Eco403 - Final Term Notes

MacroeconoMics
eco 403
Made by: Muniba ch

Lesson 19
ECONOMIC GROWTH
MCQs:
1. Economic growth is measured by an increase in which of the following?
a) Population
b) Labor force
c) Total output of goods and services
d) Capital stock
Answer: c) Total output of goods and services
2. The Solow Growth Model is designed to show the interaction of which
factors in an economy?
a) Government policies and population growth
b) Capital stock, labor force, and technology
c) Inflation and interest rates

d) Import and export levels
Answer: b) Capital stock, labor force, and technology
3. In the Solow Growth Model, the production function represents the
transformation of inputs into outputs. Which inputs are considered in
the production function?
a) Labor (L) and investment (I)
b) Capital (K), labor (L), and production technology
c) Consumption (C) and savings (S)
d) Gross Domestic Product (GDP) and inflation rate
Answer: b) Capital (K), labor (L), and production technology
4. What is the national income identity in the Solow Growth Model?
a) Y = C + I + G
b) Y = C + I
c) Y = C + S
d) Y = C + I + G + (X - M)
Answer: b) Y = C + I
5. In the Solow model, what does "s" represent?
a) Saving rate
b) Capital stock per worker
c) Population growth rate
d) Investment per worker
Answer: a) Saving rate
6. What is the equation of motion for capital (k) in the Solow model?
a) ∆k = sf(k) - ∂k
b) ∆k = i - c
c) ∆k = s - f(k)
d) ∆k = sf(k) + ∂k
Answer: a) ∆k = sf(k) - ∂k
7. What is the steady state in the Solow model?
a) The point where investment is zero
b) The point where the capital stock remains constant (∆k = 0)

c) The point where consumption equals investment
d) The point where the production function reaches its maximum output
Answer: b) The point where the capital stock remains constant (∆k = 0)
8. Which variable represents the fraction of income that is saved in the
Solow model?
a) c b) y c) s d) k
Answer: c) s (Saving rate)
9. Which equation represents the investment function in the Solow model?
a) i = sf(k)
b) i = ∆k
c) i = c + y
d) i = ∂k
Answer: a) i = sf(k)
10.What does the Solow Growth Model primarily focus on studying?
a) Fiscal policies and government spending
b) Monetary policies and interest rates

c) The relationship between capital, labor, and technology in economic growth
d) Income distribution and poverty alleviation
Answer: c) The relationship between capital, labor, and technology in economic growth
11.Which economist won the Nobel Prize for his contributions to the study
of economic growth?
a) Adam Smith
b) Robert Solow
c) John Maynard Keynes
d) Milton Friedman
Answer: b) Robert Solow
12.In the Solow Growth Model, what are the factors that interact to affect
a nation's total output of goods and services?
a) Growth in population and advances in technology
b) Growth in labor force, advances in technology, and growth in the capital stock
c) Growth in capital stock and advances in technology
d) Growth in population, growth in labor force, and growth in the capital stock
Answer: b) Growth in labor force, advances in technology, and growth in the capital stock
13.The production function represents the transformation of inputs (labor
and capital) into outputs (goods and services). In aggregate terms, it is
expressed as:
a) Y = C + I b) Y = F(K, L)
c) Y = C + I + G d) Y = C + I + X - M
Answer: b) Y = F(K, L)
14.What does "y" represent in the Solow Growth Model?
a) Total output of goods and services
b) Output per worker
c) Capital per worker
d) Labor force
Answer: b) Output per worker
15.What is the national income identity in "per worker" terms in the
Solow Growth Model?
a) y = C + I
b) y = c + i
c) y = C + I + G
d) y = C + I + X - M
Answer: b) y = c + i
16.The consumption function in the Solow Growth Model is given by:
a) c = (1–s) y b) c = (1–s) f(k) c)
c = (1–s) i d) c = (1–s) L
Answer: a) c = (1–s) y
17.What is the equation of motion for the change in capital stock (Δk) in
the Solow Growth Model?
a) Δk = s f(k) - δk b) Δk = sf(k) + δk
c) Δk = sf(k) - δk d) Δk = s + δk
Answer: c) Δk = s f(k) - δk
18.What is the steady state in the Solow Growth Model?
a) A state where the economy experiences rapid growth
b) A state where capital per worker is decreasing

c) A state where capital per worker is constant (Δk = 0)
d) A state where capital per worker is increasing
Answer: c) A state where capital per worker is constant (Δk = 0)
19.What does the Solow Growth Model aim to explain?
a) How population growth affects total output
b) The interaction between investment, labor force, and technology in an economy
c) The impact of fiscal policy on economic growth
d) How consumption and investment are related in an economy
Answer: b) The interaction between investment, labor force, and technology in an economy
20.Which of the following assumptions is true in the Solow Growth Model?
a) The capital stock (K) remains fixed over time.
b) The labor force (L) remains constant.
c) Depreciation causes the labor force to shrink.
d) Population growth affects investment.
Answer: b) The labor force (L) remains constant.

21.What is the production function in the Solow Growth Model?
a) Y = F(K, L) b) Y = C + I
c) Y = F(k, 1) d) Y = F(K, 1)
Answer: a) Y = F(K, L)
22.In per worker terms, what does y represent?
a) National income b) Output per worker
c) Consumption per worker d) Investment per worker
Answer: b) Output per worker
23.What is the consumption function in the Solow Growth Model?
a) c = (1–s) y b) c = (1–s) k
c) c = (1–k) y d) c = (1–k) k
Answer: a) c = (1–s) y
24.What does the saving rate (s) represent in the Solow Growth Model?
a) The fraction of income saved
b) The rate of population growth

c) The growth rate of the capital stock
d) The rate of depreciation
Answer: a) The fraction of income saved
25.What is the equation of motion for capital (k) in the Solow Growth
Model?
a) Δk = s + δk b) Δk = s - δk
c) Δk = sf(k) + δk d) Δk = sf(k) - δk
Answer: d) Δk = sf(k) - δk
26.What does the steady state in the Solow Growth Model represent?
a) The point where investment equals zero
b) The point where depreciation equals zero
c) The constant value of capital per worker where investment equals depreciation
d) The maximum output per worker that can be achieved
Answer: c) The constant value of capital per worker where investment equals depreciation
(Δk = 0)
Q&A:
1. What is the Solow Growth Model primarily used for in policy making?
A: The Solow Growth Model is used to understand how growth in the capital stock, labor force,
and advances in technology interact in an economy and how they affect a nation's total output of
goods and services. It serves as a benchmark for comparing growth theories in policy-making.
2. In the Solow Growth Model, what does "k" represent?
A: "k" represents the capital per worker in the economy.
3. How is the consumption function defined in the Solow Growth Model?
A: The consumption function in the Solow Growth Model is represented as c = (1-s) y, where "c"
is consumption per worker, "s" is the saving rate, and "y" is output per worker.
4. What is the equation of motion for the capital stock "k" in the Solow model?
A: The equation of motion for "k" is given by ∆k = s f(k) - ∂k, where ∆k is the change in capital
stock, "s" is the saving rate, "f(k)" represents the production function, and ∂k is the depreciation
of the capital stock.
5. When does the economy reach the steady state in the Solow Growth Model?
A: The steady state in the Solow Growth Model is reached when investment (s f(k)) is equal to
the depreciation of the capital stock (∂k), resulting in a constant capital stock per worker (k*).
6. What is the production function's role in the Solow Growth Model?

A: The production function represents the transformation of inputs (capital, labor, and production
technology) into outputs (final goods and services). It helps analyze the supply and demand for
goods and determines the economy's total output of goods and services.
7. How is the national income identity defined in the Solow Growth Model?
A: The national income identity is represented as Y = C + I, where "Y" is the total output of
goods and services, "C" is consumption, and "I" is investment. In per worker terms, it becomes y
= c + i.
8. What does "s" represent in the Solow Growth Model?
A: "s" represents the saving rate, which is the fraction of income that individuals save.
9. How does the Solow Growth Model differ from previous growth theories?
A: The Solow Growth Model introduces the concept of capital accumulation, where investment
leads to the growth of the capital stock, and depreciation causes it to shrink. Additionally, it
considers population growth as a factor influencing labor force growth.
10. What is the primary objective of the Solow Growth Model?
A: The primary objective of the Solow Growth Model is to explain the factors that contribute to
economic growth and understand the long-term behavior of an economy's output and capital
stock.
11. What is the Solow Growth Model and its significance?

A: The Solow Growth Model, developed by Robert Solow, is a major paradigm widely used in
policy-making and serves as a benchmark for comparing recent growth theories. It shows how
growth in the capital stock, labor force, and technological advancements interact in an economy,
influencing the nation's total output of goods and services.
12. How is the Solow model different from other growth models in terms of its
assumptions?
A: In the Solow Growth Model, both the capital stock (K) and labor force (L) are no longer
fixed. Investment causes the capital stock to grow, while depreciation causes it to shrink.
Population growth causes the labor force to grow. Additionally, there are no government
expenditures (G) or taxes (T) considered in this model, simplifying its presentation.
13. What does the production function represent in the Solow model, and what are the
assumptions related to returns to scale?
A: The production function represents the transformation of inputs (labor, capital, and production
technology) into outputs (final goods and services). In aggregate terms, it is denoted as Y = F(K,
L), where Y represents total output. The production function assumes constant returns to scale,
meaning that if all inputs are multiplied by a constant factor (z), output will be multiplied by the
same factor (zY = F(zK, zL)).
14. Explain the national income identity in the Solow model and its relation to
consumption and investment.

A: The national income identity is given by Y = C + I, where Y represents total output, C is
consumption, and I is investment. In "per worker" terms, it can be written as y = c + i, where y
represents output per worker, c is consumption per worker, and i is investment per worker. The
identity shows that total output (Y) is allocated between consumption (C) and investment (I).
15. What is the consumption function in the Solow model, and what does "s" represent?
A: The consumption function is given by c = (1–s) y, where c represents consumption per
worker, y is output per worker, and "s" is the saving rate. "s" represents the fraction of income
that is saved by individuals.
16. How is saving and investment related in the Solow model, and what is the equation
of motion for capital (k)?
A: In the Solow model, saving (per worker) is equal to sy, where "s" is the saving rate and "y" is
output per worker. National income identity shows that investment (per worker) is also equal to
sy. The equation of motion for capital (k) is given as ∆k = sf(k) – ∂k, where ∆k represents the
change in capital stock (investment minus depreciation), "s" is the saving rate, "f(k)" represents
the production function per worker, and ∂k represents depreciation.
17. What is the steady state in the Solow model, and when does it occur?
A: The steady state in the Solow model refers to the point where the capital stock per worker (k)
remains constant (no change in k over time). It occurs when investment is just enough to cover
depreciation, meaning that sf(k) is equal to ∂k. At the steady state, the economy reaches a
balanced level of capital accumulation.

18. How does the Solow Growth Model impact economic policy-making and the study of
economic growth?
A: The Solow Growth Model provides valuable insights into the factors influencing economic
growth, such as capital accumulation, population growth, and technological advancements. It
helps policymakers understand the long-term implications of different policies and allows for
comparisons between different growth theories. Additionally, it serves as a foundational model
for studying the dynamics of economic growth in various countries.
Lesson 20
ECONOMIC GROWTH (CONTINUED)
MCQs:
1. What does the Solow Growth Model primarily analyze?
A) The short-term fluctuations in an economy's output.
B) The relationship between inflation and unemployment.
C) The long-term factors affecting economic growth, including capital accumulation and
technological advances.
D) The impact of government spending on the national income.
Answer: C) The long-term factors affecting economic growth, including capital
accumulation and technological advances.
2. In the Solow model, what does "k*" represent?
A) The capital stock at the beginning of the time period.
B) The capital stock at the end of the time period.
C) The steady state capital stock, where investment equals depreciation.
D) The depreciation rate of the capital stock.
Answer: C) The steady state capital stock, where investment equals depreciation.
3. In the Solow model, what is the relationship between saving and
investment?
A) Saving and investment are equal.
B) Saving is always greater than investment.
C) Investment is always greater than saving.
D) Saving and investment have no relationship in the model.
Answer: A) Saving and investment are equal.

4. What happens to the capital stock "k" in the Solow model when it
reaches the steady state?
A) It remains constant over time.
B) It increases at a decreasing rate.
C) It decreases at a constant rate.
D) It fluctuates randomly.
Answer: A) It remains constant over time.
5. According to the Solow model, what factor contributes to long-term
economic growth?
A) Short-term changes in government policies.
B) Technological advances and population growth.
C) Fluctuations in consumer spending.
D) External factors such as weather and natural disasters.
Answer: B) Technological advances and population growth.
6. How does an increase in the saving rate "s" affect the steady state
capital stock "k*" in the Solow model?

A) It has no effect on "k*".
B) It decreases "k*".
C) It increases "k*".
D) It causes "k*" to fluctuate.
Answer: C) It increases "k*".
7. What does the Solow model predict about countries with higher rates of
saving and investment?
A) They will experience higher short-term economic growth.
B) They will have lower levels of capital and income per worker in the long run.
C) They will experience higher long-term economic growth, with higher levels of capital and
income per worker.
D) Their economies will remain stagnant with no growth.
Answer: C) They will experience higher long-term economic growth, with higher levels of
capital and income per worker.
8. What does the Solow model primarily analyze in an economy?
A) Inflation and unemployment rates

B) Population growth and technological advances
C) Growth in the capital stock, labor force, and technology interaction
D) Government spending and taxation policies
Answer: C) Growth in the capital stock, labor force, and technology interaction
9. In the Solow Growth Model, what does "k*" represent?
A) The population growth rate
B) The rate of technological advancement
C) The steady state capital stock per worker
D) The savings rate in the economy
Answer: C) The steady state capital stock per worker
10.What happens to the economy's capital stock "k" over time if it is
initially greater than the steady state "k*"?
A) k remains constant B) k moves away from the steady state
C) k moves toward the steady state
D) k fluctuates randomly
Answer: C) k moves toward the steady state

11.Which equation represents the production function in the Solow model
for output per worker "y"?
A) y = F(K, L) B) y = f(k)
C) Y = C + I D) Y = K - L
Answer: B) y = f(k)
12.In the Solow Growth Model, what is the saving rate "s"?
A) The fraction of income saved by individuals
B) The rate of population growth
C) The rate of technological progress
D) The fraction of investment in the economy
Answer: A) The fraction of income saved by individuals
13.What is the primary objective of the Solow Growth Model?
A) To study inflation and unemployment trends
B) To analyze fiscal and monetary policy interactions
C) To explain factors contributing to economic growth
D) To predict short-term fluctuations in GDP

Answer: C) To explain factors contributing to economic growth
14.What is the steady state in the Solow Growth Model?
A) A point where economic growth stops permanently
B) The initial level of capital in an economy
C) A point where investment equals depreciation, and capital remains constant
D) A period of rapid technological advancement
Answer: C) A point where investment equals depreciation, and capital remains constant
15.What does the equation of motion for capital "k" in the Solow model
represent?
A) The rate of population growth
B) The change in capital over time
C) The fiscal policy of the government
D) The level of technological progress
Answer: B) The change in capital over time
16.What does the Solow model predict about countries with higher rates of
saving and investment?

A) They will experience higher inflation rates
B) They will have lower levels of capital and income per worker
C) They will have lower economic growth rates
D) They will have higher levels of capital and income per worker in the long run
Answer: D) They will have higher levels of capital and income per worker in the long run
17.Which variable determines the behavior of all other endogenous
variables in the Solow Growth Model?
A) Population growth rate
B) Technological advancements
C) The saving rate
D) The capital stock per worker
Answer: D) The capital stock per worker
18.What does the Solow model aim to explain?
A. Short-term fluctuations in economic output.
B. The factors contributing to economic growth and long-term behavior of output and capital
stock.
C. The impact of fiscal policy on an economy.
D. The relationship between inflation and unemployment.
Answer: B
19.In the Solow growth model, what does "k*" represent?
A. The level of consumption per worker.
B. The population growth rate.
C. The saving rate of an economy.
D. The steady state capital stock per worker.
Answer: D
20.If an economy's initial capital stock "k1" is greater than the steady state
capital stock "k*", what will happen over time?
A. The capital stock will decrease continuously.
B. The economy will experience economic recession.
C. The capital stock will move towards the steady state.
D. The capital stock will remain constant.
Answer: C
21.What is the numerical value of the saving rate "s" in the given
example?
A. 0.3 B. 0.1 C. 0.2 D. 0.9
Answer: A
22.At the steady state, what is the value of investment "i*" in relation to
depreciation "δk*"?
A. i* > δk* B. i* < δk*
C. i* = δk* D. i* and δk* are not related.
Answer: C
23.According to the Solow growth model, how do countries with higher
rates of saving and investment compare in the long run?
A. They experience lower levels of economic growth.
B. They have lower levels of capital and income per worker.
C. They reach a lower steady state capital stock.
D. They achieve higher levels of capital and income per worker.
Answer: D
24.What does the production function represent in the Solow model?
A. The transformation of inputs into outputs, such as labor and capital.
B. The relationship between inflation and interest rates.
C. The fiscal policy actions of the government.
D. The relationship between exports and imports.
Answer: A
25.What are the assumptions made in the Solow model?
A. The saving rate "s" is constant over time.
B. The depreciation rate "δ" is fixed.
C. The capital stock "k" remains constant.
D. Both A and B.
Answer: D
26.What is the primary objective of the Solow growth model?
A. To predict short-term fluctuations in the economy.
B. To analyze the impact of technological advancements on production.

C. To explain factors contributing to economic growth and long-term behavior of the economy.
D. To study the relationship between government spending and taxation.
Answer: C
27.What does "y = k1/2" represent in the given numerical example?
A. The consumption function.
B. The national income identity.
C. The per-worker production function.
D. The equation of motion for capital accumulation.
Answer: C
Q&A:
1. What does the Solow model aim to demonstrate in an economy?
A: The Solow model aims to show how growth in capital stock, labor force, and technology
interact to influence a nation's total output of goods and services.
2. What is the significance of the steady state "k*" in the Solow model diagram?
A: The steady state "k*" represents the level of capital stock where investment equals
depreciation, and the capital per worker remains constant over time.
3. In the numerical example provided, what are the assumed values for the savings
rate (s) and the depreciation rate (δ)?
A: The assumed values are s = 0.3 and δ = 0.1.
4. How does the capital stock "k" change over time as it approaches the steady state?
A: The capital stock "k" approaches a constant value as it moves towards the steady state "k*."
5. What prediction does the Solow model make regarding the relationship between
saving and investment rates and income per worker in the long run?
A: The Solow model predicts that countries with higher rates of saving and investment will have
higher levels of capital and income per worker in the long run.
6. What happens to the capital stock in the steady state "k*"?
A: In the steady state "k*", investment equals depreciation, and the capital stock remains
constant over time.
7. What does the Solow model diagram illustrate, and what does "k*" represent in the
diagram?
A: The Solow model diagram illustrates the relationship between capital stock and total output in
an economy. "k*" represents the steady-state capital stock, where investment equals
depreciation, and the capital does not change over time.

8. How does the capital stock "k" change over time as it approaches the steady state in
the numerical example provided?
A: As "k" approaches the steady state, it increases gradually over time, moving closer to the
constant value of "k*."
9. What is the significance of the steady-state capital stock "k*" in the Solow model?
A: The steady-state capital stock "k*" represents the long-term equilibrium level of capital in the
economy. At this point, investment equals depreciation, and the economy's capital stock remains
constant.
10. How does an increase in the saving rate "s" impact the economy's capital stock and
income per worker in the Solow model?
A: An increase in the saving rate "s" leads to a higher steady-state capital stock "k*."
Consequently, this results in higher income per worker "y*" in the long run, as predicted by the
Solow model.
11. In the context of the Solow model, what is the relationship between saving,
investment rates, and the long-term income per worker in an economy?
A: The Solow model predicts that countries with higher rates of saving and investment will have
higher levels of capital and income per worker in the long run. Higher saving and investment
rates lead to an increase in the steady-state capital stock and income per worker.
Lesson 21
MCQs:
1. What is the "Golden Rule" in the context of economic growth?
A) It is a rule that states the amount of gold a country should have in reserve to ensure economic
stability.
B) It is the rule that determines the optimal level of saving in an economy.
C) It is the steady-state value of capital (k*) that maximizes consumption per person (c*) in an
economy.
D) It is a policy that promotes technological progress to achieve sustained economic growth.
Answer: C) It is the steady-state value of capital (k*) that maximizes consumption per
person (c*) in an economy.
2. How is the "Golden Rule level of capital" (K*gold) determined in the
Solow model?
A) It is found by setting the investment rate equal to the population growth rate.
B) It is the level of capital at which the slope of the production function equals the depreciation
rate.
C) It is the level of capital where investment and depreciation are equal, resulting in a constant
capital stock.
D) It is the level of capital that leads to the highest value of consumption per person.
Answer: B) It is the level of capital at which the slope of the production function equals the
depreciation rate.
3. What does the basic Solow model suggest about sustained economic growth?
A) High rates of saving and investment lead to sustained economic growth in the long run.
B) Population growth is the key driver of sustained economic growth.
C) Technological progress is the primary factor leading to sustained economic growth.
D) The basic Solow model does not explain sustained economic growth, as it predicts an
eventual approach to a steady state.
Answer: D) The basic Solow model does not explain sustained economic growth, as it
predicts an eventual approach to a steady state.
Q4: How does population growth impact the steady state level of capital (k*) and income
per worker (y*) in the Solow model?
A) Higher population growth leads to higher k* and y*.
B) Higher population growth leads to lower k* and y*.

C) Population growth has no impact on k* and y*.
D) The relationship between population growth and k* and y* depends on the rate of
technological progress.
Answer: B) Higher population growth leads to lower k* and y*.
4. In the context of the "Golden Rule with population growth," what
condition must hold for the marginal product of capital (MPK) net of
depreciation to equal the population growth rate (n)?
A) MPK = n B) MPK = 
C) MPK -  = n D) MPK - n = 
Answer: C) MPK -  = n
5. What does the Golden Rule level of capital stock (K*gold) represent in
the Solow model?
A) The rate of population growth in the economy.
B) The steady state value of capital that maximizes consumption.
C) The level of investment required to keep the capital constant.
D) The depreciation rate of the economy.

Answer: B) The steady state value of capital that maximizes consumption.
6. How is the Golden Rule level of capital (Kgold) determined in the Solow
model?
A) By finding the value of capital where the production function intersects with the depreciation
line.
B) By increasing the saving rate (s) to achieve the highest consumption per person (c).
C) By adjusting the population growth rate (n) to maximize total output of goods and services.
D) By comparing the slope of the production function with the slope of the depreciation line.
Answer: D) By comparing the slope of the production function with the slope of the
depreciation line.
7. What is the break-even investment in the Solow model with population
growth?
A) The investment necessary to keep the population constant.
B) The investment required to replace worn-out capital.
C) The total investment in the economy over time.
D) The amount of investment necessary to keep the capital stock constant, considering
depreciation and equipping new workers with capital.

Answer: D) The amount of investment necessary to keep the capital stock constant,
considering depreciation and equipping new workers with capital.
8. How does population growth impact the steady state capital stock (k*)
and income per worker (y*) in the Solow model?
A) Higher population growth (n) leads to higher k* and lower y*.
B) Higher population growth (n) leads to higher k* and higher y*.
C) Higher population growth (n) leads to lower k* and lower y*.
D) Higher population growth (n) has no impact on k* and y*.
Answer: A) Higher population growth (n) leads to higher k* and lower y*.
9. What condition must be satisfied in the Golden Rule Steady State in the
Solow model with population growth?
A) The marginal product of capital (MPK) must equal the depreciation rate ().
B) The consumption per person (c*) must be equal to the investment per person (i*).
C) The capital stock (k*) must be equal to the steady state level of capital (K*gold).
D) The marginal product of capital net of depreciation must equal the population growth rate (n).
Answer: D) The marginal product of capital net of depreciation must equal the population
growth rate (n).

Q&A:
A: The "Golden Rule" refers to the steady-state level of capital (k*) that maximizes consumption
per person (c*) in an economy. It represents the most efficient and optimal level of capital stock
that leads to the highest possible well-being.
2. How is the "Golden Rule level of capital stock" (Kgold) determined in the Solow
model?
A: To find the "Golden Rule level of capital stock" (Kgold), we express consumption per person
(c*) in terms of capital per worker (k*). By graphing the production function (f(k*)) and the
depreciation line (δk*), the point where the gap between them is the largest represents the
"Golden Rule level of capital stock." This occurs when the marginal product of capital (MPK)
equals the depreciation rate (δ).
3. What does the Solow model predict about the transition to the Golden Rule steady
state?
A: The Solow model predicts that the economy does not naturally move toward the Golden Rule
steady state. Achieving the Golden Rule requires policymakers to adjust the saving rate (s)
deliberately. During the transition, consumption (c*) can either increase when starting with too
much capital (resulting in a fall in s) or initially decrease when starting with too little capital
(requiring an increase in s).

4. How does population growth impact the steady-state level of capital (k*) and income
A: Higher population growth rates lead to lower steady-state levels of capital (k*) and income
per worker (y*). The Solow model predicts that countries with higher population growth rates
will have lower levels of capital and income per worker in the long run.
5. What factors contribute to the "break-even investment" required to keep capital
constant in the Solow model with population growth?
A: The "break-even investment" necessary to maintain a constant level of capital (k) includes
two components: (1) δk, which replaces capital as it wears out, and (2) nk, which equips new
workers with capital. Without the nk component, the existing capital stock would be spread more
thinly over a larger population of workers, leading to a decline in capital per worker (k). The
equation for break-even investment is (δ + n)k.
6. What condition must hold for the "Golden Rule with population growth" in the
Solow model?
A: In the "Golden Rule with population growth," the marginal product of capital (MPK) net of
depreciation (δ) must equal the population growth rate (n). Mathematically, this is expressed as
MPK - δ = n. In the Golden Rule Steady State, the growth rate of capital per worker is balanced
with the population growth rate.

A: The Golden Rule refers to the steady-state level of capital (k*) that maximizes consumption
per person (c*) in an economy. It represents the point where economic well-being is optimized,
with the highest possible value of consumption.
8. How is the "Golden Rule level of capital stock" (Kgold) determined in the Solow
model?
A: The Golden Rule level of capital stock (Kgold) is found by expressing consumption (c*) in
terms of capital per worker (k*). It is the value of k* at which the gap between the production
function (f(k*)) and depreciation line (δk*) is the largest. This occurs when the slope of the
production function (MPK) equals the depreciation rate (δ).
9. In the transition to the Golden Rule steady state, what happens to consumption
when starting with too much capital?
A: When starting with too much capital, increasing consumption (c*) requires a decrease in the
saving rate (s). During the transition to the Golden Rule steady state, consumption is higher at all
points in time.
10. In the transition to the Golden Rule steady state, what happens to consumption
when starting with too little capital?
A: When starting with too little capital, increasing consumption (c*) requires an increase in the
saving rate (s). Future generations enjoy higher consumption, but the current generation
experiences an initial drop in consumption.
11. Why does the basic Solow model fail to explain sustained economic growth?
A: The basic Solow model predicts that high rates of saving and investment lead to temporary
economic growth, but the economy eventually approaches a steady state. However, sustained
economic growth requires the incorporation of two sources of growth: population growth and
12. How does population growth impact the steady state level of capital (k*) and income
A: Higher population growth rates (n) lead to lower steady-state levels of capital (k*) and
income per worker (y*). In the long run, countries with higher population growth rates tend to
have lower levels of capital and income per worker.
13. What is "break-even investment" in the context of population growth?
A: Break-even investment refers to the amount of investment necessary to keep the capital stock
constant in the face of population growth. It includes the investment required to replace
depreciated capital (δk) and to equip new workers with capital (nk) to prevent a decline in the
capital stock per worker (k).
14. What is the equation of motion for capital (k) in the Solow model with population
growth?
A: The equation of motion for capital (k) in the Solow model with population growth is given
by: ∆k = sf(k) - (δ + n)k. Here, ∆k represents the change in capital stock, sf(k) is actual
investment, and (δ + n)k is the break-even investment required to maintain a constant capital
stock per worker.

15. What is the relationship between the marginal product of capital (MPK) net of
depreciation and the population growth rate (n) in the Golden Rule steady state?
A: In the Golden Rule steady state, the marginal product of capital net of depreciation (MPK - δ)
is equal to the population growth rate (n). This condition ensures that the economy operates at
the optimal level of capital, maximizing consumption per person.
Lesson 22
MCQs:
1. In the Solow model with technological progress, what is the new
variable introduced to represent the increase in labor efficiency?
a) E b) L c) K d) Y
Answer: a) E
Q2: How is the production function expressed per effective worker (y = f(k)) in the Solow model
with technological progress?
a) y = Y / (L × E) b) y = Y / K
c) y = f (k) / E d) y = L × E / Y
Answer: a) y = Y / (L × E)
2. What constitutes the "break-even investment" required to maintain a
constant level of capital per effective worker (k) in the Solow model with
technological progress?
a) δk to replace depreciating capital
b) nk to provide capital for new workers
c) gk to provide capital for the new "effective" workers due to technological progress
d) All of the above
Answer: d) All of the above
3. In the Golden Rule with technological progress, what condition must
hold to maximize consumption per effective worker (c*)?
a) MPK = δ b) MPK - δ = n + g
c) MPK = δ + n + g d) MPK - δ = n
Answer: b) MPK - δ = n + g
4. What does it mean if (MPK - δ) > (n + g) in the Solow model with
a) The economy is above the Golden Rule steady state and should increase saving (s).
b) The economy is below the Golden Rule steady state and should reduce saving (s).
c) The economy is at the Golden Rule steady state and should maintain the current saving rate
(s).
d) The economy is in a recession and should implement expansionary monetary policies.
Answer: a) The economy is above the Golden Rule steady state and should increase saving
(s).
5. How is (MPK - δ) calculated in the Solow model with technological
progress?
a) MPK - δ = 0.12 - 0.04 b) MPK - δ = 0.08
c) MPK - δ = 0.12 d) MPK - δ = 0.04
Answer: b) MPK - δ = 0.08
6. What does "n + g = 0.03" represent in the Solow model with
a) The growth rate of capital per effective worker (k).
b) The growth rate of output per effective worker (y).
c) The sum of population growth rate (n) and technological progress rate (g).
d) The rate of capital depreciation (δ).
Answer: c) The sum of population growth rate (n) and technological progress rate (g).
7. In the Solow model with technological progress, what variable
represents the increase in labor efficiency at an exogenous rate?
a) E b) L c) k d) s
Answer: a) E
8. What is the equation for break-even investment in the Solow model with
a) (δ + g)k b) (n + g)k
c) (δ + n + g)k d) (s + g)k
Answer: c) (δ + n + g)k
9. In the Solow model with technological progress, what is the steady-state
growth rate of output per worker (Y/L)?
a) 0 b) n c) g d) n + g
Answer: c) g
10.What condition must hold in the Golden Rule with technological
progress?
a) MPK - δ = n b) MPK - δ = g
c) MPK - δ = n + g d) MPK - δ = s
Answer: c) MPK - δ = n + g
11.What is the policy implication if (MPK - δ) is greater than (n + g) in an
economy?
a) Increase the saving rate (s).
b) Decrease the saving rate (s).
c) Increase the population growth rate (n).
d) Decrease the population growth rate (n).
Answer: a) Increase the saving rate (s).
12.How can the Golden Rule be used to evaluate the rate of saving in an
economy?
a) By comparing the population growth rate (n) to the technological progress rate (g).
b) By comparing the marginal product of capital net of depreciation (MPK - δ) to the sum
of population growth rate (n) and technological progress rate (g).
c) By comparing the steady-state growth rate of output per worker (Y/L) to the saving
rate (s).
d) By comparing the depreciation rate (δ) to the saving rate (s).
Answer: b) By comparing the marginal product of capital net of depreciation (MPK
- δ) to the sum of population growth rate (n) and technological progress rate (g).
Q&A:
1. What is the new variable introduced in the Solow model to represent labor
efficiency and its effect on output?
A: The new variable is E, which represents labor efficiency. Increases in labor efficiency (E)
have the same effect on output as increases in the labor force (L), leading to higher output per
effective worker (y).
2. How is the production function expressed per effective worker (y = f(k)) in the
Solow model with technological progress?
A: The production function per effective worker is expressed as y = f(k), where y represents the
output per effective worker and k represents the capital per effective worker.
3. What does the term "break-even investment" (δ + n + g)k represent in the Solow
model with technological progress?
A: The term "break-even investment" represents the amount of investment necessary to keep the
capital per effective worker (k) constant. It includes δk to replace depreciating capital, nk to
provide capital for new workers, and gk to provide capital for the new "effective" workers
created by technological progress.
4. What is the condition that must hold to maximize consumption per effective worker
(c*) in the Golden Rule with technological progress?
A: To maximize consumption per effective worker (c*), the condition that must hold is MPK - δ
= n + g, where MPK is the marginal product of capital, δ is the rate of capital depreciation, and n
+ g represents the sum of the population growth rate (n) and the rate of technological progress
(g).
5. What does it mean if (MPK - δ) > (n + g) in the Solow model with technological
progress?
A: If (MPK - δ) > (n + g), it indicates that the economy is below the Golden Rule steady state. In
this case, policymakers should increase the saving rate (s) to achieve faster economic growth and
move towards a new steady state with higher consumption per capita.
6. How is (MPK - δ) calculated in the Solow model with technological progress?
A: (MPK - δ) is calculated as 0.12 - 0.04 = 0.08.

