Econ110 - Marcoeconomics CourseCram Solutions PDF

©Course Cram Econ110 Booklet Solutions
Market Failure and Government
1. A
2. E
3. A
4. C
5. D
6. B
Efficient quantity of a public good maximizes net benefit.
Net benefit = total benefit – total cost.
Q=5, NB = 45 – 15 = 30
Q=15, NB = 70 – 20 = 50
Q=25, NB = 80 – 80 = 0
Q=28, NB <0

7. B, In Canada, the average rate of taxes increases with the level of income.
8. E,
Marginal tax rate = change in tax / change in income
Change in tax =$500; Change in income (before tax) = $500
ÆMarginal tax rate = 500 / 500 = 100 %

9. C,
The average tax rate for the Brown family = 5000 / 200,000= 2.5%
The average tax rate for the Clinton family = 5000 / 50,000= 10%
The average tax rate decreases with the level of income.

10. A,
Under proportional income tax system, income is taxed at a fixed rate, regardless of the level of
income.
11. B,
The average tax rate for the Brown family = 5%
The average tax rate for the Clinton family = 4%
The average tax rate for the Simpson family = 0%
The average tax rate increases with the level of income.

12. E
13. E,A, and D,
Redistribution increases the share of income received by the poor by decreasing the share of
income received by the rich. It weakens incentives to work and save and thus, decreases
efficiency.
14. C,
Profit is maximized when D=MC ÆQ = 40 units and P = $5
Solutions will be posted at www.coursecram.com/solutions 1

15. C,
Efficient level of output is 30 at a price of $10. In unregulated market, 40 units are produced at
$5. When 40 units are produced, social marginal cost is $12.
Deadweight loss = (1/2)*(12‐ 5)*(40‐30) = 35

16. D,
Efficient level is achieved when MB = MSC Æ 4 tonnes
17. D,
Efficient level is achieved when D = MSC Æ Q = 60 and P = $15
At Q= 60, MPC = $9 Æ tax = $15 ‐ $9 =$6

A factory dumps toxic waste into a local waterway used by water skiers. Use the figure below
that shows the demand curve and cost curves of the factory to answer questions 18 and 19:
Cost &
benefit ($)

MSC

MPC
20

D
15
20 40 60 80 Quantity of waste
18. B,
No property rights Æ external cost is not taken into account Æ maximize profit where MPC = D
Æ waste = 60 tonnes

19. C,
Property rights and low transactions costs Æ outcome is efficient where MSC =D Æwaste = 40

20. C,
A pure public good (national defense, for example) is nonrival, because consumption by one
person does not decrease the amount consumed by others. It’s also nonexcludable, because
individuals cannot be prevented from consuming it

21. D,
Efficient output is achieved when MSC =D Æ Q= 50.
When Q=50, MPC = $4 and MSC = $8 Æ Pigovian tax = SMC‐PMC=$4

22. A,
The optimal level is 50 units of output Æ sell 50 permits allowing the production of 50 units of
output.

At the optimal level, MPC=$4 and MB=$8 Æ the price of a permit will be $4
23. C,
Efficient output, Q= 50 units, and per unit tax $4 Æ Tax revenue = 50*4 = $200
Deadweight loss associated with the externality = (1/2)*(70‐ 50)*(10 – 6) = $40

24. C
25. E
26. C
27. A
28. A

Introduction to Macroeconomics
Q1.
Solution: a) Increased by 4 %
% change in nominal GDP ≈ % change in real GDP + % change in price level
Æ % change in price level= % change in nominal GDP ‐ % change in real GDP
= 3% – (–1%) = 4%

Q2.
Solution: c) From 2004 to 2005, both real GDP and prices rose.
Real GDP in 2004 = (Nominal GDP / GDP deflator) X 100 = 125
Real GDP in 2005 = (Nominal GDP / GDP deflator) X 100 = 160

Q3.
Solution: a) Between 1990 and 2005, the real GDP per person did not change
Real GDP per person in 1990 = {(1,500 / 300) * 100} / 200 = 2.5
Real GDP per person in 2005 = 750 / 300 = 2.5
Q4.
Solution: e) either prices of goods and services decreased or the economy produced fewer goods and
services, or both.

