Exam Prep Ch17 A Brief History Of Macroeconomic Thought And

Chapter 17: A Brief History of Macroeconomic Thought and Policy

Multiple Choice

1. Prior to the Great Depression of the 1930s, macroeconomics was dominated by

A) Keynesian economics.

B) monetarism.

C) classical economics.

D) supply-side economics.

Difficulty: Easy

2. Prior to the Great Depression, the dominant economic view held that

A) fiscal policy could effectively eliminate a recessionary gap and return the economy to its

potential output.

B) economies should be able to reach full employment through a process of self-correction.

C) monetary policy should be used to move the economy back to its potential output because it

was more immediate than fiscal policy.

D) any movement away from potential output was due to either an excess aggregate demand or an excess aggregate supply.

Difficulty: Easy

3. In the 1960s, despite the successful application of expansionary fiscal policy in the United States, Milton Friedman argued that

A) Keynesian supply-side policies were more effective at stimulating aggregate demand than expansionary fiscal policies.

B) aggregate demand is affected by money and not by fiscal policy, and therefore only monetary policy should not be used to move the economy back to its potential output.

C) aggregate demand is affected by money and not by fiscal policy, which is why policymakers should institute a policy of steady money growth and allow the economy to reach full employment through a process of self-correction.

D) fiscal policy must be combined with monetary policy to move the economy back to its potential output, without increasing inflationary pressure.

Difficulty: Easy

4. The inability of the government to stabilize the economy in the 1970s when real GDP has fallen, but inflation has remained high, led Robert Lucas to challenge the Keynesian macroeconomic policy prescriptions. Which of the following is the main tenet of his argument?

A) Active stabilization policies tend to be destabilizing because of the long policy lags and consequently, slow down the economy’s self correction.

B) There is no role for active stabilization policies because they do not take into account rational choices by individuals; failure to do so generally cancels the impact of fiscal and monetary policies.

C) Individuals respond in predictable ways to their changing economic environment; active stabilization interferes with people’s ability to respond to changing economic conditions.

D) The economy is inherently stable and any role for stabilization policy should be limited to those that affect long-run aggregate supply to promote economic growth and not aggregate demand.

Difficulty: Easy

5. Which of the following is true about the Great Depression?

A) Following the Great Depression of 1929, the economy did not regain its potential output until

the early 1940s when the pressures of WWII sharply increased aggregate demand.

1. Expansionary monetary and fiscal policies successfully moved the economy from the Great

Depression of 1929 within three to five years.

C) The Great Depression of 1929 was considered to be a normal stage of business cycles.

D) The Great Depression could be explained by classical economic theory.

Difficulty: Easy

6. Who was the economist who laid the foundations for classical economics?

A) John Locke

B) David Ricardo

C) Adam Smith

D) John Maynard Keynes

Difficulty: Easy

7. David Ricardo’s work is associated with _______ economics.

A) Keynesian

B) new Keynesian

C) classical

D) monetarist

Difficulty: Easy

8. Early classical macroeconomics was based largely on the foundation of

A) flexible wages and prices.

B) persistent unemployment.

C) government intervention in the market.

D) Adam Smith’s model of imperfectly competitive markets.

Difficulty: Medium

9. The body of economic thought associated with 19th century economist

A) David Ricardo is called Ricardian economics.

B) Adam Smith is called Smithian economics.

C) David Ricardo is called classical economics.

D) Adam Smith is called classical economics.

Difficulty: Easy

10. A fundamental feature of early classical macroeconomics is that

A) aggregate demand and aggregate income are usually unequal.

B) prices of inputs and outputs are relatively rigid.

C) the economy’s level of employment can remain substantially below its natural level over a

prolonged period of time.

D) the economy can achieve full employment on its own, though there could be temporary

periods in which employment falls below the natural level.

Difficulty: Medium

11. According to early classical macroeconomics, unemployment

A) can persist for long periods of time, because wages are inflexible.

B) could not prevail for long periods of time, because wages are flexible.

C) can never occur.

D) could not prevail for long, because the government intervenes to eliminate unemployment.

Difficulty: Medium

12. David Ricardo focused on the economy in the _______ and on the forces that determined an

Economy’s _______.

A) short run; full employment level of output

B) long run; potential output

C) short run; market gluts

D) short run; money supply

Difficulty: Medium

13. Classical economists believed

I. there could be temporary periods of unemployment.

II. emphasis should be placed on the long run, and in the long run all would be set right

because of the smooth functioning of the price system.

III. the Great Depression would be a short-run aberration.

A) I only

B) I and II only

C) II only

D) I, II, and III

Difficulty: Medium

14. The General Theory of Employment, Interest, and Money was written by

A) Robert Lucas.

B) David Ricardo.

C) John Maynard Keynes.

D) Thomas Malthus.

Difficulty: Easy

15. John Maynard Keynes argued that _______

A) flexibility in wages and prices could block adjustments to full employment.

B) stickiness in wages and prices could block adjustments to full employment.

C) wage and price rigidities were caused by producer and consumer expectations about future

prices.

D) wage and price rigidities could be eliminated by government wage and price setting.

