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Flashcards in Practice Final Examination 1 Deck (30):
1

The labour force in a car plant has approached management with the following proposition: ‘We shall raise average labour productivity (cars per worker) by 5 per cent if you agree to increase our wages by 5 per cent.’ Assuming all additional cars produced can be sold at current prices, what would happen to the payments to all other factors of
production if management agreed?

They would

A. increase by 5 per cent.

B. be unchanged.

C. decrease by 5 per cent.

D. decrease by more than 5 per cent.

The correct answer is A. The effect of selling 5 per cent more cars at the current price is to increase total revenue by 5 per cent. It is therefore possible to increase the payments to all factors of production, including labour, by 5 per cent.

2

Suppose that the highly competitive market for electronic calculators is in equilibrium
today. If the government decided that every school pupil should be given a calculator,
bought at government expense, and at the same time the average total cost of produc-
ing calculators were to decrease because of another technological breakthrough in the
electronics industry, what would be the joint effects of the government decision and the technological breakthrough?

A. An increase in the equilibrium price of calculators and an increase in the equilibrium quantity.

B. An increase in the equilibrium quantity of calculators; the equilibrium price might rise, fall or be unaltered.

C. A decrease in the equilibrium price of calculators; the equilibrium quantity might rise, fall or be unaltered.

D. A decrease in the number of firms in the industry, and an increase in the equilibrium price of calculators.

The correct answer is B. The government decision to buy every school pupil a calculator would shift the demand curve to the right. The reduction in the costs of producing calculators, i.e. a lowering of the average total cost curve, would shift each firm’s short-run marginal cost curve to the right and consequently shift the industry short-run supply curve to the right. Whether the new equilibrium price would be higher, the same or lower than the original price will depend upon the relative shifts of the demand and supply curves. Thus the joint effect on price cannot be determined from the information given. However, both curves will intersect to the right of the original equilibrium position

3

It has been said that the fundamental fact of scarcity is no longer applicable to the UK economy.

Which of the following is correct? This statement is

A. true, because the welfare system in the UK ensures that the basic needs of the poor are met.

B. true, because goods such as tea and coffee, which are not produced in the UK, can be imported from abroad.

C. false, because not all wants of all UK citizens are fully satisfied.

D. false, because a significant number of families in the UK have incomes below what is generally accepted as the poverty level.

The correct answer is C. No country today has sufficient resources to satisfy all the wants of every member of its population; this is the ‘fundamental fact of scarcity’. The fact that society’s basic needs, however defined, might be being met or that commodities not produced in the UK can be imported from abroad does not imply that scarcity no longer exists. Even if every family in the UK were above poverty level, however defined, scarcity would still remain.

4

The table below shows how the factors of production may be combined to produce 100 units of a certain good. Using only the information in the table, which one of the methods can be dismissed by the producer on the grounds of technical inefficiency?

The correct answer is C. Since no prices are provided, it is not possible to compare options A and B since A uses less labour and more capital than B. However, it is possible to compare B and C since they use the same quantity of capital, but C uses more labour; B is therefore more efficient than C, which can be dismissed on the grounds of technical efficiency. B and C is the only pair that it is possible to compare in this way.

5

Which one of the following quotations is not an example of the ‘law’ of diminishing marginal utility?

A. ‘The second glass of beer tastes just as good as the first.’

B. ‘There’s a limit to how much ice cream you can eat in a day.’

C. ‘After a while, even TV gets boring.’

D. ‘All work and no play makes Jack a dull boy.’

The correct answer is A. Any statement that suggests diminishing additional utility derived from additional consumption is consistent with the ‘law’ of diminishing marginal utility. Diminishing marginal utility is consistent with a limit to the amount of ice cream that can be eaten in a day, with boredom watching TV after a time, and with dullness from spending too much time working. However, to say that the second glass of beer tastes just as good as the first suggests that the utility is the same for the second as for the first glass of beer, and is not consistent with dimin- ishing marginal utility.