7. What does "n + g = 0.03" represent in the Solow model with technological progress?
A: "n + g = 0.03" represents the sum of the population growth rate (n) and the rate of
technological progress (g) in the economy. In this example, the real GDP grows at an average
rate of 3% per year.
Lesson 23
MCQs:
1. Which of the following policies can help increase the saving rate?
a) Increase capital gains tax
b) Reduce government budget surplus
c) Replace federal income tax with a consumption tax
d) Discourage tax incentives for retirement savings accounts
Answer: c) Replace federal income tax with a consumption tax

2. In the Solow model, the types of capital in the real world can be
categorized into:
a) Public capital stock and private infrastructure
b) Human capital and public infrastructure
c) Private capital stock and human infrastructure
d) Private capital stock, public infrastructure, and human capital
Answer: d) Private capital stock, public infrastructure, and human capital
3. What are the two viewpoints on how to allocate investment among
different types of capital in the economy?
a) Equalize tax treatment for all types of capital and rely on the market to allocate
investment based on the highest marginal product.
b) Encourage investment in all types of capital equally to ensure balanced growth.
c) Allocate investment based on the government's preferences, regardless of market
forces.
d) Provide tax incentives for certain types of capital to promote investment in specific
industries.
Answer: a) Equalize tax treatment for all types of capital and rely on the market to allocate
investment based on the highest marginal product.
4. What is one possible problem with industrial policy regarding
investment allocation?
a) Government lacks the ability to "pick winners" in the market.
b) Industrial policy is always influenced by economic considerations rather than politics.
c) Industrial policy may discourage investment in certain industries.
d) Industrial policy is more effective in promoting technological progress.
Answer: a) Government lacks the ability to "pick winners" in the market.
5. How does the Solow model predict the growth of "poor" countries
compared to "rich" ones?
a) Poor countries grow slower than rich countries due to lower savings rates.
b) Poor countries grow faster than rich countries due to higher population growth.
c) Poor countries grow faster than rich countries due to lower initial capital levels and
diminishing returns.
d) Poor countries grow at the same rate as rich countries due to the law of balanced
growth.
Answer: c) Poor countries grow faster than rich countries due to lower initial capital levels
and diminishing returns.
6. What does the concept of convergence mean in the context of the Solow
model?
a) Poor and rich countries will have similar growth rates over time.
b) Income gaps between poor and rich countries will remain constant over time.
c) Poor countries will catch up to rich countries in terms of economic growth.
d) Poor countries will continue to grow at a slower rate than rich countries indefinitely.
Answer: c) Poor countries will catch up to rich countries in terms of economic growth.
7. What does the Solow model predict regarding income per capita and its
convergence?
a) The Solow model predicts constant income per capita over time.
b) The Solow model predicts that all countries will converge to the same steady state income per
capita.
c) The Solow model predicts conditional convergence, where countries converge to their own
steady states determined by saving, population growth, and education.

d) The Solow model predicts that income per capita differences among countries will widen over
time.
Answer: c) The Solow model predicts conditional convergence, where countries converge to
their own steady states determined by saving, population growth, and education.
8. What are the two main factors identified by studies for income per
capita differences among countries?
a) Differences in saving rates and investment levels.
b) Differences in trade policies and exchange rates.
c) Differences in capital per worker and production efficiency.
d) Differences in government policies and regulations.
Answer: c) Differences in capital per worker and production efficiency.
9. What is the key difference between the Solow model and endogenous
growth theory?
a) The Solow model focuses on population growth, while endogenous growth theory focuses on
b) The Solow model assumes constant returns to capital, while endogenous growth theory
considers increasing returns to capital.

c) The Solow model assumes exogenous technological progress, while endogenous growth
theory makes it endogenous within the model.
d) The Solow model emphasizes government intervention, while endogenous growth theory
relies on market forces.
Answer: c) The Solow model assumes exogenous technological progress, while endogenous
growth theory makes it endogenous within the model.
10.How does the endogenous growth model differ from the Solow model in
terms of capital returns and the role of investment?
a) The endogenous growth model assumes diminishing returns to capital, while the Solow
model assumes constant returns to capital.
b) In the endogenous growth model, investment plays a minimal role in economic growth, while
in the Solow model, it is the main determinant of growth.
c) In the endogenous growth model, investment plays a crucial role in sustaining economic
growth, while the Solow model considers it as an exogenous variable.
d) The endogenous growth model assumes constant returns to capital, while the Solow model
considers increasing returns to capital.
Answer: c) In the endogenous growth model, investment plays a crucial role in sustaining
economic growth, while the Solow model considers it as an exogenous variable.

11.What are the two sectors in the two-sector model of endogenous growth
theory, and how does the model explain steady-state growth?
a) The two sectors are agriculture and services, and steady-state growth is explained by
population dynamics.
b) The two sectors are private and public enterprises, and steady-state growth is explained by
government policies.
c) The two sectors are manufacturing firms and research universities, and steady-state growth is
explained by an exogenous function related to research efforts.
d) The two sectors are import and export industries, and steady-state growth is explained by trade
balances.
Answer: c) The two sectors are manufacturing firms and research universities, and steady-
state growth is explained by an exogenous function related to research efforts.
12.What does the Solow model predict about the convergence of countries'
income per capita to their own steady states?
a) The Solow model predicts that all countries will converge to the same steady state income per
capita.
b) The Solow model predicts conditional convergence, where countries converge to their own
steady states determined by saving, population growth, and education.

c) The Solow model predicts that income per capita differences among countries will widen over
time.
d) The Solow model predicts that income per capita remains constant over time.
Answer: b) The Solow model predicts conditional convergence, where countries converge
to their own steady states determined by saving, population growth, and education.
13.According to studies, why do income per capita differences exist among
countries?
a) Differences in government policies and regulations.
b) Differences in trade policies and exchange rates.
c) Differences in capital (physical or human) per worker and differences in the efficiency of
production.
d) Differences in saving rates and investment levels.
Answer: c) Differences in capital (physical or human) per worker and differences in the
efficiency of production.
14.What is the key difference between the Solow model and endogenous
growth theory?
a) The Solow model assumes exogenous technological progress, while endogenous growth
theory considers increasing returns to capital.

b) The Solow model focuses on population growth, while endogenous growth theory focuses on
c) The Solow model assumes constant returns to capital, while endogenous growth theory makes
the growth rate of productivity endogenous.
d) The Solow model emphasizes government intervention, while endogenous growth theory
relies on market forces.
Answer: c) The Solow model assumes constant returns to capital, while endogenous growth
theory makes the growth rate of productivity endogenous.
15.In the endogenous growth model, what is the condition for income to
grow forever and what role does investment play?
a) Income grows forever if investment rate (s) multiplied by efficiency of production (A) is
greater than depreciation rate (δ), and investment is the "engine of growth."
b) Income grows forever if investment rate (s) is lower than the depreciation rate (δ), and
investment has no impact on growth.
c) Income grows forever if technological progress rate (A) is greater than the investment rate (s),
and investment is the "engine of growth."
d) Income grows forever if technological progress rate (A) is constant, and investment is an
exogenous variable.
Answer: a) Income grows forever if investment rate (s) multiplied by efficiency of
production (A) is greater than depreciation rate (δ), and investment is the "engine of
growth."
16.In the two-sector model of endogenous growth theory, what are the two
sectors and what growth rate is represented in the steady state?
a) The two sectors are agriculture and services, and the growth rate is represented by
b) The two sectors are private and public enterprises, and the growth rate is represented by
government policies.
c) The two sectors are manufacturing firms and research universities, and the growth rate is
represented by the fraction of labor in research (u).
d) The two sectors are import and export industries, and the growth rate is represented by trade
balances.
Answer: c) The two sectors are manufacturing firms and research universities, and the
growth rate is represented by the fraction of labor in research (u).
17.Which variables affect the level of income, but not its growth rate, in the
endogenous growth model?
a) The investment rate (s) and the fraction of labor in research (u).
b) The savings rate (s) and the investment rate (u).
c) The fraction of labor in research (u) and the population growth rate.
d) The investment rate (s) and the population growth rate.
Answer: a) The investment rate (s) and the fraction of labor in research (u).
18.How does an increase in the fraction of labor in research (u) affect the
economy in the endogenous growth model?
a) It leads to an increase in income level but has no impact on the growth rate of income.
b) It leads to an increase in both the income level and the growth rate of income.
c) It leads to a decrease in income level but an increase in the growth rate of income.
d) It has no effect on either the income level or the growth rate of income.
Answer: b) It leads to an increase in both the income level and the growth rate
of income.
19.Which of the following is NOT a fact about research and development
(R&D) in the real world, as mentioned in the passage?
a) Research is often conducted by firms aiming for profits.
b) Patents can provide a monopoly advantage to the first firm with a new invention.
c) Innovation leads to positive externalities that reduce the cost of subsequent innovation.
d) The social return to R&D is always less than 40% per year.
Answer: d) The social return to R&D is always less than 40% per year.
What does the existence of positive externalities in the creation of knowledge
suggest about the private sector's involvement in R&D?
a) The private sector is doing enough R&D to maximize social welfare.
b) The private sector is not doing enough R&D due to a lack of profit motives.
c) The private sector is efficiently allocating resources for R&D efforts.
d) The private sector's R&D efforts are mostly duplicative and wasteful.
Answer: b) The private sector is not doing enough R&D due to a lack of profit motives.
20.Why do many believe that the government should encourage research
and development (R&D)?
a) To promote competition among firms and increase innovation.
b) To reduce the duplication of R&D efforts among competing firms.
c) To create a stream of monopoly profits for patent holders.
d) To address the positive externalities associated with R&D and boost social welfare.
Answer: d) To address the positive externalities associated with R&D and boost social
welfare.
Q&A:
1. What are some policies to increase the saving rate?
A: There are several policies that can be implemented to increase the saving rate:
 Reduce the government budget deficit (or increase the budget surplus): When the
government runs deficits, it typically borrows money, which can lead to higher interest
rates and reduce private saving. By reducing deficits or increasing surpluses, the
government leaves more resources available for private saving.
 Increase incentives for private saving: a. Reduce capital gains tax, corporate income tax,
and estate tax: These taxes can discourage individuals and businesses from saving and
investing. Lowering these taxes can increase the return on saving and provide more
incentives to save. b. Replace federal income tax with a consumption tax: Income taxes
can create disincentives for saving, as individuals are taxed on their earnings, including
interest and dividends. A consumption tax taxes individuals based on what they spend
rather than what they earn, encouraging saving and investment.
 Expand tax incentives for retirement accounts: Governments can provide tax advantages
for individual retirement accounts (IRAs) and other retirement savings accounts. These
incentives can encourage individuals to save more for their retirement, leading to higher
overall saving rates.

2. How should investment be allocated among different types of capital in the
economy?
A: There are two viewpoints on how to allocate investment among different types of capital:
 Market Allocation: Equalize tax treatment of all types of capital in all industries and let
the market determine the allocation based on the highest marginal product. In this
approach, the government does not actively intervene in the allocation process and relies
on market forces to guide investment decisions.
 Industrial Policy: Under this approach, the government actively encourages investment in
specific types of capital or industries that are deemed important for economic growth.
This could be due to their potential positive externalities (additional benefits beyond the
private returns) that private investors may overlook.
However, there are potential problems with industrial policy, such as the government's ability to
accurately "pick winners" or identify industries with the highest returns or externalities. Politics
may also influence which industries receive preferential treatment, potentially leading to
inefficiencies or favoritism.
3. How can technological progress be encouraged?
A: Encouraging technological progress is crucial for long-term economic growth. Several
policies can be implemented to promote innovation and technological advancements:
 Patent Laws: Grant temporary monopolies to inventors of new products, encouraging
innovation by providing exclusive rights and rewards for their inventions.

 Tax Incentives for R&D: Provide tax breaks or credits to companies that invest in
research and development (R&D). This incentivizes businesses to allocate resources
towards technological improvements.
 Grants for Basic Research: Support universities and research institutions through grants
for basic research. Basic research lays the foundation for technological breakthroughs and
often leads to innovative discoveries.
 Industrial Policy for Key Industries: Encourage investment in specific industries that are
critical for rapid technological progress. However, the concerns mentioned earlier about
the government's ability to pick winners and potential political influences need to be
carefully considered.
4. What is the concept of convergence in the context of the Solow model, and how does
it relate to real-world observations?
A: The concept of convergence in the Solow model suggests that, under certain conditions,
"poorer" countries with lower output per worker (Y/L) and capital per worker (K/L) should
experience faster economic growth rates compared to "richer" countries. This is based on the
idea that diminishing returns to capital accumulation lead to higher marginal returns on
investment in countries with lower initial levels of capital.
In the real world, while many poor countries do experience faster growth rates than richer ones,
convergence does not always hold true. The reason for this discrepancy is that the Solow model's
predictions assume that all other factors are equal, which is not the case in reality. Various other
factors can influence economic growth, including differences in savings rates, population
growth, and human capital (knowledge and skills acquired through education).
When controlling for these additional factors, studies have shown that, on average, income gaps
between countries do tend to shrink over time, and living standards converge at a rate of around
2% per year. However, this convergence process is gradual and subject to a wide range of
economic and institutional factors in different countries.
5. What are some policies to increase the saving rate?
A: Some policies to increase the saving rate include:
 Reducing the government budget deficit or increasing the budget surplus.
 Providing incentives for private saving, such as reducing capital gains tax, corporate
income tax, and estate tax, which discourage saving.
 Replacing federal income tax with a consumption tax.
 Expanding tax incentives for individual retirement accounts and other retirement savings
accounts.
6. How should investment be allocated among different types of capital in the
economy?
A: There are two viewpoints on how to allocate investment among different types of capital:
 Equalize tax treatment of all types of capital in all industries and then let the market
allocate investment to the type with the highest marginal product.
 Implement an industrial policy where the government actively encourages investment in
certain types of capital or industries that may have positive externalities not considered
by private investors.
7. What are some ways to encourage technological progress?
A: To encourage technological progress, several measures can be taken, including:
 Implementing patent laws to grant temporary monopolies to inventors of new products,
providing incentives for innovation.
 Offering tax incentives for research and development (R&D) activities by companies.
 Providing grants to fund basic research conducted at universities.
 Considering industrial policy to support specific industries that are essential for rapid
8. What does the concept of "convergence" refer to in the Solow model?
A: Convergence in the Solow model refers to the prediction that, under certain conditions,
"poorer" countries with lower output and capital per worker should experience faster economic
growth rates compared to "richer" countries. This would lead to a shrinking income gap between
rich and poor countries over time, as living standards converge. However, in the real world,
convergence doesn't always occur due to various other factors influencing economic growth in
different countries.
9. What does the Solow model predict regarding income per capita and its
convergence?
A: The Solow model predicts conditional convergence, where countries converge to their own
steady states determined by factors such as saving, population growth, and education. This
prediction holds true in the real world.

10. In the context of income per capita differences among countries, what are the two
main factors identified by studies?
A: Studies show that income per capita differences among countries can be attributed to two
main factors: differences in capital (physical or human) per worker and differences in the
efficiency of production (the height of the production function).
11. What is the key difference between the Solow model and endogenous growth
theory?
A: In the Solow model, the rate of technological progress is considered exogenous, while in
endogenous growth theory, the growth rate of productivity and living standards is endogenous
and determined within the model.
12. How does the endogenous growth model differ from the Solow model in terms of
capital returns and the role of investment?
A: In the endogenous growth model, the assumption of constant returns to capital is more
plausible, and investment plays a crucial role in sustaining economic growth. If the investment
rate (s) multiplied by the efficiency of production (A) is greater than the depreciation rate (δ),
income will grow forever, making investment the "engine of growth."
13. What are the two sectors in the two-sector model of endogenous growth theory, and
how does the model explain steady-state growth?
A: The two sectors in the model are manufacturing firms, which produce goods, and research
universities, which generate knowledge to increase labor efficiency in manufacturing. In the

steady state, manufacturing output per worker and the standard of living grow at a rate
represented by ΔE/E = g(u), where u is the fraction of labor in research and g(u) is an exogenous
function related to research efforts.
14. What are the key variables in the endogenous growth model and how do they affect
income?
A: The key variables in the endogenous growth model are "s" and "u." "s" affects the level of
income, while "u" affects both the level and growth rate of income.
15. Would an increase in "u" be unambiguously good for the economy?
A: Yes, an increase in "u" would lead to higher levels of income and faster economic growth,
making it unambiguously good for the economy.
16. What are three facts about research and development (R&D) in the real world?
A:
 Much research is conducted by firms seeking profits.
 Firms profit from research through patents, which create monopoly profits until the
patent expires.
 Innovation produces positive externalities, reducing the cost of subsequent innovation.
17. According to the existence of positive externalities, is the private sector doing
enough R&D?
A: No, the existence of positive externalities suggests that the private sector is not doing enough
R&D.
18. Why do many believe that the government should encourage R&D?
A: Many believe that the government should encourage R&D because there is much duplication
of R&D effort among competing firms, and the social return to R&D is estimated to be at least
40% per year. Encouraging R&D can help address positive externalities and promote
Lesson 24
AGGREGATE DEMAND AND AGGREGATE SUPPLY
MCQs:
1. In which time horizon are prices flexible and respond to changes in
supply or demand?
a) Long run b) Short run

c) Intermediate run d) Sticky run
Answer: a) Long run
2. According to classical macroeconomic theory, what determines output
in the long run?
a) Changes in demand for goods and services
b) Fiscal policy and monetary policy
c) Supplies of capital, labor, and technology
d) Exogenous changes in consumption and investment
Answer: c) Supplies of capital, labor, and technology
3. When prices are sticky, what affects output and employment in the
economy?
a) Changes in supply of capital and labor
b) Exogenous changes in consumption and investment
c) Demand for goods and services, influenced by fiscal policy, monetary policy, and other
factors
d) Complete price flexibility

Answer: c) Demand for goods and services, influenced by fiscal policy, monetary policy,
and other factors
4. What does the aggregate demand curve show in the aggregate demand
and supply model?
a) The relationship between price level and quantity of output demanded.
b) The relationship between price level and quantity of output supplied.
c) The relationship between fiscal policy and aggregate output.
d) The relationship between monetary policy and price level.
Answer: a) The relationship between price level and quantity of output demanded.
5. Why does the aggregate demand curve slope downwards in the
aggregate demand and supply model?
a) An increase in the price level leads to an increase in real money balances, increasing demand
for goods and services.
b) An increase in the price level leads to a decrease in real money balances, decreasing demand
for goods and services.
c) An increase in the price level causes a fall in supply of goods and services, decreasing
demand.
d) An increase in the price level causes a fall in investment, decreasing demand for goods and
services.
Answer: b) An increase in the price level leads to a decrease in real money balances,
decreasing demand for goods and services.
What happens to the Aggregate Demand (AD) curve when there is an increase in the money
supply?
a) It shifts to the left b) It shifts to the right
c) It becomes steeper d) It becomes flatter
Answer: b) It shifts to the right
6. In the long run, what determines the level of output in the economy?
a) Changes in demand for goods and services
b) Factor supplies and technology
c) The price level
d) The money supply
Answer: b) Factor supplies and technology
7. What does the Long Run Aggregate Supply (LRAS) curve look like in
the long run?

a) It is upward-sloping b) It is downward-sloping
c) It is vertical d) It is horizontal
Answer: c) It is vertical
8. In the long run, does full-employment output depend on the price level?
a) Yes, it is positively related to the price level.
b) Yes, it is negatively related to the price level.
c) No, it is independent of the price level.
d) No, it varies randomly with the price level.
Answer: c) No, it is independent of the price level.
9. What is the long-run effect of an increase in the money supply on the
Aggregate Demand (AD) curve?
a) It shifts the AD curve to the left.
b) It shifts the AD curve to the right.
c) It does not affect the AD curve.
d) It depends on other economic factors.
Answer: b) It shifts the AD curve to the right.

10.In the short run, what is the shape of the Short-Run Aggregate Supply
(SRAS) curve?
a) Upward-sloping b) Downward-sloping
c) Vertical d) Horizontal
Answer: d) Horizontal
11. What does the horizontal SRAS curve imply about prices in the short run?
a) Prices are fixed at a predetermined level
b) Prices fluctuate dramatically
c) Prices are determined by demand and supply
d) Prices are determined by changes in technology
Answer: a) Prices are fixed at a predetermined level
12.What happens to the SRAS curve when prices are sticky in the short
run?
a) It becomes steeper b) It becomes flatter
c) It shifts to the left d) It remains horizontal
Answer: d) It remains horizontal

13.In the short run, if output (Y) is greater than the full-employment
output (Y), what happens to prices over time?
a) Prices rise b) Prices fall
c) Prices remain constant d) Prices are unpredictable
Answer: a) Prices rise
14.What is the purpose of price adjustments over time in the economy?
a) To create short-run fluctuations
b) To keep prices constant in the long run
c) To move the economy to its long-run equilibrium
d) To stimulate demand for goods and services
Answer: c) To move the economy to its long-run equilibrium.
Q&A
1. What are the key characteristics of the long run and short run in macroeconomics?
A: In the long run, prices are flexible and respond to changes in supply or demand. In the short
run, many prices are "sticky" at some predetermined level.

2. How is output determined in classical macroeconomic theory?
A: Output is determined by the supply side, which includes supplies of capital, labor, and
technology. Changes in demand for goods and services (C, I, G) only affect prices, not
quantities. Classical theory applies in the long run, assuming complete price flexibility.
3. When prices are sticky, what factors influence output and employment in the
economy?
A: Output and employment also depend on demand for goods and services, which is affected by
fiscal policy (G and T), monetary policy (M), and other factors such as exogenous changes in
consumption (C) or investment (I).
4. What is the model of aggregate demand and supply used for in economics?
A: The model of aggregate demand and supply is the paradigm most mainstream economists and
policymakers use to understand economic fluctuations and devise policies to stabilize the
economy. It shows how the price level and aggregate output are determined and how the
economy's behavior differs in the short run and long run.
5. What does the aggregate demand curve represent in the AD/AS model?
A: The aggregate demand curve represents the relationship between the price level and the
quantity of output demanded in the economy.
6. How does the quantity equation relate to aggregate demand in the AD/AS model?
A: The quantity equation, M V = P Y, implies the money demand function (M/P)d = kY, where
V = 1/k = velocity. For given values of money supply (M) and velocity (V), these equations
indicate an inverse relationship between the price level (P) and the quantity of output demanded
(Y).
7. Why does the aggregate demand curve slope downwards in the AD/AS model?
A: An increase in the price level causes a fall in real money balances (M/P), leading to a
decrease in the demand for goods and services, resulting in the downward-sloping aggregate
demand curve.
8. What happens to the Aggregate Demand (AD) curve when there is an increase in the
money supply?
A: It shifts to the right.
9. In the long run, what determines output in the economy?
A: Output is determined by factor supplies and technology.
10. What does the Long Run Aggregate Supply (LRAS) curve represent in the long
run?
A: The LRAS curve represents the full-employment or natural level of output, which is the level
of output at which the economy's resources are fully employed. It is vertical, indicating that full-
employment output does not depend on the price level.
11. Does full-employment output depend on the price level in the long run?
A: No, full-employment output is independent of the price level.
12. What is the long-run effect of an increase in the money supply on the Aggregate
Demand (AD) curve?
A: An increase in the money supply shifts the AD curve to the right.
13. What is the shape of the Short-Run Aggregate Supply (SRAS) curve in the real
world?
A: The SRAS curve is horizontal, indicating that in the short run, all prices are stuck at a
predetermined level, and firms are willing to sell as much as buyers demand at that price level.
14. What happens to the SRAS curve when prices are sticky in the short run?
A: When prices are sticky, the SRAS curve remains horizontal, indicating fixed prices at a
predetermined level.
15. In the short run, how does an increase in the money supply (M) affect the
equilibrium?
A: An increase in the money supply leads to an increase in output (Y), while the price level
remains fixed at the predetermined level.
16. What happens to the economy over time as prices become "unstuck"?
A: Over time, as prices become "unstuck," they will rise if the output (Y) in the short-run
equilibrium is greater than the full-employment output (Y). If the output is less than the full-
employment output, prices will fall. If the output equals the full-employment output, prices will
remain constant.
17. What is the purpose of price adjustments over time in the economy?
A: The adjustment of prices over time is what moves the economy to its long-run equilibrium,
where output reaches the full-employment level and prices reach their appropriate levels.
Lesson 25
AGGREGATE DEMAND AND AGGREGATE SUPPLY
(CONTINUED)
MCQs:
1. What are shocks in the context of the economy?
a) Exogenous changes in aggregate supply or demand
b) Changes in consumer preferences
c) Monetary policy adjustments

d) Changes in technological advancements
Answer: a) Exogenous changes in aggregate supply or demand
2. What effect do shocks have on the economy in the short run?
a) They push the economy towards full employment
b) They lead to a temporary decrease in aggregate demand
c) They move the economy away from full employment
d) They increase the velocity of money in the economy
Answer: c) They move the economy away from full employment
3. What is the result of an exogenous increase in aggregate demand in the
short run?
a) Output and employment fall
b) Output and employment rise
c) Output exceeds its natural level
d) Prices fall gradually
Answer: c) Output exceeds its natural level
4. What happens over time in the economy after a positive demand shock?
a) Prices rise, and output gradually returns to its natural level
b) Prices fall, and output gradually returns to its natural level
c) Output remains above its natural level indefinitely
d) Prices remain constant, and output increases further
Answer: a) Prices rise, and output gradually returns to its natural level
5. How does a negative demand shock affect the economy in the short run?
a) It shifts the aggregate demand (AD) curve to the right
b) It causes output and employment to rise
c) It shifts the AD curve to the left, leading to a decrease in output and employment
d) It leads to a decrease in the money supply and an increase in aggregate demand
Answer: c) It shifts the AD curve to the left, leading to a decrease in output and
employment.
6. What is a supply shock?
A) A change in aggregate demand that affects production costs.
B) An exogenous change that alters production costs and impacts the prices charged by firms.
C) A government policy aimed at reducing short-run economic fluctuations.

D) A shift in the long-run aggregate supply curve caused by changes in factor supplies and
technology.
Answer: B) An exogenous change that alters production costs and impacts the prices
charged by firms.
7. Which of the following is an example of an adverse supply shock?
A) Lowering taxes to stimulate economic growth.
B) Implementing new technology that increases productivity.
C) Workers unionizing and negotiating wage increases.
D) Reducing interest rates to encourage borrowing and spending.
Answer: C) Workers unionizing and negotiating wage increases.
8. What is the likely consequence of an adverse supply shock in the short
run?
A) Output and employment will increase.
B) Prices will remain unchanged.
C) Output and employment will fall.
D) Prices will decrease significantly.

Answer: C) Output and employment will fall.
What is the purpose of stabilization policy?
A) To increase short-run economic fluctuations.
B) To reduce the severity of long-run economic fluctuations.
C) To reduce the severity of short-run economic fluctuations.
D) To control aggregate demand and supply in the long run.
Answer: C) To reduce the severity of short-run economic fluctuations.
9. How did the 1970s oil shocks impact the economy?
A) They caused a decrease in oil prices, leading to lower production costs.
B) They increased aggregate demand, resulting in higher output and employment.
C) They shifted the short-run aggregate supply curve up, causing output and employment to fall.
D) They led to long-term stability in prices and output levels.
Answer: C) They shifted the short-run aggregate supply curve up, causing output and
employment to fall.
10.According to the graph, what was the impact of the oil price shock in
the late 1970s on inflation?

A) Inflation increased significantly.
B) Inflation remained unchanged.
C) Inflation decreased gradually.
D) Inflation fluctuated but remained constant on average.
Answer: A) Inflation increased significantly.
11.What was the predicted effect of the oil price shock in the 1970s on
output and unemployment?
A) Output increased, and unemployment decreased.
B) Output decreased, and unemployment increased.
C) Output and unemployment both remained constant.
D) Output and unemployment fluctuated but remained stable on average.
Answer: B) Output decreased, and unemployment increased.
12.What was the impact of the 1980s favorable supply shock on inflation
and unemployment?
A) Inflation increased, and unemployment decreased.
B) Inflation remained unchanged, and unemployment increased.