Difficulty: Medium

16. An important distinction between the classical and Keynesian view of the economy is that

A) Keynes stressed the supply side of an economy while classical economists stressed the demand side of the economy.

B) classical economists argued that output gaps were caused by shifts in the long-run aggregate supply while Keynes’ maintained that output gaps were created by shifts in aggregate demand.

C) Keynes stressed the demand side of an economy while classical economists stressed the supply side of the economy.

D) classical economists argued that output gaps were caused by shifts in the long-run aggregate supply while Keynes’ maintained that output gaps were created by wage and price rigidities.

Difficulty: Medium

17. Which component of aggregate demand plunged sharply at the start of the Great Depression?

A) investment

B) consumption

C) government purchases

D) transfer payments

Difficulty: Medium

18. During the Great Depression, investment plummeted because

A) government policies related to investment tax credit changed the incentives for firms to

undertake investment spending.

B) the investment boom of the 1920s had left firms with an expanded stock of capital and as the capital stock approached its desired level, firms did not need as much new capital.

C) more and more firms invest abroad rather than in the domestic economy to cut production costs.

D) consumers were not spending enough to justify expenditures on investment.

Difficulty: Medium

19. Which of the following factors contributed to the sharp reduction in aggregate demand during the Great Depression?

I. reduction in wealth

II. reduced consumer confidence

III. tax increases

IV. an expansionary monetary policy that caused inflation

A) I and II only

B) I and IV only

C) I, II, and III only

D) I, II, and IV only

Difficulty: Medium

20. Which of the following factors contributed to the sharp reduction in aggregate demand during the Great Depression?

I. reduction in wealth

II. reduction in net exports

III. a financial crisis that reduced money supply

IV. tax increases

A) I and III only

B) I, III, and IV only

C) I, II, and III only

D) I, II, III, and IV

Difficulty: Medium

21. Which of the following statements is true about the Great Depression?

A) The fall in aggregate demand at the start of the Great Depression began with the collapse consumption because of the decrease in incomes, following the stock market crash of 1929.

B) The fall in the short-run aggregate supply at the start of the Great Depression began with the collapse in investment.

C) The fall in aggregate demand at the start of the Great Depression began with the collapse in investment.

D) The fall in the short-run aggregate supply at the start of the Great Depression began with the collapse in exports because of the passage of Smoot-Hawley Tariff Act of 1930 which raised tariffs on imported goods.

Difficulty: Medium

22. In the initial stages of the Great Depression, fiscal authorities responded to the decline in

output by

A) increasing government purchases to stimulate aggregate demand.

B) raising taxes to increase government revenue.

C) lowering taxes to encourage spending.

D) subsidizing private production to create jobs.

Difficulty: Medium

23. The Smoot-Hawley Tariff Act of 1930

A) was passed to protect domestic jobs by imposing fines on firms that imported raw materials

from abroad.

B) mandated the federal budget be balanced.

C) dramatically raised tariffs on products imported into the U.S. and led to retaliatory trade-

restricting legislation around the world.

D) subsidized domestic firms which produced products for export.

Difficulty: Medium

24. The Smoot-Hawley Tariff Act of 1930 contributed to the collapse of global trade

A) by raising tariffs on products imported into the U.S., which in turn led to retaliatory

trade-restricting legislation around the world.

B) by imposing economic sanctions against third-world countries.

C) by banning foreign consumer products.

D) by raising tariffs on exports, which deterred domestic producers from selling in foreign

markets.

Difficulty: Medium

Use the following to answer questions 25-31.

Exhibit: Aggregate Demand and Aggregate Supply and the Great Depression

25. (Exhibit: Aggregate Demand and Aggregate Supply and the Great Depression) Which point best illustrates where the U.S. economy was just prior to the Great Depression?

A) point j

B) point k

C) point m

D) point n

Difficulty: Medium

26. (Exhibit: Aggregate Demand and Aggregate Supply and the Great Depression) Which price level and output level best illustrates where the U.S. economy was before the Great Depression began?

A) P_m; Y_m

B) P_n; Y_n

C) P_k; Y_k

D) P_j; Y_j

Difficulty: Medium

27. (Exhibit: Aggregate Demand and Aggregate Supply and the Great Depression) The Great Depression began with a shift of

A) AD₂ to AD₁.

B) AD₁ to AD₂ .

C) SRAS₂ to SRAS₁.

D) Y_P to Y_k.

Difficulty: Medium

28. (Exhibit: Aggregate Demand and Aggregate Supply and the Great Depression) During the Great Depression, aggregate demand declined sharply. As a result, the economy moved to

A) point k creating a recessionary gap equal to (Y_m − Y_k).

B) point k creating a recessionary gap equal to (Y_P − Y_k).

C) point j creating a recessionary gap equal to (Y_P − Y_j).

D) point j creating a recessionary gap equal to (Y_n − Y_j).

Difficulty: Medium

29. (Exhibit: Aggregate Demand and Aggregate Supply and the Great Depression) During the Great Depression, aggregate demand declined sharply, thrusting the economy into a recessionary gap. Nominal wages plunged roughly 20% between 1929 and 1933. How did the economy respond to the falling wages?