6

A consumer’s typical demand curve for a good is downward-sloping to the quantity axis because at higher prices the consumer

I. encounters a leftward-shifting supply curve for that good, resulting in a lesser equilibrium quantity.

II. buys less of the good in place of other goods, which are now relatively less expen-sive.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is B. A demand curve shows the quantity of a good that a consumer would buy at different prices, cet. par. This is independent of the condi- tions of supply; therefore statement I is incorrect. As the price increases, the quantity typically decreases for a number of reasons, one of which is that other goods become relatively more attractive; this is the substitution effect. Thus statement II is correct.

7

The correct answer is C. In deciding which policy contributes most to economic efficiency, it is necessary to compare marginal costs and marginal benefits of each. Since no cost information is provided, it is not possible to draw a conclusion.

8

Perfect weather conditions in Brazil have produced a bumper coffee crop this year.
Although the whole crop could be sold at a price that would more than cover the cost of storing and delivering it, a Brazilian economist has suggested that sufficient coffee be burned to prevent the price of Brazilian coffee beans from falling.

Which of the following would result from acting upon this suggestion?

A. A reduction in Brazilian coffee growers’ real income.
B. A reduction in world real income.
C. An increase in Brazilian coffee growers’ real income.
D. An increase in Brazilian real income.

The correct answer is B. The Brazilian economist’s advice was probably based on his belief that the demand for coffee is price-inelastic, i.e. that the bumper crop could only be sold as the result of a price reduction, which would lead to a decrease in total revenue. However, no such definite information on the market is provided. The only definite outcome of burning the coffee would be to reduce the total of consumption goods available to the world, i.e. to decrease world real income.

9

The diagram shows two production frontiers for catching mackerel, in other words the maximum amount of fish that can be caught with two different amounts of a fixed factor of production (boat) and with different amounts of a variable factor of production (labour). The rental costs of the boats are $100 and $200 respectively. All units of
labour are identical.

I. A movement from X to Y exhibits increasing marginal returns to labour.

II. A movement from X to Z exhibits increasing returns to scale.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is D. The output of the first 6 man-days, as shown by point X, was 300 kilos; the addition of a further 6 man-days, as shown by point Y, added just over 100 kilos, thus the marginal product of labour decreased between points X and Y; statement I is thus incorrect. The movement from X to Z involves doubling both the input of labour and of capital; if there were increasing returns to scale, output would more than double. However, the output of mackerel also doubled from 300 to 600 kilos, exhibiting constant returns to scale. Statement II is incorrect.

10

People buy more fuel when prices are reduced and less when they are raised. Suppose that advertising does not increase the amount of fuel bought but does influence the choice of brand. Suppose also that fuel of any one grade is for practical purposes a
homogeneous product across brands and that any change in industry cost is passed on in part to the public in higher or lower fuel prices. Which of the following would necessarily be true?

A. If all fuel refiners increase advertising expenditure, refining industry total profits will increase but the general public will be worse off.

B. If all fuel refiners increase advertising expenditure, refining industry total profit will decrease and the general public will be worse off.

C. If one fuel refiner increases his advertising expenditure, that refiner’s profit will decrease but other refiners’ profits will increase.

D. If one fuel refiner increases his advertising expenditure, that refiner will have higher profit, higher sales and lower costs per gallon sold than other refiners.

The correct answer is B. The effect of increased advertising is to increase the cost of production and alter the distribution of expenditure between brands, while leaving total expenditure unchanged. Thus, if all refiners increased their advertising, there would be a redistribution of consumer expenditure between brands, depending on how much additional advertising each refiner carried out, and industry total profit would decrease. When the increased advertising costs were passed on in price increases, the general public would become worse off. Option A is therefore incorrect and B is correct. Since the amount of brand switching in response to changed advertising is unknown, it is not possible to predict the effect on an individual refiner of a change in his advertising.

