Timed practice

Full practice exams

Pick an exam. Each one shows its format first, then runs one section at a time on its own clock.

Practice Exam 1

60 multiple-choice and 3 free-response questions, in the format of the AP Macroeconomics Exam. Each section runs on its own clock and ends when time runs out.

Section	Questions	Time
Section I: Multiple Choice	60	70 minutes
Section II: Free Response	3	60 minutes

A four-function calculator is allowed on both sections of the exam.

One section at a time. When a section's clock reaches zero, the section ends and is scored.
Multiple choice is scored when its section ends, with an explanation for every choice.
Free response is never scored by the page. When the section ends, you see the scoring guide and a model response for each part and tick the points your answer earns.
At the end you get your score and the time you used for each section.
Want the answers as you go? Pick Study mode below. Each multiple-choice answer is checked as soon as you give it, with its explanation, and each free-response question has a button that opens its scoring guide.
Your answers are kept in this browser tab if the page reloads, and nowhere else.

Time for each section Standard time Time and a half Double time Untimed Study mode

Choose before Section I starts. Time and a half and double time match common AP testing accommodations; untimed shows the time you use without ending a section. Study mode is untimed and shows each answer as you go.

Section I: Multiple Choice

60 questions · 70 minutes

Zandoria produces only sailboats and olive oil, and its production possibilities curve (PPC) is bowed outward from the origin. Zandoria is producing at a point on its PPC and moves resources from olive oil into sailboats, one sailboat at a time. Which statement is correct?
Answer: D.
1. A
  A constant cost per sailboat would make the PPC a straight line. A PPC bowed outward shows a rising cost: each sailboat takes more oil than the one before.
2. B
  On the PPC every resource is already in use, so more sailboats need resources taken from olive oil. Each sailboat costs some oil; only a point inside the PPC frees output at no cost.
3. C
  Falling costs would bow the PPC inward toward the origin. Zandoria's PPC bows outward, the shape of rising opportunity cost.
4. D
  Correct. A PPC bowed outward shows increasing opportunity cost. The resources moved into boatbuilding are less and less suited to it, so each extra sailboat means giving up more oil than the one before.
5. E
  Choosing a different point on the PPC moves Zandoria along the curve. The curve shifts outward only when its resources or technology change.
In one day, a worker in Ithmar can make either 12 baskets or 4 lamps, and a worker in Druvel can make either 6 baskets or 3 lamps. Each country faces constant opportunity costs. Which of the following is correct?
Answer: C.
1. A
  Ithmar makes more of both goods, which is an absolute advantage in both. Comparative advantage compares opportunity costs, and a country with the lower cost of one good has the higher cost of the other, so no country has a comparative advantage in both.
2. B
  A Druvel worker makes 3 lamps a day and an Ithmar worker makes 4, so Ithmar has the absolute advantage in lamps.
3. C
  Correct. A lamp costs Druvel 6/3 = 2 baskets and costs Ithmar 12/4 = 3 baskets. Druvel gives up less to make a lamp, so it has the comparative advantage in lamps.
4. D
  Ithmar makes more lamps, but each lamp costs it 3 baskets against Druvel's 2. Making more of a good is absolute advantage; the lower opportunity cost decides comparative advantage, and that is Druvel's.
5. E
  Both countries gain only if the price of a lamp falls between their opportunity costs, 2 and 3 baskets. At 1.5 baskets, Druvel would be paid less for a lamp than the 2 baskets it gives up to make one.
In one town, store-label cereal is an inferior good. This year the price of national-label cereal, a substitute, falls sharply, and household incomes rise. What happens in the town's market for store-label cereal?
Answer: C.
1. A
  This treats store-label cereal as a normal good. For an inferior good, higher incomes lower demand, and a cheaper substitute lowers it as well.
2. B
  The price of store-label cereal did not change first, so this is not a movement along its demand curve. A substitute's price and buyers' incomes are determinants of demand, and changes in them shift the curve.
3. C
  Correct. Cheaper national-label cereal pulls buyers away from the store label, and higher incomes lower the demand for an inferior good. Both events shift demand to the left.
4. D
  The two events push demand the same way, both down, so there is nothing to offset.
5. E
  A change is indeterminate only when two events push in opposite directions. Here both lower the demand for store-label cereal.
A region's government begins collecting a tax of 25 cents from bottlers on every bottle of spring water they sell. In the region's market for bottled spring water, this is an example of
Answer: A.
1. A
  Correct. A per-unit tax collected from sellers adds to the cost of every bottle they sell, so bottlers offer less at every price. The supply curve shifts left.
2. B
  Nothing here says the market price fell. The tax lowers what bottlers will offer at every price, which is a shift of the supply curve, not a movement along it.
3. C
  The tax is collected from bottlers, so it shifts supply. Buyers end up paying a higher price, but that is a movement along an unchanged demand curve.
4. D
  Expected prices can shift supply, but nothing here says bottlers expect a different price later. The tax raises their cost of selling each bottle now.
5. E
  No new bottlers entered the market, and the tax makes the ones already there offer less, not more.
A town's market for bags of garden mulch starts in equilibrium. In spring, buyers want more mulch at every price, and the supply of mulch does not change. What happens at the old price, and how does the market reach its new equilibrium?
Answer: D.
1. A
  More mulch is wanted at every price, so at the old price buyers want more bags than sellers offer. That is a shortage, not a surplus, and it pushes the price up.
2. B
  Supply has not changed, so the supply curve stays where it is. The shortage is closed by a higher price, which moves sellers up along the curve they already have.
3. C
  The shortage does push the price up, but a higher price lowers the quantity demanded along the new demand curve. Buyers drop out as the price climbs until the two quantities meet.
4. D
  Correct. At the old price, quantity demanded now exceeds quantity supplied, a shortage. Sellers raise the price, which draws out more mulch along the unchanged supply curve and trims the quantity buyers want, until the two are equal at a higher price and a larger quantity.
5. E
  The demand curve has shifted right, so the old price no longer clears the market. Buyers want more bags than sellers offer there, and the price rises.
Economists can measure GDP by adding up spending on final goods and services, or by adding up the wages, rent, interest and profit earned producing them. Why do the two methods give the same total?
Answer: B.
1. A
  Households do save. Saving does not break the equality, because GDP counts spending on final output, and every dollar paid for that output still ends up as somebody's earnings.
2. B
  Correct. The price of a final good is paid out as wages, rent, interest and profit to the workers, owners and lenders who produced it, so total spending on final output equals total income earned producing it.
3. C
  Neither method adds intermediate goods on top of final goods. Their value is already inside the price of the final good, and adding them again would count it twice.
4. D
  Transfer payments, such as pensions, are not payment for producing anything, so they are left out of both totals.
5. E
  Imports are subtracted from spending because they were produced abroad, and they are never part of domestic income at all. Nothing is added to one total to balance the other.
Countries P and Q have the same real GDP per capita. Workers in P average 50 hours of work a week, and workers in Q average 35 hours. In comparing how well people live in the two countries, what does real GDP per capita leave out?
Answer: A.
1. A
  Correct. GDP measures output, not the time people give up to produce it. Workers in Q get the same output per person with 15 fewer hours of work a week, a gain in well-being that GDP does not record.
2. B
  Output and income are two ways of measuring the same total, and neither counts it twice. The gap here is the leisure GDP leaves out.
3. C
  Real GDP per capita is the same in both countries, and Q's output is measured like P's. What is missing is the leisure, not any output.
4. D
  GDP puts no value on leisure at all. If it did, Q would show a higher figure than P.
5. E
  GDP does not adjust for hours worked. The equal figures hide that people in Q work far less for the same output.
Quorvia has 60,000 adults. Of them, 37,600 are employed and 2,400 are unemployed. Then 1,000 adults who had not been looking for work start looking, and 200 of them find jobs right away. Nothing else changes. What is Quorvia's new unemployment rate, to one decimal place?
Answer: C.
1. A
  That divides the 3,200 unemployed by all 60,000 adults. The unemployment rate divides by the labor force, which is now 41,000.
2. B
  6.0 percent, 2,400 / 40,000, was the rate before the change. The 800 new job seekers who did not find work are now unemployed, so the rate rises.
3. C
  Correct. Employment rises to 37,600 + 200 = 37,800 and unemployment to 2,400 + 800 = 3,200, so the labor force is 41,000. The rate is 3,200 / 41,000 = 7.8 percent.
4. D
  That divides 3,200 by the old labor force of 40,000. All 1,000 new job seekers joined the labor force, so it is now 41,000.
5. E
  That divides 3,200 by the 37,800 employed. The denominator of the unemployment rate is the labor force, the employed plus the unemployed.
Which of the following people is counted as unemployed?
Answer: B.
1. A
  Anyone who works for pay, even part time, is counted as employed. That is one reason the measured rate understates joblessness.
2. B
  Correct. He has no job and is actively looking for one, which is what it takes to be counted as unemployed. Between jobs and searching, he is frictionally unemployed.
3. C
  She has stopped looking, so she is a discouraged worker. Discouraged workers are counted outside the labor force, not as unemployed.
4. D
  A retiree who is not looking for work is outside the labor force.
5. E
  A student who is not looking for work is outside the labor force.
Mirabel's salary rose from $48,000 in Year 1 to $51,000 in Year 2. The consumer price index was 120 in Year 1 and 132 in Year 2. Measured in base-year dollars, what happened to Mirabel's real salary?
Answer: E.
1. A
  Those are her nominal salaries. They have not been adjusted for the 10 percent rise in prices between the two years.
2. B
  That deflates both years by the Year 1 index of 120. Year 2's salary has to be deflated by Year 2's index: 51,000 / 1.32 = $38,636.
3. C
  That multiplies by the index instead of dividing by it. To remove the effect of prices, divide each salary by its year's index over 100.
4. D
  That deflates Year 2 but leaves Year 1 in nominal dollars. In base-year dollars Year 1's salary is 48,000 / 1.20 = $40,000.
5. E
  Correct. Year 1: 48,000 / 1.20 = $40,000. Year 2: 51,000 / 1.32 = $38,636. Her pay rose 6.25 percent while prices rose 10 percent, so her real salary fell.
A refrigerator model sells for the same price this year as last year, but the new version uses half as much electricity. The consumer price index records no change in the refrigerator's price. Which shortcoming of the CPI does this show?
Answer: C.
1. A
  That is substitution bias, which comes from buyers switching away from goods whose prices rose. Nobody switched here. The same product got better at the same price.
2. B
  The CPI prices the refrigerator once, as an item in the basket. The electricity it saves is not counted as part of the refrigerator.
3. C
  Correct. The buyer gets more for the same price, so the cost of what the refrigerator provides has fallen. Recording no change misses that, and missing quality gains pushes the measured inflation rate above the true rise in the cost of living.
4. D
  The direction is backwards. A better product at the same price is a hidden price cut, so missing it makes the CPI overstate inflation, not understate it.
5. E
  Durable goods such as appliances are in the CPI basket, and the stem says the index recorded this refrigerator's price.
Everyone expected 6 percent inflation this year, and contracts were written with that in mind. Actual inflation turned out to be 2 percent. Which of the following people is better off than planned?
Answer: E.
1. A
  The loan's rate was set to cover 6 percent inflation. With only 2 percent, each dollar the family repays buys more than planned, so the loan costs them more in real terms.
2. B
  The firm planned a raise that kept real wages about steady. With 2 percent inflation, a 6 percent raise lifts real wages about 4 percent more than planned, and the firm pays for that.
3. C
  A pension tied to actual inflation keeps its purchasing power whatever inflation turns out to be, so the retiree ends up where planned.
4. D
  The fixed rent was expected to lose about 6 percent of its real value over the year. It lost only about 2 percent, so the tenant pays more in real terms than planned.
5. E
  Correct. The raise was sized for 6 percent inflation. Prices rose only 2 percent, so her real pay rose about 4 percent more than she and her employer planned.
From Year 1 to Year 2, Brascany's nominal GDP rose, but its real GDP fell. Which of the following must be true?
Answer: E.
1. A
  If the deflator had fallen while spending rose, real GDP would have risen by even more than nominal GDP. Real GDP can fall while nominal GDP rises only if the deflator rises.
2. B
  Real GDP measures how much is produced, and it fell. Brascany spent more in Year 2 but produced less.
3. C
  Then real GDP, nominal GDP divided by the deflator, would have risen. For real GDP to fall, the deflator has to rise faster than nominal GDP.
4. D
  Population matters for GDP per capita, not for real GDP itself. Real GDP is nominal GDP adjusted for the price level, whatever the population does.
5. E
  Correct. Real GDP is nominal GDP divided by the GDP deflator. Nominal GDP measures spending at current prices and real GDP measures production at constant prices, so spending can rise while production falls only if the deflator rose by more than nominal GDP did.
Which of the following describes the trough of a business cycle?
Answer: D.
1. A
  That is a peak, the turning point at the top of an expansion.
2. B
  Output below potential is a negative output gap. An economy can stay below potential for a long time after the trough, while it recovers.
3. C
  Unemployment equals its natural rate when output is at potential, which is not a turning point of the cycle.
4. D
  Correct. The trough is the turning point at the bottom of the cycle: real GDP stops falling, the recession ends and an expansion begins.
5. E
  Falling real GDP describes a recession, the phase that ends at the trough, not the trough itself.
The demand curve for a single good slopes downward partly because buyers switch to other goods when its price rises. Why does that reason not explain the downward slope of the aggregate demand curve?
Answer: B.
1. A
  The long-run aggregate supply curve is the vertical one. The aggregate demand curve slopes down, and the question is why.
2. B
  Correct. Buyers of a single good switch to other goods whose prices have not risen. When the overall price level rises, the other domestic goods have risen too, so there is nothing cheaper at home to switch to. The slope of aggregate demand comes instead from the real wealth effect, the interest rate effect and the exchange rate effect.
3. C
  Government purchases are one component of aggregate demand, and they do not explain its slope. The slope comes from the real wealth, interest rate and exchange rate effects on households, firms and foreign buyers.
4. D
  Aggregate demand includes consumption, investment, government purchases and net exports, not consumption alone.
5. E
  Buying more foreign goods when domestic prices rise belongs with the exchange rate effect. The real wealth effect is about the money people hold buying less as the price level rises.
Which of the following would shift an economy's aggregate demand curve to the left?
Answer: B.
1. A
  A change in the price level moves the economy along the aggregate demand curve. This is the real wealth effect, not a shift.
2. B
  Correct. Households that cut spending to repay their debts consume less at every price level. Consumption falls for a reason other than the price level, so aggregate demand is lower at every price level and the curve shifts left.
3. C
  More transfer payments raise disposable income and consumption, which shifts aggregate demand to the right.
4. D
  Lower production costs shift short-run aggregate supply to the right. They do not shift aggregate demand.
5. E
  Greater wealth that did not come from a change in the price level raises consumption and shifts aggregate demand to the right.
In Duskavar, households save 25 cents of every extra dollar of disposable income. The government cuts taxes by $18 billion, and nothing else changes. What is the maximum change in aggregate demand?
Answer: D.
1. A
  That is only the first round of new spending, 18 x 0.75. Each round of spending becomes someone's income, and the multiplier counts every round.
2. B
  The spending the tax cut starts is multiplied as it passes from one household to the next, so the total is larger than the $18 billion cut.
3. C
  That divides 18 by the MPC of 0.75. The tax multiplier is MPC / MPS = 0.75 / 0.25 = 3.
4. D
  Correct. The MPS is 0.25, so the MPC is 0.75. The tax multiplier is 0.75 / 0.25 = 3, and 18 x 3 = $54 billion.
5. E
  That uses the spending multiplier, 1 / 0.25 = 4. A tax cut works through the tax multiplier, 3, because households save part of the cut before any spending happens.
Firms in Corrabay decide to spend more on new equipment, and nothing else changes. Why can Corrabay's real GDP rise by more than the new equipment spending?
Answer: A.
1. A
  Correct. One firm's spending is someone else's income. Those workers and owners spend part of what they receive, which is income for others who spend part again, so total output rises by a multiple of the first round of spending.
2. B
  GDP counts each final good once. Equipment is investment spending when it is bought, and using it later adds nothing a second time.
3. C
  Real GDP removes the effect of the price level. A higher price level raises nominal GDP, not the quantity of output.
4. D
  Saving is the part of income that is not spent, so it ends the chain rather than adding to it. If households saved every new dollar, there would be no further rounds of spending.
5. E
  Imports are subtracted in GDP because they are produced abroad. Spending that goes to imports leaks out of the rounds instead of adding to them.
A new national rule requires every factory to buy and maintain costly safety equipment each year. Nothing else changes. This is best described as
Answer: A.
1. A
  Correct. The rule raises what firms pay to produce each unit of output, so they supply less at every price level and the SRAS curve shifts left.
2. B
  Households' spending plans did not change first. The rule falls on firms' costs, which is the supply side of the model.
3. C
  A movement along SRAS comes from a change in the price level. Here costs rose at every price level, which shifts the curve.
4. D
  Safer workplaces may be a benefit, but the rule is a cost that firms pay every year, and higher costs reduce SRAS.
5. E
  Nothing in the stem changes the number of workers. The rule raises costs, which shifts short-run aggregate supply.
Which statement correctly contrasts the short-run aggregate supply (SRAS) curve with the long-run aggregate supply (LRAS) curve?
Answer: C.
1. A
  That reverses them. Sticky wages and prices are why SRAS slopes upward, and full adjustment of wages and prices is why LRAS is vertical.
2. B
  LRAS has no upward slope. In the long run wages and prices fully adjust, so output is at its full-employment level whatever the price level.
3. C
  Correct. In the short run some input prices are fixed, so a higher price level raises output. In the long run all wages and prices adjust, so LRAS is vertical at full-employment output.
4. D
  Only LRAS is vertical. SRAS slopes upward because some input prices are fixed in the short run.
5. E
  LRAS shifts when the economy's resources or technology change. Better technology shifts both curves to the right.
Vanthor's full-employment real output is $940 billion. Its aggregate demand and short-run aggregate supply are shown below, in billions of dollars of real output.
- Price level 100: $940 demanded, $820 supplied
- Price level 105: $920 demanded, $860 supplied
- Price level 110: $900 demanded, $900 supplied
- Price level 115: $880 demanded, $940 supplied
- Price level 120: $860 demanded, $980 supplied
Which describes Vanthor's short-run equilibrium?
Answer: A.
1. A
  Correct. The aggregate quantity demanded equals the aggregate quantity supplied at a price level of 110, where both are $900 billion. That is $940 - $900 = $40 billion below full employment, a negative (recessionary) output gap.
2. B
  The equilibrium is right but the sign is not. Output of $900 billion is below the full-employment $940 billion, so the gap is negative.
3. C
  At 115 firms supply $940 billion but buyers want only $880 billion, so unsold output piles up and the price level falls. Full-employment output is the short-run equilibrium only if the curves cross there.
4. D
  At 100 buyers want $940 billion but firms supply only $820 billion, a shortage that pushes the price level up.
5. E
  At 120 firms supply $980 billion but buyers want only $860 billion. The equilibrium is where the two quantities are equal.
An economy is in long-run equilibrium when the price of imported electronic components, which most of its firms build into their products, falls sharply and stays low. In the short run, what happens to the price level, real output and unemployment?
Answer: B.
1. A
  A higher price level with more output is what a rightward shift of aggregate demand does. A fall in a cost shifts SRAS right, which lowers the price level.
2. B
  Correct. Cheaper components lower production costs, so SRAS shifts right. The new short-run equilibrium has a lower price level and more output, and firms hire more workers to produce it, so unemployment falls.
3. C
  A lower price level with less output is a leftward shift of aggregate demand. Here costs fell, which raises output.
4. D
  That is the effect of a sharp rise in the price of components, a negative supply shock. This shock is positive.
5. E
  The rightward SRAS shift moves the economy along aggregate demand to more output, so output and employment change in the short run.
Economies P and Q both start in long-run equilibrium. In P, hospitals abroad place large new orders for the medical scanners that P's firms build. In Q, premiums for the insurance that nearly every business carries rise sharply. In the short run, which of the following compares the two economies correctly?
Answer: E.
1. A
  That reverses the two. The scanner orders shift AD right in P, so output rises and unemployment falls; costlier insurance shifts SRAS left in Q, so output falls and unemployment rises.
2. B
  Only P's higher prices come from more spending. In Q the costlier insurance shifts SRAS left, so output falls and unemployment rises while prices climb.
3. C
  Higher insurance premiums raise firms' costs, so Q's price level rises, not falls. Q's unemployment rises, because its output falls.
4. D
  Q's SRAS shifts left, so its real output falls. Firms need fewer workers, so unemployment rises rather than staying put.
5. E
  Correct. P has demand-pull inflation: the new export orders shift AD right, raising the price level and output, so unemployment falls. Q has cost-push inflation: SRAS shifts left, raising the price level while output falls, so unemployment rises.
An economy is at full employment when banks across the country make it much easier for households to borrow for cars and appliances. Which explains the short-run effect on unemployment?
Answer: B.
1. A
  Easier borrowing raises spending at every price level, which shifts aggregate demand. A movement along AD comes only from a change in the price level.
2. B
  Correct. Easier credit raises consumption at every price level, so AD shifts right. Firms produce more and hire more workers, so in the short run unemployment falls below its natural rate while the price level rises.
3. C
  What households buy is aggregate demand. SRAS shifts with production costs, which this change does not touch.
4. D
  Unemployment returns to its natural rate only in the long run. In the short run, more output means more workers hired.
5. E
  The higher price level comes with more output, not less. Firms hire to produce the extra output, so unemployment falls.
An economy starts in long-run equilibrium. A sharp drop in investment spending moves it to a short-run equilibrium with a recessionary gap, and no policy action is taken. Compared with that short-run equilibrium, what happens as the economy adjusts in the long run?
Answer: A.
1. A
  Correct. With unemployment above its natural rate, nominal wages and other input prices fall over time. SRAS shifts right until output is back at full employment, at a price level below both the original level and the short-run level.
2. B
  Wages rise when output is above full employment. In a recessionary gap, high unemployment pushes them down.
3. C
  With no policy action, nothing moves aggregate demand back. The adjustment comes through wages and SRAS.
4. D
  Wages do fall and SRAS does shift right, but a rightward SRAS shift lowers the price level. It falls further rather than climbing back.
5. E
  Full-employment output depends on resources and technology, which the drop in spending did not change. The economy returns to its original LRAS.
Over several years, firms in an economy add a large amount of new machinery and equipment, while the labor force stays the same. What happens to the long-run aggregate supply curve and to full-employment output?
Answer: D.
1. A
  A larger stock of capital changes what the economy can produce at full employment, which moves the LRAS curve itself.
2. B
  Buying equipment adds to the capital stock, which raises productive capacity rather than lowering it.
3. C
  The position of LRAS is full-employment output. If LRAS moves right, full-employment output has risen.
4. D
  Correct. More capital raises the economy's maximum sustainable output, so LRAS shifts right and full-employment output rises. That is economic growth.
5. E
  Spending on equipment adds to aggregate demand while it happens, but the lasting effect is a larger capital stock, which raises full-employment output.
To fight a recession, Pomaro's government raises the monthly payments it makes to families with young children. Nothing else changes. Which component of aggregate demand does this change first, and in which direction?
Answer: E.
1. A
  The payments are transfers, not purchases of goods and services. The government buys nothing with them, so they are not part of government purchases.
2. B
  Families spend much of a new payment rather than save all of it, and saving is not investment until firms borrow and build. The first and largest effect is on consumption.
3. C
  Buying more goods from other countries raises imports, which lowers net exports. And most of the new spending goes to goods made at home.
4. D
  Transfers are left out of GDP, but they still change spending. They raise disposable income, and households spend part of it, so consumption rises.
5. E
  Correct. A transfer payment works indirectly: it raises disposable income, households spend part of it, and consumption rises. That shifts AD right, which is why larger transfers are expansionary fiscal policy.
A recession starts, and lawmakers pass a large increase in government purchases to fight it. By the time most of the money is spent, private spending has recovered on its own and real output is back at full employment. What is the short-run effect of the spending when it arrives?
Answer: D.
1. A
  There is no longer a gap to close. Output is already at full employment, so the added spending pushes it past that level.
2. B
  Government purchases are part of aggregate demand. They do not lower firms' production costs.
3. C
  GDP counts purchases when the goods and services are bought, not when a law is passed, so the spending adds to aggregate demand when it happens.
4. D
  Correct. Because of the lag, the spending lands on an economy already at full employment. Aggregate demand shifts right, the price level rises and output moves above full employment, a positive output gap that the policy itself created.
5. E
  A rightward shift of aggregate demand moves the economy up along the upward-sloping SRAS curve, so the price level rises as well.
A government wants its automatic stabilizers to do more to soften recessions, without passing a new law each time one starts. Which change would do that?
Answer: C.
1. A
  A balanced-budget rule forces spending cuts just as tax revenue falls in a recession, which deepens the fall in aggregate demand. It weakens the stabilizers.
2. B
  A benefit that has to be voted on in each recession is discretionary policy, the opposite of what the government wants. Automatic stabilizers pay out under laws already in place.
3. C
  Correct. Unemployment insurance pays out automatically as people lose their jobs. A larger replacement share keeps more disposable income and consumption flowing in a recession, with no new law needed each time.
4. D
  Faster lawmaking still produces discretionary policy, passed one recession at a time. Automatic stabilizers work without any new action.
5. E
  Cutting benefits in a recession takes income away just when spending is falling, which makes the recession deeper.
Which of the following is the opportunity cost of holding wealth as cash and checking deposits instead of as bonds?
Answer: B.
1. A
  That is a risk of holding bonds, not a cost of holding money. A household holding cash avoids it.
2. B
  Correct. Money in cash or a checking account earns little or nothing. What a household gives up by holding it there is the interest it could have earned by holding bonds instead, and that forgone interest is the opportunity cost of holding money.
3. C
  That is liquidity, the benefit of holding money. The opportunity cost is what the household gives up to get that liquidity.
4. D
  A fee is a charge for a service, and cash carries no fee at all. The opportunity cost of holding money is the best alternative given up, which is the interest bonds would have earned.
5. E
  The question compares money with bonds, so the alternative given up is the interest the bonds pay. Dividends are the return on a different asset.
A firm with branches in Calmora and in Dessin takes out a one-year loan in each country, in that country's currency. Lenders in both countries want the same expected real interest rate, but people in Dessin expect much faster inflation over the year than people in Calmora do. Which of the following describes the nominal interest rates on the two loans?
Answer: C.
1. A
  Equal expected real rates do not mean equal nominal rates. The nominal rate is the expected real rate plus expected inflation, and expected inflation differs.
2. B
  Lenders expecting their money to keep its value need less added on, not more. The loan where faster inflation is expected needs the higher nominal rate.
