Revision

Midterm Revision on Economic Policy

 Topic One
Overview of Macroeconomics

C. Key concepts D. Aggregate

A. Introduction to B. Birth of
of Supply and
Macroeconomics Macroeconomics
Macroeconomics Demand
 Topic Two
Principles of Economic Polices

Term Economic Policy

The concept of Economic Policy

Definition of Economic Policy

Assessment of Economic Policy

Topic Three
Fiscal Policy
 Multiple Choice Questions
Which of the following are central themes of macroeconomics?
A)The short-term fluctuations in output, employment, financial conditions, and prices.
B)The longer-term trends in output and living standards.
C)Studies in individual prices, quantities, and markets.
D)Both A and B.
E)none of the above.

Answer: D
 Multiple Choice Questions
Who in responsible for the major breakthroughs in macroeconomics?
A)Adam Smith.
B)John Maynard Keynes.
C)Joseph Schumpeter.
D)Ben Bernanke.
E)none of the above.

Answer: B
 Multiple Choice Questions
How did the U.S. Congress formally proclaim the federal responsibility for
macroeconomic performance?
A)Employment Act of 1946.
B)Macroeconomic Act of 1930.
C)Federal Economic Act of 1950.
D)none of the above.
E)all of the above.

Answer: A
 Multiple Choice Questions
The goals of macroeconomic policy include:
A) high employment.
B) low unemployment.
C) stable prices.
D) growing real GDP.
E) all of the above.

Answer: E
 Multiple Choice Questions
Which of the following items is NOT part of fiscal policy?
A) Government purchases of goods and services.
B) Transfer payments.
C) The money supply.
D) Taxes.
E) Government borrowing by selling bonds.

Answer: C
 Multiple Choice Questions
In the United States, monetary policy is enacted by:
A)Congress.
B)both Congress and the President.
C)the Treasury Department.
D)the Federal Reserve.
E)none of the above.

Answer: D
 Multiple Choice Questions
The GDP gap is measured as the difference between:
A) the inflation and unemployment rates.
B) AD and AS at a particular price level.
C) potential and actual GDP.
D) nominal and real GDP.
E) fiscal and monetary policy.

Answer: C
 Multiple Choice Questions
Which of the following most accurately describes a recession?
A) a period of significant decline in total output, income, and employment, usually lasing
more than a few months and marked by widespread contractions in many sectors of the
economy.
B) a period of slight decline in employment, usually lasing only a few months.
C) a period of significant decline in total output, income, and employment, usually lasing
more than a few years and marked by widespread contractions in many sectors of the
economy.
D) a period of decline in total output, usually lasing more than a few months and marked by
contractions in one or two sectors of the economy.
E) none of the above.

Answer: A
 Multiple Choice Questions
Price stability means:
A) price movements that, on the average, tend to cancel so that the CPI holds steady.
B) absolutely no movement of all prices.
C) absolutely no movement in the prices of the goods contained in CPI market basket.
D) that real GDP cannot climb over time.
E) none of the above.

Answer: A
 Multiple Choice Questions
Personal income taxes are examples of:
A)fiscal-policy instruments.
B)monetary-policy instruments.
C)trade-policy instruments.
D)incomes policy instruments.
E)all of the above.

Answer: A
 Multiple Choice Questions
High inflation imposes what kind of costs?
A)taxes become highly variable.
B)the real values of people’s pensions are eroded.
C)people spend real resources to avoid depreciating money.
D)all of the above.
E)none of the above.

Answer: D
 Multiple Choice Questions
The aggregate demand curve is downward-sloping because:
A) higher prices make businesses more profitable and thus output expands.
B) lower prices makes business conditions more attractive so that quantities expand.
C) lower prices make some people feel wealthier and they therefore demand more.
D) lower prices cause substitutions that increase the quantity demanded.
E) none of the above.

Answer: C
 Multiple Choice Questions
The ups and downs of real GDP are called:
A)statistical errors.
B)accounting errors.
C)business cycles.
D)the Phillips curve.
E)consumption wave patterns.

Answer: C
 Multiple Choice Questions
Potential GDP is:
A) the total value of goods and services measured at current prices.
B) the total value of goods and services that could be produced at full employment.
C) the total value of goods and services measured at prices corrected for inflation.
D) the total value of goods and services net of government borrowing.
E) none of the above.