11

When travelling to an airport from a city centre, most people use the airport bus or travel by taxi. In response to rising fuel costs, taxi fares have risen although the bus fare has remained unaltered. If some travellers change their mode of transport in response to the change in fares, what impact will this have on taxi and bus revenues?

A. Taxi revenues will rise and bus revenues will remain unaltered.
B. Taxi revenues will fall and bus revenues will remain unaltered.
C. Bus revenues will rise and taxi revenues may rise, fall or remain unaltered.
D. Bus revenues will rise and taxi revenues will rise.

The correct answer is C. Since more people now use the bus (because taxi fares have risen) and the fares are unchanged, bus revenues will rise. The effect of increased taxi fares on total revenues depends on the price elasticity of demand. Since this is unknown, taxi revenues may rise, fall or be unaltered.

12

For several decades the Eastfield iron foundry has been processing iron ore and has been an important employer in the local area. Until recently, no one complained about the ash particles, the bulk of which fell on vacant land. However, a farmer who bought the vacant land and is now cultivating it has complained to the government that the ash particles are polluting his fields and causing wheat yields to be less than they would otherwise be. If the government wishes to promote efficient resource use in the area, which of the following policies should it adopt?

A. Force the iron foundry to stop polluting the area or put it out of business.
B. Allow the iron foundry to continue as it is but charge the owners for any resultant decrease in the value of the farmer’s output.
C. Refuse to intervene and let market forces resolve the conflict between the farmer and the foundry owners.
D. Provide the farmer with an alternative field and compensate him for any loss of income incurred.

The correct answer is B. The social cost of producing iron is greater than the private cost of production by an amount equal to the decrease in the farmer’s output; consequently, because of this externality, setting output at the level where marginal revenue equals private marginal cost is not economically efficient. The solution is to include the decrease in the farmer’s output as a cost to the firm, i.e. to charge it according to how much output the farmer loses as a result of iron production. The firm’s private marginal cost will now be equal to marginal social cost and the iron foundry will set its output at a lower profit-maximising level. Consequently B is correct. None of the other responses contributes to equalising private and social cost.

13

Approximately one-half of a city university’s students live in rooms/flats that they rent in the private market. The others live in university rooms or flats. Average housing expenditure does not vary significantly between the two groups. In the light of govern-
ment cutbacks in university finance, the university has decided to convert its student accommodation to offices and seminar rooms. The 3000 students who will be affected have been told they will have to find their own accommodation in the private housing
market in the city. Other things being unchanged, such as population, what effect will the university’s decision have on the market for private rental housing when the university housing service ceases?
A. An increase in rent, followed later by an increase in the quantity of private rental housing supplied.

B. A decrease in the number of non-student tenants and simultaneously a decrease in rent.

C. A decrease in rent as home owners and landlords anticipate the increased student demand.

D. No effect, because the students who occupy university housing will not be able to afford private housing.

right of the demand curve for rented accommodation. The stock of rented accom- modation is fixed in the short run; therefore this will result in an increase in the market rent. In the long run, potential landlords will be attracted into the private renting sector because of the higher rents obtainable, and thus there will later be an increase in the quantity of private rental housing supplied.

14

‘The more money there is in the economy, the more people spend. The more people spend, the higher is GNP. Therefore, the greater the supply of money, the better off people must be.’ Which of the following is correct?

A. The statement is correct because increases in the money supply lead to decreases in interest rates, which in turn lead to increases in investment.

B. The statement is incorrect because real GNP is limited by the economy’s potential to produce goods and services.

C. The statement is correct because increases in the money supply lead to increases in interest rates, which in turn lead to increases in consumer saving.

D. The statement is incorrect because the supply of money has no effect on consumer, government or investment expenditure.

The correct answer is B. While it is possible to increase aggregate demand by increasing the supply of money, potential output sets an upper limit to real GNP. Therefore it does not always follow that the greater the supply of money, the better off people will be.