3. C
  Correct. Lenders and borrowers set the nominal rate as the expected real rate plus expected inflation. With the same expected real rate, the Dessin rate is higher by about how much more inflation people there expect.
4. D
  The higher nominal rate in Dessin only makes up for the faster expected inflation. The expected real rate is the same in both countries, as the stem says.
5. E
  Repayment in money expected to lose value is exactly why lenders in Dessin ask for more. They add the expected inflation to the nominal rate.
In Jessavar, a lender and a borrower both expect inflation of 2 percent over the coming year. They agree on a one-year loan at the nominal interest rate that gives the lender an expected real interest rate of 3 percent. Inflation over the year turns out to be 6 percent. What real interest rate did the lender actually earn on the loan?
Answer: D.
1. A
  That adds inflation to the nominal rate, 5 + 6. Inflation is subtracted from the nominal rate to find the real rate: 5 - 6 = -1 percent.
2. B
  That is the real rate the two sides expected. The higher-than-expected inflation means the lender actually earned less: 5 - 6 = -1 percent.
3. C
  That subtracts the nominal rate from inflation, 6 - 5, which flips the sign. The real rate is nominal minus inflation, 5 - 6 = -1 percent.
4. D
  Correct. The nominal rate was set at the expected real rate plus expected inflation, 3 + 2 = 5 percent. In hindsight the real rate is the nominal rate minus actual inflation, 5 - 6 = -1 percent, so the lender lost purchasing power.
5. E
  That subtracts actual inflation from the expected real rate, 3 - 6. The real rate is found from the nominal rate the loan actually charged, which is 3 + 2 = 5 percent.
Which of the following is counted in a country's monetary base but not in its M1?
Answer: B.
1. A
  Currency held by the public is in both measures. The monetary base is that currency plus bank reserves, and M1 counts it too.
2. B
  Correct. The monetary base is currency in circulation plus bank reserves. Reserves are money banks hold for themselves rather than money households and firms spend, so M1 leaves them out.
3. C
  Checking deposits are in M1, since households and firms spend them directly. They are not part of the monetary base.
4. D
  Savings deposits are not part of the monetary base. Under the Federal Reserve's current definitions they are counted in M1, and they have always been in M2.
5. E
  Bonds are assets the central bank owns. They are not money, and they appear in neither measure.
Quenlow's banking system has limited reserves, and its required reserve ratio is 20 percent. Its monetary base is $600 billion and its money supply is $1,500 billion. What are Quenlow's money multiplier and the maximum value its money multiplier could take?
Answer: B.
1. A
  5 is only the maximum, 1 / 0.20. The actual multiplier is the money supply over the monetary base, 1,500 / 600 = 2.5.
2. B
  Correct. The money multiplier is the money supply over the monetary base, 1,500 / 600 = 2.5. Its maximum value is the reciprocal of the required reserve ratio, 1 / 0.20 = 5.
3. C
  0.4 is the monetary base over the money supply, 600 / 1,500, which is upside down. The multiplier is 1,500 / 600 = 2.5.
4. D
  The actual multiplier is 2.5, but the maximum comes from the required reserve ratio: 1 / 0.20 = 5. The two are equal only when every dollar of excess reserves is lent and redeposited.
5. E
  0.2 is the required reserve ratio itself. The maximum multiplier is its reciprocal, 1 / 0.20 = 5.
A commercial bank has $800,000 in demand deposits and $140,000 in reserves, and the required reserve ratio is 15 percent. The banking system has limited reserves. The central bank then lowers the required reserve ratio to 10 percent. What is the largest new loan this one bank can now make?
Answer: C.
1. A
  That is the excess reserves at the old ratio, 140,000 - 0.15 x 800,000. The lower ratio frees more reserves: at 10 percent, required reserves are $80,000.
2. B
  That is only the drop in required reserves, 120,000 - 80,000. The bank also still has its old $20,000 of excess reserves, so it can lend 20,000 + 40,000 = $60,000.
3. C
  Correct. At 10 percent, required reserves are 0.10 x 800,000 = $80,000. Excess reserves are 140,000 - 80,000 = $60,000, and a single bank can safely lend no more than its excess reserves.
4. D
  That lends out all of the reserves. The bank must still keep 0.10 x 800,000 = $80,000 as required reserves, which leaves $60,000 to lend.
5. E
  That is the most the whole banking system could add to the money supply, 60,000 x 1 / 0.10. One bank can lend only its own excess reserves, $60,000.
The nominal interest rate in Umbravia's money market is below its equilibrium level. Which of the following describes how the market returns to equilibrium?
Answer: A.
1. A
  Correct. Below equilibrium, people want to hold more money than the central bank has supplied, a shortage of money. To get it they sell bonds, which pushes bond prices down. Lower bond prices mean higher interest rates, and the rate rises until the quantity of money demanded equals the quantity supplied.
2. B
  That is what happens when the rate is above equilibrium and there is a surplus of money. Here the rate is too low, so people are short of money, not holding too much.
3. C
  The central bank sets the money supply; it does not respond automatically to a shortage. Market forces close the gap by moving the interest rate.
4. D
  The money supply curve is vertical: the quantity supplied does not depend on the interest rate. The quantity demanded falls as the rate rises instead.
5. E
  A disequilibrium does not shift either curve. The interest rate moves along the money demand curve until the quantity demanded equals the fixed quantity supplied.
Most employers in an economy switch from paying their workers every week to paying them once a month, so households keep larger cash and checking balances on hand between paydays. The central bank keeps the money supply constant. In the money market, what happens to the equilibrium nominal interest rate and the equilibrium quantity of money?
Answer: D.
1. A
  That treats the money supply curve as sloping upward. The central bank holds the money supply fixed, so the quantity of money cannot rise.
2. B
  That has money demand shifting left. Keeping larger balances on hand between paydays raises the demand for money.
3. C
  That lets the quantity of money adjust instead of the rate. With the money supply fixed, the rate is what moves.
4. D
  Correct. With a month between paychecks, households hold more money on average to cover their purchases, so people want to hold more money at every interest rate and money demand shifts right. With a vertical money supply curve that has not moved, the interest rate rises and the quantity of money stays where the central bank set it.
5. E
  That describes an increase in the money supply, which the central bank did not make. Here only money demand changes.
In an economy whose banks have limited reserves, an inflationary gap has opened. Which of the following describes a central bank action that would act to close the gap, and how it works?
Answer: D.
1. A
  Buying bonds pays reserves into the banks, which increases the money supply and lowers the interest rate. That raises investment, the wrong direction for an output level above full employment.
2. B
  A lower required reserve ratio frees reserves for lending, so banks lend more, the money supply rises and the interest rate falls. That is expansionary.
3. C
  Selling bonds takes reserves out of the banks, not into them. The effects listed are those of a purchase, which would widen the gap.
4. D
  Correct. When the central bank sells bonds, banks pay for them with reserves, so reserves and the money supply fall. The nominal interest rate rises, investment and other interest-sensitive spending fall, and AD shifts left toward full employment.
5. E
  A lower discount rate makes it cheaper for banks to borrow reserves, which adds to reserves and lowers interest rates. That is expansionary.
Unemployment in Yelveron began rising in January, but its central bank did not see the trend in its data until May. The bank cut its policy rate in June, and business investment did not pick up until the following spring. The delays in this example illustrate
Answer: C.
1. A
  Crowding out is when government borrowing raises interest rates and private investment falls. Here rates were cut, and the story is about timing.
2. B
  That limitation is about how much the money supply grows, not about how long policy takes to work.
3. C
  Correct. It took months to recognize the problem, and months more for spending to respond after the rate cut. Those delays are the lags in monetary policy.
4. D
  The amount of reserves decides which tool moves the policy rate. It does not explain a delay between the problem, the action and the result.
5. E
  Automatic stabilizers are fiscal: taxes and transfers that change on their own as income changes, with no decision needed. This is a central bank decision and its delays.
Last year in Pirhaven, households had disposable income of $900 billion and spent $760 billion on consumption. The government collected $310 billion in taxes, before paying out any transfers. It bought $280 billion of goods and services and paid $60 billion in transfer payments. On net, $25 billion of financial capital flowed out of Pirhaven to other countries. Assume all private saving is done by households. What was investment in Pirhaven?
Answer: A.
1. A
  Correct. Private saving is 900 - 760 = $140 billion. Public saving is 310 - 280 - 60 = -$30 billion, a deficit. National saving is 140 - 30 = $110 billion. Investment equals national saving plus net capital inflow, and an outflow of $25 billion is an inflow of -25, so investment is 110 - 25 = $85 billion.
2. B
  That is national saving. In an open economy, investment also counts net capital inflow, which here is negative because $25 billion flowed out: 110 - 25 = $85 billion.
3. C
  That leaves out public saving. The government ran a deficit of 310 - 280 - 60 = $30 billion, which lowers national saving to $110 billion before the outflow is subtracted.
4. D
  That adds the $25 billion as if it flowed in. Funds that leave the country are not available for investment at home, so they are subtracted: 110 - 25 = $85 billion.
5. E
  That leaves transfer payments out of government spending, which makes public saving +$30 billion instead of -$30 billion. Public saving is taxes minus purchases minus transfers.
Households in Wyncrest see the value of their homes rise sharply and decide to save a smaller share of their income at every real interest rate. Their incomes and firms' plans for new equipment do not change. What happens to Wyncrest's real interest rate, to consumption spending and to private investment spending?
Answer: E.
1. A
  That is what more saving would do to the rate. Saving less means fewer funds offered at every rate, so funds become scarcer and the real interest rate rises, which cuts investment.
2. B
  Households do spend more, but the higher real interest rate makes borrowing costlier, so firms move along their unchanged demand curve to less investment, not more.
3. C
  Investment does fall, but not with a lower rate. Less saving shifts the supply of loanable funds left, which raises the real interest rate; a falling rate would raise investment.
4. D
  A shift of the supply of loanable funds changes the real interest rate, and with it the amount firms borrow to invest.
5. E
  Correct. Households that save a smaller share of their income spend a larger share, so consumption rises. Less saving at every real interest rate shifts the supply of loanable funds left, and along an unchanged demand curve the real interest rate rises and firms borrow and invest less.
An economy with ample reserves in its banking system is producing above full employment, and inflation is rising. Which of the following combinations of fiscal and monetary policy would both act to close the output gap?
Answer: C.
1. A
  The tax increase fits, but lowering the interest rate on reserves is expansionary and pushes aggregate demand the other way.
2. B
  Buying bonds is expansionary. With ample reserves it would also do little to interest rates; the interest rate on reserves is the working tool.
3. C
  Correct. Both are contractionary. Higher taxes cut consumption, and a higher interest rate on reserves raises interest rates across the economy, which cuts investment and consumption. Both shift aggregate demand left, toward full employment.
4. D
  The monetary step fits, but more transfer payments raise consumption and shift aggregate demand right, which widens a positive output gap.
5. E
  Lowering the required reserve ratio is an expansionary step, and with ample reserves it has little effect on interest rates anyway.
A country's economy is in a recessionary gap, and its banking system has ample reserves. Its leaders want real output to rise without interest rates rising. Which of the following combinations of policies could achieve both goals?
Answer: A.
1. A
  Correct. Both policies raise aggregate demand, so real output rises. The extra government borrowing puts upward pressure on interest rates, and a large enough cut in the interest rate on reserves offsets it, so rates need not rise.
2. B
  The monetary step works against both goals: it pushes interest rates up directly and pulls aggregate demand back down.
3. C
  The tax cut raises aggregate demand, but the extra borrowing it needs pushes interest rates up, and raising the required reserve ratio is a contractionary step that pushes the same way. Nothing here holds rates down, and with ample reserves the ratio has little effect anyway.
4. D
  Both of these are contractionary. Real output would fall in the short run, deepening the recession.
5. E
  Selling bonds is a contractionary step, and with ample reserves it is not the tool that moves interest rates. It does nothing to hold rates down.
An economy is in long-run equilibrium with unemployment at its natural rate of 5 percent and inflation of 2 percent, the rate people expect. Its central bank then lets the money supply grow faster year after year, so aggregate demand keeps growing faster than before. The economy moves to an unemployment rate of 3.5 percent and inflation of 4.5 percent. If no other policy action is taken, which of the following describes the economy once it is back in long-run equilibrium?
Answer: A.
1. A
  Correct. Demand keeps growing faster, so inflation stays above 2 percent and people come to expect it. Higher expected inflation shifts the short-run Phillips curve right, and the economy ends up back on the long-run Phillips curve at the natural rate of 5 percent, with inflation above where it started.
2. B
  That is the short-run point. Unemployment of 3.5 percent is below the natural rate, so it cannot last once expectations catch up with the faster inflation.
3. C
  Unemployment does return to the natural rate, but the faster growth of demand keeps going, so inflation does not fall back. Expected inflation rises, and long-run equilibrium comes at a higher inflation rate.
4. D
  That needs the natural rate itself to fall to 3.5 percent. Faster demand growth moves the economy along the short-run curve; it does not move the long-run Phillips curve.
5. E
  The adjustment returns the economy to the natural rate; it does not overshoot into a recessionary gap. Long-run equilibrium is on the long-run Phillips curve at 5 percent.
Most of a country's states agree to recognize each other's occupational licenses, so nurses, electricians and other licensed workers who lose a job can take an open job in another state without waiting months for a new license. Unemployment that comes from searching for and moving to a new job falls for good. Which of the following describes the change in the Phillips curve model and in the AD-AS model?
Answer: E.
1. A
  A lower natural rate puts the vertical long-run curve at a lower unemployment rate, which is to the left. The extra employment at full employment raises potential output rather than lowering it.
2. B
  Faster moves into open jobs lower the natural rate rather than raise it, so the long-run curve moves left and potential output rises.
3. C
  The natural rate is frictional plus structural unemployment. Cutting the time licensed workers spend between jobs lowers frictional unemployment for good, so the natural rate itself changes. Nothing here changes total spending, which is what moves the economy along the short-run curve.
4. D
  The long-run curve does shift left, but LRAS stands at full-employment output. With a lower natural rate, more people are working when the economy is at full employment, so potential output rises.
5. E
  Correct. The natural rate is frictional plus structural unemployment, and letting licensed workers take open jobs in other states without delay cuts it for good. The long-run Phillips curve, vertical at the natural rate, shifts left. With more people working at full employment, potential output rises, so LRAS shifts right.
In the quantity theory of money, written MV = PY, what does V, the velocity of money, measure?
Answer: C.
1. A
  Valuing the money supply in base-year dollars gives its real value. Velocity is about how often money changes hands, not what it is worth.
2. B
  Money growth is a change in M, a separate term in the equation. Velocity measures how often each unit of money is used.
3. C
  Correct. Velocity is nominal GDP divided by the money supply, PY / M: the average number of times each unit of money is spent on final output in a year.
4. D
  How much money people want to hold is money demand. Velocity is how often the money that exists gets spent.
5. E
  Output per dollar would be Y / M. Velocity is PY / M, which compares spending at current prices with the money supply, not with the monetary base.
Over a decade, Tessimor and Bestry each had a constant velocity of money and the same growth rate of real output. Tessimor's inflation rate averaged far higher than Bestry's. According to the quantity theory of money, which of the following best explains the difference?
Answer: B.
1. A
  In the quantity theory, the price level depends on money, velocity and real output. Interest rates are not part of MV = PY.
2. B
  Correct. With velocity constant and real output growing at the same rate in both countries, the quantity theory says inflation follows the growth rate of the money supply. Higher inflation in Tessimor means its money supply grew faster.
3. C
  Unemployment cannot stay below its natural rate for a decade; in the long run it returns there, whatever the inflation rate. Long-run inflation comes from money growth.
4. D
  Slower money growth, with the same velocity and the same output growth, would give Tessimor lower inflation, not higher.
5. E
  If money grew at the rate of real output with velocity constant, the price level would stay about the same. That means little or no inflation.
This year the government of Lindmarch collects more in tax revenue than it spends on purchases of goods and services and transfer payments. Which of the following describes its budget this year?
Answer: A.
1. A
  Correct. The budget balance is tax revenue minus purchases and transfer payments, and here it is positive, a surplus. The government needs no new borrowing and can use the surplus to repay some of what it owes.
2. B
  A deficit is purchases plus transfers above tax revenue. Here revenue is larger, so there is nothing to borrow for.
3. C
  The debt grows when the government borrows to cover a deficit. A surplus means no new borrowing, and it can reduce the debt.
4. D
  Transfer payments are part of government spending in the budget balance, even though they are not purchases of goods and services. Revenue above purchases plus transfers is a surplus.
5. E
  Whether money leaves households and firms does not decide the balance. Revenue above purchases plus transfers is a surplus.
Ixmoor's national debt is $2,000 billion, and it pays an average interest rate of 4 percent on that debt. This year Ixmoor's tax revenue exactly equals its government purchases plus transfer payments, not counting interest. It borrows to pay the interest. By how much does Ixmoor's national debt change this year?
Answer: B.
1. A
  That uses 40 percent, 0.4 x 2,000. Four percent is 0.04, so the interest bill is 0.04 x 2,000 = $80 billion.
2. B
  Correct. Interest on the debt is 0.04 x 2,000 = $80 billion. With everything else balanced, that interest is the year's deficit, and borrowing to cover it adds $80 billion to the national debt.
3. C
  That uses 0.4 percent, 0.004 x 2,000. Four percent is 0.04, so the interest bill is 0.04 x 2,000 = $80 billion.
4. D
  The budget balances only before interest. Interest is also a government outlay, so the year ends in a deficit equal to the interest bill.
5. E
  Paying interest does not repay any of the debt. Here the interest is paid with new borrowing, so the debt grows.
Harlinde's government raises its purchases of goods and services and borrows to pay for them. Taxes and expected inflation do not change. Which of the following is the most likely short-run effect on Harlinde's households?
Answer: B.
1. A
  Government borrowing raises the real interest rate, and other borrowing rates rise with it. Higher rates on car loans and mortgages discourage buying.
2. B
  Correct. Borrowing to pay for the new purchases raises the demand for loanable funds, so the real interest rate rises. With expected inflation unchanged, rates on car loans and mortgages rise too, and households put off buying cars and new homes: crowding out of interest-sensitive private spending, such as car purchases (consumption) and new homes (investment).
3. C
  Households borrow in the same loanable funds market as firms. Purchases made with loans, such as cars and homes, fall when rates rise.
4. D
  The government borrows from the same pool of saving as households and firms. Its extra demand raises the real interest rate for every borrower.
5. E
  Taxes have not changed, so disposable income has not fallen. What changes is the cost of borrowing.
Which of the following is an example of crowding out?
Answer: D.
1. A
  The firm's response is the same, but the cause is monetary policy. Crowding out comes from government borrowing.
2. B
  That is the spending effect of a tax cut. It raises private spending rather than reducing it, and no borrowing or interest rate is involved.
3. C
  That is a movement along the supply of loanable funds. It describes savers responding to a higher rate, not private spending being pushed out.
4. D
  Correct. Crowding out is government borrowing raising interest rates and so reducing interest-sensitive private spending, such as a firm's purchase of new trucks.
5. E
  That is a change in net exports. Crowding out works through government borrowing and interest rates, not through trade.
Workers in Orrindell produce more output per hour of work, on average, than workers in Vashtel. Which difference between the two countries would best explain this?
Answer: C.
1. A
  Population affects output per person, not how much each worker produces in an hour.
2. B
  More workers raise total output, but output per worker depends on what each worker has to work with.
3. C
  Correct. Labor productivity depends on technology and on the physical and human capital each worker has. More equipment and more training per worker let each one produce more in an hour.
4. D
  A higher price level raises the dollar value of output, not the real output each worker produces.
5. E
  The comparison is output per hour, so a longer week does not explain it. Longer hours raise output per worker, not output per hour.
Economists usually measure economic growth with real GDP per capita rather than with real GDP alone. Dividing real GDP by the population
Answer: B.
1. A
  Real GDP has already removed the effect of rising prices. Dividing by population adjusts for the number of people.
2. B
  Correct. Real GDP can rise just because there are more people. Real GDP per capita rises only when output grows faster than the population, so it shows whether the typical person has more goods and services.
3. C
  Dividing by population does not add anything to GDP. Nonmarket production stays out of the measure either way.
4. D
  That divides by the number of employed workers, not the whole population. Per capita means per person.
5. E
  Per capita GDP is an average. A country can have a high average with income shared very unevenly.
Many working-age adults in Dorrimund have left the labor force. Its government wants a fiscal policy that raises real GDP per capita over the long run by drawing more of them back into work. Which of the following policies is best suited to that goal?
Answer: D.
1. A
  A flat rebate raises spending this year, a demand-side effect. It is paid whether or not anyone works, so it gives no new reason to join the labor force.
2. B
  That is monetary policy, not fiscal policy, and it works on spending in the short run rather than on the incentive to work.
3. C
  Longer benefits support spending during hard times, but they do not reward taking a job, so they do not draw people back into the labor force.
4. D
  Correct. A lower tax rate on earnings is a supply-side fiscal policy: it raises the reward for working, which draws more people into the labor force. More people working raises output per person and potential output.
5. E
  A one-year rise in purchases raises aggregate demand for a while. It does nothing to change people's incentive to work over the long run.
Households in Avarrin deposit $50 million in savings accounts at banks in another country. How is this recorded in Avarrin's balance of payments?
Answer: E.
1. A
  The account is right, but money is leaving Avarrin for the foreign banks. A transaction that sends money out is a debit.
2. B
  A bank deposit is a financial asset, not a good or service. Purchases of assets between countries go in the capital and financial account.
3. C
  This gets both parts wrong: money leaves Avarrin, so it is a debit, and acquiring a deposit abroad is an asset purchase recorded in the capital and financial account.
4. D
  The balance of payments records all of a country's international transactions, including the purchase of financial assets such as deposits abroad.
5. E
  Correct. Placing savings abroad sends money out of Avarrin, so it is a debit. Acquiring a financial asset in another country belongs in the capital and financial account.
The exchange rate between the U.S. dollar and the tavel, the currency of Lisvaro, moves from 5 tavels per dollar to 4 tavels per dollar. Which of the following describes the change?
Answer: A.
1. A
  Correct. One tavel is worth 1 / 5 = $0.20 at first and 1 / 4 = $0.25 after. A tavel now buys more dollars, so the tavel has appreciated, and the dollar has depreciated against it.
2. B
  The prices are right, but a currency that buys more of another currency has appreciated, not depreciated.
3. C
  That flips the two rates. At 5 tavels per dollar a tavel is worth 1 / 5 = $0.20, and at 4 per dollar it is worth $0.25.
4. D
  The rates given are tavels per dollar, not dollars per tavel. A dollar now buys fewer tavels, so the dollar has depreciated.
5. E
  That reads tavels per dollar as dollars per tavel. A tavel costs 1 / 5 = $0.20 and then 1 / 4 = $0.25, so it gained value.
On a graph of the foreign exchange market for the ralo, Rennaby's currency, why does the demand curve for ralos slope downward?
Answer: E.
1. A
  That mixes up the two curves. Residents changing ralos into foreign currency supply ralos, and a cheaper ralo makes foreign goods dearer for them, not cheaper.
2. B
  The slope of a demand curve comes from buyers' choices. A central bank printing money is not part of what makes demand slope downward.
3. C
  That would make the demand curve slope upward, with more ralos wanted at a higher price. Demand slopes down because a dearer ralo makes Rennaby's goods dearer.
4. D
  A cheaper ralo makes Rennaby's exports cheaper abroad, so exports rise. Foreigners want more ralos because they buy more, not because they buy less.
5. E
  Correct. The demand for ralos comes from foreigners who want Rennaby's goods, services and financial assets. A cheaper ralo makes all of those cheaper for them, so they buy more and need more ralos to pay.
Lorell and Istravel trade under flexible exchange rates, and Lorell's households are the biggest buyers of Istravel's exports. Lorell falls into a deep recession, and its households' incomes drop. Based only on the change in Lorell households' purchases of Istravel's goods, what happens in the foreign exchange market for the istra, Istravel's currency?
Answer: D.
1. A
  The istra does depreciate, but not through supply. Abros are supplied by people in Istravel who need other currencies, and their buying has not changed.
2. B
  Lorell's households are buying less from Istravel, not more, so they want fewer istras.
3. C
  The change comes from Lorell's households, who are buyers of istras. Their smaller purchases cut the demand for istras, which leaves supply alone.
4. D
  Correct. With lower incomes, Lorell's households buy fewer of Istravel's goods, so they need fewer istras to pay for them. The demand for istras shifts left, and the istra loses value.
5. E
  The shift is right, but a decrease in demand lowers the price of the istra. Fewer istras wanted at every exchange rate means the istra depreciates.
The kezmo, Kezmara's currency, appreciates sharply against the fin, the currency of Finvale, Kezmara's main trading partner. Based only on this change in the exchange rate, what happens to Finvale's net exports and to aggregate demand in Finvale in the short run?
Answer: E.
1. A
  That is what happens to Kezmara, whose currency appreciated. For Finvale the change runs the other way, because the fin depreciated.
2. B
  An exchange rate is the price of one currency in terms of the other. If the kezmo gains against the fin, the fin loses against the kezmo.
3. C
  Net exports are part of aggregate demand. A change in net exports shifts aggregate demand, not the economy's capacity to produce, so potential output and long-run aggregate supply do not move.
4. D
  The first part is right, but net exports are a part of aggregate demand. When they rise, aggregate demand shifts right.
5. E
  Correct. If the kezmo appreciates against the fin, the fin has depreciated against the kezmo. Finvale's goods are now cheaper for Kezmara's buyers and Kezmara's goods dearer in Finvale, so Finvale's exports rise, its imports fall and its net exports increase, which shifts its aggregate demand right.
Grantova's real interest rate rises above Sedrimor's, which starts out unchanged. Financial capital can move freely between the two countries, and their bonds are equally safe. As financial capital responds, what happens to the real interest rates in the two countries?
Answer: E.
1. A
  That has the funds flowing the wrong way. Capital moves toward the higher real rate, which is now in Grantova, so it leaves Sedrimor.
2. B
  Sedrimor's rate does rise as funds leave it, but the funds arriving in Grantova add to its supply of loanable funds, which pulls Grantova's rate down, not up.
3. C
  Funds arriving in Grantova add to its supply of loanable funds. More funds offered lower its real interest rate rather than raising it.
4. D
  Real interest rates matter relative to each other. When Grantova's rises above Sedrimor's, savers move funds from Sedrimor to Grantova, and that moves both markets.
5. E
  Correct. Financial capital flows toward the country with the relatively higher real interest rate. Funds leaving Sedrimor shift its supply of loanable funds left and raise its real interest rate, while funds arriving in Grantova shift its supply right and lower its rate. The flow narrows the gap that drew it.