Answer: B
 Multiple Choice Questions
Aggregate supply refers to:
A) the total quantity of goods and services that the nation’s businesses willingly produce
and sell in a given period of time.
B) the partial quantity of goods and services that the nation’s businesses willingly produce
and sell in a given period of time.
C) the total quantity of goods and services that the nation’s government willingly produce
and sell in a given period of time.
D) the total quantity of goods and services that the nation’s businesses hope to produce and
sell in a given period of time.
E) none of the above.

Answer: A
 Multiple Choice Questions
Which is a tool of fiscal policy?
A)Wage and price controls.
B)Government expenditures.
C)Control of the money supply.
D)Control of the exchange rate.
E) None of the above.

Answer: B
 Multiple Choice Questions
Real GDP is ________.
A) the total value of goods and services net of imports.
B) the total value of goods and services deflated by an index of current prices to
correct for inflation.
C) the total value of goods and services that could be produced at low (full) employment.
D) the total value of goods and services corrected so that it is measured in terms of current prices.
E) none of the above.

Answer: B
 Multiple Choice Questions
Fiscal policy includes ________.
A) only decisions related to government expenditure on goods and services.
B) only decisions related to government expenditure on goods and services and the value of
transfer payments.
C) only decisions related to the value of transfer payments and tax revenue.
D) decisions related to government expenditure on goods and services, the value of transfer
payments, and tax revenue.

Answer: D
 Multiple Choice Questions
Fiscal policy involves ________.
A) the use of interest rates to influence the level of GDP.
B) the use of tax and spending policies by the government.
C) decreasing the role of the Federal Reserve in the everyday life of the economy.
D) the use of tax and money policies by government to influence the level of interest rates.

Answer: B
 Multiple Choice Questions
Fiscal policy attempts to achieve all of the following objectives EXCEPT ________.
A) a stable money supply
B) price level stability
C) full employment
D) sustained economic growth

Answer: A
 Multiple Choice Questions
Changes in which of the following is included as part of fiscal policy?
A) the quantity of money
B) the level of interest rates
C) monetary policy
D) tax rates
Answer: D
 Multiple Choice Questions
All of the following are part of fiscal policy EXCEPT ________.
A) setting tax rates.
B) setting government spending.
C) choosing the size of the government deficit.
D) controlling the money supply.
Answer: D
 Multiple Choice Questions
The budget process includes the ________.
A) President proposing the budget and the Congress passing the budget.
B) President passing the budget as proposed by Congress.
C) House of Representatives proposing the budget and the Senate passing the budget.
D) Senate proposing the budget and the House of Representatives passing the budget.

Answer: A
 Multiple Choice Questions
The purpose of the Employment Act of 1946 was to ________.
A) establish goals for the federal government that would promote maximum employment,
purchasing power, and production.
B) establish an unemployment compensation system.
C) set up the Federal Reserve System.
D) set targets for the unemployment rate to be achieved by the president.

Answer: A
 Multiple Choice Questions
The largest source of government revenues is ________.
A) personal income taxes
B) indirect taxes
C) corporate income taxes
D) Social Security taxes

Answer: A
 Multiple Choice Questions
The government receives tax revenues from several sources. Rank the following sources from
largest to the smallest.
I. corporate income taxes
II. personal income taxes
III. Social Security taxes
A) I, II, III
B) II, III, I
C) I, III, II
D) III, II, I

Answer: B
 Multiple Choice Questions
The largest item of government outlays is ________.
A) debt interest
B) transfer payments
C) expenditures on goods and services
D) debt reduction

Answer: B
 Multiple Choice Questions
A budget surplus occurs when government ________.
A) outlays exceeds tax revenues.
B) tax revenues exceeds outlays.
C) tax revenues equals outlays.
D) tax revenues equal Social Security expenditures.
Answer: B
 Multiple Choice Questions
The government's budget deficit or surplus equals the ________.
A) change in outlays divided by change in revenue.
B) average outlay divided by average revenue.
C) change in revenue minus change in outlays.
D) total tax revenue minus total government outlays.

Answer: D
 Multiple Choice Questions
If taxes exactly equaled government outlays the ________.
A) federal government debt would be zero.
B) federal government debt would decrease.
C) budget deficit would not change.
D) budget deficit would be zero.

