GDP & Economy Explanation – Principles of Macroeconomics

GDP & Economy Explanation – Principles of Macroeconomics

This chapter is about GDP, prices & economy principles and their explanation.


In the short run, which of the following does not explain why real GDP falls when the price level falls:

flexible input prices – Correct

money illusion

sticky input prices

menu costs

Explanation: When the price level falls, firms have the incentive to decrease their output and, hence, real GDP. The incentive to decrease output lies in menu costs, money illusion and sticky input prices. As a result, GDP falls.

Refer to the figure below. It is apparent that between 1992 and 2000 the U.S. economy went through the _________ phase of the business cycle.

Phase of the business cycle.


Trough

Expansionary – Correct

Recessionary

Contractionary

Explanation: Changes in real GDP remained positive through each quarter between 1992 and 2000 so we know that the U.S. economy was expanding during this time. In addition, the blue shaded areas indicate a time when the economy is going through a contractionary phase or recession.

Suppose OPEC members met and decided to increase their oil production (and thus lower prices) for six months.  This change will cause many firms’ input prices in the U.S. to __________.  This change in input prices will cause a _____________ aggregate supply curve.

decrease; shift in the short-run – Correct

decrease; movement along the short-run

decrease; shift in the long-run

increase; shift in the short-run

Explanation:Oil is an important input for many firms, and a decrease in oil prices will lower average input prices for those firms.  Lower input prices result in a lower cost of production at every price level, so firms are willing to produce more output at every price level, and the short-run aggregate supply curve shifts to the left.  The long-run aggregate supply curve does not shift because this is a temporary shock.

Suppose stock markets in the U.S. have a very successful month, and the indices increase by 10%.  As a result, we can expect aggregate ______ to ______.

demand; decrease

demand; increase – Correct

supply; decrease

supply; increase

Explanation:Many people own stocks and mutual funds that are tied to the stock market.  When the stock prices increase, their wealth increases, and they may be inclined to spend more today.  The result is an increase in aggregate demand. 

Suppose that the economy is in long-run equilibrium. A sudden shift in the ____ curve will eventually result in a new long-run equilibrium where the price level is exactly the same as it was initially.

long-run aggregate supply

aggregate demand

short-run aggregate supply – Correct

Review the figure below,

Suppose that the economy is in long-run equilibrium GDP & Economy Explanation- Principles of Macroeconomics


Explanation:Based on the graph below, after a change in SRAS, the economy returns to long-run equilibrium when the SRAS eventually shifts back to exactly where it was originally. The new graph of long-run equilibrium will be exactly the same, implying no long-run change to the price level. If the LRAS curve shifts, output and the price level both shift in the long run. If the aggregate demand curve shifts, output remains the same in the long run but the price level shifts.

Suppose the economy is in long run equilibrium and the new President decides to cut income taxes. With this sudden increase in aggregate demand, which of the following statements is true?

in the long run, real GDP stays below the full employment level

short run real GDP will fall

the price level will rise in the short run and will continue to rise in the long run – Correct

short run unemployment will rise

Explanation: Referring to the graph below, in the short run, Real GDP rises, the unemployment rate falls, and the price level rises. In the long run, real GDP goes back to the full-employment level, the unemployment rate returns to the natural rate, and the price level rises further. In the short run, AD curve shifts from AD1 to AD2. Equilibrium will be at point b. In the long run, equilibrium will be at point C

Suppose the economy is in long run equilibrium..GDP & Economy Explanation- Principles of Macroeconomics

Suppose you have two economies in recession. Economy A has workers with long term contracts that guarantee high nominal wages for the next five yers. Economy B has workers with annual contracts that are indexed to changes in the price level. Based on this information, which of the following statements is true?

Both economies will return to the natural rate of output at the same time

Economy A will return to the natural rate of output sooner

There is not enough information to make a decision.

Economy B will return to the natural rate of output sooner – Correct

Explanation: For economy A, high nominal wages are set for five years. Therefore they cannot adjust for five years. The SRAS cannot increase for five years, and the economy cannot get back to long run equilibrium for at least five years. This makes the recession last longer. For economy B, wage contracts are going to change annually with the price level. Since wages can adjust relatively quickly, SRAS will be able to increase more quickly than in economy A. This will end the recession and bring the economy back to a long run equilibrium relatively faster.