Q5.
Solution: b) ‐3%
Real interest rate = nominal interest rate – inflation = 4 – 7 =‐3
Q6.
Solution: e) True, because during inflation the average price level increases, while prices of some
individual goods may be falling.
Q7.
Solution: a) David
Q8.
Solution: d) Linda and Helen

Q9.
Solution: d) In 1996 and 2000.
Q10.
Solution: a) 18%
(130 – 110) / 110 * 100% =18%.
Q11
Solution: c) 94.1 million; 5.9 percent
The new number of people employed equals 100 – 6 – 0.2 + 0.3 = 94.1. Then the new number
of unemployed people is reduced by 0.1 (0.3 – 0.2) and becomes 6 – 0.1 = 5.9. The new
unemployment rate is 5.9 / 100 * 100 = 5.9.

Q12.
Solution: a) 5.4%
Inflation rate = (CPI2003 – CPI2002)/CPI2002 * 100 = (116 – 110)/110 * 100 = 5.45%.
Q13.
Solution: a) 158.3
CPI (2005; 2004 as base year) =
(2005 prices * 2004 quantities)/(2004 prices * 2004 quantities) * 100 =

(3*50 + 8*100) / (2*50 + 5*100) * 100 = (950 / 600)*100=158.3.
Q14
Solution: d) 58.3 %
2005 CPI = 158.3
2004 CPI = 100
Inflation rate= {(CPI this year– CPI last year)/ CPI last year}*100 = {(158.3–100)/100}* 100 = 58.3%
Q15.
Solution: a) David who retired three weeks ago and is not looking for work.
To be included in the labour force one has to be employed or unemployed. David does not have a job, so
he is not employed.
To be unemployed one has to search for a job. David is not looking for a job, so he is not unemployed.
Q16.
Solution: c) decrease; increase.
Bonnie and Clyde enter unemployment Æ Unemployment increases Æ Labour ‐force increases.
Employment rate = employed / labour force. Employment does not change, but labour force increases
Æemployment rates decreases.
Labour‐force participation rate = labour force / working‐age population.
Working‐age population does not change, but labour force increases Æ labour‐force participation rate
increases.
Q17.
Solution: e) 1.6%
After‐tax nominal interest rate= 8*(1‐0.30) = 5.6%
After‐tax real interest rate = after‐tax nominal interest rate – rate of inflation
= 5.6% ‐ 4% = 1.6%.
Q18.
Solution: c) decrease, increase

Lower interest rates in Canada make investment in foreign interest‐bearing assets less attractive. Æ
Buy foreign currency and sell CAD. Æ Demand for Canadian dollar (CAD) falls, Canadian produced goods
and services become cheaper and foreign goods become more expensive. Æ Canadian exports increase,
imports decrease Æ net exports increase.
Q19.
Solution: b) The real interest rate is negative.
Real interest rate ≈ nominal interest rate – rate of inflation;
Rate of inflation > Nominal interest rate Æ Real interest rate < 0.

Q20.
Answer: a) Nominal GDP; real GDP

Q21.
Answer: c) standard of living

Q22.
Answer: c) Real; potential
Q23.
Answer: e) employed, unemployed

Q24.
Answer: d) part‐time workers

Q25.
Answer: e) nominal; real

Q26.
Answer: d) depreciation; appreciation

Q27.
Answer: a) negative effects from production (i.e. externalities.)


Income‐expenditure Analysis and the Multiplier
Q1.
Solution: a) Decreases the government expenditures multiplier resulting in a smaller effect of
government expenditures on aggregate demand.
The Government expenditure multiplier = 1 / (1‐[b*(1‐t)‐m]). When b falls, denominator
increases and the multiplier decreases. ÆGovernment expenditures have smaller effect on
aggregate demand.