Answer: D
 Multiple Choice Questions
A country has been in existence for only two years. In the first year, tax revenues were $1.0
million and outlays were $1.5 million. In the second year, tax revenues were $1.5 million and
outlays were $2.0 million. At the end of the second year, the total government debt was
________.
A) $0.5 million
B) $1 million
C) $2.5 million
D) $3.5 million

Answer: B
 Multiple Choice Questions

What is the amount of the surplus or deficit incurred Government Government

in year 1 by the government shown in the above table? Year
tax revenues expenditures
A) $0 (billions of (billions of
B) $25 billion deficit dollars) dollars)
C) $25 billion surplus 1 240 240
2 250 245
D) $240 billion surplus
3 260 255
4 300 320
Answer: A 5 325 340
 Multiple Choice Questions

What is the amount of the surplus or deficit incurred Government Government

in year 2 by the government shown in the above table? Year
tax revenues expenditures
A) $0 (billions of (billions of
B) $5 billion surplus dollars) dollars)
C) $5 billion deficit 1 240 240
2 250 245
D) $250 billion surplus
3 260 255
4 300 320
Answer: B 5 325 340
 Multiple Choice Questions

What is the amount of the surplus or deficit incurred Government Government

in year 3 by the government shown in the above table? Year
tax revenues expenditures
A) $0 (billions of (billions of
B) $5 billion surplus dollars) dollars)
C) $5 billion deficit 1 240 240
2 250 245
D) $260 billion surplus
3 260 255
4 300 320
Answer: B 5 325 340
 Multiple Choice Questions

What is the amount of the surplus or deficit incurred Government Government

in year 4 by the government shown in the above table? Year
tax revenues expenditures
A) $20 billion deficit (billions of (billions of
B) $35 billion surplus dollars) dollars)
C) $5 billion surplus 1 240 240
2 250 245
D) $320 billion surplus
3 260 255
4 300 320
Answer: A 5 325 340
 Multiple Choice Questions

What is the amount of the surplus or deficit incurred Government Government

in year 4 by the government shown in the above table? Year
tax revenues expenditures
A) $20 billion deficit (billions of (billions of
B) $35 billion surplus dollars) dollars)
C) $5 billion surplus 1 240 240
2 250 245
D) $320 billion surplus
3 260 255
4 300 320
Answer: A 5 325 340
 Multiple Choice Questions
Looking at the supply-side effects on aggregate supply shows that a tax hike on labor income
________.
A) weakens the incentive to work.
B) decreases potential GDP.
C) increases potential GDP because people work more to pay the higher taxes.
D) Both answers A and B are correct.

Answer: D
 Multiple Choice Questions
According to the Laffer Curve, the amount of tax revenue _______when tax rates are
________ and tax rates are ________.
A) increases,; low; increased
B) increases; high; increased
C) decreases; low; increased
D) decreases; high; decreased

Answer: A
 Multiple Choice Questions
The Laffer curve shows that increasing ________ increases ________ when ________ low.
A) tax revenue; potential GDP; tax revenue is
B) tax rates; tax revenue; tax rates are
C) potential GDP; tax revenue; tax revenue is
D) None of the above answers is correct.

Answer: B
 Multiple Choice Questions
An increase in the tax on interest income ________ the supply of loanable funds and
________ the equilibrium investment.
A) increases; increases
B) increases; decreases
C) decreases; increases
D) decreases; decreases

Answer: D
 Multiple Choice Questions
The system that measures the lifetime tax burden and benefits of each generation is called
________
A) actuarial genealogy.
B) generational actuary.
C) generational accounting.
D) actuarial accounting.
Answer: C
 Multiple Choice Questions
Generational accounting does NOT investigate issues involving ________
A) the budget deficit.
B) government obligations such as Social Security.
C) the ownership of corporate stock.
D) the burden of taxes.
Answer: C
 Multiple Choice Questions
The present value of the government's commitments to pay benefits minus the present value
of its tax revenues is called ________
A) calculated fiscal obligations.
B) fiscal imbalance.
C) fiscal balance.
D) fiscal obligations.

Answer: B
 Multiple Choice Questions
Generational accounting shows that the present value of the government's commitments to
pay benefits are ________ the present value of its taxes.
A) greater than
B) less than
C) equal to
D) not comparable to

Answer: A
 Multiple Choice Questions
Taxes and government expenditures that change in response to changes in the level of
economic activity, without need for additional government action, are examples of ________
A) discretionary fiscal variables.
B) automatic fiscal policy.
C) built-in monetary stabilizers.
D) cyclically balanced budgets.

Answer: B
 Multiple Choice Questions
One characteristic of automatic fiscal policy is that it ________
A) requires no legislative action by Congress to be made effective.
B) automatically produces surpluses during recessions and deficits during inflation.
C) has no effect on unemployment.
D) reduces the size of the federal government debt during times of recession.
Answer: A
 Multiple Choice Questions
A fiscal action that is initiated by an act of Congress is called ________
A) the government expenditure multiplier.
B) discretionary fiscal policy.
C) automatic fiscal policy.
D) generational fiscal policy.