C) Inflation decreased, and unemployment decreased.
D) Inflation decreased, and unemployment increased.
Answer: D) Inflation decreased, and unemployment increased.
Q4: During the late 1970s, how did the change in oil prices affect the inflation rate?
A) The inflation rate remained constant.
B) The inflation rate fluctuated significantly.
C) The inflation rate gradually decreased.
D) The inflation rate sharply increased.
Answer: D) The inflation rate sharply increased.
13.Based on the graph, which period experienced a significant fall in oil
prices during the 1980s?
A) 1982-1983 B) 1984-1985
C) 1985-1986 D) 1986-1987
Answer: A) 1982-1983
Q&A
1. What are shocks in the context of the economy?
A: Shocks are exogenous changes in aggregate supply or demand that temporarily push the
economy away from full employment.
2. What is the impact of a demand shock on the economy in the short run?
A: An increase in aggregate demand due to a demand shock can move the economy to a point
above its natural level of output.
3. How does the economy respond to an exogenous decrease in velocity (V) of money?
A: A decrease in velocity leads to a decrease in demand for goods and services in the economy,
assuming the money supply remains constant.
4. What happens when the aggregate demand (AD) curve shifts to the left due to a
negative demand shock?
A: Output and employment fall in the short run, but over time, prices decrease, and the economy
moves toward full-employment.
5. What is the initial effect of an increase in aggregate demand caused by a demand
shock?
A: An increase in aggregate demand moves the economy to a point above its natural level,
leading to higher output and potentially inflation.
6. What are supply shocks in the context of the economy?

A: Supply shocks are exogenous changes that alter production costs and affect the prices that
firms charge. They can be adverse, such as increases in production costs, or favorable, leading to
lower costs and prices.
7. What are some examples of adverse supply shocks?
A: Examples of adverse supply shocks include bad weather reducing crop yields and pushing up
food prices, workers unionizing and negotiating wage increases, and new environmental
regulations requiring firms to reduce emissions, leading to higher prices.
8. How does the economy respond to an adverse supply shock?
A: An adverse supply shock moves the economy to a point where output and employment fall
due to higher production costs and prices. Over time, prices may fall, and the economy can move
back toward full employment.
9. What is stabilization policy?
A: Stabilization policy refers to policy actions aimed at reducing the severity of short-run
economic fluctuations. It involves using monetary or fiscal policy to mitigate the effects of
shocks on the economy.
10. What were the consequences of the 1970s oil shocks?
A: The 1970s oil shocks, caused by OPEC reducing the supply of oil, led to significant increases
in oil prices. These supply shocks shifted the short-run aggregate supply (SRAS) curve up,
causing output and employment to fall. Over time, prices may fall back toward full employment
levels if no further price shocks occur.
11. What are the predicted effects of an oil price shock on inflation, output, and
unemployment?
A: The predicted effects of an oil price shock are an increase in inflation, a decrease in output,
and an increase in unemployment, followed by a gradual recovery.
12. During the late 1970s, what was the impact of the oil price shock on the economy?
A: During the late 1970s, the oil price shock caused inflation to rise significantly, output to
decrease, and unemployment to increase.
13. What occurred during the 1980s oil shocks that led to a favorable supply shock?
A: During the 1980s oil shocks, there was a significant fall in oil prices, which resulted in a
favorable supply shock.
14. What were the consequences of the favorable supply shock in the 1980s on inflation
and unemployment?
A: The consequences of the favorable supply shock in the 1980s were a decrease in inflation and
a decrease in unemployment.
15. How did the economy respond to the exogenous changes in oil prices in the 1980s?
A: In the 1980s, the exogenous changes in oil prices caused fluctuations in inflation and
unemployment rates, leading to changes in the overall economic performance.
Lesson 26
KEYNESIAN THEORY OF INCOME & EMPLOYMENT
MCQs
1. In the long run, what determines output?
A) Planned expenditure
B) Aggregate demand
C) Factors of production & technology
D) Government expenditure
Answer: C) Factors of production & technology
2. What happens to prices in the short run?
A) Prices are flexible
B) Prices are fixed

C) Prices are determined by aggregate demand
D) Prices are determined by factors of production
Answer: B) Prices are fixed
3. How is unemployment related to output in the short run?
A) Unemployment is positively related to output
B) Unemployment is negatively related to output
C) Unemployment is unrelated to output
D) Unemployment is determined by government policy variables
Answer: B) Unemployment is negatively related to output
4. In the Keynesian Cross model, what does E represent?
A) Actual expenditure
B) Unplanned expenditure
C) Government expenditure
D) Planned expenditure
Answer: D) Planned expenditure

5. What is the equilibrium condition in the Keynesian Cross model?
A) Actual expenditure equals planned expenditure.
B) Investment is exogenous.
C) Consumption function determines output.
D) Unemployment equals its natural rate.
Answer: A) Actual expenditure equals planned expenditure.
6. What is the slope of the planned expenditure line in the graph of the
Keynesian Cross model?
A) 1
B) MPC (Marginal Propensity to Consume)
C) GDP (Gross Domestic Product)
D) Investment
Answer: B) MPC (Marginal Propensity to Consume)
7. What is the government purchases multiplier in the given model?
A) It is equal to the Marginal Propensity to Consume (MPC)
B) It is equal to the Marginal Propensity to Save (MPS)

C) It is equal to the Marginal Propensity to Invest (MPI)
D) It is equal to the Marginal Propensity to Tax (MPT)
Answer: A) It is equal to the Marginal Propensity to Consume (MPC)
8. In the Keynesian Cross model, what does the government purchases
multiplier measure?
A) The impact of an increase in government purchases on inflation.
B) The impact of an increase in government purchases on output and income.
C) The impact of an increase in government purchases on the trade balance.
D) The impact of an increase in government purchases on the interest rate.
Answer: B) The impact of an increase in government purchases on output and income.
9. Why the government is purchases multiplier greater than 1?
A) Because an increase in government purchases directly increases income by the same amount.
B) Because an increase in government purchases leads to an increase in consumer spending,
which further increases income.
C) Because an increase in government purchases reduces taxes, leading to higher disposable
income.
D) Because an increase in government purchases directly increases investment by the same
amount.
Answer: B) Because an increase in government purchases leads to an increase in consumer
spending, which further increases income.
10.In the Keynesian Cross model, what happens when there is an increase
in taxes?
A) Consumption increases, and output rises to a new equilibrium.
B) Consumption decreases, and output falls to a new equilibrium.
C) Investment increases, and output rises to a new equilibrium.
D) Investment decreases, and output falls to a new equilibrium.
Answer: B) Consumption decreases, and output falls to a new equilibrium.
11.In the context of the Keynesian Cross model, what does the equilibrium
condition represent?
A) The level of government purchases needed to achieve full employment.
B) The point where planned expenditure equals actual expenditure.
C) The point where the marginal propensity to consume equals zero.
D) The level of income needed to achieve price stability.

Answer: B) The point where planned expenditure equals actual expenditure.
12.What is the tax multiplier?
A) The change in income resulting from a $1 increase in government purchases.
B) The change in income resulting from a $1 decrease in government purchases.
C) The change in income resulting from a $1 increase in taxes.
D) The change in income resulting from a $1 decrease in taxes.
Answer: C) The change in income resulting from a $1 increase in taxes.
13.If the marginal propensity to consume (MPC) is 0.8, what is the value of
the tax multiplier?
A) 0.2 B) -0.8 C) -5.0 D) -1.25
Answer: B) -0.8
14.What does the negative sign of the tax multiplier signify?
A) An increase in taxes leads to an increase in income.
B) A decrease in taxes leads to a decrease in income.
C) A tax hike reduces consumer spending, which reduces income.
D) A tax cut increases consumer spending, which increases income.

Answer: C) A tax hike reduces consumer spending, which reduces income.
15.What is the IS curve in macroeconomics?
A) A curve that shows the relationship between income and investment.
B) A curve that shows the relationship between income and taxes.
C) A curve that shows the relationship between interest rates and investment.
D) A curve that shows the relationship between income and government purchases.
Answer: D) A curve that shows the relationship between income and government
purchases.
Q&A
1. What are the characteristics of the long run?
A: In the long run, prices are flexible, output is determined by factors of production and
technology, and unemployment equals its natural rate.
2. How are prices and output determined in the short run?
A: In the short run, prices are fixed, and output is determined by aggregate demand.
3. What is the relationship between unemployment and output in the short run?
A: In the short run, unemployment is negatively related to output.

4. What is the Keynesian Cross?
A: The Keynesian Cross is a simple closed economy model in which income is determined by
expenditure, presented by J.M. Keynes.
5. What does "E" represent in the Keynesian Cross model?
A: "E" represents planned expenditure, which is the amount households, firms, and the
government would like to spend on goods and services.
6. What is the equilibrium condition in the Keynesian Cross model?
A: The equilibrium condition is when actual expenditure equals planned expenditure.
7. What does "MPC" stand for in the graph of planned expenditure?
A: "MPC" stands for Marginal Propensity to Consume, representing the slope of the planned
expenditure line.
8. What is the tax multiplier?
A: The tax multiplier is the change in income resulting from a $1 increase in taxes.
9. If the marginal propensity to consume (MPC) is 0.8, what is the value of the tax
multiplier?
A: If MPC = 0.8, the tax multiplier equals -5.
10. What are the properties of the tax multiplier?

A: The properties of the tax multiplier are as follows:
 The tax multiplier is negative: A tax hike reduces consumer spending, which reduces
income.
 The tax multiplier is greater than one (in absolute value): A change in taxes has a
multiplier effect on income.
 The tax multiplier is smaller than the government spending multiplier: Consumers save
the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller
than from an equal increase in government spending.
11. What does the IS curve represent in macroeconomics?
A: The IS curve represents a graph of all combinations of interest rates (r) and income (Y) that
result in goods market equilibrium, where actual expenditure (output) equals planned
expenditure. It shows the relationship between interest rates and income in the economy.
Lesson 27
IS-LM FRAMEWORK
MCQs
1. What is the general slope of the IS curve?

a) Positively sloped b) Horizontally sloped
c) Vertically sloped d) Negatively sloped
Answer: d) Negatively sloped
2. What is the relationship between interest rates and investment spending
in the IS curve?
a) A fall in interest rates leads to a decrease in investment spending.
b) A fall in interest rates leads to an increase in investment spending.
c) An increase in interest rates leads to a decrease in investment spending.
d) Interest rates have no impact on investment spending.
Answer: b) A fall in interest rates leads to an increase in investment spending.
3. How does an increase in government spending (G) affect the IS curve?
a) It shifts the IS curve to the left. b) It has no effect on the IS curve.
c) It shifts the IS curve upward. d) It shifts the IS curve to the right.
Answer: d) It shifts the IS curve to the right.
4. What does the IS-LM model help analyze in relation to fiscal policy?
a) The impact of fiscal policy on interest rates.

b) The impact of fiscal policy on investment spending.
c) The impact of fiscal policy on aggregate demand and output.
d) The impact of fiscal policy on monetary policy.
Answer: c) The impact of fiscal policy on aggregate demand and output.
5. How does the central bank raise the interest rate?
a) By increasing the money supply (M)
b) By reducing the money supply (M)
c) By increasing the fiscal policy measures
d) By reducing the fiscal policy measures
Answer: b) By reducing the money supply (M)
6. What does the LM curve represent in the economy?
a) The graph of all combinations of r and Y that equate the supply and demand for real money
balances
b) The graph of government spending and taxation equilibrium
c) The relationship between the labor market and employment levels
d) The relationship between inflation and interest rates

Answer: a) The graph of all combinations of r and Y that equate the supply and demand
for real money balances
7. What is the slope of the LM curve?
a) Positively sloped b) Negatively sloped
c) Vertical d) Horizontal
Answer: a) Positively sloped
8. Why the LM curve is positively sloped?
a) An increase in income raises money demand, and the supply of real balances is fixed, causing
an excess demand in the money market, leading to a rise in the interest rate.
b) An increase in income lowers money demand, and the supply of real balances is fixed,
causing an excess supply in the money market, leading to a rise in the interest rate.
c) A decrease in income raises money demand, and the supply of real balances is fixed, causing
an excess demand in the money market, leading to a fall in the interest rate.
d) A decrease in income lowers money demand, and the supply of real balances is fixed, causing
an excess supply in the money market, leading to a fall in the interest rate.
Answer: a) An increase in income raises money demand, and the supply of real balances is
fixed, causing an excess demand in the money market, leading to a rise in the interest rate.
Q5: What is the LM curve's equation that represents the equilibrium between money supply and
demand?
a) M/P = L(r) b) L(r, Y) = (M/P)
c) (M/P)L(r, Y) = (r, Y) d) (M/P)L(r, Y) = (M/P)
Answer: b) L(r, Y) = (M/P)
9. What does a shift in the LM curve indicate?
a) A change in government spending (G) and taxation (T)
b) A change in the money supply (M)
c) A change in interest rates
d) A change in investment (I) and consumption (C) expenditures
Answer: b) A change in the money supply (M)
10.If a wave of credit card fraud causes consumers to use cash more
frequently in transactions, how will it affect the LM curve?
a) The LM curve will shift to the right
b) The LM curve will shift to the left
c) The LM curve will become steeper

d) The LM curve will become flatter
Answer: a) The LM curve will shift to the right
11.In the short-run equilibrium, what conditions are simultaneously
satisfied in the goods and money markets?
a) Equilibrium conditions for inflation and unemployment
b) Equilibrium conditions for exchange rates
c) Equilibrium conditions for government budget deficit
d) Equilibrium conditions for interest rate and output (Y)
Answer: d) Equilibrium conditions for interest rate and output (Y)
Q4: Which equation represents the LM curve?
a) M/P = L(r) b) L(r, Y) = (M/P)
c) (M/P) L(r, Y) = (r, Y) d) LM Y C Y T I r G = - + + ( ) ( )
Answer: c) (M/P) L(r, Y) = (r, Y)
12.When the LM curve shifts to the right, what happens to the equilibrium
interest rate and output?
a) Equilibrium interest rate decreases, equilibrium output increases

b) Equilibrium interest rate increases, equilibrium output decreases
c) Equilibrium interest rate and output both increase
d) Equilibrium interest rate and output both decrease
Answer: c) Equilibrium interest rate and output both increase
Q&A
1. What does the theory of liquidity preference propose to determine the interest rate?
A: The theory of liquidity preference proposes that the interest rate is determined by the
interaction between money supply and money demand.
2. What is the role of money supply in the theory of liquidity preference?
A: In the theory of liquidity preference, the money supply refers to the fixed supply of real
money balances available in the economy.
3. What influences the demand for real money balances in the theory of liquidity
preference?
A: The demand for real money balances is influenced by the interest rate (r) and the price level
(P) in the theory of liquidity preference.
4. How does the interest rate adjust in the theory of liquidity preference to reach
equilibrium?
A: The interest rate adjusts in the theory of liquidity preference in a way that equates the supply
and demand for money, ensuring an equilibrium in the money market.
5. What does (M/P)s represent in the theory of liquidity preference?
A: In the theory of liquidity preference, (M/P)s represents the fixed supply of real money
balances.
6. How is the money demand represented in the theory of liquidity preference?
A: In the theory of liquidity preference, money demand is denoted by the function L(r), where 'r'
represents the interest rate.
7. What is the significance of equilibrium in the theory of liquidity preference?
A: Equilibrium in the theory of liquidity preference implies that the interest rate has adjusted to
a level where money supply equals money demand, ensuring a stable state in the money market.
8. How does the central bank raise the interest rate?
A: To raise the interest rate, the central bank reduces the money supply (M).
9. What does the LM curve represent?
A: The LM curve represents a graph of all combinations of the interest rate (r) and real GDP (Y)
that equate the supply and demand for real money balances.
10. What does the equation for the LM curve show?

A: The equation for the LM curve shows the relationship between the interest rate (r) and real
GDP (Y) that equates the supply and demand for real money balances.
11. What is the slope of the LM curve?
A: The slope of the LM curve is positively sloped.
12. Why the LM curve is positively sloped?
A: The LM curve is positively sloped because an increase in income raises money demand, and
since the supply of real money balances is fixed, the interest rate must rise to restore equilibrium
in the money market.
13. What happens to money demand when income increases along the LM curve?
A: When income increases along the LM curve, money demand also increases.
14. What does the LM curve represent on the graph?
A: On the graph, the LM curve represents all the combinations of the interest rate (r) and real
GDP (Y) that satisfy the equilibrium condition in the money market where money supply equals
money demand.
15. How does an increase in money supply (ΔM) affect the LM curve?
A: An increase in money supply (ΔM) shifts the LM curve to the right.
16. How does a wave of credit card fraud affecting cash usage influence the LM curve?
A: A wave of credit card fraud causing consumers to use cash more frequently in transactions
leads to an increase in money supply (ΔM). As a result, the LM curve shifts to the right.
17. What does the short-run equilibrium represent?
A: The short-run equilibrium is the combination of the interest rate (r) and real GDP (Y) that
simultaneously satisfies the equilibrium conditions in both the goods market and the money
market.
18. What do the letters C, I, G, T, and Y represent in the equation for the LM curve?
A: In the equation for the LM curve, C represents consumption, I represents investment, G
represents government spending, T represents taxes, and Y represents real GDP.
19. What does the LM curve represent on the graph?
A: On the graph, the LM curve represents all the combinations of the interest rate (r) and real
GDP (Y) that satisfy the equilibrium condition in the money market, where the demand for real
money balances equals the fixed supply of real money balances.
Lesson 28
IS-LM FRAMEWORK (CONTINUED)
MCQs:
20.What does the IS curve represent in the IS-LM model?
a) Money market equilibrium b) Fiscal policy effects
c) Equilibrium in the goods market d) Monetary policy effects
Answer: c) Equilibrium in the goods market
21.What does the LM curve represent in the IS-LM model?
a) Fiscal policy effects b) Equilibrium in the goods market
c) Monetary policy effects d) Money market equilibrium
Answer: d) Money market equilibrium
22.How is the unique combination of Y and r determined in the IS-LM
model?
a) By the intersection of the IS and LM curves
b) By the aggregate demand and aggregate supply curves
c) By analyzing fiscal policy effects
d) By analyzing monetary policy effects
Answer: a) By the intersection of the IS and LM curves

23.Which policies can policymakers use to affect macroeconomic variables
in the IS-LM model?
a) Monetary policy: M only
b) Fiscal policy: G and/or T only
c) Both monetary policy: M and fiscal policy: G and/or T
d) None of the above
Answer: c) Both monetary policy: M and fiscal policy: G and/or T
24.What does the IS-LM model explain in terms of macroeconomic analysis?
a) Long-run fluctuations b) Money market equilibrium
c) Short-run fluctuations d) Equilibrium in the goods market
Answer: c) Short-run fluctuations
25.In the IS-LM model, what happens when the IS curve shifts right by ∆G?
a) Interest rate falls, causing output and income to rise.
b) Output and income rise.
c) Money demand decreases, causing the interest rate to fall.
d) Investment increases, causing output and income to rise.

Answer: b) Output and income rise.
26.What is the effect of an increase in government purchases (∆G) on the
interest rate in the IS-LM model?
a) Interest rate falls, causing output and income to rise.
b) Money demand decreases, causing the interest rate to fall.
c) Interest rate rises, causing output and income to rise.
d) Investment increases, causing the interest rate to rise.
Answer: c) Interest rate rises, causing output and income to rise.
27.How does a tax cut (∆T) affect output and income compared to an equal
increase in government purchases (∆G) in the IS-LM model?
a) Output and income increase by the same amount for both ∆T and ∆G.
b) Output and income increase more for ∆T than for ∆G.
c) Output and income increase more for ∆G than for ∆T.
d) Output and income do not change for either ∆T or ∆G.
Answer: b) Output and income increase more for ∆G than for ∆T.
28.In the IS-LM model, what happens to the IS curve when there is a tax cut
(∆T)?
a) ∆G b) ∆T c) ∆M d) ∆Y
Answer: b) ∆T
29.How does an increase in the money supply (∆M > 0) impact the LM curve
in the IS-LM model?
a) ∆M shifts the LM curve up (or to the left).
b) ∆M shifts the LM curve down (or to the right).
c) ∆M does not affect the LM curve.
d) ∆M shifts the LM curve to the left.
Answer: b) ∆M shifts the LM curve down (or to the right).
30.What happens to the interest rate in the IS-LM model when there is an
increase in the money supply (∆M > 0)?
a) Interest rate rises. b) Interest rate falls.
c) Interest rate remains unchanged. d) Interest rate fluctuates.
Answer: b) Interest rate falls.

31.How does an increase in the money supply (∆M) affect investment and
output in the IS-LM model?
a) Investment increases, causing output to fall.
b) Investment decreases, causing output to rise.
c) Investment increases, causing output and income to rise.
d) Investment remains unchanged, causing output to remain constant.
Answer: c) Investment increases, causing output and income to rise.
32.In the real world, how might the interaction between monetary and fiscal
policy affect the impact of the original policy change?
a) Monetary policymakers adjust M in response to changes in fiscal policy.
b) Fiscal policymakers adjust G and T in response to changes in monetary policy.
c) The interaction may amplify or dampen the effects of the original policy change.
d) The interaction has no impact on the effects of the original policy change.
Answer: c) The interaction may amplify or dampen the effects of the original policy
change.
33.If the government increases G, what are the possible responses of the
central bank in the IS-LM model?
a) Hold the money supply (M) constant.
b) Hold the interest rate (r) constant.
c) Increase the money supply (M) to counteract the effect of ∆G.
d) Increase the interest rate (r) to counteract the effect of ∆G.
Answer: a) Hold the money supply (M) constant.
34.What happens if the central bank holds the money supply (M) constant in
response to an increase in government spending (G)?
a) The IS curve shifts right, and the LM curve shifts left.
b) The IS curve shifts right, and the LM curve remains unchanged.
c) The IS curve shifts right, and the LM curve shifts right.
d) The IS curve remains unchanged, and the LM curve shifts left.
Answer: b) The IS curve shifts right, and the LM curve remains unchanged.
35.If the central bank aims to keep the interest rate (r) constant in response
to an increase in government spending (G), what does the central bank
do?
a) The central bank reduces the money supply (M) to shift the LM curve right.
b) The central bank increases the money supply (M) to shift the LM curve right.
c) The central bank reduces the money supply (M) to shift the LM curve left.
d) The central bank increases the money supply (M) to shift the LM curve left.
Answer: b) The central bank increases the money supply (M) to shift the LM curve right.
36.If the central bank aims to keep output (Y) constant in response to an
increase in government spending (G), what does the central bank do?
a) The central bank reduces the money supply (M) to shift the LM curve right.
b) The central bank increases the money supply (M) to shift the LM curve right.
c) The central bank reduces the money supply (M) to shift the LM curve left.
d) The central bank increases the money supply (M) to shift the LM curve left.
Answer: c) The central bank reduces the money supply (M) to shift the LM curve left.
37.What are IS shocks in the IS-LM model?

a) Exogenous changes in the demand for money.
b) Exogenous changes in the demand for goods and services.
c) Changes in households' wealth.
d) Changes in business or consumer confidence or expectations.
Answer: b) Exogenous changes in the demand for goods and services.
38.What are LM shocks in the IS-LM model?
a) Exogenous changes in the demand for goods and services.
b) Exogenous changes in the demand for money.
c) Changes in households' wealth.
d) Changes in business or consumer confidence or expectations.
Answer: b) Exogenous changes in the demand for money.
39.If the central bank targets interest rates instead of the money supply,
what is its policy instrument?
a) The discount rate b) The reserve requirement ratio
c) The money supply (M) d) The government spending (G)
Answer: a) The discount rate

40.Why does the central bank target interest rates instead of the money
supply?
a) They are easier to measure than the money supply.
b) The central bank might believe that LM shocks are more prevalent than IS shocks, making
interest rate targeting more effective in stabilizing income.
c) The central bank can control inflation better by targeting interest rates.
d) The money supply has less impact on the economy than interest rates.
Answer: b) The central bank might believe that LM shocks are more prevalent than IS
shocks, making interest rate targeting more effective in stabilizing income.
Q&A
1. What does the IS curve represent in the IS-LM model?
A: The IS curve represents equilibrium in the goods market.
2. What does the LM curve represent in the IS-LM model?
A: The LM curve represents money market equilibrium.
3. How is the unique combination of Y and r determined in the IS-LM model?

A: The unique combination of Y (output) and r (interest rate) is determined by the intersection of
the IS and LM curves, which represents equilibrium in both the goods market and the money
market.
4. What can policymakers affect using fiscal policy and monetary policy in the IS-LM
model?
A: Policymakers can affect macroeconomic variables using fiscal policy (G and/or T) and
monetary policy (M). They can use these policies to influence aggregate demand, output, and
interest rates.
5. How is an increase in government purchases analyzed in the IS-LM model?
A: An increase in government purchases is analyzed by shifting the IS curve to the right, as it
leads to a higher level of planned expenditure and output in the short run.
6. In the IS-LM model, what does the intersection of the IS and LM curves determine?
A: The intersection of the IS and LM curves determines the short-run equilibrium combination
of output (Y) and the interest rate (r) that satisfies both goods market equilibrium and money
market equilibrium. It represents the overall equilibrium in the economy.
7. When the IS curve shifts right due to an increase in government spending (G), what
happens to output and income?
A: Output and income rise.

8. As a result of the increase in government spending (G) and the subsequent rise in
output and income, what happens to money demand, and how does it affect the
interest rate?
A: Money demand increases, causing the interest rate to rise.
9. After the increase in money demand and the rise in the interest rate due to the
government spending increase (G), what happens to investment, and how does it
impact the final increase in output (Y)?
A: Investment reduces due to the higher interest rate, resulting in the final increase in output (Y)
being smaller than the initial increase in government spending (G).
10. When there is a tax cut (T), how does the initial boost in spending compare to an
equal increase in government spending (G)?
A: The initial boost in spending is smaller for a tax cut (T) than for an equal increase in
government spending (G) because consumers save a fraction (1 - MPC) of the tax cut.
11. What happens to the LM curve when there is an increase in the money supply (M >
0)?
A: An increase in the money supply (M > 0) shifts the LM curve down (or to the right).
12. After the LM curve shifts down (or to the right) due to the increase in money supply
(M > 0), how does it affect the interest rate?

A: The interest rate falls.
13. As a result of the decrease in the interest rate and the increase in money supply (M >
0), what happens to investment and output (Y)?
A: Investment increases, leading to a rise in output and income.
14. In the real world, how might the interaction between monetary and fiscal policy differ
from the model where these policy variables are exogenous?
A: In the real world, monetary policymakers may adjust the money supply (M) in response to
changes in fiscal policy (G and T), and vice versa. This interaction between policies may alter
the impact of the original policy change.
15. When the government increases spending (G > 0), what are the possible responses of
the central bank?
A: The central bank may choose to hold the money supply (M) constant or hold the interest rate
(r) constant in response to the increase in government spending (G > 0).
16. What happens when the IS curve shifts right by ∆G in the IS-LM model?
Answer: Output and income rise.
17. How does an increase in government purchases affect the interest rate in the IS-LM
model?
Answer: It raises money demand, causing the interest rate to rise.

18. What is the effect of a tax cut in the IS-LM model, and why is it different from an
equal increase in government purchases (∆G)?
Answer: The initial boost in spending from a tax cut (∆T) is smaller than for an equal ∆G
because consumers save a fraction (1-MPC) of the tax cut. The IS curve shifts by ∆T, and the
effects on the interest rate (r) and output (Y) are smaller than for an equal ∆G.
19. How does an increase in the money supply (∆M) impact the LM curve in the IS-LM
model?
Answer: ∆M > 0 shifts the LM curve down (or to the right).
20. What happens to investment, output, and income when the interest rate falls due to an
increase in the money supply (∆M) in the IS-LM model?
Answer: The lower interest rate increases investment, causing output and income to rise.
21. How might the interaction between monetary and fiscal policy affect the impact of the
original policy change in the real world?
Answer: In the real world, monetary policymakers may adjust the money supply (M) in response
to changes in fiscal policy (G and T), or vice versa. Such interactions may alter the impact of the
original policy change.
22. What are the possible responses of the central bank to an increase in government
purchases (∆G > 0) in the IS-LM model?

Answer: The possible central bank responses are: 1. Hold the money supply (M) constant, or 2.
Hold the interest rate (r) constant.
23. What happens if the central bank holds the money supply (M) constant in response to
an increase in government spending (G)?
Response 1:
 IS curve shifts right due to the increase in government spending.
 LM curve remains unchanged since the central bank is holding the money supply
constant.
24. What happens if the central bank aims to keep the interest rate (r) constant in
response to an increase in government spending (G)?
Response 2:
 To keep the interest rate constant, the central bank increases the money supply (M) to
shift the LM curve right.
25. What happens if the central bank aims to keep output (Y) constant in response to an
increase in government spending (G)?
Response 3:

 To keep output constant, the central bank reduces the money supply (M) to shift the LM
curve left.
26. What are IS shocks in the IS-LM model?
IS shocks are exogenous changes in the demand for goods and services. Examples include stock
market booms or crashes, changes in households' wealth, and changes in business or consumer
confidence or expectations.
27. What are LM shocks in the IS-LM model?
LM shocks are exogenous changes in the demand for money. Examples include events like a
wave of credit card fraud, which increases the demand for money, or the introduction of more
ATMs or Internet transactions, which reduce money demand.
28. Use the IS-LM model to analyze the effects of a boom in the stock market, making
consumers wealthier.
In this case:
 IS curve shifts right due to increased consumer wealth.
 LM curve remains unchanged.
 Consumption (C) and investment (I) increase, leading to higher output (Y).
29. Use the IS-LM model to analyze the effects of a wave of credit card fraud, causing
consumers to use cash more frequently.
In this case:
 IS curve remains unchanged?
 LM curve shifts down due to increased demand for money.
 Consumption (C) and investment (I) decrease, leading to lower output (Y).
30. What is the central bank's policy instrument?
The central bank's policy instrument is the discount rate, which it uses to conduct monetary
policy. The central bank sets a target value for the discount rate and adjusts the money supply
(M) through monetary policy to shift the LM curve as needed to attain its target interest rate.
31. Why does the central bank target interest rates instead of the money supply?
The central bank might target interest rates instead of the money supply because it believes that
LM shocks (exogenous changes in the demand for money) are more prevalent than IS shocks
(exogenous changes in the demand for goods and services). By targeting interest rates, the
central bank can stabilize income more effectively than targeting the money supply.
Additionally, interest rates are easier to measure than the money supply.
Lesson 29
IS-LM FRAMEWORK AND AGGREGATE
DEMAND
MCQs:
32.Q1: What does the aggregate demand (AD) curve represent in the IS-LM
model?
a) Equilibrium in the goods market.
b) Equilibrium in the money market.
c) The relationship between the price level (P) and output (Y).
d) The relationship between the interest rate (r) and investment (I).
Answer: c) The relationship between the price level (P) and output (Y).
33.How does an increase in money supply (M) by the central bank affect
aggregate demand (AD)?
a) It shifts the AD curve left.
b) It shifts the AD curve right.
d) It depends on the value of the price level (P).

Answer: b) It shifts the AD curve right.
34.How does expansionary fiscal policy (decrease in taxes and/or increase in
government spending) affect aggregate demand (AD)?
a) It shifts the AD curve left.
b) It shifts the AD curve right.
d) It depends on the value of the interest rate (r).
Answer: b) It shifts the AD curve right.
35.In the short-run equilibrium, if output (Y) is greater than the natural
level of output (Y), what will happen to the price level (P) over time?
a) P will remain constant.
b) P will rise.
c) P will fall.
d) P will fluctuate without any clear trend.
Answer: b) P will rise.