Q2.
Answer: B
Calculation of Potential GDP assumes normal utilization rates of resources.
Q3.
Solution: c) mpc = 0.9
C = a + mpc*(1‐t)*Y
C = 2 + 0.72Y Æ mpc*(1‐t) = 0.72 Æmpc = 0.72 / (1‐t) = 0.72 / 0.8 = 0.9
Q4.
Solution: e) AE = 19 + 0.62Y
AE = C + I + G + (X – M) = 2 + 0.72Y + 7 + 9 + 1 – 0.1Y= 19 + 0.62Y
Q5.
Solution: b) 19 + 0.52Y
M0 = mpi0*(1‐t)*Y
Marginal propensity to import increases twofold Æ M1 = (mpi0*2)*(1‐t)*Y =
= 2* {mpi0*(1‐t)*Y} = 2*M0
ÆM1 = 2*0.1Y = 0.2Y
AE = C + I + G + (X – M) = 2 + 0.72Y + 7 + 9 + 1 – 0.2Y= 19 + 0.52Y

Q6.
Solution: a) Y=50
The equilibrium level output, Y= AE= C + I + G + (X – M)
Æ Y= C + I + G + (X – M) = 2 + 0.72Y + 7 + 9 + 1 – 0.1Y= 19 + 0.62Y
ÆY= 19 / (1‐ 0.62) = 50

Q7.
Solution: c) 50/19
Y=AE=19 + 0.62YÆ Y = [1 / (1‐0.62)] * 19, where [1 / (1‐0.62)] is a multiplier.
Multiplier =[1 / (1‐0.62)] = 1/ 0.38=50/19
More formally:
C = a + mpc*(1‐t)*Y
M = mpi*(1‐t)*Y
AE = C + I + G + (X – M) = I + G + X + [a + mpc*(1‐t)*Y] ‐ [mpi*(1‐t)*Y]
AE = (I + G + X + a) + (mpc ‐ mpi)*(1‐t)*Y
In equilibrium: AE=Y
ÆY = (I + G + X + a) + (mpc ‐ mpi)*(1‐t)*Y
ÆY*{1 ‐ (mpc ‐ mpi)*(1‐t)} = (I + G + X + a)
ÆY = [1 / {1 ‐ (mpc ‐ mpi)*(1‐t)}]* (I + G + X + a)
Multiplier = 1 / {1 ‐ (mpc ‐ mpi)*(1‐t)}

Q8.
Solution: b) Y=60
New consumption function: C = 4 + 0.72Y; new Investment = 7+1.8=8.8
Old AE = C + I + G + (X – M) = 2 + 0.72Y + 7 + 9 + 1 – 0.1Y= 19 + 0.62Y
New AE = 4 + 0.72Y + 8.8 + 9 + 1 – 0.1Y= 22.8 + 0.62Y
ÆY= 22.8 / (1‐ 0.62) = 60

Q9.
Solution: a) 100/19
Increase in output = increase in government expenditure* multiplier = 2* (50/19) = 100/19
Alternatively:
Old Y = 50
New Y = C + I + G + (X – M) = 2 + 0.72Y + 7 + 11 + 1 – 0.1Y= 21 + 0.62Y
ÆNew Y= 21 / (1‐ 0.62) = 1050/19
Increase = 1050/19 – 50 = 100/19

Flatland is a closed economy operating with fixed wages, prices, and interest rates. Use this information
to answer questions 10 to 12:

Q10
Solution: d) $25 million
Equilibrium Y = AE = C + I + G = a+ mpc*(1‐t)*Y + I + G
Multiplier = 1 / [1‐ mpc*(1‐t)] = 2.5
Multiplier * change in autonomous expenditure = 10*2.5=25
Q11.
Solution: e) $1.25 million
Multiplier = 1 / [1‐ mpc*(1‐t)] = 1 / (1‐ mpc) = 4
Change in equilibrium Exp = Multiplier * change in gov. expenditure.
Change in gov. expenditure = Change in equilibrium Exp / Multiplier
Change in gov. expenditure = 5 / 4 = 1.25
Q12.
Solution: a) 0.2
Multiplier= Change in equilibrium Exp / change in gov. expenditure = 50 / 10 = 5
Multiplier= 1 / (1‐ MPC)
Æ MPC = 1 – 1/ multiplier = 1 ‐1/5 = 0.8
ÆMPS= 1 – MPC = 0.2
Q13.
Solution: b) 0.5; 0.5
mps + mpc =1;
mpc =0.5 Æmps = 1‐ 0.5 = 0.5
Q14.
Solution: b) 120 + 0.4*Y
C = 10 + 0.5*(dY) = 10+ 0.5*(Y‐ 0.2*Y) = 10 + 0.4*Y
AE = C + I + G = 10 + 0.4*Y + 50 + 60 = 120 + 0.4*Y