Answer: B
 True or False Questions
• If prices are falling, nominal GDP may decline even if the economy is growing. Answer: True

• Real GDP is the total value of goods and services produced by an economy in 1 year measured at current
prices. Answer: False

• Real GDP is the most comprehensive measure of an economy’s output. Answer: True

• Macroeconomic policy has increasing emphasized a low and stable inflation rate. Answer: True

• The major instruments governments can use to pursue their macroeconomic goals are monetary policy
and fiscal policy. Answer: True

• Potential GDP represents the maximum sustainable level of output that the economy can produce.
Answer: True
 True or False Questions
• The CPI measures the price level by considering the prices of a complete and comprehensive list of
goods and services produced by an economy. Answer: False

• An increase in defense spending is an example of monetary policy. Answer: False

• The aggregate supply curve is positively sloped. Answer: True

• The inflation rate is the percentage change in the overall level of prices from one year to the next.
Answer: True

• Deflation occurs when prices decline. Answer: True

• The CPI uses a "market basket" of representative goods to measure the overall price level. Answer: True

• Fiscal policy is the government using taxes and government expenditure to affect the economy. Answer:
True
 True or False Questions
• Real GDP is generally increasing at a faster rate than nominal GDP during periods of high inflation.
Answer: False

• An increase in the taxes paid on wages and salaries is an example of fiscal policy. Answer: True
 Essay Questions
• What is fiscal policy, who makes it, and what is it designed to influence?
➢ Fiscal policy is the use of the federal budget to achieve macroeconomic objectives.
Fiscal policy is made by the president and Congress. It is designed to influence
employment, economic growth, and price level stability.

• How does a tax on labor income influence the equilibrium quantity of employment?
➢ A tax on labor income drives a wedge between the after-tax wage rate of workers and
the before-tax wage rate paid by firms. The tax on labor income decreases the supply of
labor. That is, for each before-tax wage rate, workers provide a lower quantity of labor
when faced with a tax that lowers their after-tax wage. The decrease in labor supply
raises the before-tax wage rate, even though the after-tax wage rate received by
workers falls. The decrease in labor supply also means that the quantity of employment
at full employment (i.e., equilibrium employment in the labor market) falls.
 Essay Questions
• What is the Laffer curve ?
➢ The Laffer curve is the relationship between the tax rate and the amount of tax revenue
collected. The amount of tax revenue collected increases with the tax rate only up to a
certain tax rate, after which, further increases in the tax rate cause tax revenue to fall. When
tax rates are higher than the tax rate that maximizes tax revenue, a country is said to be on
the wrong side of the Laffer curve.

• What fiscal policy action might increase investment and speed economic growth?
Explain how the policy action would work.
➢ A decrease in the tax on capital income will increase investment and thereby increase
economic growth. A decrease in the tax on capital income increases the supply of loanable
funds. The real interest rate falls and investment increases. The increase in investment
increases economic growth.
 Essay Questions
• How can economic policies be assessed?
- The effectiveness of economic policies can be assessed in one of two ways, known
as positive and normative economics.
- Positive economics attempts to describe how the economy and economic policies work
without resorting to value judgments about which results are best. The distinguishing feature
of positive economic hypotheses is that they can be tested and either confirmed or rejected.
For example, the hypothesis that “an increase in the supply of money leads to an increase in
prices” belongs to the realm of positive economics because it can be tested by examining the
data on the supply of money and the level of prices.
- Normative economics involves the use of value judgments to assess the performance of the
economy and economic policies. Consequently, normative economic hypotheses cannot be
tested. For example, the hypothesis that “the inflation rate is too high” belongs to the realm of
normative economics because it is based on a value judgment and therefore cannot be tested,
confirmed, or refuted. Not surprisingly, most of the disagreements among economists
concern normative economic hypotheses.
 Essay Questions
• What are the four types of entities of economic policies?
• In most modern economies operate four types of entities of economic policy:
1- Macroeconomic entities that have the power to make binding economic decisions
2- Association of basic economic entities that bring macroeconomic decisions (chambers of
commerce, trade unions, etc.).
3- Political parties, civic associations and NGOs
4- Large commercial organizations, whose activity directly reflects on the entire business
community, and by the importance of having an objective macroeconomic character
 Case Studies
Case Study:

The government is considering raising the tax rate on labor income. Explain the supply-side
effects of such an action and use appropriate graphs to show the directions of change, not
exact magnitudes. What will happen to:
a. The supply of labor and why?
b. The demand for labor and why?
c. Equilibrium employment and why?
d. The equilibrium before-tax wage rate and why?
e. The equilibrium after-tax wage rate and why?
f. Potential GDP?
Solution
a. The supply of labor and why?
The supply of labor will decrease. As shown
in Figure 30.1, the supply of labor curve
shifts leftward from LS0 to LS1. The supply
of labor decreases because at each real
wage rate, the hike in the tax rate on labor
income lowers the after-tax wage rate
received by workers.

b. The demand for labor and why?