Section II: Free Response

3 questions · 60 minutes

Question 1: Long 10 points

Brakkeholm is in short-run equilibrium with real GDP of 1,305 billion brak. Its full-employment real GDP is 1,340 billion brak, and its marginal propensity to consume is 0.8. The brak is Brakkeholm's currency. Brakkeholm trades freely with other countries, financial capital moves freely across its borders, and the brak has a flexible exchange rate. Any change in government purchases described below is spending on current services, such as more staff hours at public offices, not on roads, buildings or other public capital.

Answer parts (a) through (g). Draw any graph on your own paper.
1. (a)
  
  Draw a correctly labeled AD-AS graph for Brakkeholm with aggregate demand, short-run aggregate supply and long-run aggregate supply. Mark the current short-run equilibrium price level and real output as PL1 and Y1, and full-employment output as YF.
  Question 1, part (a): your response. It stays in this browser tab and is never sent anywhere.
  Score part (a)
  - 1 point Draws a correctly labeled AD-AS graph: the vertical axis is the price level, the horizontal axis is real GDP (or real output), AD slopes down, SRAS slopes up, and PL1 and Y1 are marked on the axes at the point where AD crosses SRAS.Earns it: "Price level up the side, real GDP along the bottom, AD down to the right, SRAS up to the right, dotted lines from where they cross to PL1 and Y1"; "axes PL and Real Output, with Y1 and PL1 at the AD and SRAS intersection"Does not: axes labeled price and quantity (those are the axes of a single market, not of the whole economy); PL1 and Y1 placed where AD crosses LRAS (the economy is in short-run equilibrium, which is where AD meets SRAS)
  - 1 point Draws a vertical LRAS curve to the RIGHT of Y1 and labels the output where it meets the horizontal axis YF.Earns it: "a vertical LRAS at YF, to the right of Y1"; "LRAS straight up from YF = 1,340, with Y1 = 1,305 to its left"Does not: LRAS drawn to the left of Y1 (real GDP of 1,305 billion is below full employment of 1,340 billion, so Y1 sits left of YF); LRAS drawn through the AD and SRAS intersection (that would put the economy at full employment, and it is not)
  Model response
  The vertical axis is labeled Price Level and the horizontal axis Real GDP. AD slopes down to the right and SRAS slopes up to the right. They cross at a point where dotted lines run left to PL1 on the price level axis and down to Y1 on the real GDP axis. A vertical line labeled LRAS stands to the right of Y1, rising from a point on the horizontal axis labeled YF. The economy produces 1,305 billion brak of real output when it could produce 1,340 billion, so Y1 is left of YF: a negative (recessionary) output gap.
2. (b)
  
  The government of Brakkeholm decides to close the output gap by changing its purchases of goods and services. Using the spending multiplier, calculate the change in government purchases that would close the gap exactly. Show your work.
  Question 1, part (b): your response. It stays in this browser tab and is never sent anywhere.
  Score part (b)
  - 1 point Calculates an increase in government purchases of 7 billion brak and shows work: the gap is 1,340 - 1,305 = 35 billion, the spending multiplier is 1 / (1 - 0.8) = 5, and 35 / 5 = 7.Earns it: "Multiplier = 1/0.2 = 5. Gap = 35 billion. 35/5 = 7 billion brak more spending"; "G x 5 = 35, so G = 7 billion"Does not: 28 or 35 billion (35 is the gap itself, not the spending, and 28 multiplies by the tax multiplier); 8.75 billion (that divides the gap by the tax multiplier of 4, but the change here is in purchases, which use the spending multiplier of 5); 7 billion with no work shown (the task says show your work, and the point needs it)
  Model response
  The output gap is 1,340 - 1,305 = 35 billion brak. The spending multiplier is 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5. Each brak of new government purchases raises real GDP by up to 5 brak, so the increase that closes the gap is 35 / 5 = 7 billion brak.
3. (c)
  
  Suppose that instead of changing its purchases, the government cuts taxes by the amount you calculated in part (b). Calculate the maximum change in real GDP that the tax cut would cause. Show your work.
  Question 1, part (c): your response. It stays in this browser tab and is never sent anywhere.
  Score part (c)
  - 1 point Calculates an increase in real GDP of 28 billion brak and shows work: the tax multiplier is 0.8 / (1 - 0.8) = 4 (or the spending multiplier minus 1, 5 - 1 = 4), and 7 x 4 = 28. A student who found a different amount in part (b) earns this point for that amount times 4 with work shown.Earns it: "Tax multiplier = MPC/MPS = 0.8/0.2 = 4. 7 x 4 = 28 billion brak"; "Households spend 0.8 x 7 = 5.6 billion at first; 5.6 x 5 = 28 billion"Does not: 35 billion (that uses the spending multiplier of 5, but part of a tax cut is saved before any of it is spent, so its multiplier is smaller); -28 billion (a tax cut raises disposable income and so raises real GDP; the minus sign belongs to a tax increase)
  Model response
  The tax multiplier is MPC / (1 - MPC) = 0.8 / 0.2 = 4. A 7 billion brak tax cut raises real GDP by at most 7 x 4 = 28 billion brak. That is 7 billion short of the 35 billion gap, because households save a fifth of the first round instead of spending it.
4. (d)
  
  Return to the increase in government purchases from part (b). The government pays for it by borrowing, and its budget moves into deficit. Draw a correctly labeled graph of the loanable funds market in Brakkeholm, and show the effect of the government borrowing on the real interest rate.
  Question 1, part (d): your response. It stays in this browser tab and is never sent anywhere.
  Score part (d)
  - 1 point Draws a correctly labeled loanable funds graph: the vertical axis is the real interest rate (or interest rate, or r), the horizontal axis is the quantity of loanable funds, the demand for loanable funds slopes down, the supply slopes up, and the equilibrium real interest rate is marked.Earns it: "Real interest rate on the side, quantity of loanable funds on the bottom, DLF down, SLF up, r1 where they cross"; "r and Q of LF axes with D and S curves and an equilibrium r1"Does not: the vertical axis labeled nominal interest rate (that is the money market axis; savers and borrowers in this market respond to the real rate); a vertical supply curve (that is the money supply curve; the supply of loanable funds slopes up)
  - 1 point Shows the demand for loanable funds shifting to the right, or the supply of loanable funds shifting to the left, and the real interest rate rising from r1 to a higher r2.Earns it: "DLF1 shifts right to DLF2, r rises from r1 to r2"; "lower public saving shifts SLF left, so r2 is above r1"Does not: the supply of loanable funds shifting right (government borrowing adds to demand or subtracts from national saving; it does not add to supply); a shift drawn with no new interest rate marked (the point needs the higher real interest rate shown)
  Model response
  The vertical axis is labeled Real Interest Rate and the horizontal axis Quantity of Loanable Funds. DLF1 slopes down, SLF slopes up, and they cross at r1. Government borrowing adds to the demand for loanable funds, so DLF1 shifts right to DLF2. The new intersection is at r2, above r1, so the real interest rate rises.
5. (e)
  
  (i) Based on the change in the real interest rate shown in part (d), what will happen to private investment spending in Brakkeholm in the short run?
  