Q15.
Solution: c) Y=200
In the equilibrium, Y=AEÆ Y=AE=120 + 0.4*YÆ Y = 120 / (1‐0.4) = 200
Q16.
Solution: a) ‐20
Public saving = T – G = 0.2*Y – G = 0.2*200 ‐ 60 = ‐20
Q17.
Solution: a) increase to 250
Old Y = 120 / (1‐0.4) = 200
Increase in income = (20 +10)*multiplier = 30 / (1‐ 0.4) = 50
Ænew Y = 200+ 50 = 250
Q18.
Solution: a) 0.6
AE = C + I + G = 15+ 0.6*Y + 20 + 30 = 65 + 0.6*Y
The slope is 0.6

Q19
Solution: d) move to Y2 because aggregate expenditure exceeds actual output.
At Y1, Aggregate expenditures exceed output. The economy produces only Y1, but people are willing to
buy moreÆ Firms increase production and output rises until AE=output (at Y2).
Q20
Solution: a) decreases; decreases
In equilibrium: Y = C + I + G = a + mpc*Y + I + G = (a + I + G) + mpc*Y
Y= (a + I + G) + mpc*Y ÆSlope = mpc Æas mpc falls, slope decreases
Y= (a + I + G) + mpc*Y Æ Y = 1/ (1‐ mpc) * (a + I + G) Æ the multiplier= 1 / (1‐ mpc) Æas mpc falls, (1 –
mpc) increases and thus, 1/ (1‐ mpc) falls

Q21
Solution: c) Induced; autonomous
Q22.
Solution: c) AE=Y; AE > Y; AE < Y
Q23.
Solution: a) When the consumption line is above the 45° line, consumption exceeds disposable income
(C > YD) and saving is negative. This is called dissaving. Households can (temporarily) finance dissaving by
spending from past savings or borrowing money.
Q24.
Solution: a) and c)
All else being equal, higher (lower) real interest rates lead to lower (higher) desired investment
expenditure in capital goods, inventories, and housing. The real interest rate is the price (or
opportunity cost) of using borrowed money or retained earnings for investment. With higher
interest rates, firms find it more expensive to borrow money or prefer spending more of their
retained earnings on interest earning financial assets instead of investment. Finally, most
consumers buy new homes (considered investment) with borrowed money and higher interest
rates mean the price of mortgages has gone up, so investment in housing goes down.

Q25.
Solution: a) marginal propensity to import is lower
The multiplier will be smaller when marginal propensity to consume is small (or marginal propensity to
save is large) and when the marginal propensity to import is higher. This is because taxes, saving, and
spending on imports are what are called leakages in the economy. If new income is taxed, saved or
spent on imports (benefiting foreign economies), then less will be spent in the economy and the
multiplier effect will fizzle out.
Q26.
Solution: c) Real GDP will increase, because the aggregate expenditure function will shift upward.
When interest rates are low, it’s cheaper to borrow and invest. So, firms increase their investments.
When investments increase, aggregate expenditures increase. AE curve shifts up and the new
equilibrium occurs at a higher level of real GDP.
Q27.
Solution: a) decrease, increase production, increase.
Q28.

Solution: a) 0.75
Slope of the AE curve = change in induced expenditure / change in real GDP = (250‐ 175) / (250 – 150) =
75 / 100 = 0.75.
Q29.
Solution: b) 4
Multiplier = [1/ (1 ‐ Slope of the AE curve)] = [1 / (1 – 0.75)] = 1/.25 = 4 .
Q30.
Solution: e) $187.5 billion
Induced expenditure =0.75*250 = 187.5.
Aggregate Demand and Aggregate Supply
Q1.
Answer: E
Q2.
Solution: a) Rises, remains constant
In the short run, as the price level increases, the real wage rate falls (because money wage rate is fixed)
Æreal GDP increases. With higher prices, in the long run, money wage rate increases and the real wage
rate returns to its full‐employment equilibrium level.
Q3.
Solution: b) Increase potential GDP
Increase in technology Æ Labour productivity increases Æ Potential GDP increases
Q4.
Solution: e) a) and b)
Increase in the population Æthe real wage rate falls Æfull‐employment quantity of labour increases Æ
potential GDP increases.
Increase in labour productivity Ædemand for labour increases Æthe real wage rate increasesÆfull‐
employment quantity of labour increases Æ potential GDP increases.