15

It is rumoured that the government intends to increase the sales tax on alcohol and tobacco from 5 per cent of the selling price to 20 per cent and to use this tax revenue to subsidise gas and electricity production, i.e. to lower the prices of these commodities. If the government carries out such a plan

I. the average consumer will have a lower real income because the cost of living will be higher.

II. income inequality will be increased if people with lower incomes spend a greater proportion of their incomes on alcohol and tobacco but no higher a proportion on gas and electricity than higher-income groups.


Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is B. For any given consumer, the greater the proportion of income spent on alcohol and tobacco, the greater will be the amount of tax paid and, since the smaller will be the amount of income available for all other purchases, including gas and electricity, the less will be the amount of the subsidy received. Thus, if people with lower incomes spend a greater proportion of their incomes on alcohol and tobacco than do people with higher incomes, but not a higher propor- tion on gas and electricity, then the scheme will increase income inequality. Thus statement II is correct. Real income is determined by the nation’s resources and you might argue that distortions caused by the tax subsidy programme would cause real income to fall. However, this fall would not be because the cost of living would be higher; this cost of living, e.g. the consumer price index or GNP deflator, could be rising, constant or falling. Thus statement I is incorrect.

16

A government announces that it does not intend to launch any more satellites; the ten it has launched so far are more than adequate for its needs. On average each satellite cost
$1 million; they are all monitored from a single station, whose running costs are $50 000 per annum. A group of businesses with plants abroad and a private university with isolated students have requested permission to use one of the satellites to ‘bounce’ messages to their plants and students. Such a use of the satellite will not affect any government use and will not incur any additional government cost. Given that the government goal is efficient allocation of resources, how much should the government
charge the businesses and the university for using the satellite each year?

A. Zero.

B. Zero to the university and a share of the $50 000 to each of the businesses.

C. A share of the $50 000 to both the university and to each of the businesses.

D. A share of the $50 000 and a share of the $1 million to the university and to each of the businesses.

The correct answer is A. The use to which the businesses and the university wish to put the satellite does not exclude any other use; therefore the opportunity cost is zero. Furthermore, there are no negative externalities; thus the marginal social cost is zero. A necessary condition for economic efficiency is that price equals marginal social cost, which in this case is zero.

17

One year, the serfs in a feudal manor produced only $500 worth of ploughs, together with $2000 worth of wheat, all of which they used to produce $3000 worth of flour, all of which in turn they used to produce $4000 worth of bread. The feudal lord took half
the bread as his dues and exchanged it for other goods from outside the manor such as cloth, meat and drink.

Which of the following represents the gross output (gross product) of the manor for the year?

A. $4500.
B. $6500.
C. $9500.
D. $11 500.

The correct answer is A. The value of final or gross output in economy was $500 worth of ploughs and $4000 worth of bread. The wheat and flour are intermediate goods and to include them in the value of gross output would be double counting. What the feudal lord did with his share of gross output does not affect the value of gross output.

18

The following table shows Money GNP and Real GNP in a hypothetical closed economy for three years:

Assuming a constant number of workers, it follows that I. the supply of money increased by $7 million between Year t and Year t + 2. II. output per worker was higher in Year t + 2 than in Year t.
Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is B. The fact that money GNP has risen faster than real GNP indicates rising prices. This could be associated with an increasing money supply, increasing velocity of circulation of money, or both. There is no proof that the money supply increased by £7 million. Statement I is therefore incorrect. Output per worker is real GNP divided by the number of workers; since real GNP in- creased between Year t and Year t + 2 and the number of workers did not, it follows that output per worker was higher in Year t + 2 than in Year t. Statement II is therefore correct.