  (ii) Explain how the change you identified in part (e)(i) affects the growth of Brakkeholm's production possibilities in the long run.
  Question 1, part (e): your response. It stays in this browser tab and is never sent anywhere.
  Score part (e)
  - 1 point (i) States that private investment spending decreases. A student whose graph in part (d) showed the real interest rate falling earns this point for stating that investment increases.Earns it: "Investment falls"; "It decreases; that is crowding out"Does not: investment stays the same because the government is the one borrowing (firms borrow in the same market and now face a higher real interest rate); consumption decreases, with nothing said about investment (the question asks about private investment)
  - 1 point (ii) Explains that lower investment means less physical capital is built, so the production possibilities curve (or LRAS) shifts outward by less, or more slowly, than it otherwise would. Consistent with the answer to (e)(i).Earns it: "Firms buy fewer machines and buildings, so the capital stock grows more slowly and the PPC shifts out less in the future"; "Less capital accumulation means LRAS moves right more slowly, so long-run growth is lower"Does not: the PPC shifts inward right away (crowding out slows how fast capital is added; it does not destroy capital the country already has); growth falls because AD falls (that is a short-run demand story; long-run growth depends on how much capital is accumulated); "growth is slower" with no reason (the explanation needs the link through physical capital)
  Model response
  (i) Private investment spending decreases. The higher real interest rate makes borrowing to build factories and buy equipment more expensive, so some projects are dropped. This is crowding out.
  
  (ii) With less investment, Brakkeholm adds less physical capital each year than it would have. A smaller capital stock means its production possibilities curve shifts outward more slowly over time, so long-run economic growth is lower.
6. (f)
  
  How will the change in Brakkeholm's real interest rate shown in part (d) affect the demand for the brak in the foreign exchange market? Explain.
  Question 1, part (f): your response. It stays in this browser tab and is never sent anywhere.
  Score part (f)
  - 1 point States that the demand for the brak increases and explains that the higher real interest rate makes Brakkeholm's financial assets more attractive, so foreign savers buy them and need brak to do it (financial capital flows into Brakkeholm). A student whose part (d) showed the rate falling earns this point for a decrease with the mirror explanation.Earns it: "Demand for the brak rises, because foreigners want Brakkeholm's higher-interest bonds and must buy brak to pay for them"; "Higher r attracts financial capital inflows, which increases demand for the brak"Does not: demand for the brak decreases because the government is in debt (the debt is not what moves the currency here; the higher return on Brakkeholm's assets is); the supply of the brak increases (buying Brakkeholm's assets takes brak, which is a demand for it); "the brak appreciates" with no statement about demand and no reason (the question asks about demand, and the point needs the explanation)
  Model response
  The demand for the brak increases. Brakkeholm's real interest rate is now higher than before, so bonds and other financial assets there pay a better return compared with those abroad. Foreign savers move financial capital into Brakkeholm, and to buy those assets they first have to buy brak.
7. (g)
  
  Based on your answer to part (f), what will happen to Brakkeholm's net exports?
  Question 1, part (g): your response. It stays in this browser tab and is never sent anywhere.
  Score part (g)
  - 1 point States that net exports decrease. A student who said in part (f) that demand for the brak decreases earns this point for stating that net exports increase.Earns it: "Net exports fall"; "They decrease, since the brak appreciates"Does not: net exports increase because the government is spending more (the stronger brak makes Brakkeholm's goods dearer abroad and foreign goods cheaper at home); exports fall and imports fall (an appreciation lowers exports but raises imports)
  Model response
  Net exports decrease. The higher demand for the brak makes it appreciate, so Brakkeholm's goods cost more in other currencies and foreign goods cost fewer brak. Exports fall and imports rise.
Your score: 0 of 10, from the boxes you ticked.
Question 2: Short 5 points

The table shows the consumer price index (CPI) for the country of Duvendal last year and this year. This year Duvendal's unemployment rate is 4 percent, and its natural rate of unemployment is 5.5 percent.

Consumer price index in Duvendal
Year CPI

Last year 250
This year 260

Answer parts (a) through (d). Draw any graph on your own paper.
1. (a)
  
  Using the data in the table, calculate Duvendal's inflation rate from last year to this year. Show your work.
  Question 2, part (a): your response. It stays in this browser tab and is never sent anywhere.
  Score part (a)
  - 1 point Calculates an inflation rate of 4 percent and shows work: (260 - 250) / 250 x 100 = 4.Earns it: "(260 - 250)/250 x 100 = 4%"; "10/250 = 0.04, so 4 percent"Does not: 10 percent (10 is the change in index points, not a percentage change); about 3.8 percent (that divides by this year's CPI of 260 instead of last year's 250); 4 percent with no work shown (the point needs the work)
  Model response
  Inflation rate = (260 - 250) / 250 x 100 = 10 / 250 x 100 = 4 percent.
2. (b)
  
  Draw a correctly labeled graph of the short-run Phillips curve and the long-run Phillips curve for Duvendal. Label the short-run Phillips curve SRPC1. Plot Duvendal's current position on SRPC1, label it point A, and show its numerical values on the axes.
  Question 2, part (b): your response. It stays in this browser tab and is never sent anywhere.
  Score part (b)
  - 1 point Draws a correctly labeled Phillips curve graph: the vertical axis is the inflation rate, the horizontal axis is the unemployment rate, SRPC1 slopes down, and a vertical LRPC sits at an unemployment rate of 5.5 percent.Earns it: "Inflation rate up the side, unemployment rate along the bottom, SRPC1 sloping down, LRPC straight up from 5.5%"; "axes Inflation (%) and Unemployment (%), a downward SRPC1, and LRPC vertical at the natural rate of 5.5"Does not: axes labeled price level and real GDP (those are AD-AS axes; the Phillips curve plots inflation against unemployment); LRPC drawn at 4 percent (the long-run curve stands at the natural rate, which is 5.5 percent)
  - 1 point Plots point A on SRPC1 to the LEFT of the LRPC, at 4 percent unemployment and 4 percent inflation (or at the inflation rate found in part (a)).Earns it: "Point A on SRPC1 at unemployment 4% and inflation 4%, left of the LRPC"; "A at (4, 4), to the left of LRPC at 5.5"Does not: point A on the LRPC (unemployment is 4 percent, below the natural rate of 5.5, so A is to its left); point A to the right of the LRPC (points right of the LRPC have unemployment above the natural rate)
  Model response
  The vertical axis is labeled Inflation Rate (%) and the horizontal axis Unemployment Rate (%). SRPC1 slopes down to the right. A vertical line labeled LRPC rises from 5.5 percent on the unemployment axis. Point A sits on SRPC1 to the left of the LRPC, with a dotted line down to 4 percent unemployment and a dotted line across to 4 percent inflation. Unemployment is below its natural rate, so Duvendal has a positive (inflationary) output gap.
3. (c)
  
  A cyberattack shuts down much of Duvendal's electricity grid for several months, and firms across the country have to run costly backup generators to keep producing. On your graph from part (b), show the effect of the outage on the short-run Phillips curve. Label the new curve SRPC2.
  Question 2, part (c): your response. It stays in this browser tab and is never sent anywhere.
  Score part (c)
  - 1 point Shows SRPC1 shifting to the right (or up) to SRPC2, with the LRPC left where it is.Earns it: "SRPC2 drawn to the right of SRPC1, LRPC unchanged"; "the short-run curve shifts up and to the right"Does not: a movement along SRPC1 to a new point (higher production costs are a supply shock, and supply shocks shift the SRPC; demand shocks move along it); SRPC shifting left (higher production costs are a negative supply shock, which raises inflation and unemployment together); the LRPC shifting too (a temporary rise in production costs does not change the natural rate of unemployment)
  Model response
  SRPC2 is drawn to the right of SRPC1, parallel to it. The LRPC stays at 5.5 percent. Running backup generators raises production costs for most firms, a negative supply shock: at every unemployment rate, inflation is now higher than before.
4. (d)
  
  After the outage, Duvendal's economy is at a point on SRPC2. Its central bank then uses contractionary monetary policy to bring inflation down. In the short run, will Duvendal's unemployment rate increase, decrease or stay the same? Explain.
  Question 2, part (d): your response. It stays in this browser tab and is never sent anywhere.
  Score part (d)
  - 1 point States that the unemployment rate increases and explains why: contractionary monetary policy reduces aggregate demand, so firms produce less and need fewer workers, which moves the economy down and to the right along SRPC2. An explanation through lower aggregate demand, or through lower output and employment, earns the point. A bare statement that the economy moves along SRPC2, or that lower inflation means higher unemployment, with no reason why spending or output falls, does not.Earns it: "It increases. Higher interest rates cut investment and AD, so the economy moves down along SRPC2 to lower inflation and higher unemployment"; "Increase: less spending means firms produce less and lay off workers, a movement along the short-run Phillips curve"Does not: decreases, because lower inflation shifts the SRPC back to the left (the policy changes spending, not production costs or expected inflation, so in the short run the economy moves along SRPC2 rather than shifting it); stays the same, because unemployment is set by the LRPC (the LRPC is where the economy ends up in the long run; in the short run it moves along its SRPC); "increases, because the economy moves down along SRPC2" with nothing about spending, output or jobs (the point needs the reason the economy moves: lower aggregate demand); "increases" with no explanation
  Model response
  Duvendal's unemployment rate increases. Contractionary monetary policy raises interest rates, so investment and consumption fall and aggregate demand shifts left. Firms produce less and need fewer workers. On the Phillips curve graph that is a movement down and to the right along SRPC2: inflation falls, but unemployment rises. After a supply shock, bringing inflation down costs jobs in the short run.
Your score: 0 of 5, from the boxes you ticked.
Question 3: Short 5 points

The banking system in Orrisford has limited reserves, and its required reserve ratio is 8 percent. Orrisford's central bank buys $2.4 billion of government bonds from commercial banks. Before the purchase, the banks hold no excess reserves.

Answer parts (a) through (d). Draw any graph on your own paper.
1. (a)
  
  Calculate the maximum change in Orrisford's money supply that can result from the purchase. Show your work.
  Question 3, part (a): your response. It stays in this browser tab and is never sent anywhere.
  Score part (a)
  - 1 point Calculates a maximum increase in the money supply of $30 billion and shows work: the money multiplier is 1 / 0.08 = 12.5, and 2.4 x 12.5 = 30.Earns it: "Money multiplier = 1/0.08 = 12.5. 2.4 x 12.5 = $30 billion"; "Excess reserves rise by 2.4 billion; 2.4 / 0.08 = 30 billion"Does not: $27.6 billion (that subtracts the 2.4 billion as if it were not new money; the banks sold bonds, so the whole 2.4 billion is new excess reserves that can be lent out); $0.192 billion (that multiplies by the reserve ratio instead of dividing by it); $30 billion with no work shown (the point needs the work)
  Model response
  The money multiplier is 1 / required reserve ratio = 1 / 0.08 = 12.5. The banks sold the bonds for reserves, so their excess reserves rise by the full $2.4 billion. The maximum change in the money supply is 2.4 x 12.5 = $30 billion.
2. (b)
  
  Draw a correctly labeled graph of the money market in Orrisford, and show the effect of the bond purchase on the nominal interest rate.
  Question 3, part (b): your response. It stays in this browser tab and is never sent anywhere.
  Score part (b)
  - 1 point Draws a correctly labeled money market graph: the vertical axis is the nominal interest rate (or interest rate, or i), the horizontal axis is the quantity of money, money demand slopes down, money supply is vertical, and the equilibrium nominal interest rate is marked.Earns it: "Nominal interest rate on the side, quantity of money along the bottom, MD sloping down, MS vertical, i1 where they cross"; "i and Q of money axes, vertical MS1, downward MD, i1"Does not: the vertical axis labeled real interest rate (that is the loanable funds axis; the money market sets the nominal rate); a money supply curve that slopes up (the central bank sets the money supply, so it does not depend on the interest rate and is drawn vertical)
  - 1 point Shows the money supply curve shifting to the right, from MS1 to MS2, and the nominal interest rate falling from i1 to a lower i2.Earns it: "MS shifts right to MS2, interest rate falls from i1 to i2"; "MS1 to MS2 rightward, i2 below i1"Does not: money demand shifting right (the purchase changes the supply of money, not how much people want to hold); MS shifting left (buying bonds pays reserves into the banks, which adds to the money supply)
  Model response
  The vertical axis is labeled Nominal Interest Rate and the horizontal axis Quantity of Money. MD slopes down to the right, and MS1 is a vertical line. They cross at i1. The bond purchase increases the money supply, so the vertical line shifts right to MS2. It crosses MD at i2, below i1, so the nominal interest rate falls.
3. (c)
  
  Explain one reason the actual change in Orrisford's money supply could be smaller than the amount you calculated in part (a).
  Question 3, part (c): your response. It stays in this browser tab and is never sent anywhere.
  Score part (c)
  - 1 point Explains that banks may choose to hold some of the new reserves as excess reserves rather than lend them, or that people may hold some of the money they receive as currency rather than deposit it, so less is redeposited and lent in each round. The stem describes the banks before the purchase, so choosing to keep some of the NEW reserves is a correct reason.Earns it: "Banks might keep some excess reserves instead of lending it all, so fewer loans get made"; "Borrowers may hold cash instead of putting it back in a bank, so the next bank has less to lend"; "Banks might want a safety cushion and keep part of the new reserves as excess reserves, so the actual multiplier is smaller than 12.5"Does not: "the multiplier is just an estimate" (true, but the point needs a reason that shrinks lending); "the central bank could sell the bonds back" (that is a different policy action, not a reason this purchase falls short); interest rates rise (the purchase lowers the nominal interest rate, so this is not why lending falls short)
  Model response
  The simple multiplier assumes every bank lends out all its excess reserves and every loan comes back as a deposit. If banks decide to keep some of the new reserves as excess reserves, or if people keep some of the money they borrow as cash, then each round of lending is smaller, and the money supply rises by less than $30 billion.
4. (d)
  
  Suppose instead that Orrisford's banking system had ample reserves. Would a bond purchase of the same size be an effective way for the central bank to lower the nominal interest rate in the short run? Explain.
  Question 3, part (d): your response. It stays in this browser tab and is never sent anywhere.
  Score part (d)
  - 1 point States that it would not be effective and explains that when reserves are ample, changes in the money supply (or in reserves) do not effectively change the nominal interest rate. Naming what the central bank would do instead, lower its administered interest rates such as the interest it pays on reserves, is not required.Earns it: "No. With ample reserves, adding more reserves barely moves the rate. The central bank would cut the interest on reserves instead"; "Not effective, because banks already have plenty of reserves, so more money supply does not change the interest rate; it lowers its administered rates"; "No, with ample reserves changes in the money supply do not effectively change the nominal interest rate"; "No. Banks are already on the flat part of the demand curve for reserves, so more reserves barely move the rate"Does not: yes, because the money supply still increases (with ample reserves, a bigger money supply does not by itself push the interest rate down); no, because buying bonds raises interest rates (an open-market purchase never raises rates; the problem is that it barely moves them); "no" with no explanation (the point needs the reason)
  Model response
  No. When the banking system already has ample reserves, banks have far more reserves than they need, so adding another $2.4 billion of reserves does not effectively change the nominal interest rate. To lower the rate, the central bank would cut its administered interest rates, such as the interest rate it pays on reserves, and the policy rate would follow.
Your score: 0 of 5, from the boxes you ticked.

Consumer price index in Duvendal
Year	CPI
Last year	250
This year	260

Practice Exam 2

60 multiple-choice and 3 free-response questions, in the format of the AP Macroeconomics Exam. Each section runs on its own clock and ends when time runs out.

Section	Questions	Time
Section I: Multiple Choice	60	70 minutes
Section II: Free Response	3	60 minutes

A four-function calculator is allowed on both sections of the exam.

One section at a time. When a section's clock reaches zero, the section ends and is scored.
Multiple choice is scored when its section ends, with an explanation for every choice.
Free response is never scored by the page. When the section ends, you see the scoring guide and a model response for each part and tick the points your answer earns.
At the end you get your score and the time you used for each section.
Want the answers as you go? Pick Study mode below. Each multiple-choice answer is checked as soon as you give it, with its explanation, and each free-response question has a button that opens its scoring guide.
Your answers are kept in this browser tab if the page reloads, and nowhere else.