The ______________ effect helps explain why an increase in the price level causes a decrease in real gross domestic product.

money

nominal interest rate

export

international trade – Correct

Explanation: The three effects that explain why an increase in the price level causes a decrease in real gross domestic product are the wealth effect, the interest rate effect, and the international trade effect. An increase in the price level of the U.S. raises the price of U.S. goods relative to the price of foreign goods. So, imports are less expensive and exports are more expensive. The net export component of GDP decreases, lowering real GDP.

The price level falls in the United States. Ceteris paribus, which of the following occurs?

Quantity of aggregate demand decreases

Import purchases increase

Aggregate demand increases

Import purchases decrease – Correct

Explanation: When the price level in the United States decreases, all else constant, U.S. goods become cheaper relative to foreign goods. This means that people in the United States buy fewer foreign goods, so imports fall. Exports also rise, because other countries will buy more U.S. goods. Since imports are subtracted from net exports, this means that net exports rise. Therefore, a lower price level increases the quantity of aggregate demand. This is the international trade effect, which contributes to the downward slope of aggregate demand. Note that the change in price level does not cause a shift in aggregate demand, but only a change in quantity of aggregate demand, or a movement along the aggregate demand curve.

GDP & Economy Explanation- Principles of Macroeconomics




The shift in aggregate demand depicted above is due to a(n):

increase in income taxes. – Correct

increase in consumer confidence.

decrease in interest rates.

increase in exports.

Explanation: An increase in income taxes leads to a decrease in disposable income, which leads to a decrease in consumer spending. This will cause aggregate demand to decrease and the aggregate demand curve will shift leftwards. An increase in consumer confidence will lead to increased consumer spending. A decrease in interest rates will lead to an increase in consumer and investment spending. An increase in exports will lead to an increase in consumer spending. These 3 factors will all shift the aggregate demand curve rightwards.

Which of the following scenarios will cause a higher price level in the long run?

Consumer wealth increases due to a rise in housing prices – Correct

The value of the U.S. dollar increases

The internet is widely adopted

Oil supplies are restricted for six months

Explanation:When consumer wealth rises due to an increase in housing prices, aggregate demand will increase.  Output and the price level are greater than at full-employment output.  In the short run, input prices are sticky and do not change.  In the long run, contracts are renegotiated and the short-run aggregate supply curve shifts to the left.  The new equilibrium restores the full-employment output level, but also results in a new, higher price level.

You work for Dr. Zhang, the autocratic dictator of Zhouland. After taking an economics course, you decide that devaluing your currency (Zhoullars) is the way to increase GDP. Following your advice, Dr. Zhang orders massive increases in the supply of Zhoullars, which reduces the value of Zhoullars in world markets. Use the AD–AS model and assume the economy was in long-run equilibrium before this change. Remember to consider only this change as you determine your answers.

In the short run, the policy will cause the price level to ___________, real GDP to___________, and the unemployment rate to___________.

increase; increase; decrease – Correct

increase; increase; increase

increase; decrease; increase

decrease; increase; decrease

Explanation:The reduction in the value of the Zhoullar means an increase in AD. The value of the dollar (or Zhoullar, in this case) is a shift factor for AD. In this case, a devaluing of the Zhoullar leads to an increase in AD. The new intersection with SRAS will be at a price level above the long-run equilibrium price level, at a level of real GDP above the long-run equilibrium level of real GDP, and at a level of unemployment below its natural rate.

In the short run, which of the following does not explain why real GDP falls when the price level falls:GDP & Economy Explanation- Principles of Macroeconomics

______ will most likely increase the economy’s long-run aggregate supply.

Advances in technology – Correct

Unfavorable weather in the corn-producing states

Favorable weather in the corn belt

A low rate of investment

Explanation: A lower rate of investment is something that would lead to a decrease in the long run aggregate supply. Unfavorable weather in corn-producing states is temporary and would lead to a decrease in short run aggregate supply. Favorable weather is also temporary and will lead to an increase in short run aggregate supply. Advances in technology will lead to an increase in long run aggregate supply, because it will tend to increase productivity for firms and this is something that will be sustained and permanent.

