Version A

I. Multiple choice [1 pt each: 22 pts total]

(1)c. (2)a. (3)c. (4)a. (5)b. (6)a. (7)b. (8)a. (9)b. (10)b.
(11)a. (12)a. (13)b. (14)a. (15)c. (16)c. (17)b. (18)a. (19)b. (20)d.
(21)b. (22)b.

II. Problems

(1) [Keynesian cross, Keynesian multipliers: 12 pts]

1. $30 trillion.
2. up.
3. $0.5 trillion.
4. increase.
5. $1.0 trillion. (Find this by drawing the new expenditure line carefully.)
6. 2. (ΔY/ΔG = 1/0.5)

(2) [Consumption function, Keynesian cross, Keynesian multipliers: 8 pts]

1. 0.9 = MPC.
2. 0.8 = MPC - MPI.
3. 5 = 1 / (1-MPC+MPI).
4. $1500 billion = $300 × govt purchases multiplier.
5. $60 billion = $300 / govt purchases multiplier.
6. 4 = govt purchases multiplier - 1.
7. $75 = $300 / tax cut multiplier.
8. $300, because the deficit-neutral multiplier always = 1.0.

(3) [Monetary policy rule: 8 pts]

1. 2 percent.
2. 4 percent, because real interest rate = nominal interest rate - inflation rate.
3. up, because "tightened" monetary policy means the interest rate is raised without any change in inflation.
4. decrease, because a higher interest rates would decrease C, I, and X.
5. unchanged, because inflation has momentum in the short run.

(4) [How business cycles begin: 20 pts] Full credit requires correct graphs on page 6.

1. up, right, boom.
2. down, left, recession.
3. up, right, boom.
4. up, right, boom.

(5) [Inflation adjustment: 16 pts] Begin by drawing the "inflation adjustment line" at the current rate of inflation, 2 percent.

1. $30 trillion, where aggregate demand curve 1 intersects current inflation rate.
2. equal to natural rate of unemployment* because GDP = potential GDP.
3. $31 trillion (an increase).
4. 2 percent, because inflation rate has momentum in short run.
5. less than the natural rate* because GDP > potential GDP.
6. $30 trillion, because eventually the inflation rate will rise until GDP once more equals potential GDP.
7. 6 percent, where aggregate demand curve 2 intersects potential GDP.
8. equal to natural rate of unemployment* because once again GDP = potential GDP.

III. Critical thinking [4 pts]

(1) One should disagree with this statement. The Federal Reserve can decrease the unemployment rate by relaxing monetary policy. However, if unemployment rate falls below the noncyclical rate of unemployment (or natural rate), then inflation rises. The noncyclical rate is currently roughly 4%. (It is always positive due to frictional and structural unemployment.) So any attempt to reduce the unemployment rate to zero would result in rising inflation.

(2) If the federal budget were required to be exactly balanced every year, it would be more difficult to control recessions and booms. To control booms, countercyclical fiscal policy requires that taxes increase and government spending decreases. To shorten recessions, taxes should decrease and government spending should increase. As a result, even if the budget is balanced during normal times, countercyclical fiscal policy requires budget surpluses in booms and budget deficits in recessions. If the budget were required to be exactly balanced every year, fiscal policy could not be used to stabilize the economy. Either booms and recessions would be larger and longer, or monetary policy would have to be much more vigorous. A more realistic constitutional amendment would include a clause allowing the federal government to run budget surpluses during booms and deficits during recessions.

Version B

I. Multiple choice [1 pt each: 22 pts total]

(1)c. (2)c. (3)e. (4)c. (5)c. (6)c. (7)d. (8)b. (9)a. (10)d.
(11)b. (12)c. (13)a. (14)c. (15)a. (16)c. (17)a. (18)c. (19)d. (20)a.
(21)d. (22)d.

II. Problems

(1) [Keynesian cross, Keynesian multipliers: 12 pts]

1. $30 trillion.
2. up.
3. $1 trillion.
4. increase.
5. $1.5 trillion. (Find this by drawing the new expenditure line carefully.)
6. 1.5 (ΔY/ΔG = 1.5/1)

(2) [Consumption function, Keynesian cross, Keynesian multipliers: 8 pts]

1. 0.8 = MPC.
2. 0.75 = MPC - MPI.
3. 4 = 1 / (1-MPC+MPI).
4. $1200 billion = $300 × govt purchases multiplier.
5. $75 billion = $300 / govt purchases multiplier.
6. 3 = govt purchases multiplier - 1.
7. $100 = $300 / tax cut multiplier.
8. $300, because the deficit-neutral multiplier always = 1.0.

(3) [Monetary policy rule: 8 pts]

1. 3.5 percent.
2. 8.5 percent, because real interest rate = nominal interest rate - inflation rate.
3. down, because "relaxed" monetary policy means the interest rate is lowered without any change in inflation.
4. increase, because a lower interest rates would decrease C, I, and X.
5. unchanged, because inflation has momentum in the short run.

(4) [How business cycles begin: 20 pts] Full credit requires correct graphs on page 6.

1. down, left, recession.
2. down, left, recession.
3. up, right, boom.
4. down, left, recession.

(5) [Inflation adjustment: 16 pts] Begin by drawing the "inflation adjustment line" at the current rate of inflation, 4 percent.

1. $30 trillion, where aggregate demand curve 1 intersects current inflation rate.
2. equal to natural rate of unemployment* because GDP = potential GDP.
3. $28.5 trillion (a decrease).
4. 4 percent, because inflation rate has momentum in short run.
5. greater than the natural rate* because GDP < potential GDP.
6. $30 trillion, because eventually the inflation rate will rise until GDP once more equals potential GDP.
7. 1 percent, where aggregate demand curve 2 intersects potential GDP.
8. equal to natural rate of unemployment,* because once again GDP = potential GDP.

III. Critical thinking [4 pts]

Same as Version A.

[end of answer key]