Time for each section Standard time Time and a half Double time Untimed Study mode

Section I: Multiple Choice

60 questions · 70 minutes

A country has rich farmland, a large and skilled workforce, modern factories and high average incomes. Why does it still face scarcity?
Answer: C.
1. A
  High prices are a result of scarcity, not its cause. Even if every price fell, the country could still not make everything its people want with what it has.
2. B
  Idle resources mean the country is producing inside its PPC, which is inefficiency. Scarcity would remain even with every resource fully employed.
3. C
  Correct. Scarcity means wants exceed what limited resources can make. Wealth raises what a country can produce, but its land, labor and capital are still limited, so choices must still be made.
4. D
  Trade is one way to respond to scarcity, not the reason it exists. A country that traded nothing would still face it.
5. E
  Money is not an economic resource. More money would not add one acre, worker or machine, so it would not make wants and resources match.
Calmere and Taveth have identical production possibilities curves for consumer goods and capital goods, and both produce on their curves. For the next ten years, Calmere puts far more of its resources into new machines and factories than Taveth does, and Taveth produces more consumer goods. Nothing else differs. What is most likely true at the end of the ten years?
Answer: A.
1. A
  Correct. Capital is a factor of production. Producing more capital goods each year adds to Calmere's stock of machines and factories, so its PPC shifts outward by more than Taveth's.
2. B
  Equal starting resources do not mean equal growth. The choice of where to produce on the curve decides how much capital each country adds.
3. C
  Consumer goods are used up; they do not add to what an economy can produce later. This mixes up enjoying output now with the capacity to produce in the future.
4. D
  Giving up consumer goods is the opportunity cost of the machines, a movement along the PPC. It does not shrink the curve; the extra capital shifts it out.
5. E
  The choice does not move the curve at the moment it is made, but capital goods are resources, so over ten years they shift the curve out.
A worker in Hethria needs 9 hours to weave a rug and 3 hours to build a clock. A worker in Nyrrow needs 16 hours to weave a rug and 4 hours to build a clock. Each country faces constant opportunity costs. Then new looms cut the time a Nyrrow worker needs to weave a rug to 8 hours, and a Nyrrow clock still takes 4 hours. After the change, which of the following is correct?
Answer: E.
1. A
  Before the looms, a rug cost Hethria 9 / 3 = 3 clocks and Nyrrow 16 / 4 = 4 clocks, so Hethria did have it then. After the change a rug costs Nyrrow only 8 / 4 = 2 clocks, less than Hethria's 3, so the advantage switched.
2. B
  A clock still takes a Nyrrow worker 4 hours and a Hethria worker 3, so Hethria keeps the absolute advantage in clocks. The looms changed only rugs.
3. C
  Needing fewer hours for a rug is an absolute advantage. Comparative advantage compares opportunity costs, and a clock costs Nyrrow 1/2 rug against Hethria's 1/3, so Hethria keeps the comparative advantage in clocks.
4. D
  After the looms a rug takes 8 hours in Nyrrow and 9 in Hethria, so it is Nyrrow that now has the absolute advantage in rugs.
5. E
  Correct. After the change a rug costs Nyrrow 8 / 4 = 2 clocks and Hethria 9 / 3 = 3 clocks, so Nyrrow has the lower opportunity cost of rugs. A clock costs Hethria 1/3 rug and Nyrrow 1/2 rug, so Hethria has the lower opportunity cost of clocks.
A new rail line between two cities cuts the fare for the trip by train to half of what it was. Many travelers between the cities treat the train and a flight as two ways of making the same trip. What happens in the market for flights between the two cities?
Answer: B.
1. A
  The price of a related good is a determinant of demand. A change in the train fare changes how many flights people want at every airfare.
2. B
  Correct. Train trips and flights are substitutes. When the train becomes much cheaper, travelers want fewer flights at every airfare, so demand for flights decreases.
3. C
  A movement along the demand curve for flights happens only when the price of a flight changes. Here the airfare did not change; the price of a substitute did.
4. D
  Losing travelers is a change on the buyers' side. Nothing about the airlines' costs changed, so it is demand, not supply, that moves.
5. E
  Complements are used together, like a flight and an airport parking space. Travelers use the train instead of a flight, so the two are substitutes and demand for flights falls.
The market for firewood in a mountain town is in equilibrium when a storm closes several logging roads for the season, and supply decreases. Demand does not change. As the market moves to its new equilibrium, what happens?
Answer: D.
1. A
  With less supply at the old price, sellers offer fewer bundles than buyers want. That is a shortage, not a surplus, so the price rises.
2. B
  Nothing changed buyers' wants, so the demand curve stays put. The shortage is closed by a rise in price that moves buyers along the demand curve.
3. C
  A higher price raises quantity supplied along the new supply curve; it does not shift supply back. The roads are still closed for the season.
4. D
  Correct. At the old price, buyers want more firewood than sellers now offer. The price rises, buyers move up along the unchanged demand curve, and sellers move up along the new supply curve until the two quantities are equal.
5. E
  In a market with flexible prices, buyers who cannot get firewood bid the price up. A price that stays at the old level would leave the shortage in place.
Last year Wynlass recorded these figures, in billions of dollars.
- Consumption: 820
- Business spending on new equipment and buildings: 210
- Newly built homes bought by households: 90
- Change in business inventories: a decrease of 30
- Government purchases of goods and services: 260
- Government transfer payments: 140
- Exports: 150
- Imports: 190
What was Wynlass's GDP last year?
Answer: A.
1. A
  Correct. Investment is 210 + 90 - 30 = 270, since a fall in inventories is subtracted. GDP = 820 + 270 + 260 + (150 - 190) = $1,310 billion. Transfer payments buy no output, so they are left out.
2. B
  This leaves out the change in inventories. Goods sold last year from stock made in earlier years were not produced last year, so the 30 decrease is subtracted from investment.
3. C
  This adds the inventory change as if inventories had grown. A decrease of 30 lowers investment by 30.
4. D
  This counts the $140 billion of transfer payments. The government buys no good or service with them, so they are not part of GDP.
5. E
  This adds imports instead of subtracting them. Imports were produced abroad, so they are taken out through net exports, 150 - 190 = -40.
Visitors from other countries pay Orbanth's hotels and restaurants for rooms and meals. When Orbanth measures its GDP by the expenditures approach, this spending is counted as part of
Answer: C.
1. A
  Consumption is spending by the country's own households. These buyers live abroad, so their purchases of Orbanth's output are exports.
2. B
  Imports are goods and services bought from abroad. Here the hotels and restaurants are in Orbanth, so Orbanth is selling, not buying.
3. C
  Correct. The rooms and meals are produced in Orbanth and bought by foreigners. Selling output to buyers abroad is exporting, even when the buyers travel to the country to use it.
4. D
  Investment is spending on new capital such as buildings. Renting a room for a night buys a service; it does not build a hotel.
5. E
  GDP counts everything produced in the country, whoever buys it. Output bought by foreigners enters as exports.
Over ten years, a country's real GDP per capita rose steadily. Over the same ten years, the real income of its median household, the one in the middle of the income range, fell slightly. Which limitation of real GDP per capita do these figures show?
Answer: E.
1. A
  Who produced the output is not the issue here. The figures show average income rising while the household in the middle fell behind.
2. B
  Real GDP per capita is already adjusted for inflation, and so is the median household's real income. Both figures are in real terms.
3. C
  Home production is a real limitation of GDP, but nothing in these figures is about unpaid work at home. They are about who received the income.
4. D
  GDP values final output at market prices, whoever buys it. Nothing is counted above its price.
5. E
  Correct. Real GDP per capita is total real output divided by the population, an average. If the income gains go mostly to people at the top, the average can rise while the household in the middle is no better off.
From Year 1 to Year 2, a nurse's hourly wage rose from $40.00 to $44.00, and a welder's hourly wage rose from $30.00 to $31.80. Over the same year, the consumer price index rose from 125 to 135. What happened to each worker's real wage?
Answer: D.
1. A
  Both nominal wages rose, but prices rose (135 - 125) / 125 = 8 percent. The welder's raise, (31.80 - 30) / 30 = 6 percent, is smaller than that, so the welder's pay buys less than before.
2. B
  An index above 100 compares prices with the base year. What decides each real wage is whether the raise beat this year's 8 percent rise in prices, and the nurse's 10 percent raise did.
3. C
  That reverses the two. The nurse's 10 percent raise beat the 8 percent rise in prices; the welder's 6 percent raise did not.
4. D
  Correct. Prices rose (135 - 125) / 125 = 8 percent. The nurse's wage rose (44 - 40) / 40 = 10 percent, so her real wage rose, from 40 / 1.25 = $32.00 to 44 / 1.35 = about $32.59 in base-year dollars. The welder's wage rose 6 percent, so his real wage fell, from 30 / 1.25 = $24.00 to 31.80 / 1.35 = about $23.56.
5. E
  The welder's 6 percent raise fell short of the 8 percent rise in prices, so his real wage fell rather than staying the same: about $24.00 to $23.56 in base-year dollars.
Why is the natural rate of unemployment above zero, even when an economy produces its full-employment output?
Answer: B.
1. A
  At full-employment output cyclical unemployment is zero. The natural rate is frictional plus structural unemployment only.
2. B
  Correct. Frictional unemployment, people searching for a job match, and structural unemployment, people whose skills do not fit the jobs available, exist in every healthy economy. Their sum is the natural rate.
3. C
  A retiree who is not looking for work is not counted as unemployed. Retirement does not add to the natural rate.
4. D
  Retirees and students who are not looking for work are outside the labor force. They do not enter the unemployment rate at all.
5. E
  Anyone who works for pay, even part time, is counted as employed. This is one reason the measured rate is said to understate joblessness.
Economists use the consumer price index to answer which of the following questions?
Answer: A.
1. A
  Correct. The CPI measures the change in income a consumer would need to keep the same standard of living under the new prices as under the base-year prices.
2. B
  That is the job of real GDP. The CPI holds the quantities fixed and tracks prices, so it says nothing about how much was produced.
3. C
  Actual spending changes when people buy more or less. The CPI prices the same basket every year, whatever households really bought.
4. D
  That describes the GDP deflator, which covers all final output. The CPI covers only a basket of goods and services bought by consumers.
5. E
  The CPI prices what consumers buy, not the wages and materials that firms pay for as inputs.
A bank is about to make ten-year loans. It worries that inflation over those years could turn out much higher than anyone now expects. Which way of writing the loans would best protect the bank against that risk?
Answer: D.
1. A
  A rate fixed today builds in only the inflation expected today. If inflation turns out higher, the bank is repaid in dollars that buy less than it planned.
2. B
  A longer fixed-rate loan leaves the bank exposed for longer, so surprise inflation would hurt it more, not less.
3. C
  Fixed dollar payments are exactly what unexpected inflation erodes. Each payment would buy less than the bank expected.
4. D
  Correct. Unexpected inflation hurts lenders because repayments fixed in dollars lose value. A rate that moves with actual inflation keeps the real value of the repayments close to what the bank planned.
5. E
  Higher inflation lowers the real value of every fixed-rate loan at once. Making more of them adds to the bank's loss instead of spreading it.
A country reports these figures for two years, in billions of dollars.
- Year 1: nominal GDP $1,200, GDP deflator 120
- Year 2: nominal GDP $1,377, GDP deflator 135
By about what percent did the country's real GDP change from Year 1 to Year 2?
Answer: C.
1. A
  That is the rise in the GDP deflator, (135 - 120) / 120 = 12.5 percent. The deflator measures prices, not the quantity produced.
2. B
  That subtracts the deflator's 12.5 percent rise from nominal GDP's 14.75 percent rise, a shortcut that is only approximate. Converting each year to real GDP gives $1,000 billion and $1,020 billion, a rise of 2 percent.
3. C
  Correct. Real GDP = nominal GDP / (deflator / 100): 1,200 / 1.20 = $1,000 billion in Year 1 and 1,377 / 1.35 = $1,020 billion in Year 2. That is a rise of 20 / 1,000 = 2 percent.
4. D
  That is the rise in nominal GDP, (1,377 - 1,200) / 1,200 = 14.75 percent, which includes the higher prices.
5. E
  Real GDP rose, from $1,000 billion to $1,020 billion. The deflator rose by less than nominal GDP did.
Last year Sevrin's real GDP was well above its potential output. Since then real GDP has fallen in each of the last three quarters and is still falling, but it remains above potential output. Which describes Sevrin's economy now?
Answer: B.
1. A
  The phase of the cycle is about the direction real GDP is moving, not about where it sits compared with potential. Output that keeps falling is a recession.
2. B
  Correct. Falling real GDP marks the recession phase, which began at last year's peak. The output gap compares actual with potential output, and actual output is still the larger, so the gap is positive.
3. C
  A trough is the lowest point, where a recession ends and real GDP starts to rise. Sevrin's real GDP is still falling.
4. D
  A recession does not require output below potential. The gap turns negative only once real GDP falls past potential output, which has not happened yet.
5. E
  The peak was the turning point last year, where real GDP stopped rising. Three quarters of falling output put Sevrin well past it.
Whose spending does an economy's aggregate demand curve add up at each price level?
Answer: E.
1. A
  Government purchases of goods and services are one of the four parts of aggregate demand, whatever process sets them.
2. B
  Foreign buyers of the country's output are part of aggregate demand through net exports.
3. C
  Imports are output made in other countries. They are subtracted, not added, because spending on them does not buy domestic output.
4. D
  Firms' investment, government purchases and net exports are separate parts of aggregate demand, not part of consumption.
5. E
  Correct. Aggregate demand is consumption by households, investment by firms, government purchases and net exports, which is exports minus imports.
Households in an economy come to expect that prices will rise sharply next year, so they buy cars, furniture and appliances now instead of waiting. Wage contracts and firms' costs do not change. What happens to the economy's aggregate demand?
Answer: A.
1. A
  Correct. Expectations about future prices are a determinant of consumption. Buying now rather than later raises consumer spending at every current price level, so AD shifts right.
2. B
  The expectation of higher prices later makes buying now more attractive, so spending today rises rather than falls.
3. C
  A movement along AD needs a change in the current price level. Here spending changes at every price level, which is a shift of the curve.
4. D
  Expected inflation shifts SRAS when it changes wage contracts and costs, and the stem says those do not change. What changed is how much households spend.
5. E
  AD depends on planned spending at each price level, and planned spending rose even though current prices have not moved yet.
Why does an economy in which households spend a larger share of each extra dollar of income have a larger spending multiplier?
Answer: B.
1. A
  Taxes are a leak from the rounds of spending, not a source of more of them. The multiplier works through what households spend of their new income.
2. B
  Correct. The spending multiplier is 1 / (1 - MPC). When households spend a larger share of each extra dollar, less leaks into saving at each round, so each round of new income is larger and the total change in output is a larger multiple of the first round of spending.
3. C
  The multiplier describes a change in real output. Higher prices would raise nominal GDP, but they are not why the multiplier is larger.
4. D
  Spending a larger share of each extra dollar means saving a smaller share. Saving is the leak that ends each round, so less of it makes the multiplier larger.
5. E
  GDP counts only final goods produced this year, and resales of used goods are not counted. The multiplier comes from new income being spent again.
In Drummaval, firms raise their spending on new equipment by $20 billion, and nothing else changes. Economists estimate that the largest possible change in aggregate demand from this spending is an increase of $80 billion. What marginal propensity to consume does that estimate assume?
Answer: C.
1. A
  That is the MPS that would go with a multiplier of 5, which comes from adding the first $20 billion to the $80 billion, (80 + 20) / 20 = 5. The $80 billion already includes the first round of spending, so the multiplier is 80 / 20 = 4.
2. B
  That is the marginal propensity to save. A multiplier of 80 / 20 = 4 means 1 / MPS = 4, so MPS = 0.25 and the MPC is 1 - 0.25 = 0.75.
3. C
  Correct. The spending multiplier is 80 / 20 = 4. Since the multiplier is 1 / (1 - MPC), 1 - MPC = 1 / 4 = 0.25, so MPC = 0.75.
4. D
  That makes the same misreading, a multiplier of 5, and takes MPC = 1 - 1 / 5 = 0.80. The multiplier is 80 / 20 = 4, so MPC = 1 - 1 / 4 = 0.75.
5. E
  That is the spending multiplier itself, 80 / 20 = 4. The MPC is a share of each extra dollar, so it lies between 0 and 1.
Nominal wages across an economy are fixed by contracts that run for another year. Aggregate demand increases, and the price level rises before any contract can be renegotiated. In the short run, what happens to workers' real wages and to employment?
Answer: D.
1. A
  With nominal wages fixed and prices higher, each hour of pay buys less, so real wages fall rather than rise.
2. B
  A real wage is the nominal wage deflated by the price level. A fixed nominal wage with a higher price level is a lower real wage.
3. C
  Firms' selling prices rose while the wages they pay did not, so producing more is profitable and they hire more workers, not fewer.
4. D
  Correct. The price level rose while nominal wages stayed fixed, so real wages fall. Firms get higher prices for their output but pay the same wages, so they produce more and hire more workers: the economy moves up along its upward-sloping SRAS curve.
5. E
  The higher price level changes both: it cuts what fixed wages buy and makes more output profitable for firms.
Across Quindara, firms install new scheduling and inventory software that lets the same workers and machines produce more output each hour. Nominal wages and other input prices do not change. What happens to Quindara's short-run aggregate supply curve?
Answer: E.
1. A
  Needing fewer workers for the same output lowers the cost of each unit, which lets firms supply more at every price level. That is a shift to the right, not the left.
2. B
  Input prices are not the only cost factor. With the same wages, more output per hour means a lower cost for each unit produced, and a change in production costs shifts SRAS.
3. C
  SRAS stays upward-sloping in the short run, because some input prices are still fixed. Better software changes where the curve sits, not its slope.
4. D
  A movement along SRAS comes from a change in the price level. Here costs changed at every price level, which shifts the curve.
5. E
  Correct. With wages and other input prices unchanged, producing more each hour lowers the cost of each unit of output. Any change in production costs shifts SRAS, and lower costs shift it to the right.
An economy starts with real GDP equal to its potential output. Over the next two years its labor force and capital stock grow, so its long-run aggregate supply curve shifts to the right, but real GDP grows more slowly than potential output does. Compared with the start, which of the following is true at the end of the two years?
Answer: B.
1. A
  A positive gap means real GDP is above potential output. Here real GDP grew more slowly than potential, so it ended below it.
2. B
  Correct. Potential output is full-employment output, where unemployment equals its natural rate. LRAS moved right faster than real GDP grew, so real GDP ends below potential: a negative output gap, with unemployment above the natural rate.
3. C
  The gap compares real GDP with potential output, not with last year's real GDP. Growth slower than potential opens a gap even though output rose.
4. D
  Output below potential means firms employ fewer workers than at full employment, so unemployment is above its natural rate, not below it.
5. E
  The growth in resources is what moved potential output. Real GDP did not keep up with it, so a gap opened.
Grisholt's real output equals its full-employment output, and its unemployment rate equals its natural rate. Its price level, however, is well above what it was a year ago. Which describes Grisholt's economy now?
Answer: A.
1. A
  Correct. Long-run equilibrium means AD and SRAS intersect at full-employment output, which is where LRAS stands. Output at full employment with unemployment at its natural rate means that is where the economy is. A higher price level than last year does not change that.
2. B
  An output gap compares real output with full-employment output. Here they are equal, so the gap is zero whatever happened to prices.
3. C
  Long-run equilibrium does not require any particular price level. It requires output at full employment, and Grisholt has that.
4. D
  Real output equals full-employment output, so there is no gap. A higher price level moves the economy along AD; it does not decide whether output is below full employment.
5. E
  Equilibrium means the quantities of output demanded and supplied are equal at the current price level. A price level that rose over the past year can still be an equilibrium now.
An economy is in long-run equilibrium. Which of the following events would raise both its price level and its unemployment rate in the short run?
Answer: D.
1. A
  More consumer spending shifts AD to the right. The price level rises, but output rises and unemployment falls.
2. B
  Using less energy lowers firms' costs and shifts SRAS to the right, which lowers the price level and unemployment.
3. C
  Lower exports shift AD to the left. Unemployment rises, but the price level falls.
4. D
  Correct. Security is now a lasting extra cost of producing for nearly every firm. SRAS shifts to the left, so the price level rises while real output falls and unemployment rises.
5. E
  Lower government purchases shift AD to the left. Unemployment rises, but the price level falls.
In an economy with an upward-sloping SRAS curve, a drop in investment shifts AD to the left by $40 billion at every price level. SRAS does not move. Why does short-run real output fall by less than $40 billion?
Answer: E.
1. A
  The $40 billion shift already measures the change in AD at a given price level. The question is why equilibrium output moves less than the curve does.
2. B
  The stem says SRAS does not move. Firms cutting prices and output is a movement down along SRAS, not a shift of it.
3. C
  Investment is one of the four components of aggregate demand, and the $40 billion is already the shift in AD.
4. D
  LRAS limits output in the long run. In the short run output does fall, along the upward-sloping SRAS curve.
5. E
  Correct. At the old price level output demanded would fall by the full $40 billion. As firms move down along SRAS, the price level falls, and a lower price level raises the real output demanded along the new AD curve, so the drop in equilibrium output is smaller than the shift.
An economy starts in long-run equilibrium. Then a lasting rise in consumer spending shifts AD to the right, and no policy action follows. Once the economy has fully adjusted, how do the price level, real output and real wages compare with the original long-run equilibrium?
Answer: C.
1. A
  Higher output and lower real wages describe the short run, before nominal wages catch up. In the long run output returns to full employment.
2. B
  AD stays to the right, so the economy ends where the new AD meets LRAS, at a higher price level and the same full-employment output.
3. C
  Correct. With output above full employment, nominal wages rise and SRAS shifts left until it meets the new AD on LRAS. Output is back at full employment at a higher price level, and nominal wages have risen with prices, so real wages are where they started.
4. D
  This leaves nominal wages where they were. In the long run wages are fully flexible and rise with the price level, so real wages recover.
5. E
  This treats the economy as if AD had shifted back. The rise in spending lasts, so the price level ends higher.
Over two years, an economy's real GDP climbs from well below its full-employment output back up to it, with no policy action. Its labor force, capital and technology stay the same throughout. This rise in real GDP is best described as
Answer: B.
1. A
  Economic growth means full-employment output itself rises. Here the labor force, capital and technology are unchanged, so LRAS stays where it was.
2. B
  Correct. The economy started to the left of LRAS. As it recovers, it moves back to the full-employment output it could already produce, and LRAS does not move.
3. C
  Putting idle workers back to work moves production from inside the PPC to the curve. The curve shifts only when resources or technology change.
4. D
  Falling unemployment is the economy using its existing capacity more fully. Full-employment output is set by resources and technology, which did not change.
5. E
  A positive gap means output above full employment. Here real GDP rises only as far as full-employment output, so the gap closes to zero.
Faldria's real GDP is above full-employment output, and its marginal propensity to consume is 0.6. Its government is considering a $30 billion cut in its purchases of goods and services. Assuming the full multiplier effects, what cut in transfer payments would reduce aggregate demand by the same amount?
Answer: A.
1. A
  Correct. The spending multiplier is 1 / (1 - 0.6) = 2.5, so the cut in purchases lowers AD by 30 x 2.5 = $75 billion. A change in transfers works through disposable income, with a multiplier of 0.6 / 0.4 = 1.5, so the transfer cut must be 75 / 1.5 = $50 billion.
2. B
  A transfer cut of the same $30 billion lowers AD by only 30 x 1.5 = $45 billion, because households would have saved part of the transfers.
3. C
  That is 0.6 x 30, the first round of lower spending from a $30 billion transfer cut. It is not the transfer cut that matches a $75 billion fall in AD.
4. D
  That is the fall in AD from the cut in purchases, 30 x 2.5 = $75 billion, not the size of the transfer cut needed to match it.
5. E
  That is the fall in AD from a $30 billion transfer cut, 30 x 1.5 = $45 billion, not the transfer cut that matches the purchase cut.
Tiveria's economy has a negative output gap, and its government cuts personal income tax rates to close it without changing its purchases or transfer payments. In the short run, what happens to aggregate demand and to the government's budget balance?
Answer: C.
1. A
  A cut in personal income taxes changes households' disposable income, not firms' production costs, so it works through AD rather than SRAS. It also lowers the government's revenue.
2. B
  Higher income does bring back some revenue, but lower tax rates collect less on every dollar earned, and the extra income recovers only part of that loss. The budget moves toward deficit.
3. C
  Correct. Lower taxes raise disposable income, so consumption rises and AD shifts right. With lower tax rates the government collects less revenue while its spending stays the same, so the budget moves toward deficit: a larger deficit or a smaller surplus.
4. D
  Government purchases did not change. The tax cut raises consumption, so AD shifts right.
5. E
  The budget balance is tax revenue minus purchases and transfers. Spending is unchanged, but revenue falls, so the balance moves toward deficit.
Which statement correctly contrasts automatic stabilizers with discretionary fiscal policy?
Answer: D.
1. A
  This reverses them. Discretionary policy is a new decision each time, while automatic stabilizers work under laws already in place.
2. B
  Automatic stabilizers also work in expansions: tax revenue rises with income, which slows consumption. Discretionary policy can be contractionary too.
3. C
  Automatic stabilizers soften swings in the business cycle; they do not by themselves return output to full employment.
4. D
  Correct. Taxes and transfers change on their own as income rises and falls, so there is no wait for lawmakers to decide. They moderate the business cycle without closing a gap by themselves.
5. E
  This reverses them. Discretionary policy is the one that waits for lawmakers, which is why it acts with lags.
Over one month, the prices of previously issued government bonds in Ostrevin fall sharply. Which of the following best explains the fall?
Answer: A.
1. A
  Correct. Bond prices and interest rates move in opposite directions. Once new bonds pay more, nobody will pay the old price for an older bond with smaller fixed payments, so its price falls until its return matches the new rate.
2. B
  This reverses the relationship. If new bonds paid less, the older bonds with their larger fixed payments would be worth more, and their prices would rise.
3. C
  A large central bank purchase adds to the demand for bonds, which pushes bond prices up and interest rates down, the opposite of what happened.
4. D
  More buyers for bonds would raise their prices. The fall in prices points to bonds becoming less attractive, which is what a rise in rates on new bonds does.
5. E
  Lower expected inflation lowers the interest rates lenders require. Lower rates on new bonds make older bonds worth more, so their prices would rise.
Which of the following is the real interest rate on a loan?
Answer: C.
1. A
  Adding inflation goes the wrong way. Inflation shrinks what each repaid dollar buys, so it is subtracted from the nominal rate.
2. B
  That is the nominal interest rate. It is the rate actually charged, unadjusted for inflation.
3. C
  Correct. The real interest rate takes inflation out of the nominal rate. It measures how much more the lender can buy with the repayment than with the money that was lent.
4. D
  This has the subtraction upside down. With a nominal rate of 5 percent and inflation of 2 percent, the real rate is 5 - 2 = 3 percent, not 2 - 5.
5. E
  That is one of the central bank's administered rates, a policy tool. It is a nominal rate, and it is not the real rate on a loan.
A saver uses part of her savings to buy a bond newly issued by a furniture company, and with the rest she buys shares of the same company's stock. Which of the following describes a difference between the two assets?
Answer: D.
1. A
  That reverses the two. Buying a bond lends money to the company, and buying stock buys part of the company.
2. B
  Neither is money. The most liquid forms of money are cash and demand deposits; bonds and stocks are other financial assets held in place of money.
3. C