Q5.

Solution: d) All of the above
Sticky‐wage theory Æ the price level changes but turns out to be different from what was expectedÆ
real wages change, because in the short run, nominal wages adjust slowlyÆoutput changes
Sticky‐price theoryÆUnexpected change in the price levelÆsome firms do not adjust their prices
because of menu costsÆsales change and output changes
The Misperceptions theoryÆ the price level changes but turns out to be different from what was
expected Æ suppliers may (mistakenly) interpret this as a change in relative prices of their goods and
adjust their production
Q6.
Solution: d) GDP and the price level fall as a result of a leftward shift in the AD curve
A wave of pessimism in the economy ÆConsumption and Investment fall Æaggregate demand
fallsÆthe AD curve shifts leftÆGDP and prices fall
Q7.
Solution: b) The price level will increase, but GDP will not be affected
Increase in government expendituresÆthe aggregate demand increases and the AD curve shifts
rightwardÆprices and GDP increaseÆexpected price level increases Æwages increase ÆSRAS shifts
leftward Æthe economy returns to full‐employment equilibrium

Q8.
Solution: a) The economy moved to point D where GDP is lower and the price level is higher. By
definition, stagflation happens when prices rise and output falls.
Q9.
Solution: a) GDP increases and the price level decrease as a result of a rightward shift in the SRAS curve.
Production costs fallÆfor a given price level, firms supply more goods and servicesÆSRAS shifts
rightward Æprices fall and GDP increases
Q10.
Solution: c) the government shifted the AD curve right in anticipation of stagflation

The price of crude oil increasesÆproduction costs increase and the SRAS shifts left Ægovernment
increases expenditures and shifts the AD curve to the right so that output does not change, but prices
rise.
Q11.
Solution: a) The SRAS curve will shift and the economy will move to point A
At point C, output exceeds potential GDP and unemployment is below its natural rateÆupward pressure
on wagesÆproduction costs increaseÆSRAS shifts left
Q12
Solution: e) All of the above
Changes in labour, capital (both human and physical), natural resources and technology shift
both LRAS and SRAS

Q13.
Solution: e) a), b), and c)
Lower prices increase the real value of the money and make people “wealthier” Æconsumption
increases Æquantity of goods and services demanded increases
Lower prices reduce the amount of money people need to buy goods and services Æmoney holdings
decrease and lending increasesÆinterest rates fallÆInvestment increases Æquantity of goods and
services demanded increases
Lower prices reduce the real exchange rate Ædomestic goods become cheaper compared to foreign
goodsÆ quantity of Canadian‐produced goods and services demanded increases
Q14. Solution: a) In the long run, shifts in aggregate demand don’t change the output level, because the
output level is determined by aggregate supply
In the long run, the AS is vertical and is determined by the factors of production. Changes in the AD will
affect the output level in the short‐run. In the long‐run, changes in AD result in changes in the price
level, not the output level.
Q15.
Solution: d) The aggregate quantity of goods demanded decreases if the interest rate decreases.

Interest rates decreasesÆthe cost of borrowing decreasesÆinvestment increasesÆthe AD increases
Q16.
Solution: c) Changes in the price level do not affect potential GDP.
The LRAS shows the relationship between Potential GDP and price level. Potential GDP is determined by
L, K, T and does not change when the price level changes.
Q17.
Solution: e) All of the above.
Q18.
Solution: a) below full‐employment equilibrium
Potential GDP exceeds Real GDP; unemployment is higher than its natural rate and employment is
below full‐employment level.
Q19.
Solution: d) 40
Equilibrium GDP = 420 and Potential GDP = 460
Recessionary gap = Potential GDP ‐ Equilibrium GDP = 40.
Q20.
Solution: b) (1) is false and (2) is false
At below full‐employment equilibrium, there is cyclical unemployment in the economy Æ actual
unemployment > than natural rate of unemployment.
SRAS will shift rightward, not LRAS.
Q21.
Solution: a) has an inflationary gap, is at full‐employment equilibrium
Real GDP > Potential GDP Æ above full‐employment equilibrium and inflationary gap
Real GDP = Potential GDP Æ full employment
Real GDP < Potential GDP Æ below full‐employment equilibrium and recessionary gap.
Q22.