36.What is the force that moves the economy from the short run to the long
run in the AD-AS model?
a) Changes in fiscal policy.
b) Changes in monetary policy.
c) Gradual adjustment of prices.
d) Changes in consumer spending.
Answer: c) Gradual adjustment of prices.
37.In the short run, what happens to output (Y), price level (P), and interest
rate (r) in response to a negative IS shock (a decrease in aggregate
demand)?
a) Y decreases, P increases, r increases.
b) Y decreases, P remains constant, r increases.
c) Y decreases, P decreases, r increases.
d) Y decreases, P decreases, r remains constant.
Answer: c) Y decreases, P decreases, r increases.

38.In the long run, what happens to the output (Y) and the price level (P) in
response to a change in the money supply (M)?
a) Y increases, and P decreases.
b) Y remains constant, and P increases.
c) Y decreases, and P remains constant.
d) Y returns to its natural level, and P increases.
Answer: d) Y returns to its natural level, and P increases.
39. In the short run, what is the impact of an increase in the money supply ( M) on the
interest rate (r)?
a) r increases. b) r remains constant.
c) r decreases. d) r first increases and then returns to its original level.
Answer: c) r decreases.
40.What happens to investment (I) in the short run and long run when the
money supply (M) increases?
a) I increases in both the short run and long run.
b) I increases in the short run but returns to its original level in the long run.
c) I remains constant in both the short run and long run.
d) I decreases in both the short run and long run.
Answer: a) I increases in both the short run and long run.
41.In the long run, why does the output (Y) return to its natural level (Y*)
when the price level (P) increases due to a change in the money supply
(M)?
a) The IS curve shifts right, increasing output.
b) The LM curve shifts left, decreasing output.
c) The AD curve shifts right, increasing output.
d) The LRAS curve shifts left, decreasing output.
Answer: b) The LM curve shifts left, decreasing output.
42.What happens to consumption (C) in the long run when the money
supply (M) increases?
a) C increases in the long run.
b) C decreases in the long run.
c) C remains constant in the long run.

d) C increases in the short run but returns to its original level in the long run.
Answer: c) C remains constant in the long run.
43.In the short run, why does the price level (P) remain constant when the
money supply (M) increases?
a) Prices are sticky in the short run.
b) LM curve shifts right, keeping P constant.
c) Aggregate demand (AD) curve shifts right, keeping P constant.
d) Long-run aggregate supply (LRAS) curve shifts right, keeping P constant.
Answer: a) Prices are sticky in the short run.
Q&A
1. What is the intuition behind the slope of the aggregate demand (AD) curve in the IS-
LM model?
Answer: The slope of the AD curve is negative because as the price level (P) increases, the real
money supply (M/P) decreases, leading to a leftward shift of the LM curve, which increases the
interest rate (r). The higher interest rate reduces investment (I), leading to a decrease in output
(Y).
2. How can the central bank increase aggregate demand (AD) through monetary policy?
Answer: The central bank can increase AD by increasing the money supply (M), which shifts the
LM curve to the right, resulting in a decrease in the interest rate (r). The lower interest rate
stimulates investment (I) and increases output (Y) at each level of the price level (P).
3. In the IS-LM model, what happens to the economy if there is an expansionary fiscal
policy, such as a decrease in taxes (T)?
Answer: An expansionary fiscal policy, like a decrease in taxes (T), increases aggregate demand.
As a result, the IS curve shifts to the right, increasing output (Y) at each value of the price level
(P). The increase in output leads to an increase in consumption (C) and investment (I) as well.
4. What is the force that moves the economy from the short run to the long run in the
AD-AS model?
Answer: The gradual adjustment of prices is the force that moves the economy from the short run
to the long run in the AD-AS model. Over time, as prices adjust, the economy reaches the long-
run equilibrium, where the output (Y) returns to its natural level, and there is no inflationary or
deflationary pressure.
5. What are the short-run impacts of a negative IS shock (a decrease in aggregate
demand) in the IS-LM model?
Answer: In response to a negative IS shock, the output (Y) decreases, as the IS and AD curves
shift left. However, in the short run, the price level (P) remains constant (sticky prices). The
interest rate (r) increases due to the movement along the LM curve, and consumption (C)
increases, while investment (I) decreases.

6. How does the economy adjust from a short-run equilibrium where the output (Y) is
greater than the natural level (Y) to the long-run equilibrium?
Answer: In the short-run equilibrium where Y is greater than the natural level of output (Y),
prices gradually fall over time. This causes the short-run aggregate supply (SRAS) to move
down, leading to an increase in real money balances (M/P). As a result, the LM curve shifts
down, leading to a decrease in the interest rate (r). This process continues until the economy
reaches the long-run equilibrium with Y equal to the natural level of output.
7. In the long run, what happens to output (Y) when the price level (P) rises due to an
increase in the money supply (ΔM)?
Answer: Output (Y) returns to its natural level (Y*).
8. How does the price level (P) change in the long run when there is an increase in the
money supply (ΔM)?
Answer: The price level (P) increases to eliminate the excess demand at the initial price level
(P0).
9. What happens to the interest rate (r) in the long run when there is an increase in the
money supply (ΔM)?
Answer: The interest rate (r) returns to its original level as the LM curve shifts left due to the
increase in P.
10. How does an increase in the money supply (ΔM) affect consumption (C) in the long
run?
Answer: Consumption (C) returns to its initial level since both output (Y) and taxes (T) return to
their initial levels.
11. What is the long-run impact on investment (I) when there is an increase in the money
supply (ΔM)?
Answer: Investment (I) decreases since the interest rate (r) has risen even more due to the
increase in P.
12. How do short-run and long-run impacts of an increase in the money supply differ?
Answer: In the short run, output (Y) and consumption (C) increase, and the interest rate (r)
decreases. In the long run, output (Y) returns to its natural level, and the interest rate (r) and
investment (I) return to their initial levels, while the price level (P) increases to eliminate the
excess demand.
13. What is the long-run impact on output (Y) when the price level (P) rises due to an
increase in the money supply (M)?
Answer: In the long run, output (Y) returns to its natural level (Y*).
14. Why does the price level (P) increase in the long run when there is an increase in the
money supply (M)?

Answer: The price level (P) increases in the long run because the LM curve shifts left due to the
increase in the money supply (M).
Answer: In the long run, the interest rate (r) returns to its original level.
16. How does an increase in the money supply (M) affect consumption (C) in the long
run?
Answer: In the long run, consumption (C) returns to its initial level.
17. What is the long-run impact on investment (I) when there is an increase in the money
supply (M)?
Answer: In the long run, investment (I) returns to its initial level.
18. What are the short-run impacts of an increase in the money supply ( M) on output
(Y), price level (P), interest rate (r), consumption (C), and investment (I)?
Answer:
 Y increases
 P remains unchanged due to sticky prices
 r decreases
 C increases
 I increases
19. What are the long-run impacts of an increase in the money supply ( M) on output
(Y), price level (P), interest rate (r), consumption (C), and investment (I)?
Answer:
 Y returns to its natural level (Y*)
 P increases to eliminate excess demand
 r returns to its original level
 C returns to its initial level
 I returns to its initial level
 Q1: What is the long-run impact on output (Y) when the price level (P) rises
due to an increase in the money supply (M)?
 A: Y returns to its natural level (Y*).
20. Why does the price level (P) increase in the long run when there is an increase in the
A: The price level (P) increases to eliminate the excess demand at the initial price level (P0).
A: The interest rate (r) returns to its original level, reflecting the leftward shift in the LM curve
due to the increase in the money supply (M).
22. How does an increase in the money supply (M) affect consumption (C) in the long
run?
A: Consumption (C) returns to its initial level, as both output (Y) and taxes (T) are back to their
original levels (C=C(Y-T)).
23. What is the impact on investment (I) in the long run when there is an increase in the
A: Investment (I) decreases, as the increase in the interest rate (r) due to the rise in the price level
(P) reduces the level of investment.
24. In the short run, why does output (Y) increase when there is an increase in the money
supply (M)?
A: Output (Y) increases because of the movement along the IS curve, caused by the decrease in
the interest rate (r) as the LM curve shifts right due to the increase in the money supply (M).
25. What is the reason for the price level (P) remaining constant in the short run despite
an increase in the money supply (M)?
A: Prices are sticky in the short run, leading to a constant price level (P) despite changes in other
economic variables.
26. How does an increase in the money supply (M) affect consumption (C) in the short
run?
A: Consumption (C) increases due to the rise in output (Y) caused by the shift in the LM curve.
27. In the short run, what happens to investment (I) when there is an increase in the

A: Investment (I) increases because of the decrease in the interest rate (r) resulting from the shift
in the LM curve to the right.
Lesson 30
THE MUNDELL-FLEMING MODEL
MCQs:
1. What is the key assumption of the Mundell-Fleming model?
a) Large open economy with perfect capital mobility
b) Small open economy with no capital mobility
c) Large closed economy with perfect capital mobility
d) Small closed economy with no capital mobility
Answer: b) Small open economy with no capital mobility
2. What does the LM* curve represent in the Mundell-Fleming model?
a) The relationship between the nominal exchange rate and the level of income (output)
b) The relationship between the interest rate and the level of investment
c) The relationship between money demand and money supply at a given exchange rate
d) The relationship between government spending and the trade balance
Answer: c) The relationship between money demand and money supply at a given
exchange rate
3. In a system of floating exchange rates, how does fiscal expansion affect
the exchange rate (e) and the level of income (Y)?
a) e > 0, Y > 0 b) e > 0, Y = 0
c) e < 0, Y > 0 d) e < 0, Y = 0
Answer: b) e > 0, Y = 0
4. In a small open economy with perfect capital mobility, what is the
"crowding out effect" of fiscal policy?
a) Fiscal policy crowds out investment by causing the interest rate to rise.
b) Fiscal policy crowds out net exports by causing the exchange rate to depreciate.
c) Fiscal policy crowds out consumption by causing the price level to increase.
d) Fiscal policy crowds out government spending by causing the budget deficit to rise.
Answer: b) Fiscal policy crowds out net exports by causing the exchange rate to appreciate.
5. How does an increase in the money supply (M) affect the exchange rate
(e) and the level of income (Y) in a floating exchange rate system?
a) e > 0, Y > 0 b) e > 0, Y = 0
c) e < 0, Y > 0 d) e < 0, Y = 0
Answer: c) e < 0, Y > 0
6. What does an expansionary monetary policy do in a small open economy
with perfect capital mobility?
a) Increases interest rates and reduces investment
b) Reduces the exchange rate and increases net exports
c) Reduces output and increases unemployment
d) Increases output and shifts demand from foreign to domestic products
Answer: d) Increases output and shifts demand from foreign to domestic products.
7. The Mundell-Fleming model portrays the relationship between which two variables?
a) Nominal exchange rate and unemployment rate
b) Nominal exchange rate and inflation rate

c) Nominal exchange rate and output (income)
d) Nominal exchange rate and interest rate
Answer: c) Nominal exchange rate and output (income)
a) Large open economy with perfect capital mobility b) Small open economy with imperfect
capital mobility c) Large open economy with imperfect capital mobility d) Small open economy
with perfect capital mobility
Answer: d) Small open economy with perfect capital mobility
9. In the Mundell-Fleming model, what is the slope of the LM* curve?
a) Positive b) Negative c) Vertical d) Horizontal
Answer: c) Vertical
10.In a system of floating exchange rates, what happens to the nominal
exchange rate (e) in response to a fiscal expansion?
a) It decreases (e < 0) b) It increases (e > 0)
c) It remains constant (e = 0) d) It is unrelated to fiscal policy changes
Answer: b) It increases (e > 0)

11.How does monetary policy affect output (Y) in a small open economy with
perfect capital mobility under floating exchange rates?
a) An increase in money supply (M) leads to an increase in output (Y > 0)
b) An increase in money supply (M) leads to a decrease in output (Y < 0)
c) Monetary policy has no impact on output in a small open economy
d) An increase in money supply (M) leads to a decrease in nominal exchange rate (e < 0)
Answer: a) An increase in money supply (M) leads to an increase in output (Y > 0)
12. What is the "crowding out effect" in a small open economy with perfect capital
mobility?
a) Fiscal policy crowds out investment by causing the interest rate to rise.
b) Fiscal policy crowds out net exports by causing the exchange rate to appreciate.
c) Fiscal policy crowds out government spending by increasing private sector borrowing.
d) Fiscal policy crowds out monetary policy by reducing the effectiveness of interest rate
changes.
Answer: b) Fiscal policy crowds out net exports by causing the exchange rate to appreciate.
13.Under fixed exchange rates, how does an increase in money supply (M)
affect output (Y) in a small open economy?

a) Output increases (Y > 0) due to the appreciation of the domestic currency.
b) Output decreases (Y < 0) due to the depreciation of the domestic currency.
c) Output remains constant (Y = 0) as exchange rates are fixed.
d) Output is unaffected by changes in the money supply under fixed exchange rates.
Answer: c) Output remains constant (Y = 0) as exchange rates are fixed.
14.What does expansionary monetary policy do to aggregate demand in a
small open economy with perfect capital mobility under floating exchange
rates?
a) Increases world aggregate demand
b) Shifts demand from domestic to foreign products
c) Shifts demand from foreign to domestic products
d) Has no effect on aggregate demand
Answer: c) Shifts demand from foreign to domestic products
Q&A
1. What does the Mundell-Fleming model portray?

A: The Mundell-Fleming model portrays the relationship between the nominal exchange rate and
the economy's output in a small open economy with perfect capital mobility.
A: The key assumption of the Mundell-Fleming model is that it considers a small open economy
with perfect capital mobility.
3. What does the IS* curve represent in the Mundell-Fleming model?
A: The IS* curve in the Mundell-Fleming model represents the goods market equilibrium,
showing the relationship between the nominal exchange rate (e) and the level of income (Y) for a
given value of the interest rate (r*).
4. Why is the LM* curve vertical in the Mundell-Fleming model?
A: The LM* curve is vertical because, for a given value of the interest rate (r*), there is only one
level of income (Y) that equates money demand with supply, regardless of the exchange rate (e).
5. What is the difference between floating and fixed exchange rates?
A: In a system of floating exchange rates, the exchange rate (e) is allowed to fluctuate in
response to changing economic conditions. In contrast, under fixed exchange rates, the central
bank intervenes in the foreign exchange market to maintain a predetermined exchange rate.
6. How does fiscal policy affect the economy under floating exchange rates?
A: In a small open economy with perfect capital mobility, fiscal expansion increases income (Y)
but has no impact on the exchange rate (e), resulting in no change in real GDP (Y = 0).
7. What is the "crowding out effect" in the context of fiscal policy?
A: The "crowding out effect" refers to the phenomenon where fiscal policy, when implemented
in a small open economy, crowds out net exports by causing the exchange rate to appreciate,
thereby offsetting the expansionary effects on income.
8. How does expansionary monetary policy affect the economy under floating exchange
rates?
A: Expansionary monetary policy, such as an increase in the money supply (M), shifts the LM*
curve rightward, leading to a decrease in the exchange rate (e) and an increase in income (Y).
9. What are the lessons about monetary policy in a small open economy?
A: Monetary policy affects output by influencing one or more components of aggregate demand.
In a small open economy with perfect capital mobility, an increase in the money supply (M)
leads to a decrease in the exchange rate (e) and an increase in net exports (NX), boosting income
(Y) domestically but causing losses abroad.
Lesson 31
THE MUNDELL-FLEMING MODEL (CONTINUED)

MCQs:
1. Under floating exchange rates, what is the impact of a tariff or quota on
imports and net exports?
a) Increases imports and decreases net exports
b) Decreases imports and increases net exports
c) Decreases both imports and net exports
d) Increases both imports and net exports
Answer: c) Decreases both imports and net exports
2. What is the main reason import restrictions cannot reduce a trade deficit
in a small open economy with perfect capital mobility?
a) Exchange rate appreciation reduces exports
b) Trade restrictions increase imports
c) Import restrictions reduce exports
d) Net exports remain unchanged

Answer: d) Net exports remain unchanged
3. Under fixed exchange rates, how does fiscal expansion affect the
economy?
a) It increases income (Y) and the exchange rate (e)
b) It decreases income (Y) and the exchange rate (e)
c) It increases income (Y) but keeps the exchange rate (e) constant
d) It has no impact on income (Y) or the exchange rate (e)
Answer: a) It increases income (Y) and the exchange rate (e)
4. How does a restriction on imports affect the exchange rate (e) and income
(Y) under fixed exchange rates?
a) It decreases income (Y) and the exchange rate (e)
b) It increases income (Y) and the exchange rate (e)
c) It has no impact on income (Y) or the exchange rate (e)
d) It increases income (Y) but keeps the exchange rate (e) constant
Answer: b) It increases income (Y) and the exchange rate (e)

5. What are the two reasons why the domestic interest rate (r) may differ
from the world interest rate (r*) in the Mundell-Fleming model?
a) Trade deficit and expected exchange rate changes
b) Trade surplus and country risk
c) Country risk and expected exchange rate changes
d) Fiscal expansion and monetary expansion
Answer: c) Country risk and expected exchange rate changes
6. Under floating exchange rates, what is the impact of an increase in
country risk (θ) on the IS* and LM* curves?
a) IS* shifts left, and LM* shifts right
b) IS* shifts right, and LM* shifts left
c) Both IS* and LM* shift left
d) Both IS* and LM* shift right
Answer: a) IS* shifts left, and LM* shifts right
7. How does an increase in country risk (θ) affect the exchange rate (e) and
income (Y) in the Mundell-Fleming model?

a) It decreases the exchange rate (e) and increases income (Y)
b) It increases the exchange rate (e) and decreases income (Y)
c) It has no impact on the exchange rate (e) or income (Y)
d) It decreases both the exchange rate (e) and income (Y)
Answer: b) It increases the exchange rate (e) and decreases income (Y)
Q&A:
1. What does a tariff or quota do under floating exchange rates in the Mundell-Fleming
model?
A: A tariff or quota reduces imports, increases net exports (NX), and shifts the IS* curve to the
right.
2. What are the lessons about trade policy in the context of the Mundell-Fleming model?
A: Import restrictions cannot reduce a trade deficit as NX remains unchanged. While it reduces
imports, the exchange rate appreciation reduces exports, resulting in less overall trade and fewer
gains from trade.
3. Under a system of fixed exchange rates, what does the country's central bank do?
A: Under fixed exchange rates, the central bank stands ready to buy or sell the domestic currency
for foreign currency at a predetermined rate to keep the nominal exchange rate fixed.
4. How does fiscal policy affect the economy under fixed exchange rates?
A: A fiscal expansion under fixed exchange rates raises the exchange rate (e), but the central
bank counteracts it by selling domestic currency, leading to an increase in income (Y).
5. How does monetary policy affect the economy under fixed exchange rates?
A: An increase in the money supply (M) under fixed exchange rates reduces the exchange rate
(e), but the central bank offsets it by buying domestic currency, resulting in no change in the
exchange rate (e = 0) or income (Y = 0).
6. What happens when a restriction on imports is implemented under fixed exchange
rates?
A: A restriction on imports puts upward pressure on the exchange rate (e), and the central bank
sells domestic currency to prevent e from rising, leading to an increase in income (Y) and net
exports (NX).
7. What are the impacts of fiscal expansion and monetary expansion in a floating
exchange rate system?
A: In a floating exchange rate system, fiscal expansion increases income (Y) and exchange rate
(e), while monetary expansion increases income (Y) and decreases the exchange rate (e).
8. What are the reasons for interest rate differentials (r - r*) in the Mundell-Fleming
model?
A: Interest rate differentials can occur due to country risk, where higher interest rates
compensate for the risk of default, and expected exchange rate changes, where higher interest
rates compensate for expected currency depreciation.
9. How does an increase in country risk or expected depreciation affect the M-F model?
A: An increase in country risk or expected depreciation leads to a rise in the interest rate (r),
causing the IS* curve to shift left due to a decrease in investment (I) and the LM* curve to shift
right due to decreased money demand (M/P), resulting in an increase in income (Y).
10. Under floating exchange rates, how does a tariff or quota affect imports and net
exports?
A: A tariff or quota under floating exchange rates reduces imports, increases net exports (NX),
and shifts the IS* curve to the right.
11. What is the main lesson about trade policy under floating exchange rates?
A: Import restrictions cannot reduce a trade deficit. Although net exports (NX) remain
unchanged, there is less overall trade due to reduced imports and exchange rate appreciation that
reduces exports.
12. In a fixed exchange rate system, how does fiscal expansion affect the exchange rate
and output?
A: Under fixed exchange rates, a fiscal expansion raises the exchange rate (e), but to prevent it
from rising, the central bank must sell domestic currency, leading to an increase in the money
supply (M) and a rightward shift in LM*. The result is an increase in output (Y) without any
change in the exchange rate (e).
13. How does monetary policy impact the economy under fixed exchange rates?
A: In a fixed exchange rate system, an increase in the money supply (M) shifts LM* rightward,
reducing the exchange rate (e). To prevent the fall in the exchange rate, the central bank must
buy domestic currency, reducing the money supply (M) and shifting LM* back left. As a result,
monetary policy cannot be used to affect output (Y = 0).
14. Under fixed exchange rates, what is the effect of an import restriction on the exchange
rate and output?
A: In a fixed exchange rate system, an import restriction puts upward pressure on the exchange
rate (e). To prevent the rise in the exchange rate, the central bank must sell domestic currency,
increasing the money supply (M) and shifting LM* rightward. The result is an increase in output
(Y) without any change in the exchange rate (e) and an increase in net exports (NX).
15. What are the impacts of interest-rate differentials in the Mundell-Fleming model?
A: Interest-rate differentials can arise due to country risk and expected exchange rate changes.
These differentials affect the interest rate (r) in the model, which, in turn, influences investment
(I) and the money demand (M/P) causing shifts in IS* and LM* curves.
16. How does an increase in country risk or expected depreciation affect the exchange
rate and output?
A: An increase in country risk or an expected depreciation causes the interest rate (r) to rise,
leading to a leftward shift in IS* due to decreased investment (I). At the same time, it causes the
money demand (M/P) to fall, leading to a rightward shift in LM* to restore money market
equilibrium. The result is an increase in output (Y) and a fall in the exchange rate (e).
17. Why does an increase in expected depreciation have a significant impact on output
(Y)?
A: An increase in expected depreciation creates a self-fulfilling prophecy. The fall in the
exchange rate (e) makes the country's currency less attractive, leading to an increase in net
exports (NX). The boost in NX is even greater than the fall in investment (I) caused by the rise in
the interest rate (r), resulting in an overall increase in output (Y).
Lesson 32
THE MUNDELL-FLEMING MODEL (CONTINUED)
& THE THREE MODELS OF
AGGREGATE SUPPLY
MCQs:
1. In the Mundell-Fleming model, which of the following actions by the
central bank would shift the LM* curve leftward and prevent income
(output) from rising?
a) Reducing the money supply to prevent depreciation.
b) Boosting the price of imports, leading to a decrease in the real money supply.
c) Encouraging consumers to hold more money due to increased risk.
d) All of the above.
Answer: d) All of the above.
2. During the South East Asian Crisis, which country experienced the
largest nominal GDP percentage change from 1997 to 1998?
a) Indonesia b) Japan c) Malaysia d) Thailand
Answer: a) Indonesia
3. Which of the following is an argument in favor of fixed exchange rates?
a) Allowing monetary policy to be used for stable growth and low inflation.
b) Avoiding uncertainty and volatility in international transactions.

c) Disciplining monetary policy to prevent excessive money growth.
4. In the Mundell-Fleming model, why does the AD curve have a negative
slope?
a) An increase in the price level (P) leads to a decrease in money demand, shifting the LM*
curve leftward.
b) A decrease in the price level (P) causes an increase in net exports (NX) and output (Y).
c) A fixed price level (P) leads to changes in the exchange rate (e) and shifts in the IS* curve.
d) An increase in output (Y) causes a decrease in money supply (M) and shifts the LM* curve.
Answer: a) An increase in the price level (P) leads to a decrease in money demand, shifting
the LM* curve leftward.
5. Which of the following can shift the LM* curve leftward in the Mundell-
Fleming model?
A) The central bank increasing the money supply.
B) Depreciation boosting the price of imports, leading to an increase in the price level.
C) Consumers responding to increased risk by holding more money.

D) All of the above.
Answer: D) All of the above.
6. In the South East Asian crisis, which country experienced the highest
percentage change in exchange rates from July 1997 to January 1998?
A) Indonesia B) Japan C) Malaysia D) Singapore
Answer: A) Indonesia
7. What argument supports the use of fixed exchange rates?
A) Allows monetary policy flexibility to pursue stable growth and low inflation.
B) Avoids uncertainty and volatility, making international transactions easier.
C) Disciplines monetary policy to prevent excessive money growth and hyperinflation.
D) None of the above.
Answer: B) Avoids uncertainty and volatility, making international transactions easier.
8. In the Mundell-Fleming model, how does a change in the price level (P)
affect the aggregate demand (AD) curve?
A) The AD curve shifts rightward due to an increase in consumption (C) and investment (I).
B) The AD curve shifts leftward due to a decrease in net exports (NX).

C) The AD curve is unaffected by changes in the price level (P).
D) The AD curve shifts upward due to an increase in the money supply (M).
Answer: B) The AD curve shifts leftward due to a decrease in net exports (NX).
Q&A:
1. Why might income not rise despite depreciation of the exchange rate in the Mundell-
Fleming model?
A: The central bank may reduce the money supply to prevent depreciation, leading to a leftward
shift of LM* curve. Additionally, the increase in import prices due to depreciation could raise the
price level, reducing the real money supply. Consumers might also respond to increased risk by
holding more money, shifting LM* curve leftward.
2. In the South East Asian Crisis, which country experienced the highest percentage
decrease in the exchange rate from July 1997 to January 1998?
A: Thailand experienced the highest percentage decrease in the exchange rate (48.3%).
3. What is an argument in favor of fixed exchange rates?
A: Fixed exchange rates avoid uncertainty and volatility, making international transactions
easier. It also disciplines monetary policy to prevent excessive money growth and hyperinflation.
4. Why does the Aggregate Demand (AD) curve have a negative slope in the Mundell-
Fleming model when considering a change in the price level (P)?

A: The AD curve has a negative slope because an increase in the price level (P) leads to a
decrease in real money supply (M/P), causing the LM* curve to shift leftward. This results in a
decrease in net exports (NX) and aggregate output (Y).
5. Which of the following models of aggregate supply assumes that firms and workers
negotiate contracts and fix the nominal wage before they know the actual price level?
A: The sticky-wage model
6. In a large open economy, what happens to net exports (NX) and investment (I)
following a monetary expansion?
A: Net exports (NX) and investment (I) both increase, but not as much as in a closed or small
open economy.
7. Which model of aggregate supply implies that the real wage should be counter-
cyclical, moving in the opposite direction as output over business cycles?
A: The sticky-wage model
8. In the context of the sticky-wage model, what happens to employment, output, and
income when the price level (P) increases?
A: Employment, output, and income all increase.
9. What does the aggregate supply curve summarize in the context of the sticky-wage
model?
A: The aggregate supply curve summarizes the changes in output and employment resulting
from changes in the price level (P) relative to the expected price level (Pe).
10. True or False: In the sticky-wage model, the real wage remains constant over the
course of business cycles.
A: False. The sticky-wage model predicts that the real wage should be counter-cyclical, meaning
it should move in the opposite direction as output over business cycles. However, this prediction
does not always hold true in the real world.
11. In the short run, if aggregate output (Y) is less than the natural rate of output (Y*),
what will happen to prices over time?
A: There will be downward pressure on prices, and over time, prices will move down.
12. In a large open economy, what happens to investment (I) and net exports (NX)
following a monetary expansion (ΔM > 0)?
A: Investment (I) decreases (though not as much as in a closed economy), and net exports (NX)
increase (though not as much as in a small open economy).
13. Which of the three models of aggregate supply assumes that firms and workers set the
nominal wage before knowing the actual price level?
A: The sticky-wage model.
14. According to the sticky-wage model, what happens to employment and output when
the price level (P) increases?

A: Employment, output, and income increase.
15. In the sticky-wage model, what assumption is made about the negotiation of contracts
between firms and workers?
A: The assumption made in the sticky-wage model is that firms and workers negotiate contracts
and fix the nominal wage before they know what the price level will turn out to be.
16. In the large open economy, what happens to investment (I) and net exports (NX) in
response to a monetary expansion?
A: In the large open economy, a monetary expansion leads to a decrease in the interest rate (r)
and an increase in net exports (NX) and investment (I), though not as much as in a closed
economy or a small open economy.
17. What is the key difference between the sticky-wage, imperfect-information, and
sticky-price models of aggregate supply?
A: The key difference lies in the assumptions about how wages and prices adjust in response to
changes in the economy. The sticky-wage model assumes firms and workers set the nominal
wage before knowing the price level. The sticky-price model assumes prices are slow to adjust.
The imperfect-information model assumes that firms and workers have imperfect information
about the price level.
18. According to the aggregate supply curve in the sticky-wage model, what happens to
output (Y) and the price level (P) if the actual price level (P) is greater than the
expected price level (Pe)?

A: If the actual price level (P) is greater than the expected price level (Pe), then output (Y) falls
below its natural rate, and the price level (P) exceeds the expected price level (Pe). The aggregate
supply curve in this model shows a negative relationship between output and the price level.
19. What is the prediction about the real wage in the sticky-wage model over the course of
business cycles?
A: The prediction in the sticky-wage model is that the real wage should be counter-cyclical,
moving in the opposite direction as output over the course of business cycles. In booms, when
prices typically rise, the real wage should fall, and in recessions, when prices typically fall, the
real wage should rise. However, this prediction does not always hold true in the real world.
Lesson 33
THREE MODELS OF AGGREGATE SUPPLY
(CONTINUED)
MCQs:
1. In the imperfect-information model, what does the supply of each good
depend on?
a) The overall price level

b) The nominal price of the good
c) The flexible prices of other goods
d) The quantity of goods consumed by the supplier
Answer: b) The nominal price of the good
2. In the sticky-price model, what are the reasons for sticky prices?
a) Perfectly flexible wages and prices
b) Long-term contracts and menu costs
c) Frequent price changes and clear markets
d) Firms' ability to set their own prices
Answer: b) Long-term contracts and menu costs
3. In the sticky-price model, how does a rise in the overall price level (P)
without a corresponding change in the expected price level (Pe) affect
output (Y)?
a) Output (Y) rises whenever P rises above Pe.
b) Output (Y) falls whenever P rises above Pe.
c) Output (Y) remains unchanged.

d) Output (Y) decreases whenever P rises above Pe.
Answer: a) Output (Y) rises whenever P rises above Pe.
4. In the sticky-price model, what fraction of firms must set their prices
before they know how P and Y will turn out?
a) Fraction "s" of firms with flexible prices b) Fraction "1 - s" of firms with flexible prices c)
Fraction "s" of firms with sticky prices d) Fraction "1 - s" of firms with sticky prices
Answer: c) Fraction "s" of firms with sticky prices
5. What does the overall price level (P) equal in the sticky-price model,
where "s" denotes the fraction of firms with sticky prices?
a) (1 - s)Pe + sY b) (1 + s)Pe - sY
c) (1 - s)Pe - sY d) (1 + s)Pe + sY
Answer: a) (1 - s)Pe + sY
6. According to the given information, in the sticky-price model, what
happens to prices (P) when aggregate output/income (Y) is high?
a) Prices (P) remain unchanged
b) Prices (P) decrease

c) Prices (P) increase
d) Prices (P) fluctuate randomly
Answer: c) Prices (P) increase
7. What is the implication of the sticky-price model regarding the
relationship between aggregate output/income (Y) and the real wage
when output/income falls?
a) The real wage remains constant
b) The real wage increases
c) The real wage fluctuates randomly
d) The real wage falls
Answer: d) The real wage falls
8. In the sticky-price model, how does the fraction of flexible price firms (s)
affect the relationship between changes in aggregate output (ΔY) and
changes in prices (ΔP)?
a) The greater the fraction of flexible price firms, the smaller the effect of ΔY on ΔP
b) The greater the fraction of flexible price firms, the larger the effect of ΔY on ΔP
c) The fraction of flexible price firms has no impact on the effect of ΔY on ΔP
d) The relationship between the fraction of flexible price firms and the effect of ΔY on ΔP is not
specified
Answer: b) The greater the fraction of flexible price firms, the larger the effect of ΔY on ΔP
9. Which model (sticky-wage or sticky-price) implies a pro-cyclical real
wage?
a) Sticky-wage model
b) Sticky-price model
c) Both models imply a pro-cyclical real wage
d) Neither model implies a pro-cyclical real wage
Answer: b) Sticky-price model
10.What is the aggregate supply (AS) equation in the sticky-price model?
a) Y = Y + α(P - Pe) b) Y = Y + α(P - Pe) / s
c) Y = Y + α(P - Pe) * s d) Y = Y + α(P - Pe) * (1 - s)
Answer: a) Y = Y + α(P - Pe)

11.In the context of the given information, what is the relationship between
income (Y) and the price level (P)?
a) High income (Y) leads to low price level (P).
b) High income (Y) leads to high price level (P).
c) Low income (Y) leads to low price level (P).
d) There is no relationship between income (Y) and the price level (P).
Answer: b) High income (Y) leads to high price level (P).
12.According to the sticky-price model, what happens to the real wage when
aggregate output/income falls?
a) The real wage remains unchanged.
b) The real wage rises.
c) The real wage falls.
d) The real wage becomes pro-cyclical.
Answer: c) The real wage falls.