  That reverses them too. A bond promises interest payments, while a stock pays its owner a share of profits only if the company chooses to pay one.
4. D
  Correct. A bond is an interest-bearing asset: the buyer lends to the company and is paid interest. A stock is equity, a share of ownership in the company.
5. E
  A bond's price falls when interest rates on new bonds rise, so a bond can lose value before it is repaid. Both prices can fall.
Shops, employers and lenders in a country state prices, wages and debts in its currency, so the values of very different things can be compared in the same terms. Which function of money does this describe?
Answer: A.
1. A
  Correct. Money serves as a medium of exchange, a unit of account and a store of value. Using one currency to state and compare the values of goods, wages and debts is its role as a unit of account.
2. B
  A store of value means money holds purchasing power over time. Stating every price in the same terms is a different job.
3. C
  A medium of exchange means money is accepted in payment. Here the currency is being used to measure and compare values, whether or not anything is paid.
4. D
  Money held as cash or checking deposits earns little or no interest. That is the opportunity cost of holding it, not one of its functions.
5. E
  The monetary base is currency in circulation plus bank reserves. It is a measure of money, not a function money serves.
A restaurant owner withdraws cash from her checking account. Count M1 as currency held by the public plus checking and other liquid deposits, count the monetary base as currency in circulation plus bank reserves, and count cash in bank vaults as reserves. At the moment of the withdrawal, what happens to M1 and to the monetary base?
Answer: E.
1. A
  The money leaves her checking account, but it does not leave M1. It is now currency in her hands, which M1 also counts.
2. B
  Reserves do fall, but the cash is now currency in circulation, which the base also counts. The two changes cancel.
3. C
  This counts the new currency in circulation but forgets that the same cash left the bank's vault, where it was counted as reserves.
4. D
  This treats the cash as if it vanished. Moving money from a deposit into a wallet changes its form, not the totals of M1 or the base.
5. E
  Correct. M1 loses the checking deposit and gains the same amount of currency held by the public, so it is unchanged. In the monetary base, the bank's vault cash, counted as reserves, falls and currency in circulation rises by the same amount, so the base is unchanged too.
A bank in an economy with limited reserves has the balance sheet below. The required reserve ratio is 12 percent.
- Assets: reserves $90,000; loans $380,000; government bonds $130,000
- Liabilities and owner's equity: demand deposits $500,000; owner's equity $100,000
The bank lends all of its excess reserves, every bank after it does the same, every loan is redeposited, and the public holds no extra currency. What is the maximum increase in the money supply?
Answer: C.
1. A
  That is the bank's excess reserves, the most this one bank can lend. Each later bank lends again, so the system multiplies the $30,000 by 1 / 0.12.
2. B
  That is the bank's required reserves, 0.12 x $500,000. Reserves the bank must hold cannot be lent, so they create no new money.
3. C
  Correct. Required reserves are 0.12 x $500,000 = $60,000, so excess reserves are $90,000 - $60,000 = $30,000. The maximum money multiplier is 1 / 0.12, so the money supply can rise by at most $30,000 / 0.12 = $250,000.
4. D
  That adds the $30,000 loan to the $250,000 again. The multiplier result already includes the first loan, which is the first new deposit in the chain.
5. E
  That multiplies all $90,000 of reserves. Only excess reserves can be lent; the $60,000 of required reserves are already backing existing deposits.
An economy's banking system has limited reserves. Count M1 as currency held by the public plus checking deposits. A sign maker repays a bank loan in full, using money in its checking account at the same bank. At the moment the loan is repaid, what happens to M1 and to the bank's excess reserves?
Answer: D.
1. A
  Total reserves are unchanged, but the checking deposit is gone, and checking deposits are part of M1. With fewer deposits the bank also needs fewer required reserves, so some of its reserves become excess.
2. B
  Loans are not reserves. The repayment cancels a loan and a deposit together; the bank's total reserves stay the same while its required reserves fall, so excess reserves rise.
3. C
  Money held by a bank is not counted in M1. The checking balance used for the repayment leaves the money supply when the loan is cancelled; it does not become anyone else's money.
4. D
  Correct. The repayment removes the sign maker's checking deposit and the loan from the bank's balance sheet at the same time, so M1 falls by the amount repaid. The bank's total reserves have not changed, but with fewer deposits it must hold fewer required reserves, so its excess reserves rise.
5. E
  The bank may lend again later, and that new loan would create new deposits. At the moment of repayment, though, a checking deposit disappears, so M1 falls.
Bonds pay interest, while cash and checking deposits pay little or none. Why do households and firms still hold part of their wealth as money?
Answer: B.
1. A
  Rising prices lower the purchasing power of money too. Money held as cash buys less after prices rise.
2. B
  Correct. Cash and demand deposits are the most liquid forms of money: they can pay for things at once, without first selling another asset. People hold some money for that, accepting the interest they give up by not holding bonds.
3. C
  Holding money gives up the interest bonds would pay, and the higher interest rates are, the more it gives up.
4. D
  Households and firms can and do buy bonds. The question is why they keep some wealth as money anyway.
5. E
  Required reserves apply to banks, not to households and firms.
Bellquay's banking system has limited reserves. Prices across Bellquay rise, and households and firms want to hold more money at every nominal interest rate. Bellquay's central bank wants the nominal interest rate to stay where it was. Which action should the central bank take?
Answer: D.
1. A
  Selling bonds shrinks the money supply. With demand already higher, that pushes the nominal interest rate up even further, away from the goal.
2. B
  A rightward shift of money demand against an unchanged, vertical money supply raises the equilibrium nominal interest rate. Holding the rate requires action.
3. C
  A higher required reserve ratio lowers the money multiplier and shrinks the money supply, shifting it left, not right.
4. D
  Correct. The rise in money demand would push the nominal interest rate up if the money supply stayed put. Buying bonds adds reserves, and with limited reserves the money supply rises. If it shifts right by the same amount as demand, the two curves cross at the old rate.
5. E
  Monetary policy tools act on the money supply. The money demand curve shifted because of the higher price level, and a lower discount rate does not undo that.
Saffrany's government has a large national debt, and every year it sells new bonds to replace bonds that come due. Its central bank raises its policy rate, and interest rates across the economy rise. If the government's tax revenue, purchases and transfer payments do not change, what is the most likely effect on its budget?
Answer: E.
1. A
  A slower economy would lower tax revenue rather than raise it, and the stem holds revenue fixed in any case. What changes is the cost of borrowing.
2. B
  Interest on the debt is a government outlay, even though it is not a purchase of goods and services.
3. C
  The stem holds tax revenue fixed. The direct effect is on what the government pays to borrow.
4. D
  Lower prices of previously issued bonds do not reduce what the government owes. The debt changes only with deficits and surpluses.
5. E
  Correct. A government must pay interest on its debt. The bonds it sells to replace maturing ones now carry higher rates, so its interest payments rise. With revenue, purchases and transfers unchanged, its outlays rise and its deficit grows.
The central bank of an economy whose banking system has limited reserves raises its discount rate. In the short run, which of the following describes the effects on the money supply, the nominal interest rate and investment spending?
Answer: D.
1. A
  These are the effects of lowering the discount rate. Raising it discourages banks from borrowing reserves, which shrinks the money supply.
2. B
  The first step is right, but a leftward shift of a vertical money supply raises the equilibrium nominal interest rate, which discourages investment.
3. C
  The money market effects are right, but investment responds to borrowing costs. A higher interest rate makes new equipment and buildings costlier to finance, so investment falls.
4. D
  Correct. A higher discount rate makes it costlier for banks to borrow reserves, so they hold fewer reserves to lend and the money supply falls. With limited reserves, a smaller money supply raises the nominal interest rate, and firms cut interest-sensitive investment.
5. E
  With limited reserves, the discount rate works through the quantity of reserves banks borrow, so the money supply does fall. That is how the interest rate rises.
Fennimar is a closed economy. The schedule shows its loanable funds market, in billions of dollars.
- Real interest rate 3 percent: 300 supplied, 500 demanded
- Real interest rate 4 percent: 360 supplied, 460 demanded
- Real interest rate 5 percent: 420 supplied, 420 demanded
- Real interest rate 6 percent: 480 supplied, 380 demanded
- Real interest rate 7 percent: 540 supplied, 340 demanded
As more of Fennimar's workers approach retirement, households plan to save $100 billion more at every real interest rate. Firms' borrowing plans do not change. What are the new equilibrium real interest rate and the quantity of loanable funds that firms borrow?
Answer: A.
1. A
  Correct. Adding $100 billion to each quantity supplied gives 400, 460, 520, 580 and 640. That matches the quantity demanded only at 4 percent, where both are $460 billion. The lower real interest rate leads firms to borrow $40 billion more, a movement along the demand curve.
2. B
  At 5 percent households would now supply $520 billion while firms want only $420 billion, a surplus, so the real interest rate must fall.
3. C
  At 3 percent firms would want $500 billion while households supply only $400 billion, a shortage, so the rate settles above 3 percent.
4. D
  That keeps borrowing at its old level. Firms' plans did not shift, but a lower real interest rate raises the quantity they borrow along the same demand curve.
5. E
  More saving adds to the supply of loanable funds, which lowers the real interest rate rather than raising it.
Glasvent's banking system has limited reserves, and its currency, the glas, has a flexible exchange rate. To shrink its budget deficit without slowing the economy, Glasvent's government raises income taxes while its central bank buys government bonds on the open market. Real interest rates in other countries do not change. In the short run, what happens to interest rates in Glasvent and to the value of the glas?
Answer: B.
1. A
  Neither policy raises interest rates. Higher taxes lower incomes and the demand for money, and the bond purchase adds to the money supply.
2. B
  Correct. Both policies push interest rates down: higher taxes lower incomes and the demand for money, and the bond purchase adds reserves and raises the money supply. With Glasvent's rates lower relative to rates abroad, financial capital flows out, the demand for glas falls and its supply rises, and the glas depreciates.
3. C
  Lower interest rates make Glasvent's assets less attractive to foreign savers, which lowers the value of the glas rather than raising it.
4. D
  Interest rates fall, not rise, and a fall in rates is what makes the glas depreciate.
5. E
  The two policies pull against each other on aggregate demand, but both push interest rates the same way: down.
Trazmora has a positive (inflationary) output gap, and its banking system has limited reserves. Its government raises income tax rates, and at the same time its central bank sells government bonds on the open market. In the short run, what happens to the unemployment rate and the price level in Trazmora?
Answer: B.
1. A
  Lower aggregate demand reduces real output, and firms need fewer workers to produce less, so unemployment rises, not falls.
2. B
  Correct. Higher taxes cut consumption, and the bond sale shrinks the money supply and raises interest rates, which cuts investment. Both shift aggregate demand left, so real output falls, the unemployment rate rises and the price level falls.
3. C
  A rising price level with rising unemployment comes from a leftward shift of short-run aggregate supply. These policies shift aggregate demand left, which lowers the price level.
4. D
  Both policies are contractionary, so they push aggregate demand in the same direction rather than offsetting.
5. E
  Both policies shift aggregate demand left, so the price level falls for certain. The policy mix whose price level effect is in doubt would be one where the two push in opposite directions.
Which of the following describes a difference between the short-run Phillips curve and the long-run Phillips curve?
Answer: A.
1. A
  Correct. In the short run, with expected inflation given, lower unemployment comes with higher inflation. In the long run, unemployment returns to its natural rate whatever the inflation rate, so the long-run curve is vertical there.
2. B
  This swaps the two curves. The trade-off between inflation and unemployment exists only in the short run.
3. C
  Once wages and expectations adjust, there is no lasting trade-off, so the long-run curve has no slope at all; it is vertical.
4. D
  The long-run curve does not slope upward. Unemployment settles at its natural rate in the long run, whatever the inflation rate.
5. E
  The long-run curve is drawn at an unemployment rate, the natural rate, so it is vertical, not horizontal at an inflation rate.
An economy's short-run Phillips curve passes through these points, and its natural rate of unemployment is 5 percent.
- 2 percent unemployment: 8 percent inflation
- 3 percent unemployment: 6 percent inflation
- 4 percent unemployment: 4 percent inflation
- 5 percent unemployment: 2 percent inflation
- 6 percent unemployment: 0 percent inflation
The economy is now at 3 percent unemployment and 6 percent inflation. Which of the following describes the economy?
Answer: C.
1. A
  Six percent is the actual inflation rate. Expected inflation is the rate where the short-run curve crosses the long-run curve, at the natural rate of 5 percent: 2 percent.
2. B
  Unemployment below the natural rate puts the economy to the left of the long-run curve, which is an inflationary gap. A recessionary gap is to the right.
3. C
  Correct. The long-run Phillips curve is vertical at 5 percent, and it crosses this short-run curve at 2 percent inflation, the rate built into the curve as expected inflation. The economy is at 3 percent unemployment, to the left of the long-run curve, which is a positive (inflationary) output gap.
4. D
  The economy is always on its short-run curve, but long-run equilibrium also requires unemployment at the natural rate. At 3 percent it is not there.
5. E
  That reads the 6 percent unemployment row. The economy is at 3 percent unemployment, and the curves cross at 5 percent, where inflation is 2 percent.
For ten years in a row, prices in Mossendar rose about 30 percent a year. Which of the following best explains inflation that lasts that long?
Answer: A.
1. A
  Correct. Inflation that lasts for years is a monetary event. When the money supply grows far faster than real output for a sustained period, more money chases a slowly growing amount of output, and the price level keeps rising.
2. B
  A one-time supply shock raises the price level once. It cannot keep prices rising 30 percent a year for a decade unless money growth keeps feeding it.
3. C
  Faster growth of real output, with the money supply given, pushes the price level down, not up, because the same money is spread over more output.
4. D
  A falling velocity of money means each unit pays for less spending, which pulls the price level down rather than up.
5. E
  Higher productivity lowers the cost of each unit produced and raises output. It does not explain a price level that rises 30 percent a year.
Over a decade in an economy, the money supply grew about 7 percent a year, real output grew about 1 percent a year, and the inflation rate averaged about 8 percent a year. Using the quantity theory of money, which of the following conclusions do these data support about the velocity of money?
Answer: D.
1. A
  That has the sign backward. Prices grew faster than money growth alone would allow once output growth is counted, so velocity must have risen.
2. B
  The quantity theory treats velocity as constant when it predicts inflation, but these data do not fit a constant velocity. With constant velocity, inflation would be about 7 - 1 = 6 percent, not 8.
3. C
  That leaves out real output. With M x V = P x Y, the growth rates give velocity growth of about 8 + 1 - 7 = 2 percent a year.
4. D
  Correct. In growth rates, M x V = P x Y becomes money growth plus velocity growth equals inflation plus real output growth. So velocity grew about 8 + 1 - 7 = 2 percent a year.
5. E
  That adds all three growth rates. Money growth belongs on the other side of the equation, so it is subtracted: 8 + 1 - 7 = 2 percent.
Which of the following adds to a country's national debt?
Answer: E.
1. A
  That is a trade deficit, part of the current account. It records the country's trade with the rest of the world, not what the government owes.
2. B
  Household borrowing is private debt. The national debt is what the government owes.
3. C
  An open-market purchase changes who holds existing government bonds. It does not add new government borrowing.
4. D
  That is a budget surplus used to repay debt, which makes the national debt smaller, not larger.
5. E
  Correct. A budget deficit financed by borrowing adds to the national debt, the total the government owes from past borrowing.
Brisquane's government borrows heavily to cover a large new budget deficit, and its real interest rate rises above the rates in other countries. Financial capital moves freely across Brisquane's borders. Compared with a closed economy facing the same borrowing, how does the inflow of foreign financial capital affect crowding out in Brisquane?
Answer: C.
1. A
  Foreign savers bring funds into Brisquane to lend at its higher rate. They add to the supply of loanable funds rather than competing for it.
2. B
  The inflow eases the rise in the real interest rate, but nothing guarantees it covers the whole deficit. Some crowding out can remain.
3. C
  Correct. Financial capital flows toward the country with the relatively higher real interest rate. The inflow adds to the supply of loanable funds in Brisquane, so the real interest rate rises by less and less private investment is crowded out than in a closed economy.
4. D
  Purchases of Brisquane's assets by foreigners are recorded in the capital and financial account, and the funds they bring are loanable funds in Brisquane.
5. E
  The inflow does not change the government's taxes or spending, so the deficit is the same. What changes is the supply of funds to cover it.
A government borrows to pay for a large program of new tunnels, water mains and flood walls, and the borrowing raises the real interest rate. Which of the following explains why the program could still leave the economy's long-run growth higher rather than lower?
Answer: A.
1. A
  Correct. Government borrowing raises the real interest rate and crowds out some private investment, which on its own slows the growth of the private capital stock. Tunnels, water mains and flood walls are public capital that make private workers and machines more productive, and that gain can be larger than the loss.
2. B
  More saving is offered at the higher rate, but firms also face a higher cost of borrowing and move up their demand curve to less investment. Private investment falls.
3. C
  Crowding out comes from the borrowing, which raises the real interest rate whatever the funds are spent on. What the spending buys decides what the economy gets in return.
4. D
  GDP counts the projects once, when they are produced. Their later use adds to the output that firms produce with them, not a second count of the projects.
5. E
  The spending multiplier applies equally to any first round of new spending and describes the short run. Long-run growth depends on the economy's capital, labor and productivity.
Pravessa's government begins borrowing to cover a new budget deficit. Show the borrowing as an increase in the demand for loanable funds, with the supply of loanable funds unchanged. Compared with before the deficit, what happens to the total quantity of loanable funds and to the quantity borrowed by private firms and households?
Answer: E.
1. A
  Private borrowers do not gain. They face a higher real interest rate and move up along their own demand curve, so they borrow less.
2. B
  The higher real interest rate is what changes private borrowing. With the rate up, private firms and households borrow less.
3. C
  With an upward-sloping supply curve, the higher real interest rate draws out more saving, so the total rises and private borrowing falls by less than the government borrows.
4. D
  A rightward shift of demand along an unchanged supply curve raises the equilibrium quantity of loanable funds; it does not lower it.
5. E
  Correct. Demand shifts right along an upward-sloping supply curve, so the real interest rate rises and savers lend more in total. The government takes part of that total, and at the higher real interest rate private borrowers want less, so their share falls. That fall is crowding out.
Yarrowen's statistics office reports these figures, with real GDP in base-year dollars.
- Year 1: real GDP $800 billion, employed workers 20 million, population 50 million
- Year 2: real GDP $840 billion, employed workers 22 million, population 50 million
Which of the following conclusions do these data support?
Answer: C.
1. A
  Output per worker rises with real GDP only if employment holds steady. Here employment grew 10 percent, faster than output, so output per worker fell.
2. B
  The population did not change, but real GDP rose, so real GDP per capita rose from $16,000 to $16,800.
3. C
  Correct. Real GDP per capita went from $800 billion / 50 million = $16,000 to $840 billion / 50 million = $16,800, a 5 percent rise. Output per employed worker went from $800 billion / 20 million = $40,000 to $840 billion / 22 million = about $38,182, a fall of about 4.5 percent, because employment grew 10 percent while output grew 5 percent.
4. D
  This swaps the denominators. Per capita divides by the population, which stayed at 50 million; productivity divides by employed workers, which rose to 22 million.
5. E
  More workers does not make each worker more productive. Employment rising 10 percent while output rose only 5 percent means each worker produced less on average.
Over five years, output per employed worker in Zimbrette rose steadily, while its physical capital per worker and its workers' education and training stayed the same. Which of the following best explains the rise?
Answer: B.
1. A
  More employed workers can raise total output, but with the same capital and skills per worker it does not raise output per worker.
2. B
  Correct. Productivity, output per employed worker, is determined by technology and by physical and human capital per worker. With capital per worker and education unchanged, better technology is the explanation left.
3. C
  Output per worker is measured in real terms, so a higher price level does not raise it.
4. D
  Fewer hours per worker would lower output per worker, not raise it.
5. E
  Population growing faster than real GDP would lower real GDP per capita. It says nothing that would raise output per employed worker.
Ulvanto's government raises the tax rate on the interest and profits that households and firms earn from saving and investing. It uses the added revenue to raise transfer payments, so its budget balance does not change, and it keeps the higher tax rate for many years. Which of the following is the most likely long-run effect?
Answer: B.
1. A
  Taxes also change incentives. A tax on returns to saving and investing affects the capital stock and potential output, which is the supply-side effect.
2. B
  Correct. A higher tax on the returns to saving and investing lowers the reward for both, so households save less and firms invest less. Capital per worker grows more slowly, and productivity and real GDP per capita grow more slowly with it.
3. C
  Transfer payments move income from some households to others; they do not add capital, skills or technology, so they do not raise long-run growth.
4. D
  The price level does not determine potential output. LRAS depends on resources and productivity, and less capital accumulation slows its growth.
5. E
  The tax lowers the reward for saving, so saving falls rather than rises. Less saving means fewer funds for investment.
Last year Pelnorth imported more goods and services than it exported, yet its current account was in surplus. Which of the following explains how that could happen?
Answer: D.
1. A
  The two accounts are separate, and they sum to zero. A capital and financial account surplus goes with a current account deficit, and it is not added into the current account.
2. B
  Borrowing from abroad is recorded, as a financial capital inflow in the capital and financial account. It does not change the current account.
3. C
  A central bank's purchase of foreign currency is a purchase of a foreign asset, a financial transaction. It is not an export of goods or services.
4. D
  Correct. The current account records net exports, net income from abroad and net unilateral transfers. Net exports were negative, but if income received from abroad plus net transfers was positive and larger than the trade deficit, the current account as a whole was in surplus.
5. E
  A change in the exchange rate can change exports and imports over time, but it does not change how the current account is added up. Last year's trade deficit is still part of it.
An American student spends a year studying in a country whose currency is the korva. Each month, the same number of U.S. dollars she exchanges gets her more korvas than it did the month before. This is an example of
Answer: B.
1. A
  If each dollar buys more korvas, each korva buys fewer dollars. The korva has depreciated against the dollar, not appreciated.
2. B
  Correct. A dollar that trades for more korvas has become more valuable in terms of korvas, so the dollar has appreciated against the korva.
3. C
  A currency depreciates when it buys less of the other currency. Her dollars buy more korvas, so the dollar gained value.
4. D
  Inflation changes what korvas buy in shops there, not how many korvas a dollar trades for. The change she sees is in the exchange rate.
5. E
  A current account deficit is a record of trade and income flows, not the change in the exchange rate she sees each month.
The schedule shows the foreign exchange market for the bryn, the currency of Bryndale, in millions of bryns a day, at exchange rates in U.S. dollars per bryn.
- $1.20 per bryn: 520 demanded, 360 supplied
- $1.30 per bryn: 480 demanded, 400 supplied
- $1.40 per bryn: 440 demanded, 440 supplied
- $1.50 per bryn: 400 demanded, 480 supplied
- $1.60 per bryn: 360 demanded, 520 supplied
A new direct flight brings many more U.S. tourists to Bryndale, and at every exchange rate they want 80 million more bryns a day than before. Nothing else changes. What are the new equilibrium exchange rate and the quantity of bryns traded?
Answer: C.
1. A
  At $1.40 the new demand is 440 + 80 = 520 million while only 440 million are offered, a shortage, so the bryn appreciates above $1.40.
2. B
  More demand for bryns raises their price. The bryn appreciates rather than falling to $1.30.
3. C
  Correct. Adding 80 million to each quantity demanded gives 600, 560, 520, 480 and 440. That matches the quantity supplied only at $1.50, where both are 480 million. The bryn appreciates from $1.40 to $1.50.
4. D
  At $1.60, 520 million are offered but only 440 million are wanted after the change, a surplus, so the rate settles below $1.60.
5. E
  560 million is the new quantity demanded at $1.30, not at $1.50. At $1.50 the new demand is 480 million, equal to the quantity supplied.
Investors in other countries come to see Corlathe's government bonds as riskier than before, and they buy fewer of them. Based only on this change, what happens in the foreign exchange market for the corl, Corlathe's currency?
Answer: C.
1. A
  A leftward shift of demand, with supply unchanged, lowers the equilibrium exchange rate, so the corl depreciates.
2. B
  An increase in supply would lower the corl's value, not raise it, and the change here starts with foreign buyers, who are on the demand side.
3. C
  Correct. Foreigners need corls to buy Corlathe's bonds. When they want fewer of those bonds, they demand fewer corls at every exchange rate, the demand curve shifts left, and the corl's value falls.
4. D
  Buying fewer of Corlathe's bonds means wanting fewer corls, so demand falls rather than rises.
5. E
  Foreign investors buying fewer bonds does not cut the supply of corls. It cuts the demand for corls, which lowers their value.
The varkel, Dunskelt's currency, depreciates against the currencies of Dunskelt's trading partners. At the same time, those trading partners fall into recession, and their real incomes drop. Based on both changes, what happens to Dunskelt's exports in the short run?
Answer: E.
1. A
  The depreciation does raise exports, but the recession abroad pulls them down at the same time. Looking at one change alone is not enough.
2. B
  Lower foreign incomes do reduce exports, but the cheaper varkel pushes the other way. Without knowing the sizes, the result is not certain.
3. C
  A recession abroad reduces what foreigners buy, so on its own it lowers Dunskelt's exports. It does not free up spending on Dunskelt's goods.
4. D
  The two effects push in opposite directions, but nothing says they are the same size. That makes the result indeterminate, not zero.
5. E
  Correct. The cheaper varkel makes Dunskelt's goods less expensive abroad, which raises exports. Lower real incomes abroad mean foreigners buy fewer goods, including Dunskelt's, which lowers exports. The two push in opposite directions, so the net effect is indeterminate.
The real interest rate in Halsgrave rises from 3 percent to 4 percent. Over the same months, the real interest rate in Wrexholm, Halsgrave's only financial partner, rises from 3 percent to 6 percent. Bonds in the two countries are equally safe, and financial capital moves freely between them. Based on these changes, what happens to financial capital flows and to the hal, Halsgrave's currency, against Wrexholm's currency?
Answer: E.
1. A
  What moves capital is the difference between the countries' real interest rates. Halsgrave's rate rose, but Wrexholm's rose more, so Halsgrave became relatively less attractive.
2. B
  Capital does not flow toward Halsgrave, since Wrexholm now pays the relatively higher rate. And an inflow would raise the demand for hals, which would appreciate them.
3. C
  Both rates rose, but by different amounts. The gap moved from zero to 2 percentage points in Wrexholm's favor, and that gap is what changes capital flows.
4. D
  The direction of the flow is right, but moving funds out of Halsgrave means selling hals for Wrexholm's currency, which lowers the hal's value.
5. E
  Correct. Capital flows toward the country with the relatively higher real interest rate. Halsgrave's rate rose, but Wrexholm's rose more, so Wrexholm's assets became relatively more attractive. Capital flows toward Wrexholm, demand for hals falls and their supply rises, and the hal depreciates.