A) The short-run aggregate supply curve shifted left, from SRAS₂ to SRAS₁, resulting in a short run equilibrium at point k.

B) The short-run aggregate supply curve shifted right, from SRAS₁ to SRAS₂, resulting in a short run equilibrium at point n.

C) The short-run aggregate supply curve shifted right, from SRAS₁ to SRAS₂, resulting in a short run equilibrium at point j.

D) The short-run aggregate supply curve shifted left, from SRAS₂ to SRAS₁, resulting in a short run equilibrium at point m.

Difficulty: Medium

30. (Exhibit: Aggregate Demand and Aggregate Supply and the Great Depression) During the Great Depression, aggregate demand declined sharply. Suppose the economy moved to a short-run equilibrium at point k. Over time, the economy moved to point j. What could have caused the economy to move to point j?

A) Falling output prices caused the aggregate supply to shift from SRAS₁ to SRAS₂.

B) Falling nominal wages caused the aggregate supply to shift from SRAS₁ to SRAS₂.

C) Expansionary fiscal policies caused the aggregate supply to shift from SRAS₁ to SRAS₂.

D) A decline in the demand for U.S. goods by foreign countries aggregate supply to shift from SRAS₁ to SRAS₂.

Difficulty: Medium

31. (Exhibit: Aggregate Demand and Aggregate Supply and the Great Depression) Suppose the U.S. economy is at point j. With the onset of World War II, expansionary fiscal policies forced by the war pushed into an inflationary gap. Which of the following best illustrates this event?

A) expansionary fiscal policies shifted the aggregate demand curve, creating an inflationary gap equal to (Y_n − Y_P).

B) expansionary fiscal policies shifted the aggregate demand curve, creating an inflationary gap equal to (Y_m − Y_P).

C) expansionary fiscal policies shifted the aggregate demand curve, creating an inflationary gap equal to (Y_m − Y_j).

D) expansionary fiscal policies shifted the aggregate demand curve, creating an inflationary gap equal to (Y_n − Y_j).

Difficulty: Medium

32. Keynes argued that the surest way to bring the economy out of the Great Depression was to

A) rely on expansionary monetary policy.

B) use expansionary fiscal policy.

C) impose wage controls to prevent drastic decreases in disposable income.

D) leave the economy alone and flexible wages and prices would eventually lead to increases in income and employment.

Difficulty: Easy

33. According to Keynes, the remedy for a recessionary gap is

A) to subsidize big business.

B) to increase aggregate supply.

C) to boost aggregate demand.

D) to lower business taxes.

Difficulty: Easy

34. Keynesian theory was a response to the prevailing

A) classical theory that held that the economy could suffer from a period of sustained

unemployment.

B) classical theory that held that the economy is self-correcting.

C) monetarist theory that held that the economy is self-correcting.

D) monetarist theory that held that monetary policy should be used to return the economy to its potential output.

Difficulty: Medium

35. In developing his macroeconomic theory, Keynes

A) focused primarily on how potential GDP can change over time.

B) focused on how fiscal policy can change potential output.

C) was concerned with output gaps and how they could be eliminated.

D) was primarily concerned with the supply-side of the economy and how producer behavior led

to output gaps.

Difficulty: Medium

36. Keynes’s theory of macroeconomics rejects classical macroeconomists’ assumptions that

A) prices and wages are flexible.

B) all investment comes from saving.

C) self-correction takes a long time.

D) equilibrium can be achieved below full employment.

Difficulty: Medium

37. Which of the following statements is true about Keynes’ macroeconomic theory?

A) Keynes agreed that the notion that the economy would achieve the potential level of output

in the long run is crucial to explaining prolonged recessions.

B) Keynes dismissed the notion that the economy would achieve full employment in the long run as irrelevant in explaining prolonged recessions.

C) Keynes stressed the notion that the economy would achieve price stability in the long run only if expansionary fiscal and monetary policies were used to address recessions.

D) Keynes argued that the economy would achieve full employment in the long run because of wage and price flexibility.

Difficulty: Medium

38. Keynes believed that wages and prices were sticky. Therefore, a rightward shift of the

aggregate demand curve would cause

A) a decrease in the level of income.

B) an increase in the unemployment level.

C) a change in the long-run aggregate supply curve.

D) an increase in employment, production, and income.

Difficulty: Medium

39. According to the Keynesian theory of income and employment,

A) the economy automatically tends toward equilibrium at the level of full employment.

B) the economy never tends toward equilibrium.

C) the economy may be in equilibrium at less than full employment.

D) the economy’s level of employment is unrelated to its level of income.

Difficulty: Medium

40. According to Keynesian theory,

A) sticky prices and wages do not have an effect on aggregate expenditures.

B) because of sticky prices and wages, changes in total spending have the biggest impact on

output and employment.

C) wage and price stickiness cause output and employment to remain close to their full employment levels, even when total spending changes.

D) wages and prices fall in the early stages of a recession even when total spending is declining.

Difficulty: Medium

41. The theory that argues most strongly for countercyclical policy activism is

A) Keynesian economics.

B) classical economics.

C) monetarism.

D) rational expectations theory.