19

In any given year, some businesses sell more goods and services than they produce, some sell exactly what they produce while others sell less than they produce. However, in the national income accounts in a closed economy, total expenditure for final goods
and services is always equal to total output. Which of the following is correct? This apparent disparity is explained by the fact that

A. what is produced must be sold eventually.

B. in the national income accounts, total expenditure is defined to exclude depreciation.

C. in the national income accounts, total expenditure is defined to include any change of inventories.

D. the businesses that sell more than they produce always cancel out the businesses that sell less than they produce.

The correct answer is C. Total expenditure on final goods and services includes expenditure on goods sold from inventories; however, investment expenditure is calculated net of additions to or deductions from inventories. Consequently the net calculation of total expenditure is equal to the value of final output.

20

A government hopes this year to balance its budget (i.e. make government expenditure (G) and tax receipts (T) equal), achieve full employment, and distribute gross national product (GNP) among consumption expenditure (C), investment expenditure (I) and
government expenditure (G) in the proportions 60 per cent/20 per cent/20 per cent. The Chief Economic Adviser has warned the government not to make a public statement to this effect. On which of the following is his professional advice based?

A. The setting of 20 per cent of GNP as being devoted to government expenditure is incompatible with a balanced budget.

B. Only by remote chance will values of GNP, C, I, G and T occur that will achieve the three objectives.

C. Balanced budgets are incompatible with full employment.

D. It is not possible to influence the distribution of GNP among C, I and G.

The correct answer is B. In order to balance the budget, the government has to predict national income and, on the basis of the prediction, calculate total tax revenue from the selected tax rate. This total tax revenue must be equal to the selected government expenditure plus transfers; transfers depend partly on the unemployment rate, and hence on the actual value of national income. However, disposable income, and hence national income itself, depends on transfers; therefore it is extremely complicated to calculate in advance the appropriate values for tax rates and government expenditure. The calculation is made even more complex if government expenditure is to be 20 per cent of national income; furthermore, consumption expenditure must be 60 per cent of national income, again adding to the complexity of the calculation. To ensure that investment expenditure is 20 per cent of national income, it is again necessary to make a prediction of national income and the rate of interest that will have the desired effect. Given that the government can only make one set of policy decisions for a given year, it is extreme- ly unlikely that the three objectives will be attained. Thus option B is correct. Government expenditure of 20 per cent of GNP is not incompatible with a balanced budget, which in turn is not incompatible with full employment. Thus options A and C are incorrect. Since monetary and fiscal policy can influence the distribution of GNP among C, I and G, option D is also incorrect.

21

In a hypothetical economy, a group of economists estimated that the value of the
marginal propensity to consume was two-thirds. An increase in government expenditure
of $10 000 million resulted in an increase in real national income of $20 000 million. The reasons why the increase was not $30 000 million are

I. the marginal propensity to import decreased.

II. the economy was close to full employment when government expenditure was increased.

III. the increase in demand for money caused interest rates to rise and private investment to fall. Which of the following is correct?

A. II only.
B. II and III only.
C. I, II and III.
D. Not I nor II nor III.

The correct answer is B. The calculated MPC of two-thirds suggests an expenditure multiplier of 3, but the actual multiplier was only 2. One possible explanation for the multiplier turning out to be less than expected is an increase in leakages – for example an increase in the marginal propensity to import. Statement I suggests a reduction in the marginal propensity to import and is therefore incorrect. Full employment or potential output sets a limit to actual output; thus if the gap between actual and full employment output were less than $30 000 million, the multiplier would not have been able to work through fully; therefore statement II is a possible explanation. The increased government expenditure caused an increase in aggregate demand and an increase in output, thus causing an increase in the demand for money. Since the supply of money was not increased, it is possible that the price of money, i.e. the interest rate, increased, causing private investment and consumption expenditures to fall, thus reducing the net effect of the multiplier; statement III is therefore also a possible explanation.

22

Suppose a significant decrease in the GNP of other European Union countries led to a decline in United Kingdom exports; and suppose that the government, because of this, increased the interest rate from 8 per cent to 14 per cent but made no other change in policy.
Which of the following is correct?