Solution: b) decrease and shift the short‐run aggregate supply curve right
Q23.
Solution: d) The price level will decrease and the real GDP will be unaffected.
When AD decreases, the economy moves downward along the SRAS curve.
Temporarily, real GDP falls and the price level falls. Prices of resources fall. Short‐run supply increases
(SRAS shifts rightward), This continues until SRAS=AD=LRAS. At the new long‐run equilibrium, prices are
lower than the original level and real GDP is unaffected.
Q24.
Solution: a) Real GDP is 250 and the Price level is 170.
Q25.
Solution: c) Real GDP is 320 and the Price level is 140
In the long run, the short‐run aggregate supply curve shifts to the right where SRAS=LRAS=AD.
Q26.
Solution: d) If the money supply decreases, real GDP will decrease.
Changes in money supply do not have long lasting effects. The price level will rise, but real GDP will not
change.
Q27.
Solution: b) The aggregate demand curve shifts right.
The quantity of real GDP demanded for a given level of price increases resulting in a rightward
shift in the AD curve.

Q28.
Solution: a) The aggregate demand would shift left as a result of a decrease in exports.

Government Budget and Fiscal Policy
Q1.
Solution: c) Government collects more in taxes than it spends.
In a country, government outlays are constant and equal to $200 billion and revenues consist of taxes.
Assume taxes =$50 billion + 0.2*(real GDP). Use this information to answer question 2
Q2.
Solution: b) Deficit of $50 billion.
Actual deficit = outlays – revenues (taxes) = 200 – (50 + 0.2*500) = 50.
Q3.
Solution: b) The debt will increase by $15 billion.
Revenues ‐Outlays = 0.25*100 ‐ 40 = ‐15.
In 2005, there is a deficit of $15 billion.
Æ The debt will increase by $15 billion.
Q4.
Solution: c) Budget deficit increases because tax revenues decrease and transfer payments increase.
When real GDP falls, tax revenues fall and transfer payments increase. Fall in revenues and increase in
outlays, in turn, imply an increase in budget deficit.

Monetary System and Monetary Policy
Q1.
Answer: E
Because ΔM = (1/RR )Δcash => 10000 = (1/RR )1000, solving for RR (rate of return) gives an RR
of 10%.
Q2.
Answer: B
The bank has to keep 20% * 50,000 = $10,000 as required reserves, which leaves $40,000
available to loan out.
Q3.
Answer: D
Banks can lend out any cash they have in excess of the required reserves.
Q4. I
Answer: E
Excess reserves are the bank’s reserves that exceed the minimum. That is, excess
reserves=actual reserves‐minimum required reserves=500‐50=$450.
Q5.
Answer: D
Q6.
Answer: E
Q7.

Answer: c)

Q8.
Answer: c)
Q9.
Answer: b)

Q10.
Solution: e) 8%
The desired reserve ratio = reserves / deposits = 16/200=0.08
Q11.
Solution: a) $200 – the amount of deposits
Q12.
Solution: a) 20 %
Desired reserves = actual reserves – excess reserves = 500– 300= 200
Desired reserve ratio = desired reserves / deposits = 200 / 1000 = 0.2
Q13.
Solution: a) Loans will increase by $1,500
Money multiplier = 1/ 0.2 = 5
New money = 300*5=$1,500; deposits =$2,500
Loans= 2500‐ 500=2000; new loans = 2000‐ 500 = 1500
Q14.
Solution: d) The interest rate adjusts to bring the money market into equilibrium
Q15.
Solution: a) decrease; increase
A decrease in the price level Æpeople need to hold less money Ædemand for money decreases Æthe
money demand curve shifts left Æthe interest rate falls, because money supply is fixedÆlower interest
rate encourages investment.

Q16.