Difficulty: Medium

42. If prices and wages are sticky, a decrease in aggregate demand will cause

A) an increase in the price level and employment.

B) a decrease in the price level and employment.

C) an increase in the price level and a decrease in employment.

D) a decrease in the price level and an increase in employment.

Difficulty: Medium

43. If the economy’s short-run aggregate supply curve is upward sloping, a decrease in aggregate demand will cause

A) an increase in the price level and employment.

B) a decrease in the price level and employment.

C) an increase in the price level and a decrease in employment.

D) a decrease in the price level and an increase in employment.

Difficulty: Medium

44. If the economy’s short-run aggregate supply curve is upward sloping, an increase in

aggregate demand will cause

A) an increase in the price level and employment.

B) a decrease in the price level and employment.

C) an increase in the price level and a decrease in employment.

D) a decrease in the price level and an increase in employment.

Difficulty: Medium

45. Which of the following statements is true about classical economists?

A) They represent a large and cohesive group of economists who agreed with David Ricardo

concerning wage and price flexibility in both the short run and the long run.

B) They may have shared some ideas in common, but their views were far from uniform.

C) They did not believe in the neutrality of money.

D) Their theories shed little insight on the economy today because modern issues and concerns are so different from those described in their earlier writings.

Difficulty: Medium

46. Writing in 1752, David Hume’s essay, “Of Money,”

A) showed that changes in the money supply were unrelated to short-run fluctuations in output.

B) suggested that an increase in the money supply would be favorable to industry in the

long-run.

C) echoed John Maynard Keynes’ view that sticky prices would lead to short-run deviations of output from the level of potential real GDP.

D) was unable to unravel the nature and role of money in the economy because he ignored

sticky prices.

Difficulty: Medium

47. When did policy makers in the U.S. first use fiscal policy with the intent of manipulating

aggregate demand to move the economy to its potential level of real GDP?

A) During the Roosevelt administration

B) During the Truman administration

C) During the Eisenhower administration

D) During the Kennedy administration

Difficulty: Easy

48. A policy implication of Keynesian economics is that

A) full employment will always be maintained.

B) countercyclical policies have no effect on the economy.

C) constant growth of the money supply is better than discretionary policies.

D) countercyclical monetary and fiscal policies can be used to achieve full employment.

Difficulty: Medium

49. The theory that dominated macroeconomic thinking in the 1960s was

A) monetarism.

B) classical economics.

C) Keynesian economics.

D) rational expectations theory.

Difficulty: Medium

50. In 1963, President Kennedy proposed a tax cut to stimulate the economy. In 1963, Congress approved the tax cut. The one-year period between these two events is attributed to

A) an administrative lag.

B) an impact lag.

C) a recognition lag.

D) an implementation lag.

Difficulty: Medium

51. The recession in real GDP in 1970 during the Nixon administration

A) did not accord with the Keynesian theory because the price level had risen sharply; in the

Keynesian model, prices fell when real GDP and employment were falling.

B) reinforced the Keynesian theory that prices fell when real GDP and employment were falling.

C) did not accord with the Keynesian theory because expansionary fiscal policies resulted in deflation; in the Keynesian model, prices rose when expansionary fiscal policies were administered to eliminate a recessionary gap.

D) reinforced the Keynesian theory that fiscal policies were more effective than monetary policies in reducing output gaps.

Difficulty: Medium

52. Suppose the U.S. economy experiences stagflation. An expansionary fiscal policy

A) increases real GDP and lowers inflation.

B) has no effect on real GDP but raises inflation.

C) increases real GDP and aggravates inflation.

D) increases real GDP and has no effect on inflation.

Difficulty: Medium

53. In the 1970s the U.S. economy experienced a novel set of macroeconomic outcomes: rising

price level and falling output. This experience led policymakers to

A) aggregate demand was more important than aggregate supply in determining the economy’s

output level.

B) acknowledge that monetary policy and aggregate supply play a role in influencing

macroeconomic performance.

C) conclude that fiscal policy alone was enough to stabilize the economy.

D) conclude that being a vital input, oil prices should be controlled by the government.

Difficulty: Medium

54. In the 1970s, the U.S. economy experienced both inflation and unemployment. This led economists to recognize that

I. stabilization was a much more difficult task than many economists anticipated.

II. the Keynesian doctrine correctly asserts that reducing inflation and unemployment can be addressed by fiscal policies.

III. shifts in aggregate demand could frustrate policymaking efforts whereas shifts in the short-run aggregate supply were more easily addressed.

A) I only

B) II only

C) I and III only

D) III only

Difficulty: Medium

55. Which of the following is true about the classical theory and the monetarist theory with

regards to the impact of changes in the money supply on the economy?

A) Both the classical theory and monetarism conclude that changes in money supply affect

real GDP in the short run and in the long run.

B) Both the classical theory and monetarism conclude that changes in money supply

do not affect real GDP in the short run but will affect real GDP in the long run.

C) Both the classical theory and monetarism conclude that changes in money supply

affect nominal GDP in the long run.

D) Both the classical theory and monetarism conclude that changes in money supply

affect nominal GDP in the short run and real GDP in the long run.

Difficulty: Medium

56. Monetarists conclude that the primary determinant of changes in nominal GDP is

A) money growth.

