Econ 203 Test 2 || Questions and 100% Verified Answers.
Explain in simple words what do "sticky prices" mean. correct answers Some prices, like wages
and long term contracts, cannot adjust right away when the conditions in the economy change.
Since prices cannot react, that means that the self-adjustment mechanism that we studied in the
past will be ineffective and unable to bring the economy back to full employment on its own
without intervention.
The Multiplier:
a) What is the definition of the MPC? What is the definition of the Multiplier?
b) When is the Multiplier stronger? Why?
c) If the MPC is 0.9, 0.75, 0.5, 0.3, 0.2, calculate the respective multipliers.
d) For each of those cases, how much income would we need to inject in the economy if we aim
to increase Consumption by $1000? correct answers a) MPC = Marginal Propensity to Consume.
When I am given an extra dollar of income, the MPC measures how much of that amount of
money I will consume.
The Multiplier = It measures the increase in Aggregate Demand when an additional dollar of
income is given to the economy. AD increases by a multiple of that dollar, since it will change
hands more than once.
b) The multiplier is stronger when people are relatively poor: extra income allows people to buy
more necessities, and they will spend almost all of that income. When people are rich, an extra
dollar does not change spending habits that much, and people will save a larger amount of that
dollar instead of consuming it all.
c) M = 1/(1-MPC)
M = 1/(1-0.9) = 10 M = 1/(1-0.75) = 4 M = 1/(1-0.5) = 2 M = 1/(1-0.3) = 1.43 M = 1/(1-0.2) =
1.25
d) Total Increase in AD = M * "Injection" => "Injection" = Tot Inc in AD / M
Inj = 1000/10 = 100 Inj = 1000/4 = 250 Inj = 1000/2 = 500 Inj = 1000/1.43 = 700 Inj =
1000/1.25 = 800
3) Explain the relationship between government spending and taxation when we are running a
balanced budget, a budget deficit, and a budget surplus. correct answers A balanced budget
means that we are spending as much as we are earning: government income from taxation is
equal to government expenditure.
A budget deficit occurs when the government is spending more money than what it is receiving
in income from taxation. It has to borrow to finance the difference, or use saved up money from
past years.
A budget surplus occurs when the government is spending less money than what it is receiving in
income from taxation. It can use the surplus to pay back loans, or store for future deficits.
What is Discretionary Fiscal Policy? Who conducts it? What tool(s) are they using to conduct
such policy? correct answers Discretionary Fiscal Policy occurs when the government decides to
actively change their level of government spending or the level of taxation. Those two are the
tools that they use to conduct policy.
Discretionary policy needs someone to take a decision. Automatic stabilizers are not part of
discretionary policy. As an example, if I earn more this year and I jump up a tax bracket, that is
, not an indicator that the government has changed fiscal policy - I simply earned more income so
I paid higher taxes. However, if the government changes the tax code itself, then that will be
discretionary policy.
You are in long run equilibrium. A supply shock decreases SRAS. You are a Keynesian
economist and do not believe in self-adjustment. What kind of policy will you choose to
counteract that effect? Show in a graph: the original equilibrium, the supply shock, and your
policy's effects. correct answers We are at point 1, full employment.
The supply shock happens and decreases SRAS -> shift it left. This makes our new equilibrium
point 2, where output is less than full employment, and the price level increased.
Keynesians believe self-adjustment is slow or that it does not work at all. So, they propose that
the government increases government spending, to boost AD. AD will shift to the right, until we
are at point 3, back in full employment. We have caused inflation, but that is an acceptable
tradeoff for exiting the recession.
You are a New Classical economist now. You are faced with the same supply shock as in
question 5, and you know that the government is going to implement Fiscal Policy. You also
believe in self-adjustment, however. How will the economy move this time, when you combine
Fiscal Policy AND self-adjustment in one model? (Hint: Look at the mistimed Fiscal Policy
slides) correct answers This time, we believe in self-adjustment. The supply shock will happen
just as before - SRAS will decrease and we end up at point 2. However, that increases the price
level and decreases output. Firms are making smaller profits and will try to negotiate wages
down; that will decrease resource costs and shift SRAS back to its original level, and we are back
at equilibrium 1. At the same time, however, the government expands AD due to fiscal policy, so
AD shifts to the right. We are now above full employment and we have caused a short run boom
in our economy. The effect on the price level is generally unsure - it depends on the size of the
two shifts.
Explain in simple words the "Paradox of Thrift". correct answers Keynesian argument against
saving: if we all take a decision to save money, then we are not consuming. By saving our
money, we increase the supply of loanable funds, which should in turn reduce the real interest
rate (price of money in the Market for Loanable Funds). That decrease in the real interest rate
should make borrowing cheaper, so in theory, we should expect to see people taking out
consumption loans and businesses borrowing for investment and boost AD. However, since
people want to save money, nobody will take out those loans, and AD will not be boosted, even
if theory suggests it would. In the end, saving money does nothing to boost the economy.
Explain, step by step, the "Crowding Out" mechanism when the government tries to fight a
recession with expansionary Fiscal Policy. Use appropriate graphs. What are the important
implications of this effect as argued by New Classical theory? correct answers We are at point 1,
a recession, below full employment. The government decides to do expansionary Fiscal Policy.
They increase their spending, and they finance that expenditure by borrowing money. Borrowing
money means demand for loanable funds increases. That causes an increase in the real interest
rate. However, as the real interest rate increases, consumption and investment are now more
expensive, since people can borrow less and would prefer to save more. So, consumption and