According to Keynesian economists, prices tend to be ______________. As a result, Keynesian economists focus on _____________ changes and aggregate ____________.

flexible; long-run; demand

sticky; short-run; demand – Correct

flexible; short-run; supply

sticky; long-run; supply

Explanation: Keynesian economists believe that prices are sticky because of contracts and money illusion. Because of price stickiness, when aggregate demand decreases, Keynesian economists believe that the economy does not self-adjust, contrary to the beliefs of classical economists. As a result, Keynesian economists focus on short-run changes that they believe shift aggregate demand back to equilibrium.

According to classical economics, a decrease in aggregate demand causes the price level to _____________ in the long run. On the other hand, an increase in aggregate demand causes the price level to _____________ in the long run. These changes occur because of _____________.

increase; decrease; price flexibility

decrease; increase; price flexibility – Correct

decrease; increase; government intervention

increase; decrease; government intervention

Explanation: Classical economists believe that prices adjusted to long-run output equilibrium without the need for government intervention because of price flexibility. When aggregate demand decreases, prices decrease to restore the long-run equilibrium. When aggregate demand increases, prices increase to restore the long-run equilibrium.

Consider these four graphs. Graph ____ depicts the conditions of the Great Recession, and graph _____ depicts the conditions of the Great Depression.


Consider these four graphs.In the short run, which of the following does not explain why real GDP falls when the price level falls:

C; A

C; D – Correct

A; C

D; B

Explanation: Graph C refers to the Great Recession and graph D refers to the Great Depression. The U.S. economy saw declining prices but no change in long run aggregate supply during the Great Depression, which is consistent with graph D. During the Great Recession, he impact of the financial crisis on long run aggregate supply and aggregate demand is consistent with graph C, in which the price level did not change.

Identify which of the following graphs will be drawn by classical and Keynesian economists, respectively, for an economy experiencing a decrease in wealth. Note that E1 and E2, respectively, are the initial and final equilibrium points before and after the wealth decrease.

Classical: Fig 4; Keynesian: Fig 1 – Correct

Classical: Fig 1; Keynesian: Fig 2

Classical: Fig 2; Keynesian: Fig 3

Classical: Fig 2, Fig 4; Keynesian: Fig 1, Fig 3

Explanation: The economy experiences a decrease in wealth. This implies that the AD curve should shift left, irrespective of the classical or Keynesian point of view. Hence, we can exclude figures 2 and 3, since both these figures involve a rightward shift of the AD curve. According to classical economists, the economy is self-correcting and always ends up at full-employment output. So in classical economics, demand shifts only involve changes in the price level, with output being at the full-employment level. This is the case as shown in Figure 4. On the other hand, Keynesian economists hold the view that aggregate demand changes bring fluctuations to the economy and therefore demand shifts can result in equilibrium situations in which the real GDP drifts away from potential GDP. This is the case depicted in Figure 1.

If a Keynesian economist was offering policy advice to stimulate an economy, which of the following would apply?

reduce unemployment benefits for 6 months

reduce licensing requirements for cosmetologists.

let the economy work itself out, without any government action

create a program that would fix and repair existing infrastructure and highways – Correct

Explanation: An infrastructure program designed to fix infrastructure is a direct injection of money into the economy by the government. This program also creates jobs to lower the unemployment rate. This type of policy directly increases aggregate demand, and is the underlying principle behind Keynesian economics.

Which of the following explains why the Great Depression was so much worse than the Great Recession?

The decline in real GDP during the Great Depression was nearly 60%, and the decline during the Great Recession was about 25%

With the Great Recession, the economy took more than seven years to return to pre-recession level, and the Great Depression took 14 years to return to pre-depression levels

At its worst, the highest unemployment rate was 25% during the Great Recession, but during the Great Depression, the unemployment was highest at 10%

The Great Recession lasted only 18 months, whereas the Great Depression lasted about four years – Correct

Explanation: With the Great Recession, the economy took more than 4 years to return to pre-recession levels, and with the Great Depression took more than 7 years to return to pre-Depression levels. The decline in real GDP during the Great Depression was 30% and the decline in GDP during the Great Recession was about 5%.