B) growth in aggregate demand.

C) growth in aggregate supply.

D) the inflation rate.

Difficulty: Medium

57. Which of the following are reasons why monetarists oppose activist stabilization policies?

I. Monetary policy lags are so long and variable that trying to stabilize the economy using

monetary policy can be destabilizing.

II. Monetary policy affects a nation’s currency exchange rate and affects the nation’s competitiveness in the global market.

III. Because of crowding-out effects, fiscal policy has no effect on GDP.

IV. Fiscal policies must be financed by government borrowing or tax increases, both of which affect aggregate demand negatively.

A) I only

B) I and II only

C) I and III only

D) I, II, III, and IV

Difficulty: Medium

58. Monetarists argue that

A) the impact lag for monetary policy is short and predictable.

B) stabilization policies may actually be destabilizing.

C) the Federal Reserve System should use active monetary policy.

D) active monetary policy should be used to reinforce active fiscal policy.

Difficulty: Medium

59. Which of the following is true about Keynesians and monetarists with regards to policy intervention?

A) Keynesians favor the use of fiscal policy to bring the economy back to its potential output

while monetarists favor the use of monetary policy to bring the economy back to its potential output.

B) Keynesians favor active policy intervention to bring the economy back to its potential output

while monetarists argue that the uncertain nature of lags renders policy intervention

destabilizing.

C) Keynesians argue that with its shorter and more predictable policy lags, fiscal policy is more

effective that monetary policy in bringing the economy back to its potential output, while

monetarists argue that monetary policy lags are much shorter and more predictable than fiscal policy lags and therefore more effective in bringing the economy back to its potential

output.

D) While both schools favor the use of intervention policies, Keynesians argue that such policies

are more effective at eliminating recessionary gaps while Monetarists contend that they are

more effective at eliminating inflationary gaps.

Difficulty: Medium

60. The monetarists school of economics believes that changes in

A) money supply are the primary causes of changes in real GDP.

B) the level of government spending are the primary causes of changes in nominal GDP.

C) money supply are the primary causes of changes in nominal GDP.

D) price level are the primary causes of changes in real GDP.

Difficulty: Difficult

61. Milton Friedman was a leader and major proponent of

A) monetarism.

B) classical economics.

C) Keynesian economics.

D) rational expectations theory.

Difficulty: Easy

62. According to Milton Friedman, any divergence in unemployment from its natural rate is

temporary because

A) anticipated price changes affect nominal wages in the short run but workers will rectify this

over time.

B) unanticipated price changes affect real wages in the short run but workers will rectify this

over time.

C) anticipated price changes affect real wages in the short run but workers will rectify this

over time.

D) unanticipated price changes create inflation which is addressed by policymakers over time.

Difficulty: Medium

63. According to the monetarists, after an initial increase in aggregate demand,

A) short-run aggregate supply curve will tend to shift leftward, reflecting the effect of higher wages adjusting in the long run.

B) short-run aggregate supply curve will tend to shift leftward, reflecting the effect of lower wages adjusting in the long run.

C) aggregate demand curve will tend to shift rightward, reflecting the effect of income adjusting in the long run.

D) aggregate demand curve will tend to shift lower, reflecting the effect of price level adjusting in the long run.

Difficulty: Medium

64. Monetarists argue that

A) the Federal Reserve System should institute a prescribed rate of growth in the money supply.

B) since velocity is unstable, a fixed annual increase in the money supply will exacerbate inflation in the long run.

C) self-correction is less effective than activist monetary policy.

D) policymakers should use monetary policy rather than fiscal policy to stabilize the economy.

Difficulty: Medium

65. The economic theory based on an analysis of individual maximizing choices is called

A) monetarism.

B) new classical economics.

C) Keynesian economics.

D) business cycle theory.

Difficulty: Easy

66. New classical economics

A) differs from classical economics in that the latter focuses on the determination of long-run aggregate supply while the former focus on the determination of short-run aggregate supply.

B) is similar to classical economics in that both theories incorporate expectations in their analysis of the economy in the long-run.

C) differs from classical economics in that the latter focuses on producers’ expectations only while the latter also includes consumers’ expectations in the determination of long-run macroeconomic equilibrium.

D) is similar to classical economics in that both theories focus on the determination of long-run aggregate supply and the economy’s ability to reach this level of output quickly.

Difficulty: Medium

67. Economists who subscribe to the rational expectations hypothesis

A) base their belief on the economic assumption that people behave in ways that maximize their utility.

B) believe that governments can influence macroeconomic outcomes better than the private sector.

C) argue that discretionary monetary and fiscal policy can control fluctuations in economic activity adequately.

D) say that people are constantly revising their expectations about future prices based on what transpired in the past and therefore over time, fluctuations in economic activity will cease to occur.

Difficulty: Medium

68. The hypothesis that assumes that individuals form expectations about the future based on

available information and that individuals act on that information is called the

A) random expectations theory.

B) rational information hypothesis.

C) rational expectations hypothesis.

D) adaptive expectations hypothesis.

