Practice Problems (Module 3)

Question #1: A country saves ¼ of any increase in disposable income. Then government purchases, G, decrease by 100. In what direction and by how much will the AD curve shift?

A) +400, right
B) -400, left
C) +25, right
D) -25, left
E) None

A) +400, right
B) -400, left
C) +25, right
D) -25, left
E) None

In order to solve this problem, we will need to use the equation below and solve for the change in aggregate demand (∆AD):

∆AD = k * ∆G

The question tells us that government spending is decreasing by 100 (∆G)...

Question #1: A country saves ¼ of any increase in disposable income. Then government purchases, G, decrease by 100. In what direction and by how much will the AD curve shift?

...therefore, we can plug it into the equation like so:

∆AD = k * -100

Now, what should we plug in for k?

Well, we know the following equation for k...

k = 1 / (1 - MPC)

...but we don't have MPC.

However, the question gives us the following detail...

Question #1: A country saves ¼ of any increase in disposable income. Then government purchases, G, decrease by 100. In what direction and by how much will the AD curve shift?

...which, aligns with the definition of Marginal Propensity to Save (MPSv). The country is saving ¼ of additional income, therefore MPSv = ¼, or 0.25!

And... we know that MPSv relates to MPC like so...

MPC + MPSv = 1

...therefore, we can plug in MPSv...

MPC + MPSv = 1
MPC + 0.25 = 1

...and solve for MPC like so!

MPC + MPSv = 1
MPC + 0.25 = 1
MPC = 0.75

Now, we can plug this into our formula for k...

k = 1 / (1 - MPC)
k = 1 / (1 - 0.75)

...and solve for k like so!

k = 1 / (1 - MPC)
k = 1 / (1 - 0.75)
k = 1 / (0.25)
k = 4

Now, we can plug k into our equation for ∆AD like so...

∆AD = k * -100
∆AD = 4 * -100

...and solve for ∆AD!

∆AD = k * -100
∆AD = 4 * -100
∆AD = -400

Since ∆AD is negative, that means that the aggregate demand curve has shifted to the left by 400, which aligns with answer choice B!

A) +400, right
B) -400, left
C) +25, right
D) -25, left
E) None

Question #2: (Select one or many) Which of the following will shift the Aggregate Demand (AD) curve to the right?

A) The Fed lowers interest rates
B) Taxes increase
C) Government purchases increase
D) Technology increases
E) None

A) The Fed lowers interest rates
B) Taxes increase
C) Government purchases increase
D) Technology increases
E) None

For starters, when interest rates are lowered, it encourages more borrowing and lending, and in-turn spending. This increases aggregate demand, shifting the curve to the right!

A) The Fed lowers interest rates
B) Taxes increase
C) Government purchases increase
D) Technology increases
E) None

Tax increases, on the other hand, do the exact opposite. They discourage spending, shifting the aggregate demand curve to the left, so we'll cross it out as an option.

A) The Fed lowers interest rates
B) Taxes increase
C) Government purchases increase
D) Technology increases
E) None

When government purchases increase, it results in increased aggregate demand, shifting the curve to the right! So we'll select it!

A) The Fed lowers interest rates
B) Taxes increase
C) Government purchases increase
D) Technology increases
E) None

When technology increases, it impacts supply, not demand. So we'll cross it out...

A) The Fed lowers interest rates
B) Taxes increase
C) Government purchases increase
D) Technology increases
E) None

...leaving us with this as our final answer!

Question #3: (Select one or many) An economy has potential output of 120 and actual output of 140. What is true?

A) A recessionary gap exists
B) An inflationary gap exists
C) U > Un
D) U < Un
E) None

A) A recessionary gap exists
B) An inflationary gap exists
C) U > Un
D) U < Un
E) None

First, let's determine whether a recessionary or inflationary gap exists.

Since Actual Output (Y) is higher than Potential Output (Yp)... that means an inflationary gap exists. Think about it: the economy is performing at an inflated rate of output!

Therefore, we'll select answer choice B.

A) A recessionary gap exists
B) An inflationary gap exists
C) U > Un
D) U < Un
E) None

But, that's not all!

Whenever an inflationary gap exists in an economy, that means that the rate of Unemployment (U) is lower than the natural rate of unemployment (Un).

Think about it: the economy's actual output is above its potential output. It's in "hyperdrive", for lack of a better term.

Therefore, there's more workers than normal to make this actual output above potential output! This means the rate of unemployment (U) (corresponding to the actual output) is lower than the natural rate of unemployment (Un) (corresponding to the potential output).

A) A recessionary gap exists
B) An inflationary gap exists
C) U > Un
D) U < Un
E) None

This serves as our final answer!

Question #4: Which of the following are consistent with the Natural Rate Hypothesis?

A) Y always ends up equaling Yp in the long run
B) Actual U cannot be kept lower than Un indefinitely because U always returns to Un
C) If the government shifts AD to the right when initially Y = Yp, then temporarily U>Un
D) All of the above are consistent with the hypothesis
E) Only a and b are consistent with the hypothesis

A) Y always ends up equaling Yp in the long run
B) Actual U cannot be kept lower than Un indefinitely because U always returns to Un
C) If the government shifts AD to the right when initially Y = Yp, then temporarily U>Un
D) All of the above are consistent with the hypothesis
E) Only a and b are consistent with the hypothesis

The Natural Rate Hypothesis states that in the long run, an economy will always be (1) at its potential for output and (2) at its natural rate of unemployment.

"(1) at its potential for output" aligns with answer choice A...

A) Y always ends up equaling Yp in the long run
B) Actual U cannot be kept lower than Un indefinitely because U always returns to Un
C) If the government shifts AD to the right when initially Y = Yp, then temporarily U>Un
D) All of the above are consistent with the hypothesis
E) Only a and b are consistent with the hypothesis

...and "(2) at its natural rate of unemployment" aligns with answer choice B...

A) Y always ends up equaling Yp in the long run
B) Actual U cannot be kept lower than Un indefinitely because U always returns to Un
C) If the government shifts AD to the right when initially Y = Yp, then temporarily U>Un
D) All of the above are consistent with the hypothesis
E) Only a and b are consistent with the hypothesis

...therefore, we'll choose answer choice E (since this isn't a Select one or many problem).

A) Y always ends up equaling Yp in the long run
B) Actual U cannot be kept lower than Un indefinitely because U always returns to Un
C) If the government shifts AD to the right when initially Y = Yp, then temporarily U>Un
D) All of the above are consistent with the hypothesis
E) Only a and b are consistent with the hypothesis

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