Which of the following is a reason the 2007–2009 recession came to be known as the Great Recession?

The atmosphere of the country was one of celebration despite stress in the financial markets.

There was noticeable stress in financial markets. – Correct

It was greater in length of all the recessions that had occurred since the Great Depression.

The effects of the Great Recession, in terms of both high unemployment rates and slow real GDP growth, were drastic but short-lived.

Explanation: Real GDP fell by an annual rate of 8.9% in the fourth quarter of 2008. The downturn in the financial markets made the downturn similar to that aspect of the Great Depression. If you look at business cycle dates, you will see that the length of the Great Recession was not longer than all previous ones combined.

Which of the following led to the Great Recession?

a rise in AD but a decline in LRAS

a decline in both AD and LRAS – Correct

a decline in AD

a decline in LRAS

Explanation:The financial crisis that caused the Great Recession led to a permanent breakdown in the loanable funds market, resulting in reduced funding opportunities for investment for the firms, which reduced the long-run aggregate supply. At the same time, large declines in consumer wealth contributed to a significant decline in aggregate demand.

Which of the following statements is consistent with what happened during the Great Recession?

Housing prices fell during the Great Recession, causing a decrease in consumer wealth. This decrease in wealth led to a decrease in aggregate supply and a decrease in potential GDP.

Aggregate demand and long-run aggregate supply decreased, causing unemployment to rise to 10%. – Correct

Aggregate demand and short-run aggregate supply increased, causing potential GDP to decrease.

Consumer sentiment fell prior to and during the Great Recession, leading to a decline in expected income that decreased the aggregate supply curve.

Explanation: During the Great Recession, aggregate demand and long-run aggregate supply both decreased. These shifts eventually led to an unemployment rate of slightly more than 10%. Consumer sentiment did drop prior to and during the Great Recession, but this change affected aggregate demand, not aggregate supply.

Which of the following statements is consistent with what happened during the Great Depression?

The Great Depression had an unemployment rate greater than the Great Recession that was largely due to a decrease in aggregate supply.

The unemployment rate was over 25% at the height of the Great Depression. This spike in unemployment was caused by the large decrease in aggregate demand. – Correct

It took four years for potential GDP to return to its pre-Depression level after the Great Depression.

Faulty macroeconomic policies were not a part of the cause of the Great Depression.

Explanation: A large decrease in aggregate demand had tumultuous effects on the U.S. economy during the late 1920s and 1930s. By 1933, the unemployment rate was over 25%. This spike in unemployment was in large part due to faulty macroeconomic policies. It would take seven years after the start of the depression for potential GDP to return to pre-Depression levels. And it wouldn’t be until the 1940s that the unemployment rate returned to single digits.

Which of the following was one of the causes of the aggregate demand shifts during the Great Recession?

an increase in  the natural rate of unemployment

an increase in import taxes

a shift in the balance of trade

a reduction in the prices of homes – Correct

Explanation: Falling home prices led to a reduction in wealth for many households. Household’s decrease in wealth caused a reduction in aggregate demand.

Based on the data below, which of the four nations was in the worst fiscal shape in 2010? (All data comes from the OECD and is in billions of current U.S. dollars.)

GDP falls when the price level falls:


Spain, because it had the highest debt in 2010.

Ireland, because it had the lowest GDP in 2010.

Greece, because it had the highest debt-to-GDP ratio in 2010. – Correct

Spain, because it had the highest annual budget deficit between 2000 and 2010.

Explanation:The most informative number in answering this question is a nation's debt-to-GDP ratio, which is the amount of debt a country has divided by its GDP. Typically, the higher the debt-to-GDP ratio is, the worse off a country is fiscally. Greece's debt-to-GDP ratio in 2010 was 1.48 = $455 billion debt ÷ $308 billion GDP. This is worse than Ireland's (0.602), Portugal's (0.879), or Spain's (0.517). This means that relative to how much it produced, Greece had the most debt, and therefore out of the four countries was in the worst fiscal shape.