Difficulty: Medium

69. Which of the following groups of economists perceive the economy as essentially stable and self-correcting?

A) Keynesians, monetarists, and classical economists

B) Classical economists, monetarists, and new classical economists.

C) Monetarists, classical economists, and socialists

D) Classical economists, Keynesians, monetarists, and new classical economists.

Difficulty: Medium

70. When consumers and producers operate under rational expectations,

A) stabilization policy affects only the short-run aggregate supply curve.

B) stabilization policy affects only the long-run aggregate supply curve.

C) shifts in aggregate demand are perfectly anticipated by market participants, negating any attempt by policymakers to shift aggregate demand.

D) stabilization policy does not affect the short-run aggregate supply curve.

Difficulty: Medium

71. Consider the following statement: “A consistent countercyclical policy has no effect on employment and output, since individuals will recognize those policies as systematic and will anticipate them correctly.” This statement is most closely associated with

A) classical theory.

B) Keynesian theory.

C) new classical theory.

D) monetarist theory.

Difficulty: Medium

Use the following to answer questions 72-73.

Exhibit: Responses to a Decrease in Aggregate Demand

72. (Exhibit: Responses to a Decrease in Aggregate Demand) The economy is initially in equilibrium at point (1). Now suppose a reduction in the money supply causes aggregate demand to fall to AD₂. The below potential output level of Y₂ will exist as long as

A) policymakers refrain from using discretionary policies.

B) workers fail to recognize that their real wages have increased and that they need to accept lower nominal wages.

C) economic agents do not respond to falling prices by increasing aggregate demand back to AD₁.

D) producers do not increase the price of their output.

Difficulty: Medium

73. (Exhibit: Responses to a Decrease in Aggregate Demand) The economy is initially in equilibrium at point (1). Now suppose a reduction in the money supply causes aggregate demand to fall to AD₂. Which of the following explains the new classical view regarding economic agents’ response to the decrease in money supply?

A) Consumers and firms observe that the money supply has fallen and that the price level has fallen to P₂. Consumers respond by increasing their demand for output and firms in turn increase their supply to meet the rising demand. The economy moves back to point (1).

B) Consumers and firms observe that the money supply has fallen and that the price level has fallen to P₂. To prevent further reductions in the price level, firms increase output at the same time as consumers increase aggregate demand. The economy moves to point (4), bypassing point (3).

C) Consumers and firms observe that the money supply has fallen and anticipate the eventual reduction in the price level to P₃. They adjust their expectations accordingly. Workers agree to lower nominal wages, and the short-run aggregate supply curve shifts to SRAS₂ at the same time as aggregate demand falls, bypassing point (2).

D) Consumers and firms observe that the money supply has fallen and anticipate the eventual reduction in the price level to P₄. They adjust their expectations accordingly. Workers agree to lower nominal wages, and the short-run aggregate supply curve shifts to SRAS₂ at the same time as aggregate demand rises, moving the economy to point (4).

Difficulty: Difficult

74. New classical economics contends that policy activism is

A) not warranted, because we don’t know enough about the workings of the economy to stabilize it.

B) not warranted; the public defeats discretionary policies because everyone expects them, and therefore, their effectiveness is thwarted.

C) warranted, because discretionary policies have a strong effect on real output.

D) warranted, because expectations are rational only in the short run.

Difficulty: Medium

75. According to new classical economics, individuals will respond to expansionary monetary

policy by

A) incorrectly forecasting what will happen to the price level and employment.

B) predicting no change in the rate of inflation because they adjust quickly.

C) predicting a lower rate of inflation and revising their expectations about future prices accordingly.

D) predicting a higher rate of inflation and revising their expectations about future prices.

Difficulty: Medium

76. New classical theory asserts that, because people have rational expectations, if a policy of reducing the money supply is used

A) it might affect both aggregate demand and potential real GDP.

B) consumers and firms observe that the money supply has fallen, anticipate the eventual reduction in the price level, and adjust their expectations accordingly.

C) market participants react in such a way that shifts in aggregate supply will reinforce shifts in aggregate demand and real GDP will shift inevitably into inflationary or recessionary gaps.

D) All of the above are true.

Difficulty: Medium

77. In the new classical view,

A) a change in the money supply will affect real GDP only if people anticipate the policy change.

B) monetary policy can never change real GDP.

C) using monetary policy will change real GDP only if the policy takes people by surprise.

D) fiscal policy has more chance of success than monetary policy.

Difficulty: Medium

78. New classical economists argue that unless people are taken by surprise, a decrease in aggregate demand will cause

A) an increase in the price level and unemployment.

B) a decrease in the price level and employment.

C) an increase in the price level and no change in employment.

D) a decrease in the price level and no change in employment.

Difficulty: Medium

79. The Case in Point titled “Tough Medicine” stated that the Keynesian prescription for an inflationary gap was to

A) apply contractionary fiscal or monetary policy, or both.

B) combine contractionary fiscal policy with expansionary monetary policy.

C) combine expansionary fiscal policy with contractionary monetary policy.

D) decrease the money supply in order to shift the SRAS curve to the left.

Difficulty: Medium

80. In 1965 during the Johnson administration, the U.S. economy was headed toward an inflationary gap. Which of the following policies would an economist recommend?