13.In the sticky-price model, how does the fraction of firms with flexible
prices (s) affect the relationship between aggregate output (Y) and the
price level (P)?
a) A larger fraction of firms with flexible prices (s) reduces the effect of ΔY on P.
b) A larger fraction of firms with flexible prices (s) increases the effect of ΔY on P.
c) The fraction of firms with flexible prices (s) has no impact on the relationship between Y and
P.
d) A larger fraction of firms with flexible prices (s) makes the relationship between Y and P
unpredictable.
Answer: b) A larger fraction of firms with flexible prices (s) increases the effect of ΔY on P.
14.In the given equation Y = Y + α(P - Pe), what does "α" represent?
a) The overall price level (P)
b) The expected price level (Pe)
c) The aggregate output/income (Y)
d) A positive parameter influencing the relationship between Y and P
Answer: d) A positive parameter influencing the relationship between Y and P

15.What does the sticky-price model imply about the real wage when
aggregate output/income rises?
a) The real wage rises.
b) The real wage falls.
c) The real wage remains unchanged.
d) The sticky-price model does not provide any information about the real wage.
Answer: c) The real wage remains unchanged.
16.In the given equation Y = Y + α(P - Pe), what does "Y" represent?
b) The expected price level
c) The aggregate output or income
d) The fraction of flexible price firms
Answer: c) The aggregate output or income
17.What does the term "sticky-price model" refer to?
a) A model where prices are perfectly flexible
b) A model where prices are determined by aggregate demand

c) A model where some firms set their prices in advance and cannot adjust them immediately
d) A model where prices are determined by aggregate supply
Answer: c) A model where some firms set their prices in advance and cannot adjust them
immediately
18.In the sticky-price model, why does the real wage become pro-cyclical?
a) Because the nominal wage becomes pro-cyclical
b) Because the real wage is fixed and cannot change
c) Because firms with sticky prices reduce production during economic downturns
d) Because firms with flexible prices reduce production during economic downturns
Answer: c) Because firms with sticky prices reduce production during economic downturns
19.What does the parameter "α" represent in the equation Y = Y + α(P -
Pe)?
a) The fraction of firms with flexible prices
b) The fraction of firms with sticky prices
c) The effect of changes in output on the price level
d) The effect of changes in price level on output

Answer: c) The effect of changes in output on the price level
20.In the sticky-price model, how does a decrease in aggregate
output/income affect the real wage?
a) The real wage increases
b) The real wage decreases
c) The real wage remains unchanged
d) The real wage becomes pro-cyclical
Answer: b) The real wage decreases
Q&A
1. In the imperfect-information model, which assumption implies that each supplier
produces one good and consumes many goods?
A: Each supplier produces one good, consumes many goods.
2. In the sticky-price model, which of the following is NOT a reason for sticky prices?
A: Government regulations preventing firms from changing prices frequently.
3. In the imperfect-information model, how does a rise in the price level (P) without a
corresponding change in the expected price level (Pe) affect the output (Y)?
A: The output (Y) rises whenever the price level (P) rises above the expected price level (Pe).
4. In the sticky-price model, what fraction of firms have sticky prices?
A: The fraction of firms with sticky prices is denoted by "s."
5. What expression represents the overall price level in the sticky-price model, where
"s" denotes the fraction of firms with sticky prices?
A: P = (1 - s)Pe + sY
6. In the context of the sticky-price model, what happens to the overall price level when
firms with sticky prices expect high prices (Pe is high)?
A: The overall price level (P) increases when firms with sticky prices expect high prices, leading
to higher prices set by both sticky and flexible price firms.
7. In the imperfect-information model of aggregate supply, what is the primary factor
that leads to changes in output (Y) when the price level (P) rises above the expected
price level (Pe)?
A: Suppliers think their relative price has risen and produce more, resulting in an increase in
output (Y).
8. Which model of aggregate supply assumes that all wages and prices are perfectly
flexible and all markets are clear, but suppliers do not know the overall price level at
the time of production decisions?

A: The imperfect-information model
9. In the sticky-price model, what are the reasons for sticky prices?
A: Long-term contracts between firms and customers, menu costs, and firms' desire to avoid
annoying customers with frequent price changes.
10. In the sticky-price model, which firms have flexible prices and which have sticky
prices?
A: Firms with flexible prices set their prices as determined by their desired price formula, while
firms with sticky prices must set their prices before knowing the actual price level (P) and output
(Y).
11. In the sticky-price model, what happens to prices when firms with sticky prices expect
high prices?
A: Firms with sticky prices set their prices high, and other firms respond by also setting high
prices, leading to an increase in the overall price level (P).
12. True or False: In the imperfect-information model, firms know the overall price level
(P) when they make their production decisions.
A: False. In the imperfect-information model, firms know the nominal price of the good they
produce but do not know the overall price level (P) at the time they make their production
decisions, so they use the expected price level (Pe).
13. In the imperfect-information model, which factor influences the supply of each good?
A: The relative price of the good, which is the nominal price of the good divided by the overall
price level.
14. In the sticky-price model, what are the reasons for prices being sticky (not
immediately adjusting)?
A: Long-term contracts between firms and customers, menu costs, and firms not wanting to
annoy customers with frequent price changes.
15. In the sticky-price model, what is the individual firm's desired price when the firm
sets its own price?
A: The desired price is p = P + a(Y - Y^N), where "P" is the expected price level, "a" is a
positive parameter, "Y" is the actual output, and "Y^N" is the natural rate of output.
16. True or False: In the sticky-price model, firms with flexible prices set their prices
based on their expected price level (Pe).
A: False. Firms with flexible prices set their prices based on the actual price level (P).
17. In the sticky-price model, if a large fraction of firms have sticky prices and expect a
high price level (Pe), what will be the overall effect on prices?
A: The overall effect will be that firms, both sticky and flexible price firms, will set higher prices
due to the expectation of a high price level.
18. In the context of the relationship between income (Y) and prices (P), what happens
when income is high?

 The demand for goods is high, and firms with flexible prices set high prices.
19. How does the fraction of firms with flexible prices affect the relationship between
income (Y) and prices (P)?
 The greater the fraction of flexible price firms (s), the smaller the effect of ΔY
(change in output) on P (prices).
20. What does the equation Y = Y + α(P - Pe) represent?
 This is the aggregate supply (AS) equation, where Y represents aggregate output
or income, P represents the overall price level, and Pe represents the expected
price level.
21. How does the sticky-price model differ from the sticky-wage model in terms of the
real wage's behavior during economic cycles?
 In the sticky-price model, the real wage becomes pro-cyclical, meaning it moves
in the same direction as output/income changes. During economic downturns,
firms with sticky prices reduce production, leading to a decrease in the real wage.
22. What does the parameter "α" signify in the AS equation?
 The parameter "α" represents the responsiveness of the price level (P) to changes
in output (Y). It determines how much P changes for a given change in Y.
23. What happens to prices (P) when aggregate output or income (Y) is high?
 Prices (P) increase.
24. What is the implication of having a greater fraction of flexible price firms in the
economy?
 The effect of changes in aggregate output (ΔY) on prices (P) becomes larger.
25. How can the Aggregate Supply (AS) equation be derived from the given information?
 AS equation: Y = Y + α(P - Pe)
26. In the sticky-price model, how does the real wage behave during economic
downturns?
 The real wage becomes pro-cyclical, meaning it decreases during economic
downturns.
27. What happens to the demand for labor in firms with sticky prices when aggregate
output falls?
 The demand for labor in firms with sticky prices reduces as they cut production
due to the fall in demand for their products.
Lesson 34
INFLATION, UNEMPLOYMENT, AND THE PHILLIPS
CURVE
MCQs:
1. What do the three models of aggregate supply imply about the
relationship summarized by the SRAS curve and equation?
a) The SRAS curve is vertical, indicating that aggregate supply is fixed in the short run.
b) The SRAS curve slopes upward, indicating a positive relationship between output and the
price level.
c) The SRAS curve is horizontal, indicating that output can change without affecting the price
level.
d) The SRAS curve is downward-sloping, indicating an inverse relationship between output and
the price level.
Answer: d) The SRAS curve is downward-sloping, indicating an inverse relationship
between output and the price level.

2. What does the Phillips curve state?
a) Inflation depends on cyclical unemployment.
b) Inflation depends on supply shocks.
c) Inflation depends on expected inflation.
3. What is the modern form of the Phillips curve based on?
a) Only expected inflation.
b) Only cyclical unemployment.
c) Only supply shocks.
d) Expected inflation, cyclical unemployment, and supply shocks.
Answer: d) Expected inflation, cyclical unemployment, and supply shocks.
4. How is the Phillips curve derived from the equation for aggregate
supply?
a) By subtracting expected inflation from cyclical unemployment.
b) By taking the difference between actual inflation and the natural rate of unemployment.
c) By rearranging the aggregate supply equation and including supply shocks.
d) By dividing output by the price level.
Answer: c) By rearranging the aggregate supply equation and including supply shocks.
What is the relationship between output (Y) and the price level (P) according to the aggregate
supply equation?
a) Output (Y) and the price level (P) are positively related.
b) Output (Y) and the price level (P) are negatively related.
c) Output (Y) and the price level (P) are unrelated.
d) Output (Y) and the price level (P) are proportional to each other.
Answer: b) Output (Y) and the price level (P) are negatively related.
What does the equation (3) represent in the context of aggregate supply?
a) An aggregate demand shock that shifts the short-run aggregate supply curve.
b) A supply shock that alters the price level and shifts the short-run aggregate supply curve.
c) A monetary policy action affecting the overall price level.
d) A fiscal policy action influencing aggregate demand.

Answer: b) A supply shock that alters the price level and shifts the short-run aggregate
supply curve.
5. What does the equation (5) represent in terms of inflation?
a) The difference between current output and last year's output.
b) The difference between the current price level and last year's price level.
c) The difference between current unemployment and last year's unemployment rate.
d) The difference between current inflation and last year's inflation.
Answer: d) The difference between current inflation and last year's inflation.
6. What does Okun's law describe?
a) The relationship between inflation and unemployment.
b) The relationship between output and inflation.
c) The relationship between output and unemployment.
d) The relationship between aggregate demand and supply shocks.
Answer: c) The relationship between output and unemployment.
7. What does the Phillips curve relate?
a) Inflation to unemployment expectations.

b) Output to the price level.
c) Unemployment to aggregate supply shocks.
d) Unemployment to unexpected movements in the inflation rate.
Answer: d) Unemployment to unexpected movements in the inflation rate.
8. What does the concept of adaptive expectations assume?
a) People form their expectations of future inflation based on recent inflation rates.
b) People's expectations of future inflation are determined solely by government policies.
c) People's expectations of future inflation are always rational and forward-looking.
d) People's expectations of future inflation are completely static and unchanging.
Answer: a) People form their expectations of future inflation based on recent inflation
rates.
9. Which type of inflation results from supply shocks and raises production
costs?
a) Demand-pull inflation
b) Aggregate inflation
c) Cost-push inflation
d) Natural inflation
Answer: c) Cost-push inflation
10.What causes demand-pull inflation?
a) Negative supply shocks
b) Positive demand shocks
c) Rising production costs
d) Supply shortages
Answer: b) Positive demand shocks
11.In the short run, policymakers face a trade-off between which two
variables?
a) GDP and inflation
b) Unemployment and inflation
c) GDP and unemployment
d) Expectations and inflation
Answer: b) Unemployment and inflation

12.How do people's expectations affect the short-run Phillips curve trade-
off?
a) They have no effect on the trade-off.
b) They cause a movement along the curve.
c) They shift the curve in the long run.
d) They shift the curve in the short run.
Answer: d) They shift the curve in the short run.
13.What does the sacrifice ratio measure?
a) The percentage of a year's real GDP lost due to unemployment.
b) The percentage of a year's real GDP lost to reduce inflation by 1 point.
c) The percentage of inflation caused by demand shocks.
d) The percentage of inflation caused by supply shocks.
Answer: b) The percentage of a year's real GDP lost to reduce inflation by 1 point.
14.Suppose the sacrifice ratio is 5. If policymakers wish to reduce inflation
from 6 to 2 percent, how much of one year's GDP must be foregone?
a) 10% b) 15% c) 20% d) 25%

Answer: c) 20%
15.How can policymakers reduce inflation and increase unemployment
according to Okun's law?
a) By increasing aggregate demand
b) By implementing supply-side policies
c) By reducing aggregate demand
d) By controlling inflation expectations
Answer: c) By reducing aggregate demand
16.Which ways are commonly used for modeling the formation of
expectations?
a) Adaptive expectations only
b) Rational expectations only
c) Both adaptive expectations and rational expectations
Answer: c) Both adaptive expectations and rational expectations
17.In rational expectations, how do people form their expectations?

a) Based on all available information
b) Based on recently observed inflation
c) Based on historical data
d) Based on government announcements
Answer: a) Based on all available information, including information about current and
prospective future policies.
18.According to proponents of rational expectations, what might happen to
the sacrifice ratio in a painless disinflation scenario?
a) The sacrifice ratio may increase
b) The sacrifice ratio may remain unchanged
c) The sacrifice ratio may decrease
d) The sacrifice ratio may become infinite
Answer: c) The sacrifice ratio may decrease, possibly becoming very small.
19.The natural rate hypothesis suggests that changes in aggregate demand
affect output and employment:
a) Only in the short run

b) Only in the long run
c) Both in the short run and the long run
d) Neither in the short run nor the long run
Answer: a) Only in the short run. In the long run, the economy returns to the levels of
output, employment, and unemployment described by the classical model.
20.What does the hysteresis hypothesis suggest regarding the long-lasting
influence of history on variables like the natural rate of unemployment?
a) Negative shocks may decrease the natural rate of unemployment
b) Negative shocks may have no effect on the natural rate of unemployment
c) Negative shocks may increase the natural rate of unemployment
d) Negative shocks may lead to full recovery and a decrease in the natural rate of unemployment
Answer: c) Negative shocks may increase the natural rate of unemployment, causing the
economy not to fully recover.
Q&A:
1. What is the relationship between the three models of aggregate supply and the SRAS
curve and equation?

A: Each of the three models of aggregate supply implies a downward-sloping SRAS curve and
equation, indicating an inverse relationship between output and the price level.
2. What happens when a positive aggregate demand (AD) shock moves output above its
natural rate and prices above the expected level?
A: Over time, the expected price level (Pe) rises, the short-run aggregate supply (SRAS) curve
shifts up, and output returns to its natural rate.
3. What does the Phillips curve state?
A: The Phillips curve states that the inflation rate (π) depends on expected inflation (πe), cyclical
unemployment (u), and supply shocks (ν), where β > 0 is an exogenous constant.
4. Define cyclical unemployment.
A: Cyclical unemployment refers to the deviation of the actual rate of unemployment from the
natural rate, which is the unemployment rate at which there is no cyclical unemployment, and the
economy is at full employment.
5. How is the modern form of the Phillips curve derived from the equation for aggregate
supply?
A: The modern form of the Phillips curve is derived from the equation for aggregate supply by
considering expected inflation, cyclical unemployment, and supply shocks as the factors that
influence the inflation rate. It expresses the relationship between inflation (π) and these three
forces.
6. What is the purpose of adding the supply shock v in equation (3)?
A: The supply shock v represents exogenous events, such as changes in world oil prices that alter
the price level and shift the short-run aggregate supply curve.
7. How is inflation calculated in equation (4)?
A: Inflation is calculated as the difference between the current price level and last year's price
level.
8. What is Okun's law?
A: Okun's law describes the relationship between output and unemployment. It states that the
deviation of the actual rate of unemployment from the natural rate is related to the deviation of
output from potential output.
9. What does the SRAS curve represent?
A: The SRAS curve represents the relationship between output and unexpected movements in
the price level.
10. What does the Phillips curve represent?
A: The Phillips curve represents the relationship between unemployment and unexpected
movements in the inflation rate.
11. What are adaptive expectations in the context of inflation?

A: Adaptive expectations assume that people form their expectations of future inflation based on
recently observed inflation. For example, expected inflation is assumed to be equal to last year's
actual inflation.
12. What does inflation inertia imply in the Phillips curve?
A: Inflation inertia suggests that in the absence of supply shocks or cyclical unemployment,
inflation will continue indefinitely at its current rate. Past inflation influences expectations of
current inflation, which, in turn, influences the wages and prices that people set.
13. What are the two causes of rising and falling inflation?
A: The two causes are cost-push inflation resulting from supply shocks and demand-pull
inflation resulting from positive shocks to aggregate demand.
14. In the short run, what trade-off do policymakers face when dealing with inflation and
unemployment?
A: Policymakers face a trade-off between inflation (π) and unemployment (u) in the short run.
15. How do people's expectations affect the short-run Phillips curve trade-off?
A: People's expectations can shift the short-run Phillips curve. For example, an increase in
expected inflation (πe) shifts the curve upward.
16. What does the sacrifice ratio measure?

A: The sacrifice ratio measures the percentage of a year's real GDP that must be foregone to
reduce inflation by 1 percentage point.
17. If policymakers wish to reduce inflation from 6 to 2 percent and the sacrifice ratio is
5, how much of one year's GDP must be foregone?
A: To reduce inflation by 4 percentage points, 20 percent of one year's GDP must be foregone (4
× 5 = 20%).
18. How does Okun's law relate to the cost of disinflation?
A: Okun's law can be used to translate the cost of disinflation (lost GDP) into unemployment.
Policymakers can contract aggregate demand to reduce inflation, causing unemployment to rise
above the natural rate.
19. What are the two ways of modeling the formation of expectations?
A: The two ways are Adaptive expectations and rational expectations.
20. How do people form their expectations in adaptive expectations?
A: People base their expectations of future inflation on recently observed inflation.
21. How do people form their expectations in rational expectations?
A: People base their expectations on all available information, including information about
current and prospective future policies.

22. What do proponents of rational expectations believe about the sacrifice ratio in
painless disinflation?
A: Proponents believe that the sacrifice ratio may be very small.
23. According to the natural rate hypothesis, when do changes in aggregate demand
affect output and employment?
A: Changes in aggregate demand affect output and employment only in the short run. In the long
run, the economy returns to the levels described by the classical model.
24. What is hysteresis, and how does it influence variables like the natural rate of
unemployment?
A: Hysteresis refers to the long-lasting influence of history on variables like the natural rate of
unemployment. Negative shocks may increase the natural rate of unemployment, leading to a
potential lack of full economic recovery.
Lesson 35
GOVERNMENT DEBT
MCQs:
1. When a government spends more than it collects in taxes, it finances the
budget deficit by:
a) Printing more money
b) Borrowing from the private sector
c) Increasing taxes on citizens
d) Reducing government spending
Answer: b) Borrowing from the private sector
2. Which of the following is an example of permanent debt?
a) Treasury Bills b) Federal investment Bonds
c) Savings Account d) Postal Life insurance
Answer: b) Federal investment Bonds
3. Which type of debt represents an accumulation of all past annual
deficits?
a) Market Loans b) Unfunded Debts
c) Permanent Debt d) Floating Debt
Answer: c) Permanent Debt

4. What is the total domestic debt outstanding as of January 31, 2005?
a) 2,015,078 Million Rupees b) 2,015,078 Billion Rupees
c) 2,015,078 Trillion Rupees d) 2,015,078 Rs.
Answer: a) 2,015,078 Million Rupees
5. What was the percentage of GDP for debt payable in Forex in the year
2004?
a) 35.2% b) 35.3% c) 39.1% d) 48.6%
Answer: d) 48.6%
6. What is the net public debt as of 2003?
a) 3630.8 Rs. b) 3753.8 Rs. c) 3805.9 Rs. d) 3699.3 Rs.
Answer: a) 3630.8 Rs.
7. What is a meaningful deficit measurement according to economists?
a) Modifying the real value of outstanding public debt to reflect current inflation.
b) Including hidden liabilities in the accounting system.
c) Subtraction of government assets from government debt.

8. Why do most economists believe that the reported budget deficit is
overstated?
a) It does not correct for inflation.
b) It does not consider the real interest paid on the debt.
c) It includes government assets.
d) It includes uncounted liabilities.
Answer: a) It does not correct for inflation.
9. What is capital budgeting in the context of measuring government budget
deficits?
a) Accounting for government assets as well as liabilities to get an accurate assessment of the
budget deficit.
b) Measuring the budget deficit based on changes in capital expenditures only.
c) Measuring the budget deficit based on changes in the capital assets owned by the government.
d) Adjusting the budget deficit for changes in the business cycle.
Answer: a) Accounting for government assets as well as liabilities to get an accurate
assessment of the budget deficit.

10.Why can measuring the budget deficit be misleading?
a) It excludes some government liabilities such as pension payments and social security.
b) It does not account for changes in the business cycle.
c) It does not consider capital expenditures.
d) It includes government assets.
Answer: a) It excludes some government liabilities such as pension payments and social
security.
11.What is the problem with using the deficit to monitor changes in fiscal
policy?
a) The deficit can either fall or rise because of changes in government policy or the business
cycle.
b) The deficit is difficult to measure accurately.
c) Fiscal policy is not influenced by the deficit.
d) The deficit is not affected by changes in the business cycle.
Answer: a) The deficit can either fall or rise because of changes in government policy or the
business cycle.
Q&A:
1. What happens when a government spends more than it collects in taxes?
A: The government borrows from the private sector to finance the budget deficit.
2. What does the term "government debt" represent?
A: Government debt is an accumulation of all past annual deficits.
3. Which of the following is an example of permanent debt?
A: Federal Government Bonds
4. What are the three components of domestic debt?
A: Permanent Debt, Floating Debt, and Unfunded Debts.
5. What was the total domestic debt outstanding as of January 31, 2005?
A: 2,015,078 Million Rupees
6. What percentage of GDP was the debt payable in Forex in the year 2004?
A: 35.3%
7. What is the net public debt as of 2003?
A: 3,630.8 Rs.
8. What do unfunded debts refer to?
A: Debts that are not backed by any assets or securities.

9. What is a meaningful deficit measurement?
A: A meaningful deficit measurement modifies the real value of outstanding public debt to
reflect current inflation, subtracts government assets from government debt, includes hidden
liabilities currently escaping detection, and calculates a cyclically-adjusted budget deficit.
10. Why do most economists believe that the reported budget deficit is overstated?
A: Most economists believe the reported budget deficit is overstated because the commonly
measured deficit does not correct for inflation. The nominal debt rises at the rate of inflation,
leading to an overestimation of the deficit.
11. What is capital budgeting in the context of measuring government budget deficits?
A: Capital budgeting is a budget procedure that accounts for government assets as well as
liabilities. It ensures an accurate assessment of the government's budget deficit by subtracting
government assets from government debt.
12. What are uncounted liabilities in the context of measuring the budget deficit?
A: Uncounted liabilities are government liabilities that are excluded from the measurement of the
budget deficit. Examples include pension payments for government workers and the social
security system.
13. Why is it difficult to use the deficit to monitor changes in fiscal policy?
A: It is difficult to use the deficit to monitor changes in fiscal policy because changes occur
automatically in response to the business cycle. The deficit can change due to shifts in
government policy or changes in the economy, making it challenging to distinguish between the
two. Cyclically adjusted budget deficit reflects policy changes but not the current stage of the
business cycle.
Lesson 36
GOVERNMENT DEBT (CONTINUED)
MCQs:
1. According to the traditional view of government debt, how does a tax cut
affect consumer spending and national saving?
A) A tax cut stimulates consumer spending and raises national saving.
B) A tax cut stimulates consumer spending and reduces national saving.
C) A tax cut reduces consumer spending and raises national saving.
D) A tax cut reduces consumer spending and has no impact on national saving.
Answer: B) A tax cut stimulates consumer spending and reduces national saving.
2. What does the Solow growth model show when there is a reduction in
saving?
A) A higher steady-state capital stock and higher output.
B) A lower steady-state capital stock and higher output.
C) A higher steady-state capital stock and lower output.
D) A lower steady-state capital stock and lower output.
Answer: D) A lower steady-state capital stock and lower output.
3. How is the tax multiplier defined?
A) The change in income resulting from a $1 increase in government purchases.
B) The change in income resulting from a $1 increase in taxes.
C) The change in income resulting from a $1 decrease in government purchases.
D) The change in income resulting from a $1 decrease in taxes.
Answer: D) The change in income resulting from a $1 decrease in taxes.
4. What are the properties of the tax multiplier?
A) Negative, greater than one (in absolute value), and smaller than the government spending
multiplier.
B) Positive, greater than one (in absolute value), and greater than the government spending
multiplier.
C) Negative, smaller than one (in absolute value), and greater than the government spending
multiplier.
D) Positive, smaller than one (in absolute value), and smaller than the government spending
multiplier.
Answer: A) Negative, greater than one (in absolute value), and smaller than the
government spending multiplier.
5. According to the Ricardian equivalence, how do rational consumers view
government debt and future taxes?
A) Government debt is equivalent to future taxes, and future taxes are equivalent to current
taxes.
B) Government debt is equivalent to current taxes, and future taxes are equivalent to future
savings.
C) Government debt is equivalent to future savings, and future taxes are equivalent to current
taxes.
D) Government debt is equivalent to future savings, and future taxes are equivalent to future
savings.
Answer: A) Government debt is equivalent to future taxes, and future taxes are equivalent
to current taxes.
6. What does the Solow growth model show regarding the impact of lower
investment?
A) Lower investment leads to a higher steady-state capital stock and higher output.
B) Lower investment leads to a lower steady-state capital stock and lower output.
C) Lower investment has no effect on the steady-state capital stock and output.
D) Lower investment increases the growth rate of the economy.
Answer: B) Lower investment leads to a lower steady-state capital stock and lower output.
7. According to the Ricardian view of government debt, how do forward-
looking consumers perceive tax cuts?
A) Tax cuts result in an increase in current consumption and a decrease in future taxes.
B) Tax cuts have no impact on current consumption as they are offset by future taxes.
C) Tax cuts are equivalent to giving citizens government bonds as a gift.
D) Tax cuts increase current consumption but have no effect on future taxes.
Answer: B) Tax cuts have no impact on current consumption as they are offset by future
taxes.
8. What does the traditional view of government debt assume about
consumers' behavior?
A) Consumers are rational and consider future taxes when making consumption decisions.
B) Consumers are myopic and do not consider future taxes when making consumption decisions.
C) Consumers only base their spending on lifetime income, which includes both current and
future income.
D) Consumers have borrowing constraints that limit their ability to consume beyond their current
income.
Answer: B) Consumers are myopic and do not consider future taxes when making
consumption decisions.
9. How does a debt-financed tax cut impact current consumption, according
to the traditional view of government debt?
A) It increases current consumption without affecting future consumption.
B) It decreases current consumption and increases future consumption.
C) It has no impact on current consumption or future consumption.
D) It increases current consumption at the expense of future consumption.
Answer: A) It increases current consumption without affecting future consumption.

10.What does the traditional view of government debt assume about the
burden of future taxes?
A) Future taxes fall on the current generation, reducing their lifetime resources and consumption.
B) Future taxes fall on future generations, increasing the lifetime resources and consumption of
the current generation.
C) Future taxes are equally distributed among all generations, leading to no change in
consumption.
D) Future taxes are avoided altogether, resulting in no impact on the economy or consumption.
Answer: B) Future taxes fall on future generations, increasing the lifetime resources and
consumption of the current generation.
Q&A:
1. How does a tax cut and budget deficit impact the economy according to the
traditional view of government debt?
A: A tax cut stimulates consumer spending and reduces national saving, which leads to a budget
deficit. The reduction in saving raises the interest rate and crowds out investment, resulting in a
lower steady-state capital stock and lower output according to the Solow growth model.
2. What is the Solow growth model used to study in the context of government debt?
A: The Solow growth model is used to analyze the impact of reduced investment due to a lower
saving rate caused by a tax cut and budget deficit. It shows that this can lead to a lower steady-
state capital stock and lower economic well-being.
3. According to the Ricardian view of government debt, how do forward-looking
consumers perceive a tax cut?
A: Forward-looking consumers perceive a tax cut as a temporary increase in wealth due to the
reduction in taxes, but they expect higher future taxes to offset the debt-financed spending. Thus,
they do not significantly change their consumption behavior.
4. What is the General Principal of Ricardian equivalence regarding government debt
financing?
A: The General Principal of Ricardian equivalence states that government debt is equivalent to
future taxes. If consumers are forward-looking, they recognize that debt-financed spending today
will lead to higher taxes in the future.
5. How does the traditional view of government debt challenge the Ricardian view?
A: The traditional view suggests that consumers may be myopic and focus more on current
consumption than considering the impact of future taxes implied by government debt. It argues
that debt-financed tax cuts can stimulate current consumption even though they lead to future tax
liabilities.
6. How does a tax cut and budget deficit impact the economy and economic well-being
according to the traditional view of government debt?

