Second Exam

Course Number: 


Review for Second Exam
Covers content from last exam through Chapter 31
Exam on Monday, November 5th




·        Definition

·        Components of GDP: C + I + G + (X-M)

·        Equivalence of Aggregate Income

·        Real and nominal GDP

·        Per capita GDP

The Classical explanation of the business cycle

·        Say's Law

The Keynesian Critique of the Classical Model

·        the Fallacy of Composition

·        The Paradox of Thrift

·        Potential output vs. equilibrium output

Aggregate Demand

·        definition

·        explanation of its slope, including the interest rate effect, the international effect, the money wealth effect, and the            multiplier effect

·        Shift Factors (foreign income, exchange rates, distribution of income, expectations, monetary and fiscal policies)

Aggregate Supply

·        SRAS, including definition, slope and shifts

·        LRAS, including definition, slope and shifts

AD/AS Equilibrium

The Aggregate Production (AP) function

The Aggregate Expenditures (AE) function

·        Autonomous vs. induced expenditures

Marginal propensity to expend (mpe)

Marginal propensity to save (mps)

The Keynesian Multiplier (k)

The Multiplier Model

Recessionary and Inflationary Gaps

Fiscal Policy

·        definition

·        automatic vs. discretionary

·        balanced budget multiplier

·        expansionary vs. contractionary policy


·        definitions

·        functions

·        measures (M1, M2, etc.)

·        motives for holding money

The Federal Reserve System

·        structure

·        purpose and functions

Banking System

·        the process of money creation

·        the money multiplier

·        interest rates and the price of bonds

Monetary Policy

·        expansionary and contractionary

·        tools, including the required reserve ratio, the discount rate, and open market operations

Problems You Should Be Able to Solve

Calculate GDP

Manipulate AD/SRAS/LRAS graphs

Demonstrate equilibrium graphically, using AD/AS model

Calculate AE

Determine the equilibrium level of Aggregate Income using the AP and AE functions (graphically and mathematically)

Calculate the mpe and the mps and the Keynesian multiplier (k)

Demonstrate recessionary and inflationary gaps graphically

Calculate sizes of recessionary and/or inflationary gaps

Use the multiplier to determine the precise change in AE needed to close the gaps

Determine the value of the money multiplier

Calculate the amount of potential money creation in the banking system

Determine the exact amount of monetary policy action required to close a recessionary or inflationary gap

Compare the exact amount of monetary policy to the exact amount of fiscal policy needed to close gaps

Some sample problems (answers are on my office door)

1.      Assuming the economy exhibits the following relationships, what is the multiplier for this economy?


Real GDP (national income)  Consumption      Saving            Investment

            $550 billion                            $520                  $30                  $58

            $560                                        $526                $34                  $58


2.      State what fiscal policy you would recommend to eliminate the inflationary or recessionary gap in the following scenarios:

               a. Recessionary gap of $800; mpe of 0.5
               b. Inflationary gap of $1,500; mpe of 0.8

3.      The mpe is 0.6, autonomous investment is $1,000; autonomous government spending is $8,000; autonomous consumption is $10,000 and autonomous net exports are $1,000.

        a. what is the level of equilibrium income in the economy?
        b. Autonomous net exports increase by $2,000. What is likely happen to income?

4.      While you are walking to campus one morning, you find a $100 bill that was dropped from a helicopter. Not knowing how to return it, you deposit it in your checking account at the local bank. If the bank has to keep 5% of its deposits as required reserves:

a. How much money can the bank lend out?
b. What’s the money multiplier in this case?
c. how much money will eventually be created by the banking system from your $100?

5.      Assume that all expenditures are summarized in the following consumption and investment functions:


C = $200 + 0.8Y

I = $300

potential Y = $2000

a.      Identify the equilibrium rate of output.

b.      Is the economy in a recessionary or inflationary gap?

c.      How big is the gap?

d.      What would happen to equilibrium GDP is the rate of investment increased to $350?


Assume the following information for questions 6 and 7:

  1. the economy has an inflationary gap of $250 billion
  2. the required reserve ratio is 10%
  3. the MPC is 0.8
  4. for every 1% change in the interest rate, investment changes by $30 billion


6.      If the Federal Reserve decides to decrease the money supply by $150 billion to solve the inflationary problem, what dollar amount of bonds should it sell in open market operations?


7.      If the decrease in the money supply described above leads to an increase in the interest rate of 2%, by what dollar amount will Aggregate Demand change?


8.      Given the following bank balance sheet          

                         Assets                                      Liabilities

Excess reserves = $60                     Deposits = $500

Required reserves = $40

Loans = $400

  1. What is the required reserve ratio?
  2. If a person deposits an additional $200 in the bank, what is the potential deposit creation if the banking system fully uses its lending capacity?


9.   Assume that the following spending functions represent the level of AE in the American economy. All dollar figures are in billions.


C =   $250 + 0.6YD

I =    $100

G =   $200

(X-M) =   -$10

Potential Y = $2000


          a. Which of these components of Aggregate Expenditures are autonomous?

  1. For each of the kinds of autonomous spending, name one determinant that influences that spending.
  2. How much money will consumers in the economy spend and save if disposable income (YD) is $1000?
  3. What is the equilibrium level of output?
  4. Calculate in dollar terms the size of the recessionary gap.
  5. Calculate the value of the Keynesian multiplier, k
  6. By what dollar amount fo you recommend changing G to close the gap?
  7. By what dollar amount do you recommend changing taxes to close the gap?


10.   Assume that all spending is summarized in the following: 


C = $200 + 0.75Y

I = $300

G = $200

  1. If the government increases spending by $100, how much will aggregate expenditures change (assuming taxes do not change)?
  2. If the government cuts taxes by $100, how much will aggregate expenditures change (assuming no change in government spending)?
  3. Which of these two fiscal policies will be most effective in easing a recession and why?



11.   Assume that the following data describe the condition of the banking system (all $s are in billions):


               Total Reserves                                 $200

               Transactions Deposits                    $800

               Required Reserve Ratio                  0.20


If the Federal Reserve wanted to stop further lending activity in the banking system, what required reserve ratio should be imposed?


12.If the required reserve ratio for the banking system is 0.25, what is the money multiplier? Will the multiplier be larger or smaller if banks decide to keep more reserves than they legally have to?


13.   Assume that the consumption function is as follows ($ amounts are in billions):

Disposable Income                          Consumption Expenditures
$900                                                                  $750
1,000                                                                 800
1,100                                                                 825
1,200                                                                 845
1,300                                                                 960
1,400                                                                 970


a.      What is the marginal propensity to consume if disposable income changes from $900 to $1000?

b.      What is the marginal propensity to consume if disposable income is between $1,000 and $1,100?

c.      Why might the MPC have changed between a) and b)?