From the policy adopted it can be inferred that the government was more concerned about

A. the rising unemployment rate than the rising inflation rate.

B. the falling value of sterling than the rising unemployment rate.

C. the falling investment rate in export industries than the rising inflation rate.

D. the rising unemployment rate than the falling value of sterling.

The correct answer is B. The decline in exports would lead to a reduction in aggregate demand, causing the unemployment rate to be higher than would other- wise be the case. Increasing the interest rate would cause a reduction in investment and consumption expenditures, which would reduce aggregate demand further and add even more to the unemployment rate. A reduction in UK exports would cause a decrease in the demand for sterling, the value of which would fall; an increase in the UK interest rate would make the UK relatively more attractive for savers, and then the demand for sterling would increase, causing the value of sterling to rise. Thus from the policy adopted, it can be inferred that the government was more con- cerned about the falling value of sterling than the rising unemployment rate.

23

‘Since there is a limit to the amount of goods and services a nation can produce in a given year, any expansion of a nation’s currency will mean a diminution in the real value of the currency.’ Which of the following is correct?

The quotation is

A. incorrect, since even in the short run the exchange rate determines the value of a nation’s currency.

B. incorrect, since an increase in the money supply may lead to increased demand for goods and services and, given available resources to an increase in real output.

C. correct, since even in the short run all money supply increases in the UK have been associated with corresponding price increases.

D. correct, since a nation’s wealth or resources are in fixed supply at any point in time.

The correct answer is B. An increase in the money supply will make interest rates lower than they otherwise would have been and investment and consumption expenditures higher than they otherwise would have been. If the economy is already at full employment, i.e. if actual output equals potential output, the excess demand will cause inflation and consequently a reduction in the value of the currency. However, if there are unemployed resources, real output will increase without necessarily causing an increase in the price level.

24

Unemployment reached an all-time high in the United Kingdom economy in the early 1930s. Many people have argued, that had World War II never happened, the Great Depression might have continued. In the absence of the war, the following policies
would have been appropriate for decreasing unemployment:

I. a decrease in the money supply to increase interest rates and stimulate savings.
II. an increase in income taxes to decrease consumption and increase investment.
III. a decrease in government expenditure to free more resources for use in the private sector.

Which of the following is correct?

A. I only.
B. II only.
C. I and III only.
D. Not I nor II nor III.

The correct answer is D. An increase in interest rates would reduce aggregate demand, thus increasing unemployment; therefore statement I is wrong. The reduction in consumption arising from an increase in income tax would also reduce aggregate demand and increase unemployment; given there are substantial unem- ployed resources already, it is not necessary to reduce consumption in order to make resources available for investment; therefore statement II is wrong. A decrease in government expenditure would also reduce aggregate demand and increase unem- ployment; again, since there are unemployed resources, there is nothing to be gained from freeing additional resources for use in the private sector; therefore statement III is incorrect.

25

If at the beginning of a year an economy were operating at full employment and if during the year aggregate demand were to remain constant but potential output (fullemployment output) were to increase, which of the following must occur?

A. An increase in the inflation rate.

B. An increase in the unemployment rate.

C. An increase in interest rates.

D. An increase in the balance of payments deficit.

The correct answer is B. The economy develops a gap between actual and potential output during the year, and so some resources must have become unemployed. Consequently there will be an increase in the unemployment rate. There may be increases or decreases in the inflation rate, interest rate and balance of payments deficit, but a change in any is not guaranteed by a gap between actual and potential GNP in a given year.

26

Between March and September the exchange rate of the pound against the dollar fell from $1.50 to $1.40. At the same time, the interest rate in the USA rose from 8 per cent to 12 per cent. If there were no inflation in the USA, which of the following would be the effect on a UK holidaymaker who went for a week’s holiday to the USA with £500 in March compared with one who went with £500 for a week’s holiday in September?