The central bank buys bondsÆthe payments are deposited in commercial banksÆBank reserves
increase Ælending increases Æmoney supply increases and interest rate falls.
Q17.
Solution: a) shift left; shift left
Higher required reserve ratio Æcommercial banks have to increase their reserves Æcut lending
Æmoney supply decreases Æthe money supply curve shifts left Æinterest rate increases Æinterest rate
sensitive expenditure falls Æthe AD shifts left (Note: the second round effects will weaken the shift in
AD, but will not reverse the direction of the shift)
Q18.
Solution d) Increase; not change
In the short‐run, real GDP increases, because interest sensitive expenditure increases as interest rate
falls as the money supply increases. In the long‐run, however, output is determined by the LAS. Since
increase in the MS does not affect LAS, over time, SAS shifts back and real GDP returns to the full
employment level.
Q19.
Solution: a) increase; increase
Because real GDP is below potential GDP, an increase in the AD will bring the economy to full
employment equilibrium. There will not be an inflationary gap and it will not be followed by a decrease
in SAS as it would if the economy was at full employment to start with. Increase in real GDP caused by
increase in the money supply will be permanent.
Q20.
Solution: d) The Bank of Canada sells government bonds Æ bank reserves fallÆlending decreasesÆ
money supply decreases.
Q21.
Solution: a) Sell government bonds
Sell government bonds Æmoney supply decreasesÆinterest rate increasesÆ investment, consumption
and net exports fall Æaggregate demand falls.
Q22.
Solution: a) increase the money supply to reduce unemployment,
The economy is at below full‐employment equilibrium. Unemployment is above its natural rate. To
reduce unemployment, AD must shift right. This can be achieved by an increase in the money supply.

When money supply increases, interest rates fall and as a result, investment, consumption and exports
increase.
Q23.
Inflation and Unemployment
Q1. Answer: E
because ΔM = (1/RR )Δcash => 10000 = (1/RR )1000, solving for RR (rate of return) gives an RR of 10%.
Q2. Answer: B
The bank has to keep 20% * 50,000 = $10,000 as required reserves, which leaves $40,000 available to
loan out.
Q3.
Answer: D
Banks can lend out any cash they have in excess of the required reserves.
Q4.
Answer: E
Excess reserves are the bank’s reserves that exceed the minimum. That is, excess reserves=actual
reserves‐minimum required reserves=500‐50=$450.
Q5.
Answer: D
Q6.
Answer: E
Q7.

Answer: c)

Q8.
Answer: c)
Q9.
Answer: b)

Q10.
Solution: e) 8%
The desired reserve ratio = reserves / deposits = 16/200=0.08
Q11.
Solution: a) $200 – the amount of deposits
Q12.
Solution: a) 20 %
Q13.
Solution: a) Loans will increase by $1,500
Money multiplier = 1/ 0.2 = 5
New money = 300*5=$1,500; deposits =$2,500
Loans= 2500‐ 500=2000; new loans = 2000‐ 500 = 1500
Q14.
Solution: d) The interest rate adjusts to bring the money market into equilibrium
Q15.
Solution: a) decrease; increase
A decrease in the price level Æpeople need to hold less money Ædemand for money decreases Æthe
money demand curve shifts left Æthe interest rate falls, because money supply is fixedÆlower interest
rate encourages investment.
Q16.
The central bank buys bondsÆthe payments are deposited in commercial banksÆBank reserves
increase Ælending increases Æmoney supply increases and interest rate falls.

Q17.
Solution: a) shift left; shift left
Higher required reserve ratio Æcommercial banks have to increase their reserves Æcut lending
Æmoney supply decreases Æthe money supply curve shifts left Æinterest rate increases Æinterest rate
sensitive expenditure falls Æthe AD shifts left (Note: the second round effects will weaken the shift in
AD, but will not reverse the direction of the shift)
Q18.
Solution d) Increase; not change
In the short‐run, real GDP increases, because interest sensitive expenditure increases as interest rate
falls as the money supply increases. In the long‐run, however, output is determined by the LAS. Since
increase in the MS does not affect LAS, over time, SAS shifts back and real GDP returns to the full
employment level.
Q19
Solution: a) increase; increase
Because real GDP is below potential GDP, an increase in the AD will bring the economy to full
employment equilibrium. There will not be an inflationary gap and it will not be followed by a decrease
in SAS as it would if the economy was at full employment to start with. Increase in real GDP caused by
increase in the money supply will be permanent.
Q20.
Solution: d) The Bank of Canada sells government bonds Æ bank reserves fallÆlending decreasesÆ
money supply decreases.
Q21.
Solution: a) Sell government bonds
Sell government bonds Æmoney supply decreasesÆinterest rate increasesÆ investment, consumption
and net exports fall Æaggregate demand falls.
Q22.
Solution: a) increase the money supply to reduce unemployment,
The economy is at below full‐employment equilibrium. Unemployment is above its natural rate. To
reduce unemployment, AD must shift right. This can be achieved by an increase in the money supply.