A: A tax cut stimulates consumer spending but reduces national saving, leading to a higher
interest rate that crowds out investment. The Solow growth model shows lower investment,
resulting in a lower steady-state capital stock and lower output.
7. In the Solow growth model, what is the equation for change in capital stock and how
does it affect economic well-being?
A: The change in capital stock (Δk) is equal to the difference between investment (i) and
depreciation (δk), which is represented as Δk = s f(k) – δk. A lower steady-state capital stock
means lower consumption and lower economic well-being.
8. How does the IS-LM model analyze the short-run impact of a tax cut?
A: In the IS-LM model, a tax cut leads to an increase in consumer spending (C) and aggregate
expenditure (E), resulting in a shift of the IS curve to the right. The horizontal distance of the IS
shift represents the increase in output (ΔY) caused by the tax cut, given by MPC/(1 – MPC) ΔT.
9. According to the Ricardian view of government debt, how do forward-looking
consumers perceive a tax cut?
A: Forward-looking consumers consider that a tax cut now means higher taxes in the future, so
they do not significantly increase current consumption. The view is that "tax cuts are simply tax
postponements."
10. How does the Ricardian view differ from the traditional view regarding consumers
and future taxes?

A: The Ricardian view assumes consumers are rational and forward-looking, considering future
taxes implied by government debt. In contrast, the traditional view suggests that consumers may
be myopic, focusing more on current consumption and being less influenced by future taxes.
11. What do advocates of the traditional view argue regarding borrowing constraints and
current consumption?
A: Advocates argue that consumers facing borrowing constraints prioritize current consumption
over lifetime income, and thus, a debt-financed tax cut can increase current consumption even
though future income may be lower.
12. According to the traditional view, who bears the burden of implied future taxes
resulting from government debt?
A: The traditional view suggests that future generations bear the burden of implied future taxes,
as they are expected to pay for the government debt, leading to lower economic well-being for
the next generation.
Lesson 37
CONSUMPTION THEORIES
MCQs:
13.According to Keynes' conjectures, what is the range of the marginal
propensity to consume (MPC)?
a) Between -1 and 0 b) Between 0 and 1
c) Between 1 and 2 d) Greater than 2
Answer: b) Between 0 and 1
14.What does the average propensity to consume (APC) represent?
a) The sensitivity of consumption to changes in income
b) The ratio of consumption to income
c) The amount saved out of an additional dollar of income
d) The interest rate on savings
Answer: b) The ratio of consumption to income
15.Which economist developed the model for analyzing intertemporal
choices of rational, forward-looking consumers?
a) John Maynard Keynes b) Simon Kuznets
c) Irving Fisher d) Paul Samuelson
Answer: c) Irving Fisher

16.What is the intertemporal budget constraint used to analyze in consumer
decision-making?
a) The total resources available for consumption today and in the future
b) The relationship between consumption and income in the short run
c) The impact of inflation on consumption
d) The influence of interest rates on consumer savings
Answer: a) The total resources available for consumption today and in the future
17.In the short-run consumption function, what relationship is observed
between consumption and income?
a) Falling average propensity to consume (APC) as income rises
b) Rising average propensity to consume (APC) as income rises
c) Constant average propensity to consume (APC) regardless of income changes
d) Constant marginal propensity to consume (MPC) regardless of income changes
Answer: a) Falling average propensity to consume (APC) as income rises
18.According to Keynes' three conjectures, what range does the marginal
propensity to consume (MPC) fall into?

a) Between 0 and 0.5 b) Between 0.5 and 1
c) Between 0 and 1 d) Exactly 1
Answer: c) Between 0 and 1
19.What does the average propensity to consume (APC) represent in the
consumption function?
a) The amount consumed out of an additional dollar of income
b) The sensitivity of the change in consumption with respect to a change in income
c) The ratio of consumption to income
d) The total amount saved from income
Answer: c) The ratio of consumption to income
20.According to Keynes, what is the primary determinant of consumption in
the consumption function?
a) Interest rate b) Fiscal policy
c) Income d) Savings
Answer: c) Income
21.What did studies using long time-series data on consumption and income
indicate regarding the average propensity to consume (APC)?
a) APC is fairly constant over time
b) APC varies systematically with income
c) APC is always zero
d) APC is exactly one
Answer: a) APC is fairly constant over time
22.In the consumer's budget constraint, what does the factor 1/(1+r)
represent?
a) The real interest rate
b) The total resources available for consumption today and in the future
c) The price of second-period consumption measured in terms of first-period consumption
d) The sensitivity of the change in consumption with respect to a change in income
Answer: c) The price of second-period consumption measured in terms of first-period
consumption
Q&A:
1. What were the three conjectures proposed by John Maynard Keynes regarding the
A: The three conjectures proposed by John Maynard Keynes are:
 The marginal propensity to consume (MPC) is between zero and one. People will
consume part of every additional dollar of earned income and save the rest.
 The average propensity to consume (APC) falls as income rises. As income increases,
the proportion of income spent on consumption decreases.
 Income is the primary determinant of consumption, and the interest rate does not play a
significant role.
2. What are the three properties of the consumption function that Keynes
conjectured?
A: The three properties of the consumption function that Keynes conjectured are:
1. The marginal propensity to consume (MPC) is between zero and one, indicating that
consumption increases with income but at a diminishing rate.
2. The average propensity to consume (APC) falls as income rises, showing that as income
increases, the proportion of income spent on consumption decreases.
3. Consumption is determined by current income, meaning that people's consumption
decisions are influenced by their current earnings.
4. How is the marginal propensity to consume (MPC) measured, and what does it
signify?
A: The marginal propensity to consume (MPC) is measured as the sensitivity of changes in
consumption (C) with respect to changes in income (Y). For example, if an individual's MPC is
0.99, it means that for every extra rupee of income earned after tax deductions, the person will
spend 99 paisas of it on consumption. The MPC signifies how much additional income
contributes to increased consumption.
1. What was the "consumption puzzle" that emerged from the analysis of Keynes'
conjectures?
A: The "consumption puzzle" refers to the discrepancy between Keynes' conjectures about the
average propensity to consume (APC) and the findings of long-time series studies. While studies
of household data and short-time series supported Keynes' claim that APC falls as income rises
(short-run consumption function), long-time series studies found that APC did not vary
systematically with income (long-run consumption function). This inconsistency presented a
puzzle as to why Keynes' conjectures held true in some cases but not in others.
2. What did Simon Kuznets' research on consumption and investment data reveal, and
how did it challenge Keynes' conjectures?
A: Simon Kuznets' research on consumption and investment data dating back to 1869 showed
that the ratio of consumption to income remained stable over time, despite significant increases
in income. This finding challenged Keynes' conjecture that the average propensity to consume
(APC) falls as income rises. Instead, Kuznets' work suggested that APC was fairly constant over
time, bringing into question the validity of Keynes' original claim.

3. What were the three conjectures proposed by John Maynard Keynes regarding the
A: The three conjectures proposed by Keynes regarding the consumption function are:
 The marginal propensity to consume is between zero and one.
 The average propensity to consume falls as income rises.
 Income is the primary determinant of consumption, and the interest rate does not have
an important role.
4. What does the marginal propensity to consume (MPC) represent?
A: The marginal propensity to consume (MPC) represents the sensitivity of changes in
consumption with respect to changes in income. It measures the amount consumed out of an
additional dollar of income.
5. What is the consumption puzzle that emerged in the analysis of Keynes'
conjectures?
A: The consumption puzzle refers to the discrepancy between the short-run consumption
function, where the average propensity to consume falls as income rises, and the long-run
consumption function, where the average propensity to consume remains fairly constant over
time.
6. What is the intertemporal budget constraint used to analyze in consumer decision-
making?
A: The intertemporal budget constraint is used to analyze the total resources available for
consumption today and in the future. It considers the choices consumers make about how much
to consume today versus how much to consume in the future, taking into account factors like
income, savings, and the real interest rate.
7. How does the factor of 1/(1+r) in the intertemporal budget constraint affect future
consumption and income?
A: The factor of 1/(1+r) in the intertemporal budget constraint represents the discounting of
future consumption and income. It reflects the idea that future income and consumption are
worth less than current income and consumption due to the interest earned on savings. This
means that consumers are willing to forgo a certain amount of current consumption to obtain 1
unit of second-period consumption in the future.
Lesson 38
CONSUMPTION THEORIES (CONTINUED)
MCQs:
1. An indifference curve shows:
a) The combination of first-period and second-period income that makes the consumer equally
happy.
b) The combination of first-period and second-period consumption that makes the consumer
equally happy.
c) The sensitivity of the change in consumption with respect to a change in income.
d) The rate at which the consumer is willing to substitute second-period income for first-period
income.
Answer: b) The combination of first-period and second-period consumption that makes the
consumer equally happy.
2. What is the optimal level of satisfaction achieved by a consumer in
their consumption choice?
a) The point on the budget constraint that is on the highest indifference curve.
b) The point on the budget constraint that is on the lowest indifference curve.
c) The point on the budget constraint where consumption in both periods is at its highest level.
d) The point where the indifference curve is parallel to the budget constraint.
Answer: a) The point on the budget constraint that is on the highest indifference curve.
3. What are the two effects of an increase in the real interest rate on
consumption?
a) The substitution effect and the income effect.

b) The investment effect and the savings effect.
c) The borrowing constraint and the liquidity constraint.
d) The aggregate demand effect and the aggregate supply effect.
Answer: a) The substitution effect and the income effect.
4. Why does Japan have a high savings rate?
a) Because the Japanese tax system encourages saving by taxing capital income heavily.
b) Because the Japanese are more risk-averse and patient.
c) Because it is harder for households to borrow in Japan, and down payment rates are high for
borrowing.
5. What does the borrowing constraint for some consumers mean?
a) Consumption in both periods depends on the present value of lifetime income.
b) Consumption in both periods is determined by current income only.
c) Consumption in the first period cannot exceed first-period income.
d) Consumption in the second period cannot exceed second-period income.

Answer: c) Consumption in the first period cannot exceed first-period income.
6. What does an indifference curve represent in consumer preferences?
a) The combination of first-period and second-period consumption that makes the consumer
equally happy.
b) The ratio of consumption to income.
c) The sensitivity of the change in consumption with respect to a change in income.
d) The rate of interest on savings.
Answer: a) The combination of first-period and second-period consumption that makes the
consumer equally happy.
7. What is the marginal rate of substitution (MRS) between first-period
consumption and second-period consumption?
a) The change in consumption resulting from a movement to a higher indifference curve.
b) The rate at which the consumer is willing to substitute second-period consumption for first-
period consumption.
c) The change in consumption resulting from an increase in the real interest rate.
d) The sensitivity of the change in consumption with respect to a change in income.

Answer: b) The rate at which the consumer is willing to substitute second-period
consumption for first-period consumption.
8. What does the income effect refer to in the context of changes in the
real interest rate?
a) The change in consumption that results from the change in the relative price of consumption in
the two periods.
b) The inability to borrow beyond current income.
c) The change in consumption that results from the movement to a higher indifference curve.
d) The change in consumption that results from an increase in the interest rate.
Answer: c) The change in consumption that results from the movement to a higher
indifference curve.
9. What is a borrowing constraint?
a) The inability to borrow prevents current consumption from exceeding current income.
b) The rate at which the consumer is willing to borrow.
c) The constraint on a consumer's total budget.
d) The change in consumption that results from the change in income.

Answer: a) The inability to borrow prevents current consumption from exceeding current
income.
10.Why is Japan known for its high savings rate?
a) The Japanese tax system encourages saving by taxing capital income heavily.
b) Japanese households have easy access to credit and prefer to borrow.
c) Japan has a low-risk environment, encouraging people to invest in risky assets.
d) The Japanese government discourages savings by imposing high taxes on interest income.
Answer: a) The Japanese tax system encourages saving by taxing capital income lightly.
11.What does an indifference curve represent in consumer preferences?
a) The combination of goods that a consumer can afford with his current income.
b) The level of satisfaction a consumer derives from different combinations of goods.
c) The change in consumption resulting from an increase in real interest rates.
d) The ratio of consumption to income in the short run.
Answer: b) The level of satisfaction a consumer derives from different combinations of
goods.
12.What does the slope of an indifference curve indicate?

a) The level of satisfaction a consumer derives from consuming a specific quantity of a good.
b) The rate at which the consumer is willing to substitute one good for another.
c) The change in consumption that results from a movement to a higher indifference curve.
d) The change in consumption due to changes in real income.
Answer: b) The rate at which the consumer is willing to substitute one good for another.
13.How does an increase in income affect consumption in both periods if
both first-period and second-period consumption are normal goods?
a) Consumption in both periods increases.
b) Consumption in both periods decreases.
c) Consumption in the first period increases, while consumption in the second period decreases.
d) Consumption in the first period decreases, while consumption in the second period increases.
Answer: a) Consumption in both periods increases.
Q4: What are the two effects of an increase in the real interest rate on consumption, according to
economists?
a) The income effect and the substitution effect.
b) The budget constraint effect and the consumption effect.

c) The interest rate effect and the savings effect.
d) The inflation effect and the exchange rate effect.
Answer: a) The income effect and the substitution effect.
14.What does the borrowing constraint imply in the context of
consumption theory?
a) It restricts the consumer from borrowing more than a certain amount.
b) It ensures that consumption in period one does not exceed income in period one.
c) It encourages consumers to borrow and spend beyond their means.
d) It allows consumers to borrow freely and spend as much as they want.
Answer: b) It ensures that consumption in period one does not exceed income in period
one.
Q&A:
1. How are consumer preferences represented in consumption theories?
A: Consumer preferences are represented by indifference curves, which show the combinations
of first-period and second-period consumption that make the consumer equally happy.
2. What does the slope of an indifference curve represent?

A: The slope of an indifference curve represents the marginal rate of substitution between first-
period and second-period consumption. It indicates the rate at which the consumer is willing to
substitute one period's consumption for the other.
3. How does a consumer achieve their optimal level of satisfaction in consumption?
A: The consumer achieves their optimal level of satisfaction by choosing the point on the budget
constraint that is on the highest indifference curve. At the optimum, the indifference curve is
tangent to the budget constraint.
4. How do changes in income affect consumption in both periods for normal goods?
A: An increase in either first- or second-period income shifts the budget constraint outward. If
consumption in both periods is composed of normal goods (demand increases as income rises),
then this increase in income raises consumption in both periods.
5. What are the two effects of an increase in the real interest rate on consumption?
A: The two effects of an increase in the real interest rate on consumption are the income effect
and the substitution effect. The income effect results from the movement to a higher indifference
curve, and the substitution effect results from the change in the relative price of consumption in
the two periods.
6. How does the Japanese savings rate impact their economy according to the Solow
growth model?
A: The Japanese high savings rate is believed to be a key factor contributing to the rapid growth
experienced after World War II, as the Solow growth model suggests that an increase in the
savings rate raises investment and leads to capital stock growth towards a new steady state.
7. Why do some economists argue that the high Japanese savings rate may have
contributed to Japan's economic slump in the 1990s?
A: Some economists argue that high savings lead to lower consumption, which, according to the
IS-LM model, translates into low aggregate demand and reduced income. This lower
consumption could have negatively impacted the Japanese economy.
8. What are some reasons why Japanese consumers tend to save more and consume
less?
A: Japanese consumers tend to save more and consume less due to factors such as difficulties in
borrowing, high down payment rates for purchasing houses, a tax system that encourages saving
by taxing capital income lightly, and cultural factors like being more risk-averse and patient.
9. What do indifference curves represent in consumer preferences?
A: Indifference curves represent the combination of first-period and second-period consumption
that makes the consumer equally happy.
10. What does the slope of an indifference curve indicate?

A: The slope at any point on the indifference curve indicates the rate at which the consumer is
willing to substitute second-period consumption for first-period consumption. It is known as the
marginal rate of substitution.
11. How does an increase in income affect consumption in both periods, assuming both
goods are normal goods?
A: An increase in income raises consumption in both periods, as normal goods are demanded
more as income rises.
12. How does an increase in the real interest rate affect consumption, and what are the
two effects involved?
A: An increase in the real interest rate affects consumption through two effects: the income
effect and the substitution effect. The income effect is the change in consumption resulting from
the movement to a higher indifference curve, and the substitution effect is the change in
consumption due to the change in the relative price of consumption in the two periods.
13. What is the relationship between savings and the real interest rate, according to
economists?
A: Data shows no apparent relationship between savings and the real interest rate. Economists
claim that income and substitution effects of higher interest rates approximately cancel each
other out.
14. What is the borrowing constraint, and how does it impact the consumer's
consumption?
A: The borrowing constraint prevents current consumption from exceeding current income and is
expressed as C1 ≤ Y1, where C1 is consumption in period one and Y1 is income in period one.
For some consumers, the borrowing constraint is not binding, and their consumption depends on
the present value of lifetime income. However, for other consumers, the borrowing constraint
binds, and their consumption is limited to their current income.
15. Why is Japan known for having a high savings rate, and what are some factors
contributing to this phenomenon?
A: Japan has one of the world's highest savings rates. The reasons for this include:
 Difficulty in borrowing for households, making it harder to exceed current income in
consumption.
 High down payment rates (up to 40%) for borrowing to purchase a house, limiting
consumption.
 Japanese Tax system encouraging saving by taxing capital income lightly.
 Japanese culture being more risk-averse and patient, leading to higher savings habits.
16. What do indifference curves represent in consumer preferences?
A: Indifference curves represent the combinations of first-period and second-period consumption
that make the consumer equally happy.
17. What does the slope of an indifference curve indicate?

A: The slope of an indifference curve represents the marginal rate of substitution between first-
period consumption and second-period consumption. It tells us the rate at which the consumer is
willing to substitute second-period consumption for first-period consumption.
18. How does an increase in income affect consumption if both first-period and second-
period goods are normal goods?
A: An increase in income raises consumption in both periods, assuming both first-period and
second-period goods are normal goods.
Q4: How does an increase in the real interest rate affect consumption? A4: An increase in the
real interest rate affects consumption through two effects: the income effect and the substitution
effect. The income effect results from the movement to a higher indifference curve, and the
substitution effect results from the change in the relative price of consumption in the two periods.
19. What does the analysis of borrowing lead economists to conclude about
consumption functions?
A: The analysis of borrowing leads economists to conclude that there are two consumption
functions. For some consumers, the borrowing constraint is not binding, and consumption in both
periods depends on the present value of lifetime income. For other consumers, the borrowing
constraint binds, and consumption depends only on current income. If the consumer cannot
borrow, he faces the additional constraint that first-period consumption cannot exceed first-
period income.
20. Why does Japan have a high savings rate according to economists?
A: Japan's high savings rate is attributed to several factors. Firstly, it is harder for households to
borrow in Japan, leading to more cautious spending and higher savings. Secondly, down
payment rates for major purchases like houses are very high, leading to more savings to meet
these requirements. Thirdly, the Japanese tax system encourages saving by taxing capital income
lightly. Lastly, Japanese consumers are often considered more risk-averse and patient, leading to
higher savings behavior.
Lesson 39
CONSUMPTION THEORIES (CONTINUED)
MCQs:
1. According to Keynes, what is the relationship between the marginal
propensity to consume (MPC) and income?
a) MPC is always zero
b) MPC is always one
c) MPC is between zero and one
d) MPC is greater than one
Answer: c) MPC is between zero and one

2. What did Simon Kuznets' research findings suggest about the average propensity to
consume (APC) over time?
a) APC varies systematically with income over time
b) APC remains constant over time
c) APC increases as income rises
d) APC decreases as income rises
Answer: b) APC remains constant over time
3. According to the life-cycle consumption function, how does a consumer
achieve a smooth consumption pattern over their lifetime?
a) By saving a fixed percentage of their income each period
b) By borrowing in periods of low income and saving in periods of high income
c) By spending all their income in periods of high income and borrowing in periods of low
income
d) By investing all their wealth in high-return assets
Answer: b) By borrowing in periods of low income and saving in periods of high income
4. What is the essence of Milton Friedman's permanent-income
hypothesis?
a) Current consumption is proportional to permanent income
b) Current consumption is inversely proportional to permanent income
c) Current consumption depends solely on transitory income
d) Current consumption depends solely on wealth
Answer: a) Current consumption is proportional to permanent income
5. According to Robert Hall's research, how does consumption change
over time if the permanent-income hypothesis and rational expectations
hold true?
a) Consumption follows a predictable pattern over time
b) Consumption follows a random walk pattern over time
c) Consumption remains constant over time
d) Consumption is inversely related to income
Answer: b) Consumption follows a random walk pattern over time
6. In the context of the life-cycle consumption function, what does APC
stand for?
a) Average Propensity to Consume

b) Average Productivity of Consumption
c) Aggregate Price of Consumption
d) Annual Personal Consumption
Answer: a) Average Propensity to Consume
7. How does an increase in the real interest rate affect consumption
according to economists?
a) It always leads to higher consumption
b) It always leads to lower consumption
c) Its impact on consumption depends on consumer preferences
d) It has no effect on consumption
Answer: c) Its impact on consumption depends on consumer preferences
8. What is the primary determinant of consumption in Keynes' theory of
the consumption function?
a) Interest rate b) Wealth
c) Current income d) Future income
Answer: c) Current income

9. Which consumption theory suggests that changes in consumption over
time should be unpredictable?
a) Life-cycle hypothesis b) Permanent-income hypothesis
c) Random-walk hypothesis d) Rational expectations hypothesis
Answer: c) Random-walk hypothesis
10.What economic concept implies that consumption should not depend
solely on current income but also on permanent income?
a) Intertemporal choice b) Budget constraint
c) Marginal propensity to consume d) Permanent-income hypothesis
Answer: d) Permanent-income hypothesis
11.According to Keynes, what are the three properties of the consumption
function?
a) The marginal propensity to consume is between zero and one.
b) The average propensity to consume rises as income rises.
c) Consumption is determined by future income.
d) The marginal propensity to save is between zero and one.

Answer: a) The marginal propensity to consume is between zero and one.
12.What did the findings of Simon Kuznets and the failure of the secular-
stagnation hypothesis indicate?
a) Consumption is determined by current income only.
b) The average propensity to consume is fairly constant over time.
c) The interest rate is the primary determinant of consumption.
d) The consumption puzzle remains unsolved.
Answer: b) The average propensity to consume is fairly constant over time.
13.What does the Life-cycle consumption function represent?
a) The relationship between consumption and wealth.
b) How consumption changes with changes in the real interest rate.
c) The relationship between consumption and current income only.
d) How consumption is determined by both wealth and income over a person's lifetime.
Answer: d) How consumption is determined by both wealth and income over a person's
lifetime.
14.According to the Life-cycle consumption function, how does
consumption change with changes in wealth and income?
a) Consumption is only influenced by changes in income.
b) Consumption is only influenced by changes in wealth.
c) Consumption is determined by both changes in wealth and income.
d) Consumption remains constant regardless of changes in wealth and income.
Answer: c) Consumption is determined by both changes in wealth and income.
15.What does Milton Friedman's permanent-income hypothesis propose?
a) Current consumption is proportional to transitory income.
b) Current consumption is proportional to permanent income.
c) Consumption is determined by changes in wealth and income.
d) Consumption follows a random walk.
Answer: b) Current consumption is proportional to permanent income.

16.According to Robert Hall, what does the combination of the permanent-
income hypothesis and rational expectations imply?
a) Consumption follows a random walk.
b) Consumption is determined solely by changes in income.
c) Consumption is unaffected by changes in wealth.
d) Consumption is determined by future income.
Answer: a) Consumption follows a random walk.
Q&A:
1. What are the three properties of the consumption function according to John
Maynard Keynes?
A: The three properties of the consumption function according to John Maynard Keynes are:
 The marginal propensity to consume (MPC) is between zero and one.
 The average propensity to consume (APC) falls as income rises.
 Consumption is determined by current income.
2. What did Simon Kuznets' findings suggest about the average propensity to consume
(APC) over time?

A: Simon Kuznets' findings indicated that the average propensity to consume (APC) is fairly
constant over time, which presented a puzzle as Keynes' conjectures held up well in short time-
series studies but failed in long time series.
3. What does Irving Fisher's model of intertemporal choice analyze?
A: Irving Fisher's model of intertemporal choice analyzes how rational, forward-looking
consumers make choices involving different periods of time, considering the constraints they
face and their preferences regarding consumption and saving.
4. How is the intertemporal budget constraint defined?
A: The intertemporal budget constraint measures the total resources available for consumption
today and in the future when consumers are deciding how much to consume today versus how
much to consume in the future.
5. What is the basis of Franco Modigliani's life-cycle hypothesis?
A: Franco Modigliani's life-cycle hypothesis is based on the idea that consumption depends on a
person's lifetime income, which varies systematically over their life. Saving allows consumers to
adjust income from high-income periods to low-income periods.
6. How is the consumption function defined in the life-cycle consumption function?
A: In the life-cycle consumption function, the consumption (C) is defined as the sum of two
components: a fraction of wealth (W) and a fraction of lifetime earnings (R x Y). It is expressed
as C = (1 / T) W + (R / T) Y, where T represents the number of years the consumer expects to
live.
7. What does the upward shift in the average propensity to consume (APC) over
longer periods of time prevent?
A: The upward shift in the average propensity to consume (APC) over longer periods of time
prevents the APC from falling as income increases, solving Keynes's puzzle regarding the
consumption puzzle.
8. According to Milton Friedman's permanent-income hypothesis, what is the primary
determinant of current consumption?
A: According to Milton Friedman's permanent-income hypothesis, the primary determinant of
current consumption is permanent income (YP).
9. What does Robert Hall's research suggest about consumption changes over time if
the permanent-income hypothesis and rational expectations hold true?
A: Robert Hall's research suggests that if the permanent-income hypothesis and rational
expectations hold true, changes in consumption over time should be unpredictable, and
consumption would follow a random walk pattern.
10. What is the essence of the random-walk hypothesis in the context of consumption
theories?
A: The random-walk hypothesis, based on Robert Hall's research, implies that if the permanent-
income hypothesis and rational expectations are correct, changes in consumption over time
should be unpredictable, resembling a random walk pattern.
11. What are the three properties of the consumption function that Keynes
conjectured?
A: The three properties are:
 The marginal propensity to consume (c) is between zero and one.
 The average propensity to consume falls as income rises.
 Consumption is determined by current income.
12. Why did Keynes' conjectures hold well in short time-series studies but fail in long
time-series studies?
A: The long-run consumption function showed that the average propensity to consume (APC)
did not vary systematically with income. This led to the "consumption puzzle." In short time-
series studies, the relationship between consumption and income appeared to follow Keynes'
conjectures, while long time-series studies revealed a constant APC.
13. What is the basis of Franco Modigliani's life-cycle hypothesis?
A: Modigliani's life-cycle hypothesis is based on the idea that income varies systematically over
people's lives, and saving allows consumers to move income from periods of high income to
periods of low income, thus achieving a smooth consumption pattern over their lifetime.
14. What is the formula for the life-cycle consumption function for an individual's
consumption over T years?
A: The formula is: C = (1 / T) W + (R / T) Y Where: C = Consumption W = Wealth Y = Income
per year T = Number of remaining years of life R = Number of years until retirement
15. What is the main premise of Milton Friedman's permanent-income hypothesis?
A: Friedman's permanent-income hypothesis states that current consumption is primarily
determined by permanent income rather than temporary changes in income. It suggests that
consumers use savings and borrowings to smooth consumption in response to temporary changes
in income.
16. According to Robert Hall, what does rational expectations combined with the
permanent-income hypothesis imply about changes in consumption over time?
A: Robert Hall's work suggests that changes in consumption over time should be unpredictable,
following a random walk pattern, given rational expectations and the permanent-income
hypothesis.
17. Why do research findings show that the elderly do not dissave as much as the life-
cycle model predicts?
A: There are several reasons for this behavior among the elderly:
 They may be concerned about unpredictable expenses and engage in
precautionary saving.
 They may want to leave bequests to their children.
 Availability of annuity schemes of insurance companies and public health
insurance plans may also play a role in reducing the need for rapid dissaving.
Lesson 40
INVESTMENT THEORIES
MCQs:
1. Investment is the most volatile component of GDP because:
a) It is directly related to government spending.
b) It is affected by changes in exports and imports.
c) It experiences significant fluctuations during economic cycles.
d) It is influenced by changes in consumer spending.
Answer: c) It experiences significant fluctuations during economic cycles.
2. Which type of investment spending represents the largest piece of total
investment?
a) Residential investment b) Government investment
c) Business fixed investment d) Inventory investment
Answer: c) Business fixed investment
3. The standard model of business fixed investment is known as:
a) The neoclassical model of investment
b) The Keynesian model of investment
c) The classical model of investment
d) The monetarist model of investment
Answer: a) The neoclassical model of investment
4. What determines the real rental price of capital in the neoclassical
model of investment?
a) The real interest rate
b) The stock of capital in the economy
c) The level of technology
d) All of the above

5. The Cobb-Douglas production function is commonly used to
approximate the relationship between:
a) Labor and wages b) Capital and interest rates
c) Output, capital, and labor d) Government spending and GDP
Answer: c) Output, capital, and labor
6. According to the neoclassical model of investment, events that reduce
the capital stock, raise employment, or improve technology will:
a) Increase the real rental price of capital
b) Decrease the real rental price of capital
c) Have no effect on the real rental price of capital
d) Shift the demand curve for capital to the right
Answer: a) Increase the real rental price of capital
7. What does the total cost of capital for rental firms include?
a) Interest on loans and taxes
b) Maintenance costs and depreciation
c) Interest on loans, capital gains, and depreciation

d) The cost of production and labor wages
Answer: c) Interest on loans, capital gains, and depreciation
8. What causes investment to rise during economic booms and fall during
recessions?
a) Changes in government policies
b) Fluctuations in consumer spending
c) Shifts in the interest rate
d) Business cycles and economic conditions
Answer: d) Business cycles and economic conditions
9. In the neoclassical model of investment, which variable determines the
downward sloping demand curve for capital?
a) Real interest rate b) Marginal product of capital
c) Tax rates d) Inflation rate
Answer: b) Marginal product of capital
10.Which type of investment spending is primarily concerned with goods
that will stay put for a while and not for inventory?
a) Business fixed investment
b) Residential investment
c) Inventory investment
d) Government investment
Answer: a) Business fixed investment
11.Investment is the most volatile component of GDP because:
a) It is determined solely by the interest rate
b) It is not affected by changes in GDP
c) It fluctuates more than other components of GDP
d) It is always constant regardless of economic conditions
Answer: c) It fluctuates more than other components of GDP
12.The neoclassical model of business fixed investment examines the
benefits and costs of owning capital goods. Which of the following
variables do not shift investment in this model?
a) The marginal product of capital
b) The interest rate

c) Tax rules
d) The level of technology
Answer: d) The level of technology
13.What determines the downward-sloping demand curve for capital in the
neoclassical model of business fixed investment?
a) The interest rate
b) The level of technology
c) The marginal product of capital
d) The rental price of capital
Answer: c) The marginal product of capital
14.According to the Cobb-Douglas production function, what determines
the real rental price of capital in the economy?
a) The stock of capital
b) The level of technology
c) The amount of labor employed
d) All of the above

15.What is the cost of owning capital for rental firms in the neoclassical
a) Interest on loans b) Depreciation
c) Capital gain/loss d) All of the above
16.In the context of investment theories, what does the neoclassical model
of investment focus on primarily?
17.The largest piece of investment spending is:
a) Residential investment
b) Inventory investment
c) Government investment
d) Business fixed investment
Answer: d) Business fixed investment
18.Which of the following is NOT a variable that shifts investment in the
neoclassical model of business fixed investment?
a) The marginal product of capital
b) The interest rate
c) Tax rules
d) The level of technology
Answer: d) The level of technology
19.In the neoclassical model of investment, the rental price of capital
adjusts to equilibrate the demand for capital and the:
a) Marginal product of capital
b) Cost of capital
c) Interest rate
d) Supply of capital
Answer: d) Supply of capital
20.Which component of investment spending constitutes about 3/4 of the
total investment?
b) Inventory investment
c) Government investment
d) Business fixed investment
Answer: d) Business fixed investment
21.Investment is considered the most volatile component of GDP because:
a) It is directly related to government spending.
b) It experiences significant fluctuations during economic cycles.
c) It is influenced by changes in consumer spending.
d) It remains constant regardless of economic conditions.
Answer: b) It experiences significant fluctuations during economic cycles.
22.Which type of investment spending represents the largest piece of total
investment?
b) Government investment
c) Business fixed investment
d) Inventory investment
Answer: c) Business fixed investment
23.What is the name of the standard model used to examine the benefits
and costs of owning capital goods?
a) The Keynesian model of investment
b) The neoclassical model of investment
c) The classical model of investment
d) The monetarist model of investment
Answer: b) The neoclassical model of investment
24.The Cobb-Douglas production function is commonly used to
approximate the relationship between:
a) Labor and wages
b) Capital and interest rates

c) Output, capital, and labor
d) Government spending and GDP
Answer: c) Output, capital, and labor
25.In the neoclassical model of investment, what determines the downward
sloping demand curve for capital for a firm?
a) Real interest rate
b) Marginal product of capital
c) Tax rules
d) Government policies
Answer: b) Marginal product of capital
26.What variable determines the real rental price of capital in the Cobb-
Douglas production function?
a) Stock of capital in the economy
b) Real interest rate
c) Amount of labor employed
d) Level of technology
Answer: d) Level of technology
27.The total cost of capital for rental firms includes:
a) Interest on loans, taxes, and government fees
b) Maintenance costs and depreciation
c) Interest on loans, capital gains, and depreciation
d) Labor wages and production costs
Answer: c) Interest on loans, capital gains, and depreciation
28.Why does investment rise during economic booms and fall during
recessions?
a) Changes in government policies
b) Fluctuations in consumer spending
c) Shifts in the interest rate
d) Business cycles and economic conditions
Answer: d) Business cycles and economic conditions
29.Which type of investment spending involves capital goods that will stay
put for a while and not for inventory?

