MA Unit 5: Long-run Consequences

Country X's economy is in an inflationary gap. Which of the following combinations of fiscal and monetary policy actions would be most effective to restore full employment in the short run

• A decrease in income taxes and a decrease in the required reserve ratio

• A decrease in income taxes and an increase in the discount rate

• A decrease in government spending and an open-market purchase of government bonds by the country’s central bank

• An increase in government spending and targeting a lower policy rate

• An increase in income taxes and an increase in the central bank’s administered interest rates

Answer explanation

An increase in income taxes is a contractionary fiscal policy that will decrease aggregate demand and decrease real output. Increasing the central bank’s administered interest rates is a contractionary monetary policy that will decrease aggregate demand and decrease real output. Both policies are contractionary and will close the inflationary gap and move the economy closer to full employment.

An economy with limited reserves in its banking system is in short-run equilibrium as illustrated in the graph provided. Which of the following combinations of policy actions would definitely move the economy toward long-run equilibrium?

• A decrease in government spending and an increase in income taxes

• An increase in government spending and a central bank bond sale

• A central bank bond purchase and an increase in the discount rate

• A central bank bond sale and an increase in income taxes

• A decrease in income taxes and a central bank bond purchase

Answer explanation

The economy is in a recessionary gap. A decrease in income taxes is an expansionary fiscal policy that will increase aggregate demand and increase real output. A central bank bond purchase is an expansionary monetary policy that will increase aggregate demand and real output. The two policy actions are expansionary and will close the recessionary gap and move the economy toward full employment.

A decrease in the policy rate accompanied by a decrease in income taxes will result in which of the following in the short run?

• A decrease in real output

• A decrease in the price level

• A decrease in unemployment

• A decrease in nominal wages

• A decrease in the natural rate of unemployment

Answer explanation

A decrease in the policy rate is an expansionary monetary policy that will decrease nominal interest rates, increase interest-sensitive spending, and increase aggregate demand, resulting in an increase in real output and the price level. A decrease in income taxes is an expansionary fiscal policy that will increase aggregate demand, resulting in an increase in real output and the price level. Both policies are expansionary and will result in a decrease in unemployment.

Which of the following points illustrates an inflationary gap?

• X

• Y

• Z

• K

• J

Answer explanation

Point X represents an inflationary gap. Point X corresponds to a short-run equilibrium beyond full employment (in the context of the aggregate demand and aggregate supply model) with an actual inflation rate above the expected inflation rate and an unemployment rate below the natural rate of unemployment.

An increase in the expected inflation rate will cause which of the following?

• A rightward shift in the aggregate demand curve

• A rightward shift in the short-run Phillips curve

• A rightward shift in the short-run aggregate supply curve

• A leftward shift in the long-run Phillips curve

• A leftward shift in the long-run aggregate supply curve

Answer explanation

The short-run Phillips curve is drawn for a given expected inflation rate and so it shifts as inflationary expectations change. An increase in the expected inflation rate shifts the short-run Phillips curve to the right, which implies a higher unemployment rate for any given expected inflation rate.

Assume the economy is in long-run equilibrium. A decrease in net exports will result in which of the following in the short run?

• The SRPC

  will shift to the left.

• The SRPC

  will shift to the right.

• The LRPC

  will shift to the right.

• There will be a movement from point B to point C.

• There will be a movement from point B to point A.

Answer explanation

Point B illustrates long-run equilibrium. A decrease in net exports decreases aggregate demand, the price level, and real output. A negative demand shock corresponds to a downward movement along the SRPC

from point B to point C, resulting in a lower inflation rate and a higher unemployment rate in the short run.

Suppose that an economy with flexible wages and prices is in long-run equilibrium when the central bank contracts the money supply. What is the long-run effect on real output in the economy?

• Real output falls.

• Real output is unchanged.

• Real output rises.

• Real output falls as price levels fall.

• Real output rises as price levels fall.

Answer explanation

When the economy is at full employment, changes in the money supply have no effect on real output in the long run.

Assume an economy is in long-run equilibrium and the central bank engages in an expansionary monetary policy for a prolonged time period. If the velocity of money is constant, which of the following is true according to the quantity theory of money?

• The government’s budget deficit will increase.

• Price level will increase at the same rate as the money supply.

• Real output will exceed full employment in the long run.

• The actual unemployment rate will exceed the natural rate of unemployment.

• The production possibilities curve will shift inward.

Answer explanation

According to the quantity theory of money, velocity and real output are assumed to be constant in the long run, and therefore the price level rises proportionally to changes in the money supply

Suppose nominal GDP is $25 million, the price level is 1.25, and the money supply is $10 million. What is real GDP and the velocity of money according to the quantity theory of money?

• Real GDP

  is $2.5

  million, and the velocity of money is 12.5

  .

• Real GDP

  is $10

  million, and the velocity of money is 20

  .

• Real GDP

  is $12.5

  million, and the velocity of money is 8

  .

• Real GDP

  is $20

  million, and the velocity of money is 2.5

  .

• Real GDP

  is $25

  million, and the velocity of money is 8

  .

Answer explanation

Nominal GDP

is the product of real GDP

and the price level. Therefore, real GDP=$25 million/1.25=$20 million

. According to the quantity theory of money, the product of the money supply (M) and the velocity of money (V) is equal to the product of the price level (P)

and real GDP (Y)

. Therefore, V=PY/M=$25 million/$10 million=2.5

If tax revenues are less than the total of government spending plus government transfer payments, which of the following will happen?

Responses

• The tax multiplier will increase.

• The spending multiplier will increase

• The government budget will be in surplus.

• There will be an inflationary gap.

• The national debt will increase.

Answer explanation

When tax revenues are less than the sum of government spending and transfer payments, there is a government budget deficit, which increases the national debt