Unit 4 Review
1. What is the multiplier if the marginal propensity to consume is:
2. A fall in the value of the dollar against other currencies makes U.S. final goods and services cheaper to
foreigners even though the U.S. aggregate price level stays the same. As a result, foreigners demand more
American aggregate output. Your study partner says that this represents a movement down the aggregate
demand curve because foreigners are demanding more in response to a lower price. You, however, insist
this represents a rightward shift of the aggregate demand curve. Who is right? Explain.
3. Suppose that the economy is currently at potential output. You are an economic policy-maker and a
college intern asks you to rank the possible types of “shocks” in order from most preferred to least
preferred. How would you rank them and why?
4. Determine the effect on aggregate demand (AD) of each of the following events. Explain whether it
represents an upward or downward movement along the AD curve or a leftward or rightward shift of the
a. A rise in the interest rate caused by a change in monetary policy
b. A fall in the real value of money in the economy due to a higher aggregate price level
c. News of a worse-than-expected job market next year
d. A fall in tax rates
e. A rise in the real value of assets in the economy due to a lower aggregate price level
f. A rise in the real value of assets in the economy due to a surge in real estate values
Unit 4 Review
5. Suppose that in Wageland all workers sign annual contracts each year on January 1. No matter what
happens to prices of final goods and services during the year, all workers earn the wage specified in their
annual contract. This year, prices of final goods and services fall unexpectedly after the contracts are
signed. Answer the following questions using a diagram and assume the economy starts at potential output.
a. In the short-run, how will the quantity of aggregate output supplied respond to the fall in prices?
b. What will happen when firms and workers renegotiate their wages?
6. In Wageland, all workers sign annual contracts each year on January 1. In late January, a new computer
operating system is introduced that increases labor productivity dramatically. Explain and illustrate how
Wageland will move from an initial short-run equilibrium to another.
7. Determine the effect on short-run aggregate supply of each of the following events. Explain whether it
represents an upward or downward movement along the SRAS curve or a leftward or rightward shift of the
a. A rise in the consumer price index (CPI) leads producers to increase output
b. A fall in the price of oil leads producers to increase output
c. A rise in legally mandated retirement benefits paid to workers leads producers to reduce output
Unit 4 Review
8. Describe the short-run effects of each of the following shocks on the aggregate price level and on aggregate
a. The government sharply increases the minimum wage
b. Solar energy firms launch a major program of investment spending
c. Congress raises taxes and cuts spending
d. Severe weather destroys crops around the world
9. In each of the following cases, determine whether the policy is an expansionary or contractionary fiscal
a. Several military bases around the country, which together employ thousands of people, are closed
b. The number of weeks an unemployed person is eligible for unemployment benefits is increased
c. The federal tax on gasoline is increased
10. Explain why federal disaster relief, which quickly disburses funds to victims of natural disasters such as
hurricanes, floods and large-scale crop failures, will stabilize the economy more effectively after a disaster
than relief that must be legislated.
Unit 4 Review
11. In each of the following cases, either a recessionary or inflationary gap exists. Calculate both the change in
government spending on goods and services and the change in government transfers necessary to close
a. Real GDP = $100 billion, potential output = $160 billion, MPC = 0.75
b. Real GDP = $250 billion, potential output = $200 billion, MPC = 0.5
c. Real GDP = $180 billion, potential output = $100 billion, MPC = 0.8
12. Explain why a $500 million increase in government purchases of goods and services will generate a larger
rise in real GDP than a $500 million increase in government transfers.
13. Explain why a $500 million reduction in government purchases of goods and services will generate a larger
fall in real GDP than a $500 million tax increase.
14. An economy is in long-run macroeconomic equilibrium when each of the following aggregate demand
shocks occurs. Identify what kind of gap (inflationary or recessionary) will the economy face after the
shock and what type of fiscal policies would help move the economy back to potential output. Be sure to
indicate how your recommended fiscal policy would shift the aggregate demand curve.
a. A stock market boom increases the value of stocks held by households
b. Firms come to believe that a recession in the near future is likely
c. Anticipating the possibility of war, the government increases its purchases of military equipment
d. The quantity of money in the economy declines and interest rates increase