30.What are the three variables that shift investment in the neoclassical
a) Government spending, inflation rate, and tax rates
b) The marginal product of capital, the interest rate, and tax rules
c) Real GDP, consumer spending, and exports
d) Exchange rates, trade policies, and interest rates
Answer: b) The marginal product of capital, the interest rate, and tax rules
Q&A:
1. Why investment is considered the most volatile component of GDP?

A: Investment is the most volatile component of GDP because it experiences significant
fluctuations during economic cycles.
2. When expenditure on goods and services falls during a recession, what is usually the
major reason for the decline?
A: During a recession, much of the decline in expenditure on goods and services is usually due to
a drop in investment spending.
3. What are the three types of investment spending that economists study to
understand fluctuations in the economy?
A: The three types of investment spending that economists study are business fixed investment,
residential investment, and inventory investment.
4. What are the three variables that shift investment in the neoclassical model of
investment?
A: The three variables that shift investment in the neoclassical model of investment are the
marginal product of capital, the interest rate, and tax rules.
5. What is the Cobb-Douglas production function used to approximate in the
economy?
A: The Cobb-Douglas production function is used to approximate the relationship between
output, capital, and labor in the economy.

6. What determines the real rental price of capital in the neoclassical model of
investment?
A: The real rental price of capital in the neoclassical model of investment is determined by
factors such as the stock of capital, the amount of labor employed, and the level of technology.
7. Why does investment rise during economic booms and fall during recessions?
A: Investment rises during economic booms because of increased business confidence and
optimism, while it falls during recessions due to uncertainty and reduced demand.
8. What are the two kinds of firms considered in the model of investment spending?
A: The two kinds of firms considered are production firms that produce goods and services using
capital they rent, and rental firms that make all the investments in the economy.
9. What are the costs that a rental firm bears for each period of time a unit of capital is
rented out?
A: The costs that a rental firm bears include interest on loans, capital gains or losses, and
depreciation.
10. How is the cost of capital calculated for a rental firm?
A: The cost of capital for a rental firm is calculated as the sum of interest on loans, capital gains
or losses, and depreciation for each unit of capital rented out.
11. Why investment is considered the most volatile component of GDP?

A: Investment is the most volatile component of GDP because it experiences significant
fluctuations during economic cycles, leading to variations in overall economic output.
12. During a recession, which component of expenditure on goods and services usually
experiences a significant decline?
A: Investment spending usually experiences a significant decline during a recession, contributing
to the overall decrease in expenditure on goods and services.
13. What are the three variables that can shift investment in the neoclassical model of
investment?
A: The three variables that can shift investment in the neoclassical model of investment are the
marginal product of capital, the interest rate, and tax rules.
14. What is the standard model used to examine the benefits and costs of owning capital
goods?
A: The standard model used to examine the benefits and costs of owning capital goods is the
neoclassical model of investment.
15. What determines the downward sloping demand curve for capital for a firm in the
neoclassical model?
A: The marginal product of capital (MPK) determines the downward sloping demand curve for
capital for a firm in the neoclassical model of investment.

16. What factors influence the real rental price of capital in the Cobb-Douglas
production function?
A: The real rental price of capital in the Cobb-Douglas production function is influenced by the
level of technology, the stock of capital in the economy, and the amount of labor employed.
17. What are the three costs that rental firms bear when they rent out a unit of capital?
A: The three costs that rental firms bear when they rent out a unit of capital are interest on loans,
the cost of the loss or gain on the price of capital, and depreciation.
18. Why does investment rise during economic booms and fall during recessions?
A: Investment rises during economic booms because of increased optimism and profit
expectations, while it falls during recessions due to reduced confidence and lower profit
prospects.
19. What is the largest piece of investment spending, accounting for about ¾ of total
investment?
A: Business fixed investment is the largest piece of investment spending, representing about ¾ of
total investment.
20. How does the Cobb-Douglas production function relate output, capital, and labor in
the economy?
A: The Cobb-Douglas production function provides a good approximation of how the actual
economy turns capital and labor into goods and services, relating output (Y), capital (K), and
labor (L) through a specific equation.
21. A Car rental company buys cars for Rs.1, 000,000 each and rents them out
to other businesses. If it faces an interest rate i of 10% p.a. so the interest
cost, iPk = Rs.100,000 p.a.
Car prices are rising @ 6% per year, so excluding maintenance costs the firm gets a capital
gain,
Pk = Rs.60,000 p.a
Cars depreciate @ 20% p.a. so loss due to wear and tear,
Pk = Rs.200, 000
So,
total cost of capital = iPK - PK + PK
= 100,000 – 60,000 +200,000
= Rs.240, 000
Lesson 41
INVESTMENT THEORIES (CONTINUED)

MCQs:
22.Why investment is considered the most volatile component of GDP?
A) Investment is directly related to government expenditure
B) Investment is subject to frequent changes in tax rates
C) Investment experiences significant fluctuations during economic cycles
D) Investment is influenced by changes in consumer spending
Answer: C) Investment experiences significant fluctuations during economic cycles
23.According to the neoclassical model of investment, what are the three
variables that can shift investment?
A) Marginal product of labor, government spending, and inflation rate
B) Marginal product of capital, interest rate, and tax rules
C) Interest rate, consumer confidence, and exchange rate
D) Government regulation, technology, and unemployment rate
Answer: B) Marginal product of capital, interest rate, and tax rules

Q3: In the Cobb-Douglas production function, what parameter measures capital's share of
output?
A) A B) α (alpha) C) L D) Y
Answer: B) α (alpha)
24.What is the real cost of capital in terms of the economy's output?
A) iPK - PK + PK B) PK (i - PK/PK + )
C) (PK / P) (r + ) D) Real Cost of Capital = (PK / P) (r +)
Answer: D) Real Cost of Capital = (PK / P) (r +)
25.What does the investment function in the neoclassical model of
investment depend on?
A) Inflation rate and consumer confidence
B) Interest rate and consumer spending
C) Real interest rate and the relative price of capital
D) Marginal product of labor and the stock of capital
Answer: C) Real interest rate and the relative price of capital

26.How does a decrease in the real interest rate affect investment in the
neoclassical model?
A) Decrease in the real interest rate reduces investment
B) Decrease in the real interest rate increases investment
C) Decrease in the real interest rate has no effect on investment
D) Decrease in the real interest rate increases savings but reduces investment
Answer: B) Decrease in the real interest rate increases investment
27.What is the purpose of an investment tax credit?
A) To encourage firms to pay higher corporate income taxes
B) To reduce the cost of capital and raise investment
C) To discourage firms from investing in new capital goods
D) To increase the overall tax burden on corporations
Answer: B) To reduce the cost of capital and raise investment
28.How did the Swedish Investment Funds system attempt to control
aggregate demand?
A) By providing subsidies to businesses for increasing investment during economic slowdowns

B) By imposing higher corporate income taxes during economic recovery
C) By lowering the interest rates during economic recessions
D) By providing tax incentives for consumer spending
Answer: A) By providing subsidies to businesses for increasing investment during
economic slowdowns
29.What determines the net investment in the neoclassical model of
investment?
A) The difference between GDP and aggregate demand
B) The difference between the marginal product of capital and the cost of capital
C) The difference between government spending and taxation
D) The difference between interest rates and inflation rate
Answer: B) The difference between the marginal product of capital and the cost of capital
30.In the long run, what does the marginal product of capital equal in the
neoclassical model?
A) The interest rate
B) The real cost of capital

C) The inflation rate
D) The relative price of capital
Answer: B) The real cost of capital
31.Why investment is considered the most volatile component of GDP?
A) Investment spending is highly sensitive to changes in interest rates.
B) Investment spending experiences significant fluctuations during economic cycles.
C) Investment spending is directly linked to government expenditures.
D) Investment spending is independent of business confidence.
Answer: B) Investment spending experiences significant fluctuations during economic
cycles.
32.What is the relationship between the real interest rate and investment in
the neoclassical model?
A) An increase in the real interest rate leads to an increase in investment.
B) A decrease in the real interest rate leads to a decrease in investment.
C) An increase in the real interest rate leads to a decrease in investment.
D) A decrease in the real interest rate leads to an increase in investment.

Answer: D) A decrease in the real interest rate leads to an increase in investment.
33.What are the determinants of investment in the neoclassical model?
A) Government expenditure and tax rates
B) Real interest rate and inflation rate
C) Marginal product of capital and real cost of capital
D) Money supply and exchange rates
Answer: C) Marginal product of capital and real cost of capital
34.In the long run, what does the marginal product of capital equal?
A) Real interest rate
B) Inflation rate
C) Real cost of capital
D) Government expenditure
Answer: C) Real cost of capital
35.How do tax laws influence investment in the neoclassical model?
A) Corporate income tax reduces the real cost of capital.

B) Investment tax credit increases the real cost of capital.
C) Corporate income tax increases the real cost of capital.
D) Investment tax credit reduces the real cost of capital.
Answer: D) Investment tax credit reduces the real cost of capital.
36.What is the purpose of the Swedish Investment Funds System?
A) To control aggregate demand by providing investment subsidies.
B) To discourage investment during economic recoveries.
C) To increase government revenue through corporate income tax.
D) To stabilize interest rates in the economy.
Answer: A) To control aggregate demand by providing investment subsidies.
Q1: What is the equation for the total cost of capital in the neoclassical model?
A) Total cost of capital = iPK - PK + PK
B) Total cost of capital = PK (i - PK/PK +)
C) Total cost of capital = PK (i + PK - )
D) Total cost of capital = iPK + PK - PK

Answer: B) Total cost of capital = PK (i - PK/PK +)
37.In the neoclassical model, what determines the real cost of capital,
which is the cost of buying and renting out a unit of capital measured in
terms of the economy's output?
A) Real Cost of Capital = (PK / P) (r +)
B) Real Cost of Capital = (PK + P) (r - )
C) Real Cost of Capital = (PK / P) (r - )
D) Real Cost of Capital = (PK - P) (r + )
Answer: A) Real Cost of Capital = (PK / P) (r +)
38.What is the change in the capital stock called, and what does it depend
on in the neoclassical model?
A) Change in stock; depends on aggregate demand
B) Net investment; depends on the difference between the marginal product of capital and the
cost of capital
C) Depreciation; depends on the interest rate and inflation rate
D) Gross investment; depends on the level of government spending

Answer: B) Net investment; depends on the difference between the marginal product of
capital and the cost of capital
39.How does a decrease in the real interest rate affect investment in the
neoclassical model?
A) Decrease in the real interest rate reduces investment
B) Decrease in the real interest rate increases investment
C) Decrease in the real interest rate has no effect on investment
D) Decrease in the real interest rate increases savings but reduces investment
Answer: B) Decrease in the real interest rate increases investment
40.What is the investment function in the neoclassical model of
investment?
A) I = R/P - (PK /P) (r+) B) I = In [MPK - (PK / P) (r +)]
C) I = MPK - (PK / P) (r +) D) I = In [MPK + (PK / P) (r - )]
Answer: B) I = In [MPK - (PK / P) (r +)]
Q6: What does the Swedish Investment Funds system attempt to control?
A) Interest rates in the economy

B) Aggregate demand by encouraging or discouraging investment
C) Consumer spending patterns
D) Tax rates for corporations
Answer: B) Aggregate demand by encouraging or discouraging investment
41.How does the Investment Tax Credit influence investment in the
neoclassical model?
A) It reduces the cost of capital and raises investment
B) It increases corporate income tax and discourages investment
C) It decreases consumer spending and raises investment
D) It has no effect on investment
Answer: A) It reduces the cost of capital and raises investment
42.What is the purpose of the Corporate Income Tax in relation to
investment?
A) To encourage firms to invest by lowering taxes on capital gains
B) To discourage firms from investing by imposing higher taxes on corporate profits
C) To reduce the cost of capital for firms

D) To provide subsidies to firms for investing in new capital goods
Answer: B) To discourage firms from investing by imposing higher taxes on corporate
profits
43.What does the profit rate in the neoclassical model of investment
depend on?
A) Interest rate and aggregate demand
B) Inflation rate and consumer confidence
C) Real rental price and the marginal product of capital
D) Government spending and taxation
Answer: C) Real rental price and the marginal product of capital
44.What determines the long-run level of the marginal product of capital
in the neoclassical model?
A) The inflation rate B) The real interest rate
C) The relative price of capital D) The level of government spending
Answer: C) The relative price of capital

Q&A:
1. What factors determine the cost of capital in the neoclassical model?
A: The cost of capital is determined by the price of capital goods, the interest rate, the rate of
change of capital prices, and the depreciation rate.
2. How is the real cost of capital defined in the neoclassical model of investment?
A: The real cost of capital is the cost of buying and renting out a unit of capital measured in
terms of the economy's output.
3. What is the formula for the net investment in the neoclassical model?
A: Net investment (ΔK) is given by the function In [MPK - (PK / P) (r + )], where MPK is the
marginal product of capital, PK / P is the relative price of capital, and r is the real interest rate.
4. How does a decrease in the real interest rate affect investment in the neoclassical
model?
A: A decrease in the real interest rate lowers the cost of capital, which increases the profit from
owning capital and provides an incentive for firms to accumulate more capital.
5. What does the investment function represent in the neoclassical model of
investment?
A: The investment function (I) represents the total spending on business fixed investment, which
is the sum of net investment and the replacement of depreciated capital.

6. What happens as the adjustment of the capital stock continues over time in the
neoclassical model?
A: If the marginal product of capital (MPK) is initially above the cost of capital, the capital stock
will rise, and the MPK will fall. Conversely, if the MPK is initially below the cost of capital, the
capital stock will fall, and the MPK will rise. Eventually, the MPK approaches the cost of capital
when the capital stock reaches a steady state level.
7. How does the Investment Tax Credit encourage investment in the neoclassical
model?
A: The Investment Tax Credit reduces a firm's taxes by a certain amount for each unit of money
spent on capital goods. This effectively lowers the cost of capital and provides an incentive for
firms to invest more in new capital.
8. What is the impact of corporate income tax on investment in the neoclassical model?
A: The impact of corporate income tax on investment depends on how the law defines profit for
taxation. If profit rate (R/P - (PK / P) (r + )) is used for taxation, it would still be rational for
firms to invest if R/P is greater than (PK / P) (r + ). However, in reality, tax laws often treat
depreciation differently, which affects the effective tax rate and the cost of capital.
9. How did the Swedish Investment Funds system attempt to control aggregate
demand?
A: The Swedish Investment Funds system used investment subsidies as a tool to control
aggregate demand. During economic slowdowns, the government offered temporary investment
subsidies to encourage firms to invest. Conversely, during economic recovery, these subsidies
were revoked.
10. What role do tax incentives play in influencing investment and aggregate demand?
A: Tax incentives, such as the Investment Tax Credit, can influence investment decisions by
reducing the cost of capital. By lowering the cost of capital, tax incentives encourage firms to
invest more, which can have an impact on aggregate demand in the economy.
11. What factors does the cost of capital depend on in the neoclassical model?
A: The cost of capital depends on the price of capital, the interest rate, the rate of change of
capital prices, and the depreciation rate.
12. How is the real cost of capital defined in the neoclassical model of investment?
A: The real cost of capital is the cost of buying and renting out a unit of capital measured in
terms of the economy's output, represented as (PK / P) (r +), where r is the real interest rate and
PK / P is the relative price of capital.
13. What is the relationship between the marginal product of capital (MPK) and the
cost of capital in determining net investment?
A: Net investment depends on the difference between the MPK and the cost of capital. If the
MPK exceeds the cost of capital, firms will add to their capital stock. If the MPK falls short of
the cost of capital, they will let their capital stock shrink.
14. How is the investment function derived in the neoclassical model of investment?
A: The investment function, denoted as I, is derived as I = In [MPK - (PK / P) (r +)] + K,
where In ( ) represents the function showing how much net investment responds to the incentive
to invest, and K represents the replacement of depreciated capital.
15. How does a decrease in the real interest rate affect investment in the neoclassical
model?
A: A decrease in the real interest rate lowers the cost of capital, which increases the amount of
profit from owning capital and raises the incentive to accumulate more capital. As a result, firms
are more likely to increase their investment.
16. What is the long-run level of the marginal product of capital in the neoclassical
model?
A: In the long run, the marginal product of capital (MPK) equals the real cost of capital (PK / P)
(r + ). This occurs when the capital stock reaches a steady state level.
17. How do tax laws, such as the Investment Tax Credit, influence investment in the
neoclassical model?
A: The Investment Tax Credit reduces a firm's taxes by a certain amount for each unit of money
spent on capital goods. This effectively reduces the cost of capital, leading to increased
investment.
18. What is the Swedish Investment Funds system, and how did it attempt to control
aggregate demand?
A: The Swedish Investment Funds system was a policy tool used by the government of Sweden
from the mid-50s to the mid-70s to control aggregate demand. It encouraged or discouraged
investment through a subsidy system. During economic slowdowns, authorities offered a
temporary investment subsidy to boost investment and aggregate demand. Conversely, during
economic recoveries, the subsidy was revoked to control demand.
19. How does the treatment of depreciation in tax laws impact investment in the
neoclassical model?
A: The tax treatment of depreciation can affect investment decisions. In theory, if depreciation is
calculated at the current value, it would not have a significant impact on investment decisions.
However, tax laws typically calculate depreciation at historical cost, which may affect the
effective cost of capital and, in turn, influence investment choices.
20. What are the two important provisions of corporate taxes discussed in the context of
investment?
A: The two important provisions of corporate taxes discussed are:
 Corporate Income Tax: A tax on corporate profits that affects investment decisions based
on how the law defines profit for taxation.
 Investment Tax Credit: A tax provision that encourages capital accumulation by reducing
a firm's taxes for each unit of money spent on capital goods, effectively lowering the cost
of capital and promoting investment.
Lesson 42
MCQs:
1. What is Tobin's q used for in investment decisions?
a) To determine the total value of the economy's capital b) To calculate the market value of
installed capital c) To measure the expected future profitability of capital d) To compare the
price of capital goods to other goods
Answer: c) To measure the expected future profitability of capital
2. According to Tobin's q, what does it indicate when q > 1?
a) Firms can raise the value of their stock by increasing capital
b) The stock market values capital at less than its replacement cost
c) The expected future profitability of capital is low
d) Firms should not invest in new capital
Answer: a) Firms can raise the value of their stock by increasing capital
3. How are stock prices and economic activity related?
a) Stock prices and economic activity have no connection

b) Changes in stock market always lead to changes in GDP
c) A fall in stock prices is a predictor of an upcoming recession
d) Stock prices indicate the current level of inflation
Answer: c) A fall in stock prices is a predictor of an upcoming recession
4. What is one of the additional reasons for stock prices and economic
activity fluctuating together?
a) A fall in stock prices encourages people to spend more
b) Changes in stock prices reflect changes in technological progress
c) Stock prices have a direct impact on the natural rate of output
d) A fall in stock prices reduces aggregate demand
Answer: d) A fall in stock prices reduces aggregate demand
5. What are financing constraints in the context of investment?
a) The limitations on a firm's ability to access financial markets for funds
b) The government's restrictions on stock market activities
c) The interest rates set by central banks to control investment
d) The taxes imposed on corporate profits

Answer: a) The limitations on a firm's ability to access financial markets for funds
6. How does a recession affect investment for firms facing financing
constraints?
a) Recession has no impact on investment for firms with constraints
b) Recession causes firms to invest more for long-term profitability
c) Firms with constraints are less affected by a recession than others
d) Recession restricts spending on new capital for firms with constraints
Answer: d) Recession restricts spending on new capital for firms with constraints
7. What does residential investment include?
a) Investment in commercial properties by landlords
b) The purchase of new housing by people planning to live in it
c) Investment in stocks and bonds related to the housing market
d) Investment in infrastructure projects related to housing
Answer: b) The purchase of new housing by people planning to live in it
8. What determines the flow of residential investment in the housing
market model?
b) The market price of houses
c) The price of housing materials
d) The equilibrium housing price
Answer: b) The market price of houses
9. What is Tobin's q?
a) The price of capital in the stock market
b) The market value of installed capital divided by the replacement cost of installed capital
c) The interest rate in financial markets
d) The profit rate earned by firms on their installed capital
Answer: b) The market value of installed capital divided by the replacement cost of
installed capital
10.In the context of Tobin's q, if q > 1, what does it imply?
a) Firms will not replace their capital stock
b) Firms can raise the value of their stock by increasing capital
c) The stock market is experiencing a substantial decline

d) The stock market reflects bad news about technological progress
Answer: b) Firms can raise the value of their stock by increasing capital
11.How are Tobin's q and the neo-classical model of investment related?
a) Tobin's q measures the expected future profitability, while the neo-classical model
focuses on current profitability.
b) Tobin's q measures the overall market value of installed capital, while the neo-classical
model considers the replacement cost of installed capital.
c) Tobin's q and the neo-classical model are unrelated concepts.
d) Tobin's q and the neo-classical model measure the same thing but use different units of
measurement.
Answer: a) Tobin's q measures the expected future profitability, while the neo-classical
model focuses on current profitability.
12.What is the implication of a fall in stock prices in relation to Tobin's q?
a) It will result in an increase in Tobin's q.
b) It reflects investors' optimism about the future profitability of capital.
c) It indicates investors' pessimism about the current or future profitability of capital.
d) It has no impact on Tobin's q.

Answer: c) It indicates investors' pessimism about the current or future profitability of
capital.
13.What are financing constraints in the context of investment?
a) Limits on the amount of funds that financial markets can raise for firms.
b) Limits on the amount of investment a firm can make.
c) Limits on the amount of funds a firm can raise from financial markets due to recession.
d) Limits on the amount of funds a firm can raise from financial markets based on its
current earnings.
Answer: d) Limits on the amount of funds a firm can raise from financial markets based on
its current earnings.
14.In the model of residential investment, what determines the flow of
residential investment?
a) The housing price determines the flow of residential investment.
b) The market price of installed capital relative to its replacement cost.
c) The overall price level P.
d) The expected profits from owning installed capital.
Answer: a) The housing price determines the flow of residential investment.

15.How does the relative price of housing affect residential investment?
a) A higher relative price of housing increases the incentive to build houses.
b) A lower relative price of housing increases the incentive to build houses.
c) The relative price of housing has no impact on residential investment.
d) A higher relative price of housing reduces the incentive to build houses.
Answer: a) A higher relative price of housing increases the incentive to build houses.
16.What is Tobin's q in the context of investment decisions?
a) The market value of installed capital
b) The replacement cost of installed capital
c) The ratio of market value to replacement cost of installed capital
d) The rate of change of capital prices
Answer: c) The ratio of market value to replacement cost of installed capital
17.How does Tobin's q influence firms' investment decisions?
a) If q > 1, firms increase their capital; if q < 1, firms replace their capital stock
b) If q > 1, firms replace their capital stock; if q < 1, firms increase their capital
c) If q > 1, firms reduce their capital stock; if q < 1, firms increase their capital
d) If q > 1, firms increase their capital stock; if q < 1, firms do not replace their capital
stock
Answer: a) If q > 1, firms increase their capital; if q < 1, firms replace their capital
stock
18.Why Tobin’s q is closely related to the neoclassical model of
investment?
a) It measures the current profitability of capital
b) It measures the expected future profitability of capital
c) It measures both current and expected future profitability of capital
d) It measures the cost of capital
Answer: c) It measures both current and expected future profitability of capital
19.According to Tobin, what does a fall in stock prices indicate?
a) A decrease in the natural rate of output
b) An increase in aggregate demand
c) Investors' pessimism about the current or future profitability of capital

d) Technological progress and economic growth
Answer: c) Investors' pessimism about the current or future profitability of capital
20.What are financing constraints in the context of investment?
a) The limitations on the amount of funds a firm can raise from financial markets
b) The restrictions on the type of capital goods a firm can purchase
c) The limitations on the depreciation rate of capital
d) The restrictions on the total investment a firm can make
Answer: a) The limitations on the amount of funds a firm can raise from financial
markets
21.How does a recession impact firms facing financing constraints?
a) Firms continue investing for long-term profitability
b) Firms reduce investment due to a decrease in current profits
c) Firms face a small effect of recession on their investment
d) Firms do not invest in new capital goods
Answer: b) Firms reduce investment due to a decrease in current profits
22.In the model of residential investment, what does PH represent?

b) The housing price
c) The market price of materials and labor
d) The rental price of housing
Answer: b) The housing price
23.How is the housing price determined in the model of residential
investment?
a) The overall price level determines the housing price
b) The flow of residential investment determines the housing price
c) Supply and demand for the existing stock of housing determine the housing price
d) Construction firms determine the housing price
Answer: c) Supply and demand for the existing stock of housing determine the
housing price
24.What is the similarity between the model of residential investment and
Tobin's q theory?
a) Both models consider the natural rate of output

b) Both models rely on the stock market to determine investment decisions
c) Both models focus on expected profits from owning installed capital
d) Both models use the overall price level to determine investment
Answer: c) Both models focus on expected profits from owning installed capital
25.In the context of residential investment, what does the relative price of
housing depend on?
a) The demand for housing and the imputed rent individuals expect to receive
b) The replacement cost of housing
c) The flow of residential investment
d) The natural rate of output
Answer: a) The demand for housing and the imputed rent individuals expect to receive
Q&A:
1. What is Tobin's q, and how is it calculated?
A: Tobin's q is a ratio proposed by economist James Tobin, used by firms to make investment
decisions. It is calculated as the market value of installed capital divided by the replacement cost
of installed capital.
2. How does Tobin's q influence firms' investment decisions?
A: If Tobin's q is greater than 1, firms can increase the value of their stock by investing in new
capital. Conversely, if q is less than 1, the stock market values capital at less than its replacement
cost, and firms may not replace their capital stock as it wears out.
3. What relationship does Tobin's q have with the neo-classical model?
A: Tobin's q and the neo-classical model are closely related, as Tobin's q measures both expected
future profitability and current profitability.
4. Why do stock prices and economic activity tend to fluctuate together?
A: Changes in stock market prices often reflect changes in GDP, making stock prices an
indicator of economic activity. A substantial decline in the stock market may be a signal of an
upcoming recession.
5. What are some additional reasons for stock prices and economic activity fluctuating
together?
A: A fall in stock prices can make people feel poorer, leading to reduced spending and aggregate
demand. It may also reflect negative news about technological progress and economic growth,
resulting in slower expansion of the natural rate of output.
6. What are financing constraints, and how do they affect investment decisions?
A: Financing constraints refer to limitations on a firm's ability to raise funds from financial
markets to invest in new capital. Firms facing financing constraints may be restricted in their
investment decisions, as their ability to raise funds is limited to their current earnings.
7. In the context of residential investment, what does Tobin's q represent?
A: In residential investment, Tobin's q represents the relative price of housing, which adjusts to
equilibrate supply and demand for the existing stock of housing capital.
8. How does the model of residential investment relate to the q theory of business fixed
investment?
A: The model of residential investment is similar to the q theory of business fixed investment.
Both models depend on the market price of installed capital relative to its replacement cost,
which influences investment decisions based on expected profits.
9. What is Tobin's q and how is it calculated?
A: Tobin's q is a ratio proposed by James Tobin that measures the expected future profitability of
capital. It is calculated as the market value of installed capital divided by the replacement cost of
installed capital.
10. How does Tobin's q influence firms' investment decisions?
A: Tobin's q determines whether firms will invest in new capital. If q is greater than 1, firms can
increase the value of their stock by increasing capital investment. If q is less than 1, the stock
market values capital at less than its replacement cost, discouraging firms from replacing their
capital stock.
11. What is the relationship between Tobin's q and the neo-classical model?
A: Tobin's q and the neo-classical model are closely related, as Tobin's q measures both the
expected future profitability and the current profitability of capital, which aligns with the
principles of the neo-classical investment model.
12. Why the stock market is considered an economic indicator?
A: Changes in the stock market often reflect changes in GDP. A substantial decline in the stock
market can indicate an upcoming recession.
A: Stock prices and economic activity tend to fluctuate together because a fall in stock prices can
lead to reduced aggregate demand as people feel poorer, resulting in less spending. Additionally,
a decline in stock prices may reflect negative news about technological progress and economic
growth, causing a slow expansion of the natural rate of output.
A: Financing constraints refer to the limitations faced by firms in raising funds from financial
markets to invest in new capital goods.
15. How does a recession affect investment for firms facing financing constraints?
A: During a recession, firms facing financing constraints may be restricted from spending on
new capital goods due to the fall in current profits. This limitation may prevent them from
making profitable investments.
16. What is residential investment, and what are its determinants?
A: Residential investment includes the purchase of new housing by both individuals planning to
live in it and landlords planning to rent it. The determinants of residential investment include the
equilibrium housing price, which is influenced by the relative price of housing and demand for
housing based on the imputed rent individuals expect to receive from their housing.
17. What is Tobin's q, and how is it calculated?
A: Tobin's q is a ratio proposed by economist James Tobin, used by firms to make investment
decisions. It is calculated as the market value of installed capital divided by the replacement cost
of installed capital.
18. How does Tobin's q influence net investment decisions for firms?
A: Tobin's q indicates whether the market value of capital is greater or less than its replacement
cost. If q > 1, firms can increase the value of their stock by investing in capital. If q < 1, the
market values capital less than its replacement cost, leading firms to refrain from replacing their
capital stock as it wears out.
19. What does the relationship between Tobin's q and the neo-classical model suggest?
A: Tobin's q and the neo-classical model are closely related, as Tobin's q measures both the
expected future profitability and the current profitability of capital, which aligns with the
principles of the neo-classical investment model.
A: Stock prices and economic activity tend to fluctuate together because changes in the stock
market often reflect changes in the overall economic conditions. A substantial decline in the
stock market can serve as a predictor of an upcoming recession.
21. How does a fall in stock prices affect Tobin's q and investment decisions?
A: A fall in stock prices results in a decrease in Tobin's q, indicating investors' pessimism about
the current or future profitability of capital. This can lead to reduced investment as firms may be
less willing to invest in new capital.
A: Financing constraints refer to limitations faced by firms in accessing funds from financial
markets for investment purposes. Firms may not be able to raise the desired amount of funds,
restricting their spending on new capital goods.
23. How can a recession impact investment decisions for firms facing financing
constraints?
A: During a recession, firms facing financing constraints may experience a decline in current
profits, which limits their ability to invest in new capital goods. This reduced spending on new
capital may prevent such firms from making profitable investments.
24. What does residential investment include, and how is it determined?
A: Residential investment involves the purchase of new housing by individuals planning to live
in it or landlords intending to rent it out. The flow of residential investment is determined by the
relative price of housing, which depends on the equilibrium between supply and demand for
existing housing capital.
Lesson 43
MCQs:
1. Inventory investment is:
a) The largest component of spending in the economy
b) Negligible and not significant
c) One of the smallest components of spending, but of great significance

d) Unpredictable and unrelated to economic fluctuations
Answer: c) One of the smallest components of spending, but of great significance
What is production smoothing in the context of inventory investment?
a) Firms produce less than they sell when sales are high
b) Firms produce more than they sell when sales are high
c) Firms maintain the same level of production regardless of sales fluctuations
d) Firms stop production when sales are high and only produce when sales are low
Answer: a) Firms produce less than they sell when sales are high
2. The accelerator model of inventories suggests that:
a) Firms use inventories to smooth production over time
b) Inventory investment is unrelated to changes in output
c) Inventory investment is proportional to the change in output
d) Inventory investment is only influenced by seasonal fluctuations
Answer: c) Inventory investment is proportional to the change in output
3. How does the real interest rate affect inventory investment?
a) An increase in the real interest rate depresses inventory investment

b) An increase in the real interest rate boosts inventory investment
c) The real interest rate has no impact on inventory investment
d) The real interest rate only affects production smoothing, not inventory investment
Answer: a) An increase in the real interest rate depresses inventory investment
4. What is stock-out avoidance in the context of inventory investment?
a) Firms avoid holding inventory to reduce costs
b) Firms avoid stock-outs by producing more than they sell
c) Firms avoid running out of goods when sales are unexpectedly high
d) Firms avoid producing goods in advance to match seasonal patterns in sales
Answer: c) Firms avoid running out of goods when sales are unexpectedly high
5. Inventory investment is:
a) A significant component of spending in the economy
b) The smallest component of spending in the economy
c) Irrelevant in the study of economic fluctuations
d) Not affected by economic conditions
Answer: a) A significant component of spending in the economy