Section II: Free Response

3 questions · 60 minutes

Question 1: Long 10 points

Kolvarith is in long-run equilibrium, and its banking system has ample reserves. Kolvarith collects an income tax that takes a share of each person's earnings, and it pays unemployment benefits to people who lose their jobs. Kolvarith's largest trading partner ends the tariffs it had charged on goods from Kolvarith, and buyers there purchase far more of Kolvarith's goods and services. No tax or benefit law in Kolvarith changes.

Answer parts (a) through (g). Draw any graph on your own paper.
1. (a)
  
  Draw a correctly labeled graph of the aggregate demand, short-run aggregate supply and long-run aggregate supply curves for Kolvarith. Label the initial price level PL1 and full-employment output YF. Then show the short-run effect of the larger foreign purchases of Kolvarith's goods and services, labeling the new price level PL2 and the new real output Y2.
  Question 1, part (a): your response. It stays in this browser tab and is never sent anywhere.
  Score part (a)
  - 1 point Draws a correctly labeled AD-AS graph of the starting position: the vertical axis is the price level, the horizontal axis is real GDP (or real output), AD slopes down, SRAS slopes up, and a vertical LRAS stands at YF, with AD and SRAS crossing on the LRAS at PL1.Earns it: "Price level up the side, real GDP along the bottom, AD1 and SRAS crossing on a vertical LRAS, dotted lines to PL1 and YF"; "axes PL and Real Output; AD, SRAS and LRAS all meet at (YF, PL1)"Does not: axes labeled price and quantity (those belong to the market for one good, not to the whole economy); AD and SRAS crossing to the left or right of LRAS at the start (the stem says Kolvarith begins in long-run equilibrium, so all three curves meet at YF)
  - 1 point Shows AD shifting to the right, from AD1 to AD2, with the new intersection of AD2 and SRAS at a price level PL2 above PL1 and a real output Y2 to the right of YF.Earns it: "AD1 shifts right to AD2; PL2 above PL1, Y2 to the right of YF"; "Net exports rise, so AD moves right and the economy sits at Y2 > YF with a higher price level PL2"Does not: SRAS shifting right (higher foreign spending is a rise in net exports, a component of AD, and does not change production costs); the new equilibrium placed on the LRAS at a higher price level (that is the long-run outcome after wages adjust; the question asks for the short run, where output rises above YF); LRAS shifting right (more foreign buying does not add to the resources or technology Kolvarith can produce with)
  Model response
  The vertical axis is labeled Price Level and the horizontal axis Real GDP. AD1 slopes down and SRAS slopes up, and they cross on a vertical line labeled LRAS that rises from YF, at a price level marked PL1. Foreign buyers spend more on Kolvarith's goods and services, so net exports rise and AD shifts right from AD1 to AD2. AD2 crosses SRAS above and to the right of the starting point: the new price level PL2 is above PL1, and the new real output Y2 is to the right of YF, a positive (inflationary) output gap.
2. (b)
  
  Based on your graph in part (a), is Kolvarith's unemployment rate at Y2 above, below or equal to its natural rate of unemployment?
  Question 1, part (b): your response. It stays in this browser tab and is never sent anywhere.
  Score part (b)
  - 1 point States that the unemployment rate is below the natural rate. A student whose graph in part (a) showed Y2 to the left of YF earns this point for stating that it is above the natural rate.Earns it: "Below the natural rate"; "Lower than the natural rate, because output is above full employment"Does not: equal to the natural rate (unemployment equals the natural rate only at YF, and Y2 is past it); above the natural rate because prices are higher (firms producing more output hire more workers, so unemployment falls)
  Model response
  Below the natural rate. To produce Y2, which is more than full-employment output, firms hire more workers than they employ at YF, so unemployment falls under its natural rate and cyclical unemployment is negative.
3. (c)
  
  As real output rises from YF to Y2, what happens to Kolvarith's government budget balance? Explain.
  Question 1, part (c): your response. It stays in this browser tab and is never sent anywhere.
  Score part (c)
  - 1 point Grades the direction of the change only, because the stem does not give Kolvarith's starting budget balance. States that the budget balance moves toward surplus (a deficit shrinks or a surplus grows; either wording earns, and a student is not asked to say whether Kolvarith is in deficit or surplus) and explains that, with no change in law, income tax revenue rises as earnings rise, or unemployment benefit payments fall as fewer people are out of work.Earns it: "It moves toward a surplus, because people earn more and so pay more income tax, while fewer people collect benefits"; "The deficit gets smaller: tax revenue rises automatically with income"; "It moves toward surplus (the deficit shrinks or the surplus grows), since tax revenue rises with incomes and fewer people collect benefits"Does not: the balance does not change because no law changed (the tax and benefit rules stay the same, but the amounts they collect and pay change with income and unemployment); moves toward deficit because the government spends more in a boom (nothing in the stem raises spending, and benefit payments fall when unemployment falls); "tax revenue increases" with no statement about the budget balance (the question asks about the balance); a stated size or sign for the new balance in place of its direction, such as "the budget is now in surplus" (the stem gives no starting balance, so only the direction can be known)
  Model response
  The budget balance moves toward surplus. The income tax takes a share of each person's earnings, so as incomes rise toward Y2 the government collects more tax without passing any new law. At the same time fewer people are unemployed, so unemployment benefit payments fall. Revenue goes up and outlays go down, so a deficit shrinks or a surplus grows.
4. (d)
  
  Kolvarith's central bank takes a monetary policy action to close the output gap. Draw a correctly labeled graph of the reserve market in Kolvarith, and show the effect of that action on the policy rate.
  Question 1, part (d): your response. It stays in this browser tab and is never sent anywhere.
  Score part (d)
  - 1 point Draws a correctly labeled reserve market graph for a banking system with ample reserves: the vertical axis is the policy rate (or the overnight interbank lending rate, or interest rate), the horizontal axis is the quantity of reserves, the demand for reserves (DR, or any clear label for reserve demand) slopes down and is flat at its lower end, the supply of reserves (SR, or any clear label for reserve supply) is vertical and crosses DR on that lower flat part, and the starting policy rate (PR1, R1 or any clear label) is marked at the crossing. The graph expected is the reserve market model, with the policy rate against the quantity of reserves; a money market graph does not earn this point.Earns it: "Policy rate on the side, quantity of reserves on the bottom, DR sloping down then flat at interest on reserves, SR vertical through the flat part, PR1"; "axes PR and Quantity of Reserves; vertical SR crossing the flat bottom of DR at PR1"; "Nominal interest rate (policy rate) on the side, quantity of reserves on the bottom; D1 slopes down then turns flat at IORB1; S vertical in the flat part; R1 = IORB1"Does not: a money market graph with MD and MS and the nominal interest rate (with ample reserves, the reserve market is the graph that shows how the central bank moves the rate); SR crossing DR on its sloped middle (that pictures a banking system with limited reserves, and the stem says reserves are ample)
  - 1 point Shows a monetary policy action the CED allows under ample reserves, which is raising the central bank's administered interest rates: raising the interest rate it pays on reserves (alone, or with its other administered rates) moves the lower flat part of DR up, alone or together with the upper flat part, SR stays where it was, and the policy rate rises from PR1 to a higher PR2 (any clear labels for the two rates earn). The expected graph shows the action as an upward shift of the flat part of reserve demand, not as a shift of reserve supply. A student who raises the administered rates by moving both flat parts earns the point. A student whose graph lacked the flat part of DR, and so lost the first point, earns this point for showing a labeled interest rate on reserves rising and the policy rate rising from PR1 to PR2, so that one omission does not cost both points.Earns it: "The flat bottom of DR moves up from IOR1 to IOR2; SR unchanged; the policy rate rises from PR1 to PR2"; "Both flat parts of DR shift up because the central bank raises its administered rates, so PR2 is above PR1"; "The central bank raises the interest it pays on reserve balances from IORB1 to IORB2; the flat part of D shifts up to D2; S does not move; the policy rate rises from R1 to R2"Does not: SR shifting left because the central bank sells bonds (with ample reserves, SR still crosses the flat part of DR, so the policy rate does not move); the policy rate falling (the gap is inflationary, so the central bank raises rates to cool spending); the whole DR curve, sloped middle included, shifting up (only the flat parts are rates the central bank sets); SR shifted left far enough to cross the downward-sloping part of DR, raising the policy rate (the stem fixes ample reserves, and with ample reserves the central bank moves the policy rate with its administered rates; draining reserves until they are scarce changes the banking system the question describes, so it does not earn the point); raising only the discount rate, drawn as the upper flat part of DR moving up with SR still crossing the lower flat part (the policy rate sits on the lower flat part, set by interest on reserves, so moving only the upper part leaves the policy rate where it was)
  Model response
  The vertical axis is labeled Policy Rate and the horizontal axis Quantity of Reserves. DR1 is flat at the top, slopes down through the middle, and is flat at the bottom at the interest rate the central bank pays on reserves. SR is a vertical line that crosses DR1 on its lower flat part, and that crossing is marked PR1 on the vertical axis. To fight the inflationary gap, the central bank raises the interest rate it pays on reserves, so the lower flat part of DR moves up, giving DR2. SR does not move, and it now crosses DR2 at PR2, above PR1, so the policy rate rises.
5. (e)
  
  Explain how the change in the policy rate shown in part (d) affects real output in Kolvarith in the short run.
  Question 1, part (e): your response. It stays in this browser tab and is never sent anywhere.
  Score part (e)
  - 1 point States that real output decreases and explains that the higher policy rate raises other interest rates, which reduces interest-sensitive spending (investment, or consumption bought on credit) and shifts AD to the left. Explaining instead that the higher rate draws in foreign financial capital, the currency appreciates, and net exports fall, shifting AD to the left, also earns the point. A student whose part (d) showed the policy rate falling earns this point for an increase with the mirror explanation.Earns it: "Output falls: loans for equipment and cars cost more, so firms invest less and households buy less on credit, and AD shifts left"; "Higher rates cut interest-sensitive investment and consumption, so aggregate demand decreases and real GDP moves back toward YF"; "Higher interest rates attract foreign saving, so demand for the currency rises and it appreciates; exports fall and imports rise, net exports drop, and AD shifts left, so real output falls"Does not: "real output falls because AD falls" with no spending in between (the point needs the link through interest-sensitive spending); real output falls because SRAS shifts left (a rise in interest rates works through spending, which is aggregate demand); real output falls because the money supply shrinks (with ample reserves the central bank moves rates through its administered rates, and the answer needs the effect of the higher rates on spending)
  Model response
  Real output decreases. When the policy rate rises, banks charge more on business loans, car loans and mortgages too. Borrowing to build or buy becomes more expensive, so firms cut investment spending and households buy fewer things on credit. That interest-sensitive spending is part of aggregate demand, so AD shifts left, and real output falls back toward YF.
6. (f)
  
  After the central bank acts, a bank in Kolvarith makes a one-year loan to a brewery at a nominal interest rate of 8.5 percent. When they sign, the bank and the brewery both expect inflation of 3.5 percent over the year.
  