A) An open market purchase

B) A tax increase

C) A tax cut

D) Increase defense spending

Difficulty: Medium

81. During the Johnson administration, the U.S. economy was headed toward an inflationary gap. In 1967 President Johnson proposed a temporary 10% increase in personal income taxes. If the Fed wanted to mitigate the effects of this contractionary policy, what could it do?

A) Conduct an open market purchase

B) Conduct an open market sale

C) Raise the reserve requirement ratio

D) Raise the discount rate

Difficulty: Medium

82. New Keynesian economics

A) favor stabilization policies that shift the short-run aggregate supply curve to keep the economy operating close to its potential output.

B) advocates policies that increase wage and price flexibility so that the economy can self-correct quickly.

C) stresses the stickiness of prices and the need for activist stabilization policies through the aggregate demand management policies to move the economy to its potential output.

D) stresses the importance of operating at potential output and with shifting the long-run aggregate supply curve to the right.

Difficulty: Medium

83. Which of the following is true about new Keynesian economics?

I. It incorporates monetarist ideas about the importance of monetary policy.

II. It incorporates new classical ideas about the importance of aggregate supply.

III. It includes a greater use of microeconomic analysis in macroeconomic analysis than Keynesian economics.

IV. Unlike Keynesian economics, it is opposed to active stabilization policies.

A) I and III only

B) II and III only

C) I, II, and III only

D) I, II, III, and IV

Difficulty: Medium

84. New Keynesian economics is built on

I. the Keynesian approach

II. the monetarist approach

III. the new classical approach

A) I only

B) I and II only

C) II and III only

D) I, II, and III

Difficulty: Medium

85. Suppose the economy is initially in long-run equilibrium. Now suppose oil prices rise sharply and at the same time, policymakers pursue expansionary monetary and fiscal policies. Which of the following will occur as a result of these two events?

A) The price level will necessarily rise but the effect on output is indeterminate.

B) Real GDP must necessarily fall but the effect on the price level is indeterminate.

C) The price level and real GDP must rise.

D) The price level must rise and real GDP must fall.

Difficulty: Medium

86. Suppose the economy is initially in long-run equilibrium. Now suppose oil prices rise sharply and at the same time, policymakers pursue expansionary monetary and fiscal policies. Which of the following will occur as a result of these two events, given that supply-side effects dominate demand-side effects?

A) The price level will necessarily rise but the effect on output is indeterminate.

B) Real GDP must necessarily fall but the effect on the price level is indeterminate.

C) The price level and real GDP must rise.

D) The price level must rise and real GDP must fall.

Difficulty: Medium

87. In the late 1970s, oil prices rose sharply and at the same time, U.S. policymakers pursued expansionary fiscal and monetary policies. As a result, real GDP stayed at potential output, while the implicit price deflator jumped 8.1%. If the Fed’s goal was to reduce inflation, which of the following would also occur?

A) An increase in unemployment and a decrease in interest rates

B) A decrease in unemployment and an increase in interest rates

C) An increase in unemployment and an increase in interest rates

D) A decrease in unemployment and a decrease in interest rates

Difficulty: Difficult

88. In 1979, the CPI rose 13.5%, the highest inflation rate recorded in the twentieth century in the U.S. Public opinion polls in 1979 consistently showed that most people regarded inflation as the leading problem facing the U.S. How did the Fed respond to this situation?

A) It continued to pursue expansionary policies to avert a potential recession caused by rising oil

prices.

B) It switched from discretionary monetary policy to a fixed money growth rate rule where the growth rate was under 3%.

C) It pursued contractionary policies with the primary goal of lowering inflation.

D) It adopted a hands-off approach, relying on the economy’s self correcting mechanism to lower inflation.

Difficulty: Medium

89. Which of the following policies would supply-side economists favor?

A) Lowering taxes to increase work effort and investment tax credits to stimulate investments

B) Lowering taxes to increase work effort and lowering interest rates to stimulate investment

C) Eliminating welfare programs to increase employment and investment tax credits to encourage firms to provide on-the-job training programs

D) Investment tax credits and increasing government spending on applied research to increase productivity

Difficulty: Medium

90. In the early 1990s, although the U.S. economy was in a recession, Congress rejected the idea of using an expansionary fiscal policy to close the recessionary gap. What was the reason?

A) Policymakers believed that contractionary fiscal policies are more likely to increase employment because inflation would be lower and therefore producers could pay lower wages.

B) Congress recognized that fiscal policy lags rendered fiscal policy ineffective.

C) Congress was concerned that expansionary policies would increase the government budget deficit.

D) Congress believed that the economy’s self-correcting mechanism was better able to eliminate output gaps than fiscal policies.

Difficulty: Medium

91. Which of the following was not an explanation for the lower volatility of the U.S. economy during the 25-year period that preceded the Great Recession?

A) Improved monetary policy

B) Positive structural change in the economy

C) Increased government spending

D) Good luck

Difficulty: Medium

92. The close relationship between M2 and nominal GDP in the 1960s and 1970s vanished from the 1980s through 2015. Which of the following contributed to this breakdown?