6. During a recession, inventory investment:
a) Increases significantly
b) Remains constant
c) Becomes negative as firms stop replenishing their inventory
d) Has no impact on the economy
Answer: c) Becomes negative as firms stop replenishing their inventory
7. Production smoothing refers to:
a) Firms producing more than they sell to maintain inventory
b) Firms producing less than they sell to maintain inventory
c) Firms producing the same amount they sell to maintain inventory
d) Firms not using inventory at all
Answer: c) Firms producing the same amount they sell to maintain inventory
8. The accelerator model of inventories assumes that inventory investment
is proportional to:
a) The change in output
b) The change in prices

c) The change in interest rates
d) The change in consumer demand
Answer: a) The change in output
9. In industries with seasonal fluctuations in demand, firms typically use
inventories to:
a) Smooth production over time
b) Maximize profits during high-demand periods
c) Eliminate inventory completely during low-demand periods
d) Match seasonal patterns in sales
Answer: d) Match seasonal patterns in sales
10.How does the real interest rate affect inventory investment?
a) An increase in the real interest rate leads to an increase in inventory investment
b) An increase in the real interest rate leads to a decrease in inventory investment
c) The real interest rate has no impact on inventory investment
d) The real interest rate only affects retail firms, not manufacturing firms
Answer: b) An increase in the real interest rate leads to a decrease in inventory investment.
Q&A:
1. What is inventory investment?
A: Inventory investment refers to the goods that businesses put aside in storage. It is a
component of spending in the economy and is critical in the study of economic fluctuations.
2. What is production smoothing in the context of inventory investment?
A: Production smoothing refers to the practice of firms producing less than they sell when sales
are high and taking goods out of inventory. This helps in maintaining a steady production level.
3. How do inventories contribute to operating efficiency?
A: Holding inventories allows firms to operate more efficiently as they have readily available
stock to meet customer demands without delay.
4. What is stock-out avoidance in the context of inventory investment?
A: Stock-out avoidance refers to firms' desire not to run out of goods when sales unexpectedly
increase. It involves maintaining sufficient inventory to meet unexpected high demand.
5. What does the accelerator model of inventories propose?
A: The accelerator model suggests that firms hold a stock of inventories that is proportional to
their level of output. Inventory investment is predicted to be proportional to the change in output,
depending on whether the economy is speeding up or slowing down.

A: The real interest rate measures the opportunity cost of holding inventories. An increase in the
real interest rate makes holding inventories more costly, leading to a reduction in inventory
investment.
7. What is inventory investment and why is it significant in the study of economic
fluctuations?
A: Inventory investment refers to the goods that businesses store in inventory. It is one of the
smallest components of spending but is of great significance due to its volatility and impact on
economic fluctuations.
8. What is production smoothing in the context of inventory investment?
A: Production smoothing occurs when firms produce less than they sell during periods of high
sales, taking goods out of inventory to meet demand.
9. How do inventories contribute to a firm's operational efficiency?
A: Holding inventories allows firms to operate more efficiently by having the necessary goods
on hand, reducing production delays and ensuring a steady supply of products.
10. What is stock-out avoidance, and why is it important for firms?
A: Stock-out avoidance refers to firms' efforts to avoid running out of goods when sales
unexpectedly increase. It is crucial for maintaining customer satisfaction and meeting demand.
11. How does the accelerator model of inventories explain inventory investment?
A: The accelerator model suggests that firms hold a stock of inventories proportional to their
level of output. Inventory investment is thus influenced by changes in output, leading to higher
inventory holdings during economic booms and reduced inventory during slowdowns.
A: The real interest rate represents the opportunity cost of holding inventories. An increase in the
real interest rate makes holding inventories more costly, leading firms to reduce their stock and
depress inventory investment.
Lesson 44
MONEY & BANKING
MCQs:
1. What is the formula for calculating the money supply in an economy?
a) M = C - D b) M = C + D
c) M = C * D d) M = C / D
Answer: b) M = C + D
2. In a 100% reserve banking system, what happens to the money supply
when households deposit money in a bank?
a) The money supply increases
b) The money supply decreases
c) The money supply remains the same
d) The money supply becomes unpredictable
Answer: c) The money supply remains the same
3. What are reserves in the context of banking?
a) Deposits held by households in banks
b) Loans made by banks to households and firms
c) The fraction of deposits kept in reserve by banks
d) Deposits that banks have received but have not lent out
Answer: d) Deposits that banks have received but have not lent out
4. In fractional reserve banking, what is the reserve-deposit ratio?
a) The fraction of deposits that banks lend out
b) The fraction of deposits kept in reserve by banks

c) The fraction of deposits that banks earn interest on
d) The fraction of deposits that households withdraw from banks
Answer: b) The fraction of deposits kept in reserve by banks
5. How is money created in a fractional reserve banking system?
a) By households depositing money in banks
b) By banks lending out a fraction of their deposits
c) By the central bank printing more currency
d) By the government increasing taxes
Answer: b) By banks lending out a fraction of their deposits
6. What is the formula for the money supply (M) that includes both
currency (C) and demand deposits (D)?
a) M = C - D b) M = C + D
c) M = C x D d) M = C / D
Answer: b) M = C + D
7. In a 100% reserve banking system, how are deposits handled by banks?
a) All deposits are held in reserve, and banks do not make any loans.
b) Banks invest all deposits in the stock market.
c) Banks use all deposits to make loans to customers.
d) Banks hold a small percentage of deposits in reserve and use the rest to make loans.
Answer: a) All deposits are held in reserve, and banks do not make any loans.
a) The deposits that banks have lent out to customers.
b) The deposits that banks have received and kept in reserve.
c) The interest earned by banks on loans given to customers.
d) The fees charged by banks for maintaining deposit accounts.
Answer: b) The deposits that banks have received and kept in reserve.
9. In fractional reserve banking, what is the reserve-deposit ratio?
a) The fraction of deposits lent out by banks to customers.
b) The fraction of deposits that banks keep in reserve.
c) The ratio of a bank's assets to its liabilities.
d) The ratio of currency to demand deposits in the money supply.
Answer: b) The fraction of deposits that banks keep in reserve.

10.What do banks create in a fractional reserve banking system?
a) Money b) Loans c) Interest d) Reserves
Answer: a) Money
Q&A:
1. What is the money supply formula that includes both currency and demand
deposits?
A: M = C + D, where M represents the money supply, C is currency, and D is demand deposits.
2. In a 100% reserve banking system, what happens to the money supply when a new
bank is introduced?
A: In a 100% reserve banking system, the money supply remains the same when a new bank is
introduced because all deposits are held in reserve, and the banking system does not affect the
supply of money.
A: Reserves are the deposits that banks have received but have not lent out. Some reserves are
held in the vaults of local banks, while most are held at the central bank.
4. What is the key characteristic of fractional reserve banking?

A: Fractional reserve banking is a system under which banks keep only a fraction of their
deposits in reserve, allowing them to use some of their deposits to make loans.
5. How do banks create money under the fractional reserve banking system?
A: Banks create money by making loans using a portion of the deposits they hold in reserve. This
process allows for the expansion of the money supply beyond the initial deposit amount.
6. What is the reserve-deposit ratio?
A: The reserve-deposit ratio is the fraction of deposits that banks keep in reserve. Excess
reserves are reserves held above the reserve requirement.
7. What is the formula for calculating the money supply (M) that includes both
currency (C) and demand deposits (D)?
A: The formula for the money supply is M = C + D, where M represents the money supply, C
represents currency, and D represents demand deposits held in banks.
A: In a 100% reserve banking system, all deposits received by banks are held as reserves,
meaning they are not lent out to customers as loans. The deposits remain in the banks and do not
affect the money supply.

A: Reserves refer to the deposits that banks have received from customers but have not lent out.
These reserves are kept on hand to meet withdrawal demands and may be held either in the
bank's vault or at the central bank.
10. What is fractional reserve banking, and how does it affect the money supply?
A: Fractional reserve banking is a system in which banks keep only a fraction of their deposits in
reserve and lend out the rest to borrowers. This practice allows banks to create money by
effectively increasing the money supply through lending.
11. What are excess reserves?
A: Excess reserves are reserves held by banks above the required reserve ratio mandated by the
central bank. These reserves can be used to accommodate additional withdrawals or to meet
other financial needs.
12. What does the money supply formula (M = C + D) represent?
A: The money supply formula represents the total quantity of money in an economy, including
both currency held by the public and demand deposits held at banks.
A: In a 100% reserve banking system, all deposits are held as reserves, and banks do not use
them to make loans. Deposits are kept in reserve until the depositor makes a withdrawal or writes
a check against the balance.
14. How does 100% reserve banking affect the money supply in the economy?
A: In a 100% reserve banking system, the money supply remains unchanged when new banks are
introduced or when households deposit money, as all deposits are held in reserve and do not
affect the money supply.
15. What is fractional reserve banking, and how does it work?
A: Fractional reserve banking is a system where banks keep only a fraction of their deposits in
reserve and use the rest to make loans. As a result, banks can create money beyond the initial
deposits through the process of making loans.
16. What are reserves in the context of banking, and where are they held?
A: Reserves are the deposits that banks have received but have not lent out. Some reserves are
held in the vaults of local banks, but most are held at the central bank.
17. How do banks ensure that they have enough reserves to meet withdrawal demands?
A: Banks must keep a reserve-deposit ratio, which is the fraction of deposits kept in reserve, to
ensure that they have enough reserves on hand to meet withdrawal demands from depositors.
Excess reserves are reserves held above the reserve requirement.
Lesson 45
MONEY & BANKING (CONTINUED)
MCQs:
18.Which of the following are the three instruments through which the
central bank controls the money supply?
a) Open Market Operations
b) Changing the Reserve Requirements
c) Changing Discount Rate
d) All of the above
19.In a 100% reserve banking system, how are deposits handled by banks?
a) All deposits are held as reserves
b) Banks use deposits to make loans
c) Banks keep some deposits as reserves and use the rest to make loans
Answer: a) All deposits are held as reserves
20.What is the key point emphasized by portfolio theories of money
demand?
a) Money demand depends on income level

b) Money demand depends on the convenience of holding money
c) Money demand depends on the risk and return offered by money and other assets
d) Money demand depends on the cost of earning a low rate of return
Answer: c) Money demand depends on the risk and return offered by money and other
assets
21.According to the Baumol-Tobin Model of cash management, what are
the costs and benefits of holding money?
a) Benefit: Convenience; Cost: Foregone interest on money
b) Benefit: High returns; Cost: Convenience
c) Benefit: Low risk; Cost: Inconvenience
d) Benefit: High liquidity; Cost: High interest rates
Answer: a) Benefit: Convenience; Cost: Foregone interest on money
22.Which of the following equations represents the money supply function?
a) M = C + D b) M = C - D
c) M = B + D d) M = B - D
Answer: a) M = C + D
23.What does the money multiplier represent in the model of money
supply?
a) The ratio of currency to demand deposits
b) The fraction of deposits kept in reserves
c) The ratio of the monetary base to the money supply
d) The multiple by which the money supply increases for a given change in the monetary base
Answer: d) The multiple by which the money supply increases for a given change in the
monetary base
24.Which of the following are instruments used by the central bank to
control the money supply?
c) Changing the Discount Rate
d) All of the above
25.In a 100% reserve banking system, how are deposits handled by banks?
a) All deposits are held in reserve and not lent out b) Banks use all deposits to make loans
c) Banks hold a fraction of deposits in reserve
d) Banks keep excess reserves to meet withdrawal demands
Answer: a) All deposits are held in reserve and not lent out
26.Which theory of money demand emphasizes the role of money as a
medium of exchange?
a) Portfolio Theories b) Classical Theory
c) Keynesian Theory d) Transactions Theories
Answer: d) Transactions Theories
27.According to the Baumol-Tobin Model, what are the benefits and costs
of holding money?
a) Benefits: High return on investment; Costs: Foregone interest on money
b) Benefits: Convenience in making transactions; Costs: Foregone interest on money
c) Benefits: Safe store of value; Costs: Low liquidity
d) Benefits: Easy access to credit; Costs: High interest rates

Answer: b) Benefits: Convenience in making transactions; Costs: Foregone interest on
money
28.How does the money multiplier affect the money supply?
a) An increase in the money multiplier decreases the money supply.
b) The money multiplier has no effect on the money supply.
c) An increase in the money multiplier increases the money supply.
d) The money multiplier is unrelated to the money supply.
Answer: c) An increase in the money multiplier increases the money supply.
29.Which of the following are instruments used by the central bank to
control the money supply?
a) Fiscal policy
b) Open Market Operations
c) Monetary policy
d) Reserve requirements
e) Tax policy
Answer: b) Open Market Operations d) Reserve requirements

30.In the context of money supply, what does the term "monetary base"
refer to?
a) The total number of dollars held by the public as currency
b) The total number of dollars held by the banks as reserves
c) The sum of currency in circulation and demand deposits
d) The sum of currency in circulation and reserve deposits
Answer: d) The sum of currency in circulation and reserve deposits
31.What is the money multiplier in the context of money supply?
a) The ratio of the monetary base to the money supply
b) The ratio of reserve deposits to demand deposits
c) The ratio of currency to demand deposits
d) The ratio of the money supply to the monetary base
Answer: d) The ratio of the money supply to the monetary base
32.Which of the following statements is true about fractional reserve
banking?
a) Banks keep 100% of their deposits in reserve and do not use them to make loans.
b) Banks create money by holding a fraction of their deposits in reserve and using the rest to
make loans.
c) Banks can create money by selling government bonds to the public.
d) Fractional reserve banking does not affect the money supply.
Answer: b) Banks create money by holding a fraction of their deposits in reserve and using
the rest to make loans.
33.According to the Baumol-Tobin model of cash management, what are
the benefits and costs of holding money?
a) Benefits: Convenience; Costs: Foregone interest on money
b) Benefits: High returns; Costs: Increased risk
c) Benefits: Access to loans; Costs: Transaction fees
d) Benefits: Low risk; Costs: Inflation
Answer: a) Benefits: Convenience; Costs: Foregone interest on money
34.How does the central bank control the money supply?

c) Changing Discount rate
d) All of the above
35.Which of the following are the three instruments of money supply?
b) Reserve Requirements
c) Discount Rate
d) All of the above
36.According to the Classical Theory of Money Demand, what is the
relationship between the demand for real money balances and income?
a) Directly proportional
b) Inversely proportional
c) Not related
d) Constant
Answer: a) Directly proportional

37.Portfolio theories of money demand emphasize the role of money as:
a) A unit of account
b) A store of value
c) A medium of exchange
Answer: b) A store of value
38.The Baumol-Tobin Model of cash management explains the money
demand function based on:
a) Convenience and foregone interest on money
b) High returns and low risk
c) Expected inflation rate and real wealth
d) Unit of account and medium of exchange
Answer: a) Convenience and foregone interest on money
39.How is the money supply (M) calculated in the model of money supply?
a) M = C + D b) M = C - D
c) M = B + D d) M = B - D
Answer: a) M = C + D
40.The money multiplier (m) represents:
a) The ratio of currency to demand deposits
b) The fraction of deposits kept in reserves
c) The ratio of the monetary base to the money supply
d) The multiple by which the money supply increases for a given change in the monetary base
Answer: d) The multiple by which the money supply increases for a given change in the
monetary base
41.Which of the following is a transaction theory of money demand?
a) Keynesian Theory of Money Demand
b) Classical Theory of Money Demand
c) Portfolio Theories of Money Demand
d) Baumol-Tobin Model of Cash Management
Answer: d) Baumol-Tobin Model of Cash Management
42.In the money creation process, which factor determines the amount of
money a bank can create from its reserves?

a) Monetary base (B)
b) Reserve-deposit ratio (rr)
c) Currency-deposit ratio (cr)
d) Money multiplier (m)
Answer: d) Money multiplier (m)
43.What is another term for the monetary base, which has a multiplied
effect on the money supply?
a) High-powered money
b) High-interest money
c) Low-powered money
d) Low-interest money
Answer: a) High-powered money
44.How does the central bank control the money supply?

d) All of the above
45.Which instrument of money supply involves the purchase and sale of
government bonds by the central bank?
Answer: a) Open Market Operations
46.According to the Quantity Theory of Money, what is the relationship
between the demand for real money balances and income?
a) The demand for real money balances is directly proportional to income
b) The demand for real money balances is inversely proportional to income
c) The demand for real money balances is unrelated to income
d) The demand for real money balances is directly proportional to the price level
Answer: a) The demand for real money balances is directly proportional to income
47.What are the three functions of money mentioned in the discussion of
money demand theories?
a) Unit of Account, A store of value, A medium of Exchange
b) Unit of Account, A store of value, A medium of Transaction
c) Unit of Measurement, A store of value, A medium of Exchange
d) Unit of Measurement, A store of value, A medium of Transaction
Answer: a) Unit of Account, A store of value, A medium of Exchange
48.Which model analyzes the cost and benefits of holding money and
highlights the convenience and foregone interest on money?
a) Baumol-Tobin Model of Cash Management
b) Keynesian Theory of Money Demand
c) Classical Theory of Money Demand
d) Portfolio Theories of Money Demand
Answer: a) Baumol-Tobin Model of Cash Management
49.What is the formula for calculating the money multiplier (m) in the
model of money supply?

a) m = 1 / (cr + rr)
b) m = cr + rr
c) m = (cr + 1) / rr
d) m = (1 + rr) / cr
Answer: a) m = 1 / (cr + rr)
Q&A:
1. How does the central bank control the money supply?
A: The central bank controls the money supply through three main instruments: open market
operations, changing the reserve requirements for banks, and changing the discount rate.
2. What is the money supply formula, and what does it represent?
A: The money supply formula is M = C + D, where M represents the total quantity of money in
the economy, C represents currency held by the public, and D represents demand deposits held at
banks.
3. In a 100% reserve banking system, how are deposits handled by banks, and how
does it affect the money supply?

A: In a 100% reserve banking system, all deposits are held in reserve and are not used by banks
to make loans. This system does not affect the money supply as all deposits are kept in reserve
and do not circulate in the economy.
4. What is fractional reserve banking, and how does it work?
A: Fractional reserve banking is a system where banks keep only a fraction of their deposits in
reserve and use the rest to make loans. This allows banks to create money beyond the initial
deposits through the process of making loans.
5. What are the three main instruments of money supply control used by the central
bank?
A: The three main instruments of money supply control used by the central bank are open market
operations (buying or selling government bonds), changing the reserve requirements for banks,
and changing the discount rate (interest rate charged when lending to banks).
6. What are portfolio theories of money demand, and how do they explain money
holding?
A: Portfolio theories of money demand emphasize the role of money as a store of value in
people's investment portfolios. These theories predict that money demand should depend on
factors such as the expected real returns on other assets, the expected inflation rate, and the
individual's total wealth.
7. What is the Baumol-Tobin model of cash management, and how does it explain
money demand?
A: The Baumol-Tobin model analyzes the cost and benefits of holding money in cash for
convenience in making transactions. The model suggests that individuals will hold an optimal
amount of cash balances based on the trade-off between convenience benefits and the cost of
foregone interest on money not invested.
8. What is the money multiplier, and how does it affect the money supply?
A: The money multiplier is the factor by which the monetary base (B) is multiplied to determine
the money supply (M). It represents the impact of changes in the monetary base on the overall
money supply. The money supply is directly proportional to the monetary base and the money
multiplier.
A: The central bank controls the money supply through three main instruments:
 Open Market Operations, which involve buying and selling government bonds
to influence the monetary base and money supply.
 Changing Reserve Requirements, where the central bank sets regulations on
the minimum reserve-deposit ratio that banks must hold, affecting the money
multiplier and money supply.
 Changing the Discount Rate, which is the interest rate charged by the central
bank on loans to banks. Lowering the discount rate increases bank borrowing
and raises the monetary base and money supply.
10. What are the three instruments of money supply?

A: The three instruments of money supply are:
 Open market operations: The purchase and sale of government bonds by the
central bank to influence the monetary base and money supply.
 Reserve requirements: Regulations that specify the minimum reserve-deposit
ratio banks must maintain, affecting the money multiplier and money supply.
 Discount rate: The interest rate charged by the central bank on loans to banks,
influencing the monetary base and money supply.
11. Why can't the central bank control the money supply perfectly despite having
substantial power?
A: Bank discretion in conditioning business can lead to changes in the money supply that the
central bank did not anticipate. This is because banks have the freedom to make lending
decisions based on their assessment of the economic environment, which may not align with the
central bank's intentions.
12. What is the Classical Theory of Money Demand based on?
A: The Classical Theory of Money Demand assumes that the demand for real money balances is
directly proportional to income. It is represented by the equation (M/P) d = kY, where (M/P) d is
the demand for real money balances, k is a constant representing how much money people want
to hold for every dollar of income (Y), and P is the price level.
13. What are the three functions of money in an economy?

A: Money serves three functions in an economy:
 Unit of Account: It provides a common measure for quoting prices and
conducting transactions.
 Store of Value: It serves as a means to hold wealth over time.
 Medium of Exchange: It facilitates the exchange of goods and services.
14. What is the key point emphasized by Portfolio Theories of Money Demand?
A: Portfolio theories of money demand highlight the role of money as a store of value. They
suggest that people hold money as part of their portfolio of assets because money offers a
different combination of risk and return compared to other assets, particularly a safe return
(nominal) when other assets may fall in both real and nominal terms.
15. What factors influence money demand in Portfolio Theories of Money Demand?
A: Money demand in Portfolio Theories depends on various factors, including:
 Expected real return on stock (rs)
 Expected real return on bonds (rb)
 Expected inflation rate (πe)
 Real wealth (W) Changes in these factors can lead to changes in money
demand.
16. Why are some measures of money, like M1, considered dominated assets according
to economists?
A: Some measures of money, such as M1 (currency + demand deposits + travelers' checks +
other checkable deposits), are considered dominated assets because they exist alongside other
assets that are always better as a store of value. People may find alternative assets more attractive
for holding wealth, making these measures of money less optimal as part of their portfolio.
17. What is the Baumol-Tobin Model of Cash Management used for?
A: The Baumol-Tobin Model of Cash Management is used to explain the money demand
function. It analyzes the trade-off between the benefits of holding money (convenience) and the
costs (foregone interest on money that could have been deposited in a savings account). The
model helps determine the optimal size of cash balances based on the frequency of transactions
and the costs associated with trips to the bank.
18. What is the primary difference between banks and other financial institutions
regarding money creation?
A: The primary difference between banks and other financial institutions is the banking system's
ability to create money. When banks make loans, they create new money by expanding the
money supply. Other financial institutions do not have this money creation ability.
A: The central bank controls the money supply through three main instruments:
 Open Market Operations: By buying or selling government bonds, the central
bank can increase or decrease the money supply.

 Changing the Reserve Requirements: The central bank can set regulations that
impose a minimum reserve-deposit ratio on banks. Increasing reserve
requirements reduces the money supply, and decreasing them increases it.
 Changing Discount Rate: The interest rate at which banks borrow from the
central bank can be adjusted. A lower discount rate encourages more
borrowing, increasing the money supply.
20. What are the three instruments of money supply?
A: The three instruments of money supply are:
 Open Market Operations
 Reserve Requirements
 Changing Discount Rate
21. What is the Classical Theory of Money Demand based on?
A: The Classical Theory of Money Demand assumes that the demand for real money balances is
directly proportional to income. It can be expressed as (M/P) d = kY, where k is a constant
measuring how much people want to hold for every dollar of income.
22. What are the three functions of money according to the theory of money demand?
A: The three functions of money are:
 Unit of Account
 A store of value
 A medium of Exchange
23. What do portfolio theories of money demand emphasize?
A: Portfolio theories of money demand emphasize the role of money as a store of value. They
predict that demand for money should depend on the risk and return offered by money and other
assets, as well as the total wealth, as wealth measures the size of the portfolio to be allocated
among money and other assets.
24. What is the Baumol-Tobin Model of Cash Management?
A: The Baumol-Tobin Model of Cash Management is a prominent model that explains the
money demand function based on convenience and foregone interest on money. It analyzes the
optimal size of cash balances for individuals, taking into account the costs and benefits of
holding money.
25. How is money created in the banking system?
A: Money is created in the banking system through the process of lending. When a bank receives
a deposit, it keeps a portion of it as reserves and lends out the rest. The borrower of the loan may
deposit the borrowed money in another bank, which, in turn, keeps a fraction as reserves and
lends the rest again. This process continues, leading to the creation of new money in the
economy.
26. What is the primary difference between banks and other financial institutions
concerning money creation?

A: The primary difference between banks and other financial institutions is the ability of banks
to create money. Other financial institutions do not have this money creation power, making
banks a crucial component of the money supply process.
27. How is the money supply (M) calculated in the model of money supply?
A: The money supply (M) is calculated as the product of the money multiplier (m) and the
monetary base (B). M = m * B.
28. What are the factors that influence the money supply in the model of money
supply?
A: The money supply is influenced by three exogenous variables in the model:
 The monetary base (B) - the total number of dollars held by the public as
currency and by banks as reserves.
 The reserve-deposit ratio (rr) - the fraction of deposits that banks hold in
reserve.
 The currency-deposit ratio (cr) - the amount of currency people hold as a
fraction of their demand deposits.

Eco403 - Final Term Notes

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MacroeconoMics

Made by: Muniba ch

1. Economic growth is measured by an increase in which of the following?

c) Total output of goods and services

Answer: c) Total output of goods and services

2. The Solow Growth Model is designed to show the interaction of which

a) Government policies and population growth

b) Capital stock, labor force, and technology

c) Inflation and interest rates

Answer: b) Capital stock, labor force, and technology

3. In the Solow Growth Model, the production function represents the

transformation of inputs into outputs. Which inputs are considered in

the production function?

a) Labor (L) and investment (I)

b) Capital (K), labor (L), and production technology

c) Consumption (C) and savings (S)

d) Gross Domestic Product (GDP) and inflation rate

Answer: b) Capital (K), labor (L), and production technology

4. What is the national income identity in the Solow Growth Model?

b) Capital stock per worker

c) Population growth rate

d) Investment per worker

Answer: a) Saving rate

7. What is the steady state in the Solow model?

a) The point where investment is zero

b) The point where the capital stock remains constant (∆k = 0)

8. Which variable represents the fraction of income that is saved in the

Answer: c) s (Saving rate)

9. Which equation represents the investment function in the Solow model?

10.What does the Solow Growth Model primarily focus on studying?

a) Fiscal policies and government spending

b) Monetary policies and interest rates

d) Income distribution and poverty alleviation

c) John Maynard Keynes

Answer: b) Robert Solow

a nation's total output of goods and services?

a) Growth in population and advances in technology

c) Growth in capital stock and advances in technology

13.The production function represents the transformation of inputs (labor

and capital) into outputs (goods and services). In aggregate terms, it is

14.What does "y" represent in the Solow Growth Model?

a) Total output of goods and services

b) Output per worker

c) Capital per worker

Answer: b) Output per worker

15.What is the national income identity in "per worker" terms in the

Solow Growth Model?

16.The consumption function in the Solow Growth Model is given by:

a) c = (1–s) y b) c = (1–s) f(k) c)

the Solow Growth Model?

18.What is the steady state in the Solow Growth Model?

a) A state where the economy experiences rapid growth

b) A state where capital per worker is decreasing

d) A state where capital per worker is increasing

Answer: c) A state where capital per worker is constant (Δk = 0)

19.What does the Solow Growth Model aim to explain?

a) How population growth affects total output