The demand for labor will remain the same
so in Figure 30.1 the demand for labor
curve remains LD. The demand for labor
depends on the productivity of labor, which
does not change after the increase in the
tax rate on labor income.
Solution
c. Equilibrium employment and why?
As Figure 30.1 shows, the equilibrium
level of employment decreases. In the
figure, employment decreases from
310 billion hours per year to 300
billion hours per year.

d. The equilibrium before-tax wage

rate and why?
As Figure 30.1 shows, the equilibrium
before-tax wage rate increases from
$34 per hour to $35 per hour. The
before-tax wage rate rises because the
leftward shift of the supply of labor
curve leads to a movement up along
the demand for labor curve.
Solution
e. The equilibrium after-tax wage rate and why?
The equilibrium after-tax wage rate decreases. The tax
wedge in the figure is $2 per hour, so the after-tax wage rate
falls from $34 per hour to $33 per hour. The increase in the
tax rate on labor income increases the wedge between the
before-tax wage rate and the after-tax wage rate. The before-
tax wage rate increases but not by as much as the increase in
tax. So the after-tax wage rate decreases.

f. Potential GDP?

Potential GDP decreases. The equilibrium level of employment

is full employment. So as full employment decreases, potential
GDP decreases along the aggregate production function. Figure
30.2 shows this change as the movement along the aggregate
production function, PF, from point A, with 310 billion hours of
employment and potential GDP of $16.2 trillion, to point B,
with 300 billion hours of employment and potential GDP $16.1
trillion
 Case Studies
Suppose that instead of taxing nominal capital income, the government taxed real capital
income. Use appropriate graphs to explain and illustrate the effect that this change would
have on:

a. The tax rate on capital income.

b. The supply of and demand for loanable funds.

c. Investment and the real interest rate.

Solution
a. The tax rate on capital income.

The nominal interest rate is the

(nominal) income from capital. If the
government changes the tax code to
subtract the inflation rate from the
(nominal) interest rate before taxes are
imposed, the true tax rate on capital
income falls because the part of the
capital income—the inflation rate—
that is received in compensation for
inflation is no longer taxed.
Solution
b. The supply of and demand for loanable funds.

With a lower tax rate on capital income, the supply

of loanable funds increases as the after-tax real
interest rate rises. This change is illustrated in
Figure 30.3 by the rightward shift of the supply of
loanable funds curve from the initial supply of
loanable funds curve, SLF0, to SLF1.

The demand for loanable funds generally remains

the same because it depends in large part on
investment demand. Firms’ investment demand
depends on how productive capital is and the
productivity of capital does not necessarily change
when the tax code changes. In figure 30.3, the
demand for loanable funds curve does not shift.
Solution
c. Investment and the real interest rate.

As shown in Figure 30.3, the increase in the

supply of loanable funds shifts the supply of
loanable funds curve rightward. This change
leads to a lower real interest rate and a higher
amount of loanable funds and investment.
Case Studies
• Does the figure above illustrate a
recessionary or an inflationary gap? What
do potential GDP and real GDP equal?
What is an appropriate fiscal policy to
restore real GDP to potential real GDP?
• Answer: A recessionary gap occurs when
real GDP is less than potential GDP, which is
precisely what the figure illustrates. In the
figure, potential GDP equals $16 trillion but
real GDP equals only $15.5 trillion. In order
to restore real GDP back to potential GDP
using fiscal policy, the government could
increase government expenditure on goods
and services and/or decrease taxes.
Case Studies
• Does the figure above illustrate a
recessionary or an inflationary gap? What
do potential GDP and real GDP equal?
What is an appropriate fiscal policy to
restore real GDP to potential real GDP?
• Answer: A inflationary gap occurs when
real GDP is less than potential GDP, which is
precisely what the figure illustrates. In the
figure, potential GDP equals $16 trillion but
real GDP equals $16.5 trillion. In order to
restore real GDP back to potential GDP
using fiscal policy, the government could
decrease government expenditure on goods
and services and/or increase taxes.