A. The March holidaymaker would be able to buy more for her £500.

B. The September holidaymaker would be able to buy more for her £500.

C. The effect would depend on whether the £500 was exchanged for dollars in the UK or in the US.

D. It is impossible to say who was better off because of the rise in the interest rate.

The correct answer is A. In March the holidaymaker would be able to buy £500 × 1.50 = $750. In September she would be able to buy £500 × 1.40 = $700. If there were no inflation in the US, clearly the holidaymaker would be able to buy more in March with $750 than in September with only $700. The location at which the dollars were bought has no bearing on the value of the dollars. Since the holiday- maker went to the USA to spend money, not to invest it, the increase in interest rates in the USA would not affect her.

27

The German economy was operating at full employment. Its high wage rates attracted employed skilled workers from Turkey to work in Germany. These workers sent home the bulk of their wages, which were spent by their families in Turkey. The effect of the migration of labour to Germany was to

I. increase potential (full-employment) output in Germany.

II. reduce potential (full-employment) output in Turkey.

III. increase real output in Germany.

Which of the following is correct?

A. I only.
B. II only.
C. I and III only.
D. I, II and III.

The correct answer is D. The upper limit to the potential GNP of any country is determined by the quantity and quality of the labour force, the capital stock and the level of technology. Thus if Germany were able to expand its labour force through immigrant labour from Turkey, Germany’s potential GNP would increase. As the migrants were employed, actual GNP would also increase. Thus statements I and III are correct. Conversely, Turkey would experience a fall in its potential GNP when its labour force declined as workers moved to Germany. Thus statement II is correct.

28

A government decided to abandon import controls and as a result there was a sudden increase in the value of imports. Which of the following represents the impact that the increased imports would have on the country’s National Income? It would be

A. increased by an amount equal to the value of the additional imports.

B. reduced because imports are leakages from the circular flow of income.

C. unaffected because the amount paid for the additional imports would be exactly equal to their value.

D. increased by an amount equal to the value of the additional imports times the multiplier.

The correct answer is B. Y ≡ C + I + G + X − Z, where Y = National Income, C = Consumption Expenditure, I = Investment Expenditure, X = Export Expendi- ture and Z = Import Expenditure. Imports are leakages from the circular flow of income because expenditure on imports result in income being generated in countries abroad, not in the domestic economy. As a result, the increase in imports will make national income lower than it otherwise would have been.

29

A government increases expenditure on investment in the coal and steel industries by $40 million and discovers that this forces up interest rates, which in turn leads to a decrease in private investment expenditure of $40 million. Assuming no other offsetting changes in the economy, what is the impact of the increase in government expenditure? An increase in

A. real GNP.
B. the budget deficit (reduction in the budget surplus).
C. potential (full-employment) GNP.
D. the money supply.

The correct answer is B. The increase in government expenditure has crowded out an equal value of investment expenditure; therefore the net effect on real output is zero. The budget surplus or deficit is found as follows: budget surplus or deficit = total tax revenue − government expenditure − transfers. Since tax rates and national income are unchanged, total tax revenue is also unchanged. The increase in gov- ernment expenditure therefore leads to either a budget deficit or a reduction in the budget surplus.

30

A simple ‘textbook’ economy is described by the following:
C = 20 + 0.5Y, where C = consumption expenditure
Y = national income
I = 10 where I = gross investment expenditure
G = 10 where G = government expenditure
X = 10 where X = exports
Z = 10 where Z = imports
M = 300 where M = money supply
What is the value of the equilibrium level of national income?
A. 80.
B. 100.
C. 120.
D. 300.

The correct answer is A. Y ≡ C + I + G + X − Z
Substituting the values given, we have

Y = 20 + 0.5Y + 10 + 10 + 10 - 10
∴ Y = 0.5Y + 40

∴ 0.5Y = 40

∴ Y = 80