  (i) Calculate the real interest rate that the bank and the brewery expect on the loan. Show your work.
  
  (ii) Before the central bank acted, the bank charged 6.5 percent on the same kind of loan, and expected inflation was 3.5 percent then as well. Did the central bank's action change the expected real interest rate on loans like this one? Explain.
  Question 1, part (f): your response. It stays in this browser tab and is never sent anywhere.
  Score part (f)
  - 1 point (i) Calculates an expected real interest rate of 5 percent and shows work: 8.5 - 3.5 = 5.Earns it: "Expected real rate = nominal - expected inflation = 8.5% - 3.5% = 5%"; "8.5 - 3.5 = 5 percent"Does not: 12 percent (that adds expected inflation to the nominal rate instead of subtracting it); 3.5 percent (that is the expected inflation rate, not the real interest rate); 5 percent with no work shown (the task says show your work, and the point needs it)
  - 1 point (ii) States that the expected real interest rate rose, from 6.5 - 3.5 = 3 percent before the action to 5 percent after it, and explains that the nominal rate rose while expected inflation did not change, so the expected real cost of borrowing is higher. A student who found a different expected rate in part (i) earns this point for a correct comparison with that rate.Earns it: "Yes, it rose. Before: 6.5 - 3.5 = 3%. After: 8.5 - 3.5 = 5%. Expected inflation is the same, so the higher nominal rate is a higher real rate"; "The expected real rate went up by 2 points, because the nominal rate rose 2 points and expected inflation stayed at 3.5 percent"Does not: no, because the real rate depends only on inflation (the expected real rate is the nominal rate minus expected inflation, and the nominal rate changed); it fell, because higher interest rates lower inflation (expected inflation is given as 3.5 percent in both cases); "yes" with no comparison (the point needs both expected real rates, or the reason that expected inflation did not change)
  Model response
  (i) Expected real interest rate = nominal interest rate - expected inflation = 8.5 - 3.5 = 5 percent.
  
  (ii) Yes, it rose. Before the central bank acted, the expected real rate on such a loan was 6.5 - 3.5 = 3 percent. After, it is 5 percent. Expected inflation did not change, so the whole 2-point rise in the nominal rate is a rise in the expected real cost of borrowing.
7. (g)
  
  The brewery is also considering a new fermenting tank, which it would pay for with a one-year loan on the same terms as in part (f). Over that same year, with the same expected inflation of 3.5 percent, the brewery expects the tank to earn a real return of 4 percent. Based on your answer to part (f)(i), would borrowing to buy the tank pay off for the brewery?
  Question 1, part (g): your response. It stays in this browser tab and is never sent anywhere.
  Score part (g)
  - 1 point States that it would not pay off (or that the brewery should not borrow for the tank), since the tank's expected real return of 4 percent is less than the expected real interest rate of 5 percent. A student who found a different expected real rate in part (f)(i) earns this point for the answer consistent with comparing 4 percent to that rate.Earns it: "No. The tank earns 4 percent in real terms, but the loan costs 5 percent in real terms"; "It would not pay off, because 4% < 5%"Does not: yes, because 4 percent is more than zero (the return must beat the real cost of borrowing, not just be positive); yes, because the tank's return is above the 3.5 percent expected inflation (the comparison is with the real interest rate, 5 percent, not with inflation)
  Model response
  No. The tank is expected to earn a real return of 4 percent a year, but borrowing to pay for it costs an expected real interest rate of 5 percent, so the brewery would lose about 1 percent a year in real terms. Before the central bank acted, when the expected real rate was 3 percent, the same tank would have paid off.
Your score: 0 of 10, from the boxes you ticked.
Question 2: Short 5 points

The banking system in Dunhaven has limited reserves, and the required reserve ratio is 10 percent. Pemrose Bank holds no excess reserves. Its balance sheet is shown below.

Pemrose Bank balance sheet
Assets Amount Liabilities Amount

Reserves $36,000 Demand deposits $360,000
Loans $250,000
Government bonds $74,000

Answer parts (a) through (d). Draw any graph or visual on your own paper.
1. (a)
  
  Dunhaven's central bank sells $9,000 of government bonds to Pemrose Bank, and Pemrose pays for them with its reserves. Draw a correctly labeled balance sheet (T-account) for Pemrose Bank that shows only the changes caused by the sale.
  Question 2, part (a): your response. It stays in this browser tab and is never sent anywhere.
  Score part (a)
  - 1 point Draws a correctly labeled T-account: assets on one side and liabilities (and owner's equity) on the other, with reserves and government bonds listed as assets.Earns it: "A T with Assets on the left and Liabilities on the right; reserves and bonds under Assets"; "Assets | Liabilities, with the changes written under Assets"Does not: reserves or bonds listed as liabilities (the bank owns them, so they are assets); a list of numbers with no assets and liabilities sides (the point needs the T-account form)
  - 1 point Shows government bonds rising by $9,000 and reserves falling by $9,000 on the asset side, with no change in demand deposits or any other liability.Earns it: "Assets: government bonds +$9,000, reserves -$9,000. Liabilities: no change"; "Bonds +9,000 and reserves -9,000 under assets; deposits unchanged"Does not: demand deposits falling by $9,000 (the bank paid with its reserves; no customer's account changed); reserves rising (the bank gave up reserves to pay the central bank); loans falling by $9,000 (nothing has happened to loans yet; the sale changes reserves and bonds)
  Model response
  The T-account has Assets on the left and Liabilities on the right. Under Assets: government bonds +$9,000 and reserves -$9,000. Under Liabilities: no change. The bank swapped $9,000 of reserves for $9,000 of bonds, and its deposits are the same as before.
2. (b)
  
  Calculate the amount by which Pemrose Bank's reserves now fall short of the reserves it is required to hold. Show your work.
  Question 2, part (b): your response. It stays in this browser tab and is never sent anywhere.
  Score part (b)
  - 1 point Calculates a shortfall of $9,000 and shows work: required reserves are 0.10 x $360,000 = $36,000, reserves after the sale are $36,000 - $9,000 = $27,000, and $36,000 - $27,000 = $9,000.Earns it: "Required = 0.10 x 360,000 = 36,000; reserves now 36,000 - 9,000 = 27,000; short by 9,000"; "It needs $36,000 but has $27,000, so it is $9,000 short"Does not: $27,000 (that is the reserves Pemrose has left after the sale, not the amount it is short); $900 (that is 10 percent of the sale; the bank lost all $9,000 of the reserves it used to pay); $9,000 with no work shown (the point needs the work)
  Model response
  Required reserves are 10 percent of demand deposits: 0.10 x $360,000 = $36,000. After paying for the bonds, Pemrose has $36,000 - $9,000 = $27,000 of reserves. It is short by $36,000 - $27,000 = $9,000.
3. (c)
  
  Identify one action Pemrose Bank could take to meet its reserve requirement.
  Question 2, part (c): your response. It stays in this browser tab and is never sent anywhere.
  Score part (c)
  - 1 point Identifies an action that raises the bank's reserves or lowers the deposits it must back: reduce its lending (for example, not making new loans as old ones are repaid), sell other assets such as bonds for reserves, or borrow reserves from another bank or from the central bank.Earns it: "Stop making new loans until repayments rebuild its reserves"; "Sell some of its other bonds to get reserves back"; "Borrow reserves overnight from another bank, or from the central bank"Does not: lower the required reserve ratio (only the central bank can change it); make more loans (lending more would use reserves, not add to them)
  Model response
  Pemrose could stop making new loans for a while, so that as borrowers repay their old loans its reserves build back up to the $36,000 it must hold.
4. (d)
  
  Suppose Pemrose, and any other bank that is left short of reserves, meets its reserve requirement by reducing its lending rather than by borrowing reserves or selling assets. Explain why the money supply in Dunhaven could fall by more than $9,000 as a result.
  Question 2, part (d): your response. It stays in this browser tab and is never sent anywhere.
  Score part (d)
  - 1 point Explains that a bank short of reserves cuts its lending, which reduces checking deposits, and that other banks that lose reserves as a result cut their lending in turn, so deposits, which are part of the money supply, shrink by a multiple of the $9,000. The maximum fall in the simple model, $9,000 / 0.10 = $90,000, is credited alongside the explanation but is not required. The stem of this part fixes how the banks respond, so the point does not depend on which action the student named in part (c): a student whose part (c) answer was borrowing reserves or selling bonds earns this point for the multiple-contraction explanation.Earns it: "Pemrose lends less, so fewer deposits are created; other banks lose reserves and cut loans too, so deposits fall by up to 9,000 x 10 = 90,000"; "The money multiplier works in reverse: each bank short of reserves calls in loans, and deposits shrink across the system"; "Banks short of reserves cut lending, so fewer deposits are created and other banks are left short in turn; with a multiplier of 1 / 0.10 = 10, deposits and so the money supply can fall by up to $90,000"Does not: the money supply falls by $9,000 at the moment of the sale (the sale is between the central bank and Pemrose, so no checking deposit changes and M1 does not change at that moment; any fall comes as banks cut lending); "because of the money multiplier" with no account of banks cutting loans and deposits shrinking; the money supply rises (the sale drains reserves from the banking system)
  Model response
  To rebuild its reserves, Pemrose makes fewer new loans. Fewer loans mean fewer new checking deposits, and when borrowers repay loans out of their accounts, deposits shrink. Other banks that lose deposits and reserves are then short themselves and cut their lending too. Since checking deposits are part of the money supply, the money supply can fall by a multiple of the $9,000, as much as $9,000 / 0.10 = $90,000.
Your score: 0 of 5, from the boxes you ticked.

Pemrose Bank balance sheet
Assets	Amount	Liabilities	Amount
Reserves	$36,000	Demand deposits	$360,000
Loans	$250,000
Government bonds	$74,000

Question 3: Short 5 points

Fandrell has a flexible exchange rate, and its currency, the fand, trades against the U.S. dollar. The table shows all of Fandrell's international transactions last year, in billions of fands.

Fandrell's international transactions last year (billions of fands)
Transaction	Amount
Exports of goods and services	412
Imports of goods and services	455
Income earned on Fandrell-owned assets abroad	31
Income paid on foreign-owned assets in Fandrell	18
Money sent by Fandrell residents to relatives abroad as gifts	6
Purchases of Fandrell assets by foreigners	155
Purchases of foreign assets by Fandrell residents	119

Answer parts (a) through (d). Draw any graph on your own paper.

(a)

Using the data in the table, calculate Fandrell's current account balance last year. Show your work.
Question 3, part (a): your response. It stays in this browser tab and is never sent anywhere.
Score part (a)
- 1 point Calculates a current account balance of -36 billion fands (a deficit of 36 billion) and shows work: (412 - 455) + (31 - 18) - 6 = -43 + 13 - 6 = -36.Earns it: "CA = 412 - 455 + 31 - 18 - 6 = -36 billion fands"; "Net exports -43, net income +13, transfers -6, so a 36 billion fand deficit"Does not: -43 billion (that is the balance of trade alone; the current account also counts net income from abroad and transfers); -24 billion (that adds the 6 billion sent to relatives abroad, but money sent out of the country is a debit); -30 billion (that leaves out the gifts sent to relatives abroad, which are unilateral transfers and belong in the current account; it earns no credit); 0 (that adds the asset purchases too, which gives the whole balance of payments; asset purchases belong in the capital and financial account)
Model response
Current account = net exports + net income from abroad + net transfers = (412 - 455) + (31 - 18) - 6 = -43 + 13 - 6 = -36. Fandrell ran a current account deficit of 36 billion fands.
(b)

Consider only the five current account rows of the table. Did those transactions add more to the demand for fands or to the supply of fands in the foreign exchange market last year? Explain using the data in the table.
Question 3, part (b): your response. It stays in this browser tab and is never sent anywhere.
Score part (b)
- 1 point States that the current account transactions added more to the supply of fands and explains with the data: foreigners paying for Fandrell's exports and Fandrell residents converting income earned abroad add to the demand for fands (412 + 31 = 443 billion), while Fandrell residents paying for imports, foreign owners converting the income paid to them, and residents sending gifts abroad add to the supply of fands (455 + 18 + 6 = 479 billion), so supply exceeds demand by 36 billion fands. A student who found a different current account balance in part (a) earns this point for a direction and explanation consistent with that balance.Earns it: "Supply. Exports and income earned abroad bring in demand of 412 + 31 = 443; imports, income paid out and gifts need 455 + 18 + 6 = 479 fands sold. Supply is 36 billion more"; "More to supply: paying for imports, income to foreign owners and gifts all mean selling fands for dollars, and those total more than what foreigners pay for exports and what residents earn abroad"Does not: demand, because exports are a large number (imports, income paid abroad and gifts sent abroad add up to more); "supply" with no data (the question says to explain using the data in the table); including the asset purchase rows (the question asks only about the current account rows)
Model response
They added more to the supply of fands. To pay for Fandrell's exports, foreigners must buy fands, and Fandrell residents who earn income abroad convert it into fands: that adds 412 + 31 = 443 billion fands of demand. To pay for imports, Fandrell residents must sell fands for dollars, foreign owners convert the income paid to them out of fands, and residents sending gifts abroad sell fands too: that adds 455 + 18 + 6 = 479 billion fands of supply. Supply from the current account was 36 billion fands larger than demand, the same as the current account deficit.
(c)

This year Fandrell's government ends a rule that had kept its residents from buying property and shares abroad, and Fandrell households and firms start buying large amounts of foreign shares and real estate. Draw a correctly labeled graph of the foreign exchange market for the fand, and show the effect of these purchases on the exchange rate.
Question 3, part (c): your response. It stays in this browser tab and is never sent anywhere.
Score part (c)
- 1 point Draws a correctly labeled foreign exchange market for the fand: the vertical axis is the exchange rate as dollars per fand (or the price of the fand in dollars), the horizontal axis is the quantity of fands, demand slopes down, supply slopes up, and the equilibrium exchange rate is marked (e1, ER1 or any clear label).Earns it: "Dollars per fand up the side, quantity of fands along the bottom, D down, S up, e1 where they cross"; "$/fand and Q of fands axes with a downward D, upward S and e1"Does not: the vertical axis labeled fands per dollar with fands on the horizontal axis (the price on the vertical axis must be the price of the currency on the horizontal axis, dollars per fand); axes labeled price and quantity with no currency named (the graph must show the market for the fand)
- 1 point Shows the supply of fands shifting to the right, from S1 to S2, and the exchange rate falling from e1 to a lower e2 (the fand depreciates; any clear labels for the two rates, such as ER1 and ER2, earn).Earns it: "S1 shifts right to S2 because residents sell fands for dollars to buy foreign assets; e2 is below e1"; "More fands supplied, so the fand depreciates from e1 to e2"Does not: the demand for fands shifting left (the buyers are Fandrell residents, who supply fands to get dollars; foreigners' demand for fands has not changed); the supply of fands shifting left (buying foreign assets takes dollars, which residents get by offering more fands); a shift drawn with no new exchange rate marked (the point needs the lower rate shown)
Model response
The vertical axis is labeled Dollars per Fand and the horizontal axis Quantity of Fands. The demand for fands, D, slopes down, the supply, S1, slopes up, and they cross at e1. To buy foreign shares and real estate, Fandrell residents must first trade fands for dollars, so they offer more fands at every exchange rate: supply shifts right to S2. S2 crosses D at e2, below e1, so the fand depreciates.
(d)

Based on the change in the value of the fand shown in part (c), will Fandrell's current account deficit become larger, become smaller or stay the same? Explain.
Question 3, part (d): your response. It stays in this browser tab and is never sent anywhere.
Score part (d)
- 1 point States that the current account deficit becomes smaller and explains that the cheaper fand makes Fandrell's exports less expensive for foreign buyers and imports more expensive for Fandrell residents, so exports rise, imports fall and net exports increase. A student whose part (c) showed the fand appreciating earns this point for a larger deficit with the mirror explanation. The expected answer is the one the CED gives for a change in a currency's value: a change in the relative price of the country's goods and services changes exports and imports. A J-curve answer, that the deficit first grows before it shrinks, is outside the course: it is not required, and an answer of "larger" that rests on it does not earn the point. An answer of "smaller" with the price explanation still earns if it adds such an aside.Earns it: "Smaller. The fand buys fewer dollars, so Fandrell goods are cheaper abroad and foreign goods cost more fands; exports rise, imports fall"; "The deficit shrinks because the depreciation raises net exports"Does not: larger, because more money is leaving the country (the purchases of foreign assets are recorded in the capital and financial account; the question asks what the weaker fand does to trade); stays the same because the table already shows last year's balance (the depreciation changes this year's exports and imports); "smaller" with no link to prices of exports and imports (the point needs the explanation); larger in the short run because of a J-curve (that timing argument is outside the course; the question asks for the effect of the cheaper fand on the prices of exports and imports)
Model response
The current account deficit becomes smaller. After the depreciation, each fand buys fewer dollars, so a Fandrell good priced in fands costs foreign buyers fewer dollars, and a foreign good priced in dollars costs Fandrell residents more fands. Fandrell's exports rise and its imports fall, so net exports increase and the current account deficit shrinks.

Full practice exams

Practice Exam 1

Section I: Multiple Choice

Section II: Free Response

Question 1: Long 10 points

Question 2: Short 5 points

Question 3: Short 5 points

Your results

Practice Exam 2

Section I: Multiple Choice

Section II: Free Response

Question 1: Long 10 points

Question 2: Short 5 points

Question 3: Short 5 points

Your results