I. deregulation of the banking industry

II. introduction of new financial products (not included in M2) which allowed people to transfer funds into their checking accounts as and when needed

III. monetary policy lags

A) I and II only

B) II only

C) II and III only

D) I, II, and III

Difficulty: Medium

93. A recent survey of economists suggested that the _______ approach is the preferred approach to macroeconomic analysis.

A) Keynesian

B) monetarist

C) new classical

D) new Keynesian

Difficulty: Medium

94. In 2009, the Obama administration advocated and Congress passed a massive spending and tax relief package of about $800 billion to stimulate aggregate demand. This policy would be favored by

A) Keynesian economists but not new Keynesian economists.

B) monetarists but not new classical economists.

C) Keynesian and new Keynesian economists.

D) monetarists and new Keynesian economists.

Difficulty: Medium

Use the following to answer questions 95-98.

Exhibit: Economic Adjustments

95. (Exhibit: Economic Adjustments) Suppose the economy is at point a. Assume that (1) the public’s expectations are completely rational; (2) markets allocate resources instantaneously; and (3) the economy is at its natural level of employment. The theoretical adjustment path resulting from an increase in aggregate demand according to the rational expectations hypothesis is

A) a to c to d.

B) a to b to d.

C) a to d.

D) a to b and back to a.

Difficulty: Medium

96. (Exhibit: Economic Adjustments) Suppose the economy is at point a. The rational expectations hypothesis suggests that an increase in aggregate demand will result in the economy moving from

A) point a to point d whereas new Keynesian economics suggests that it will move point a to point b.

B) point a to point d whereas new Keynesian economics suggests that it will move point a to point c.

C) point a to point b whereas new Keynesian economics suggests that it will move point a to point d.

D) point a to point c whereas new Keynesian economics suggests that it will move point a to point d.

Difficulty: Medium

97. (Exhibit: Economic Adjustments) Suppose the economy is at point c. A Keynesian economist would advocate

A) allowing the economy’s self-correcting mechanism to move the economy to point a.

B) pursuing expansionary fiscal policies to move the economy to point a.

C) pursuing expansionary fiscal policies to move the economy to point b.

D) pursuing expansionary fiscal policies to move the economy to point d.

Difficulty: Medium

98. (Exhibit: Economic Adjustments) Suppose the economy is at point c. A classical economist would advocate

A) allowing the economy’s self-correcting mechanism to move the economy to point a.

B) pursuing expansionary fiscal policies to move the economy to point a.

C) pursuing expansionary fiscal policies to move the economy to point b.

D) pursuing expansionary fiscal policies to move the economy to point d.

Difficulty: Medium

True/False

1. The worst economic downturn in the United States in the twentieth century occurred during the 1930s.

2. Classical economics is based primarily on the works of John Maynard Keynes.

3. The body of economic thought associated with David Ricardo is called new classical

economics.

4. The classical school focused on the long-run forces that determined an economy’s

potential level of output.

5. Keynesian economics was mostly concerned with the short run.

6. Keynes shifted the emphasis in economics from the concept of aggregate supply to the

concept of aggregate demand.

7. The experience of the Great Depression led to the widespread acceptance of classical

economics.

8. While Keynes argued that the Great Depression was caused by government interference in

the economy, monetarists contended that it was the result of a decline in investment

expenditures.

9. In the U.S., the Great Recession was fought with traditional monetary and fiscal policies,

10. During the 1960s, Keynesian economic policies led to lower unemployment rates and

higher prices.

11. In the 1970s, the U.S. economy saw sharp changes in real GDP and in the price level. This

presented a challenge to policymakers and to economists because these outcomes could not be explained by a Keynesian analysis.

12. During the 1970s when the U.S. experienced rising inflation and unemployment, economists began to reconsider the significance of aggregate supply as well.

13. Monetarists contend that a consistent relationship exists between changes in the money

supply and changes in nominal GDP.

14. The monetarist school of economics believes that changes in the money supply are the primary causes of changes in nominal GDP.

15. Monetarists argue that impact lags associated with changes in the money supply are long and variable.

16. Supply-side economics is the belief that fiscal policy can be used to stimulate long-run

economic growth.

17. According to new classical economics, short-run stabilization policy works only if it

surprises people.

18. New classical economists believe that the potential output of the economy is stable.

19. The rational expectations hypothesis assumes that individuals form expectations about

the future based on the information available to them and that they act on those

expectations.

20. The rational expectations hypothesis suggests that monetary policy, even though it will

affect the aggregate demand curve, might have no effect on real GDP.

21. One distinguishing feature of new Keynesian economics (from earlier schools of thought)

is the greater use of microeconomic analysis in macroeconomic analysis.

22. The events of the 1980s and early 1990s appear to have been consistent with the

hypotheses of either the monetarist or new classical schools.

Short Answer

1. Compare and contrast the classical and Keynesian views of aggregate demand and

aggregate supply.

2. Suppose the economy experiences a recessionary gap. How does the new classical

approach to macroeconomic policy (to eliminate the gap) differ from the new Keynesian

approach? Illustrate your answer with an aggregate demand–aggregate supply graph.

3. What are the main arguments in favor of stabilization policy? What are the main arguments against stabilization policy?