Discretionary spending by the government is spending that

is under the direct control of congress – Correct

is developed in secret

applies to some industries but not to others

applies to some states but not to others

Explanation: Discretionary outlays comprise government spending that can be altered when the government is setting its annual budget. Discretionary outlays include federal spending on education.

Suppose that over the past 50 years, the nominal and real deficit of a country grew from $100 billion to $200 billion. Suppose that, over the same time, real GDP grew from $100 billion to $300 billion. Using __________, we can give an accurate picture of what happened in the country and conclude that the country is __________.

deficit-to-GDP ratio; worse off

deficit-to-GDP ratio; better off – Correct

real deficits; worse off

real deficits; better off

Explanation: Despite the fact that real and nominal deficits have grown, GDP grew at a much faster rate, and the country is actually better off. Looking at deficit-to-GDP ratios gives a more accurate and clearer picture of what happened to the country. Over the 50-year period, the deficit-to-GDP ratio decreased from 1 to 2/3.

The fear about Social Security is that

in several years, it will be eliminated altogether

in several years, fewer individuals will retire to take advantage of the program

in several years, benefits will be cut by 50 percent

in several years, there will not be enough funds to cover 100 percent of promised benefits – Correct

Explanation: The program requires workers to contribute a portion of their earnings into the Social Security Trust Fund with the promise that they will receive these back (including a modest growth rate) upon retirement. The goal of the program is to guarantee that no U.S. worker retires with no retirement income. In 1960 there were more than five workers per beneficiary in the Social Security system. With that number, it wasn’t very difficult to accumulate a large trust fund. But now there are fewer than three workers per beneficiary, and as the baby boomers retire, this number is set to fall to just above two, as indicated by the projections for the years 2030 and 2050.

Use the marginal income tax rates shown here to calculate the average tax rate on an income of $100,000.

Taxable IncomeTax rate
$0–$8,70010%
$8,700–$35,35015%
$35,350–$85,65025%
$85,650–$178,65028%
$178,650–$388,35033%
Over $388,35035%


Average tax rate on $100,000 of income is ____________.

21.46% – Correct

28%

24.27%

35%

Explanation: The average tax rate is calculated by first computing the total tax bill, then dividing the tax bill by the taxable income. Since the average tax rate increases with taxable income, this is a progressive income tax system.

The tax due on $100,000 is:
0.10 × $8,700 = $870
+ 0.15 × ($35,350 – $8,700) = $3,997.50
+ 0.25 × ($85,650 – $35,350) = $12,575
+ 0.28 × ($100,000 – $85,650) = $4,018
Total = $21,460.50

The average tax rate on $100,000 is $21,460.50 ÷ $100,000 = 21.46%

Use the marginal income tax rates shown here to calculate the average tax rate on an income of $200,000.

Taxable IncomeTax rate
$0–$8,70010%
$8,700–$35,35015%
$35,350–$85,65025%
$85,650–$178,65028%
$178,650–$388,35033%
Over $388,35035%


Average tax rate on $200,000 of income is ___________.

25.26% Correct

30.50%

35%

33%

Explanation: The average tax rate is calculated by first computing the total tax bill, then dividing the tax bill by the taxable income. Since the average tax rate increases with taxable income, this is a progressive income tax system.

The tax due on $200,000 is:
0.10 × $8,700 = $870
+ 0.15 × ($35,350 – $8,700) = $3,997.50
+ 0.25 × ($85,650 – $35,350) = $12,575
+ 0.28 × ($178,650 – $85,650) = $26,040
+ 0.33 × ($200,000 – $178,650) = $7,045.50
Total = $50,528

The average tax rate on $200,000 is $50,528 ÷ $200,000 = 25.26%

Using the data shown in the table below, the debt-to-GDP ratio for Greece in 2001 was _______ and the debt-to-GDP ratio for Greece in 2011 was _________.

