentage points
✓
Correct Answer
It rises by 3 percentage points
Unemployment goes from 3 percent at point A to 6 percent at point B, a rise of 6 - 3 = 3 percentage points, which is the cost of lowering inflation from 6 to 2 percent along this curve. It falls by 3 percentage points gets the direction backward. It rises by 4 percentage points uses the 4-point change in inflation instead of unemployment. It falls by 4 percentage points mixes up both the variable and the direction.
Category: Phillips Curve
Question 17
An economy is producing above potential GDP and prices are rising. Which Keynesian policy would ease that pressure?
Tax increases or government spending cuts
✓
Tax cuts or government spending increases
Lower interest rates to encourage borrowing
Higher transfer payments to households
Correct Answer
Tax increases or government spending cuts
Contractionary fiscal policy, meaning tax increases or spending cuts, shifts aggregate demand to the left and reduces upward pressure on prices. Tax cuts or government spending increases are expansionary and would add to demand. Lower interest rates to encourage borrowing would raise investment and consumption, also adding to demand. Higher transfer payments to households would raise disposable income and consumption, pushing demand up further.
Category: Output Gaps
Question 18
What does a downward-sloping Phillips curve show?
Lower unemployment comes with lower inflation
Lower unemployment comes with higher inflation
✓
Unemployment and inflation are unrelated
Higher output comes with lower prices
Correct Answer
Lower unemployment comes with higher inflation
A Phillips curve shows a tradeoff between the unemployment rate and the inflation rate, so moving to lower unemployment means accepting higher inflation. Lower unemployment comes with lower inflation describes no tradeoff at all. Unemployment and inflation are unrelated contradicts the negative relationship the curve shows. Higher output comes with lower prices is not what the curve plots, since its axes are the unemployment rate and the inflation rate.
Category: Phillips Curve
Question 19
What happened to the U.S. Phillips curve relationship in the 1970s?
It became a stable menu of policy choices
Inflation and unemployment both fell to very low levels
It appeared to shift, with inflation and unemployment rising together
✓
It became steeper but stayed in the same place
Correct Answer
It appeared to shift, with inflation and unemployment rising together
In the 1970s, attempts to exploit the tradeoff were followed by higher inflation and higher unemployment at the same time, so the curve appeared to shift out to the right. It became a stable menu of policy choices describes how many economists viewed the curve in the 1960s, before it broke down. Inflation and unemployment both fell to very low levels describes the late 1990s, not the 1970s. It became steeper but stayed in the same place is wrong, because the curve shifted rather than holding its position.
Category: Phillips Curve
Question 20
To close a recessionary gap, which policy does the Keynesian approach recommend?
Tax increases or lower government spending
Setting wages and prices by law
Taking over large corporations
Tax cuts or higher government spending
✓
Correct Answer
Tax cuts or higher government spending
Expansionary fiscal policy, through tax cuts that raise consumption and investment or through direct increases in government spending, shifts aggregate demand to the right toward potential GDP. Tax increases or lower government spending are contractionary and would widen the gap. Setting wages and prices by law is not part of the Keynesian prescription, which leaves individual markets to work. Taking over large corporations is also outside the Keynesian role for government, which is to keep total demand high enough.
Category: Output Gaps