When money supply increases, interest rates fall and as a result, investment, consumption and exports
increase.
Q23
Inflation and Unemployment
Q1.
Solution: b) The growth rate of the money supply

Q2
Solution: a) Borrowers gain at the expense of lenders
Unexpected inflationÆ real interest rate falls, because real interest rate≈ nominal interest rate –
inflation rate Æ lenders lose, borrowers gain.
Q3.
Solution: e) Workers gain at the expense of employers
If the actual inflation is much lower, the workers are paid higher real wages Æ workers gain, employers
are hurt.
Q4.
Solution: e) b) and c)
Cost‐push inflation is caused by an initial increase in costs.
An increase in money wage rates and raw materials shift the SAS curve to the left
ÆGDP falls and prices rise. If the Bank of Canada increases the money supply to increase the aggregate
demand (rightward shift in the AD curve), prices rise furtherÆthe suppliers of input factors are tempted
to increase the resource prices again (SAS shifts left)Æas long as the Bank keeps increasing the money
supply, cost push inflation continues.
Q5.
Solution: a) increase, decrease
Expected increase in aggregate demand Æ the money wage rate increases ÆSAS shifts leftward. If
aggregate demand remains unchanged, the AD curve does not shift and the new short‐run equilibrium is
at below full employment equilibrium and the price level is higher.

Q6
Solution: e) decrease; increase
Sticky‐wage theory Æ the price level changes but turns out to be higher from what was expectedÆ real
wages fall, because in the short run, nominal wages adjust slowlyÆemployers hire more workers
Q7.

Solution: d) A sacrifice ratio
Assume the growth rate of the money supply decreasesÆAD decreasesÆproduction slows downÆ
inflation falls, but unemployment increases
Over time, people start to realize that the prices are rising more slowlyÆexpected inflation falls
Æunemployment decreases
But it takes time for the unemployment to return to its natural rateÆto lower inflation, the economy
must experience high unemployment.
How much output must be sacrificed is what the “sacrifice ratio” measures.
Q8.
Solutions: c) Structural unemployment.
Since the change is permanent, the workers of the industry do not have any hope recovering their jobs
in the future.
Q9.
Solution: d) Structural unemployment
Once again the change can last fairly long and there are no hopes for the car industry workers to get
their jobs back.
Q10.
Solution: b) Frictional, structural, and seasonal unemployment.
The deviation of unemployment rate from the natural rate of unemployment is due to the cyclical
unemployment. Æ The natural rate of unemployment includes frictional, structural and seasonal
unemployment, but not cyclical unemployment.
Q11.
Solution: e) Unemployed and in labour force.
Q12.

At full employment, there is no cyclical unemployment and unemployment is at the natural rate.
Q13.
Solution: d) all of the above
Lower unemployment compensation is likely to shorten the search period and lower minimum real
wage is likely to increase the quantity of labour demanded Æ move some of the unemployed into paid
jobs and lower the natural unemployment rate.
Q14.
Answer: b) frictional
Q15.
Answer: d) cyclical
Q16.
Answer: d) structural
Q17.
Answer: c) seasonal
Q18.
Answer: a) full; cyclical
International Finance
Q1.
Solution: b) Depreciation; appreciation
Q2.
Solution: c) decrease, increase
Lower interest rates in Canada make investment in foreign interest‐bearing assets less attractive. Æ
Buy foreign currency and sell CAD. Æ Demand for Canadian dollar (CAD) falls, Canadian produced goods
and services become cheaper and foreign goods become more expensive. Æ Canadian exports increase,
imports decrease Æ net exports increase.

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