20012011
DebtGDPDebtGDP
$134.6 billion$129.8 billion$493.19 billion$289.6 billion

96.4%; 58.7%

1.037%; 1.703%

170.3%; 103.7%

103.7%; 170.3% – Correct

Explanation:To calculate the debt-to-GDP ratio divide the debt held by the country by its GDP, then multiply it by 100. In 2001, Greece had a debt-to-GDP ratio of (134.6 ÷ 129.8) × 100 = 103.7%. In 2011, Greece had a debt-to-GDP ratio of (493.19 ÷ 289.6) × 100 = 170.3%.

Which of the following represents a mandatory government outlay?

the purchase of a new tank to replace a tank destroyed during a war

rental assistance payments made to those who are poor – Correct

an interest payment made to holders of government debt

a payment made to a construction worker who was hired to pave a road

Explanation: Mandatory outlays can be either money or goods/services given to an individual who meets certain criteria, including holders of government debt. Mandatory outlays exist when the government programs and the level of spending on the government programs is determined by law.

Which of the following statements about Medicare and Social Security is true?

Medicare and Social Security represent a mandatory outlay. – Correct

Spending on Medicare and Social Security has decreased as a percentage of GDP over the last few decades.

Social Security and Medicare are social insurance programs aimed at supporting needy children.

Medicare and Social Security represent about 10% of total government spending.

Explanation: Mandatory spending on Medicare and Social Security has increased as a percentage of GDP over the last few decades. Medicare and Social Security account for over 1/3 of total government spending.  Medicare and Social Security are largely only available to the elderly.

Which of the following statements are true about deficits versus debt?

The current year deficit can be subtracted from the current year debt to find the previous year’s deficit.

The sum of all debts equal the deficit.

The sum of all deficits equal the debt. – Correct

If in year 1 the debt is $1 million and the deficit in year 2 in $200,000, the debt in year 2 is $800,000.

Explanation: A debt is the sum total of accumulated budget deficits.  If in year 3, the debt is $50 million and in year 4 the deficit is $2 million, then adding year 4’s deficit to year 3’s debt will yield a year 4 debt of $52 million.

Which of the following would be considered a transfer payment by the government?

The government directly pays the health care expenses of senior citizens.

The government spends money to replace all computers in government offices.

The government hires a construction crew to rebuild a bridge across a river

The government helps senior citizens cover their monthly expenses with a cash payment. – Correct

Explanation: Transfer payments are those cash (money) payments made where there are no goods or services received in return.  Transfer payments are payments made to senior citizens to cover their monthly expenses with a cash payment. Transfer payments do not include the purchase of goods (such as computers and bridges) or services (such as health care).

Which of the following would help to fix Social Security problems?

lower the retirement age

increase the retirement age – Correct

increase the cost of living adjustment

lowering the payroll tax rate

Explanation:People are living longer and healthier lives than when these retirement programs were implemented. If people were to work three years longer, they would have three more years of saving for retirement and three fewer years of drawing benefits. These benefits payments are adjusted on the basis of an average wage index, which has historically increased faster than the CPI. If, instead, the CPI were used to adjust benefits payments, the payments would not grow as fast and would still account for inflation. If the payroll tax rate is lowered, less funds will be paid into Social Security.

You have been hired as an economic advisor for a politician running for national office.  The politician, at a recent campaign event, said that corporations are paying too much in taxes and are funding most of the federal government’s operations.  When you speak to the politician after the event, what would you say?

We have a great deal of work to do.  On the news tonight I predict there will be an expert correcting you and questioning why anyone would vote for you.  Individuals, through income tax and social insurance taxes, provide the bulk of government revenue.” Correct

“I can’t believe you said that!  Everyone knows that taxes on cigarettes and alcohol (excise taxes) represent the largest source of tax revenue for the federal government.”

“So close!  Maybe no one will catch your error.  Corporate and estate taxes are about equal and are tied for the largest sources of tax revenue.”

“Good job! You will win this election based on your sound economic knowledge.”

Explanation:The politician was incorrect.  Individuals, through their payment of income and social insurance taxes, provide most of the government’s revenue.

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