READING 14: AGGREGATE OUTPUT, PRICES, AND ECONOMIC
LOS 14.a: Calculate and explain gross domestic product (GDP) using expenditure and income approaches. & 14.b: Compare the sum-of-value-added and value-of-final-output methods of calculating GDP.
Question 14.1: Which of the following statements about methods of calculating gross domestic product is most accurate?
A) Except for a statistical discrepancy, the income and expenditure approaches to calculating GDP should result in the same value for economic output.
B) Because it includes activity at all stages of production, the sum-of-value-added method results in a better estimate of GDP than the value-of-final-output method.
C) Value-of-final-output is used to calculate GDP under the expenditure approach, while sum-of value-added is used to calculate GDP under the income approach.
A is correct. Because aggregate income is the same as aggregate output, measuring GDP by summing incomes or expenditures should produce the same value, except for a statistical discrepancy that results from using different data sources. The sum-of-value-added method of calculating GDP records the sum of the increases in value of goods and services at each stage of their production and distribution. The resulting total for GDP is the same as that reached by the value-of-final-output method because the sum of value added to a good at allstages of processing is equal to its selling price. Both methods calculate GDP based on expenditures.
LOS 14.c: Compare nominal and real GDP and calculate and interpret the GDP deflator
Question 14.2: Nominal GDP for the year 20X7 is $784 billion and real GDP is $617 billion. If the base period for the GDP deflator is 20X1, the annual rate of increase in the GDP deflator since the base year is closest to:
GDP deflator = $784 billion / $617 billion × 100 = 127.07. Annual rate of increase = (127.07 / 100)^ 1/6 – 1 = 0.0407 = 4.07%.
LOS 14.d: compare GDP, national income, personal income, and personal disposable income.
Question 14.3: Which of the following amounts is least likely to be subtracted from gross domestic product in order to calculate national income? A) Statistical discrepancy. B) Indirect business taxes. C) Capital consumption allowance
B is correct. Indirect business taxes are not subtracted because they are included in national income.
LOS 14.e: Explain the fundamental relationship among saving, investment, the fiscal balance, and the trade balance.
Question 14.4: If private saving equals private business investment, a trade surplus implies that there is:
A) no fiscal surplus or deficit.
B) a fiscal surplus.
C) a fiscal deficit.
B is correct. The fundamental relationship among saving, investment, the fiscal balance, and the trade balance is stated as: (G – T) = (S – I) – (X – M). If S = I, this equation becomes (G – T) = – (X – M), or (T – G) = (X – M). In this case, if the trade balance is in surplus (exports are greater than imports), the fiscal balance must also be in surplus (taxes are greater than government spending).
LOS 14.f: Explain the IS and LM curves and how they combine to generate the aggregate demand curve.
Question 14.5: With respect to the IS-LM model, in an LM curve the real interest rate is:
A) positively related to real income, holding the real money supply constant.
B) held constant, resulting in excess savings being positively related to real income.
C) negatively related to real income, holding the marginal propensity to save constant.
A is correct. The LM curve illustrates a positive relationship between real income and the real interest rate, holding the real money supply constant. The IS curve illustrates a negative relationship between real income and the real interest rate, holding the marginal propensity to save constant.
The LM curve (liquidity-money) illustrates the positive relationship between real interest rates and income consistent with equilibrium in the money market. Higher real interest rates decrease the quantity of real money balances individuals want to hold, so for a given real money supply (M/P constant), equilibrium in the money market requires that an increase in real interest rates be accompanied by an increase in income. The increase in the demand for money from an increase in income can offset the decrease in demand for money from higher real interest rates and restore equilibrium in the money market.
LOS 14.g: Explain the aggregate supply curve in the short run and long run
Quesstion 14.6: A perfectly elastic aggregate supply curve represents:
A) the productive capacity of an economy at full employment.
B) the production decisions of firms only in the very short run.
C) the short-run relationship between output and the price level.
B is correct. The very short run aggregate supply curve is perfectly elastic because firms can adjust output by increasing or decreasing labor hours and capacity use without affecting input prices. The short-run aggregate supply curve is upward sloping. The long-run aggregate supply
curve is perfectly inelastic and represents potential GDP, the full-employment output level of an economy.
In the very short run, firms will adjust output without changing price by adjusting labor hours
and intensity of use of plant and equipment in response to changes in demand.
In the long run, wages and other input prices change proportionally to the price
level, so the price level has no long-run effect on aggregate supply.
LOS 14.h: Explain causes of movements along and shifts in aggregate demand and supply curves.
Question 14.7: Which of the following events is most likely to increase short-run aggregate supply (shift the curve to the right)?
A) Inflation that results in an increase in goods prices.
B) High unemployment puts downward pressure on money wages.
C) An increase in government spending intended to increase real output.
B is correct. Falling money wages would cause businesses to increase (profit-maximizing) output levels at each price level for final goods and services. Changes in the price level of goods and services are represented by a movement along a short-run aggregate supply curve,
not a shift in the curve. A rise in resource prices will decrease aggregate supply. An increase in government spending will shift the aggregate demand curve but not the aggregate supply curve.
1. Labor productivity: Holding the wage rate constant, an increase in labor productivity
(output per hour worked) will decrease unit costs to producers. Producers will increase
output as a result, increasing SRAS (shifting it to the right).
2. Input prices: A decrease in nominal wages or the prices of other important productive
inputs will decrease production costs and cause firms to increase production, increasing
SRAS. Wages are often the largest contributor to a producer’s costs and have the
greatest impact on SRAS.
3. Expectations of future output prices: When businesses expect the price of their
output to increase in the future, they will expand production, increasing SRAS.
4. Taxes and government subsidies: Either a decrease in business taxes or an increase in
government subsidies for a product will decrease the costs of production. Firms will
increase output as a result, increasing SRAS.
5. Exchange rates: Appreciation of a country’s currency in the foreign exchange market
will decrease the cost of imports. To the extent that productive inputs are purchased
from foreign countries, the resulting decrease in production costs will cause firms to
increase output, increasing SRAS
LOS 14.i: Describe how fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy and the business cycle.
Question 14.8: Based on the aggregate demand/aggregate supply model :
A) an inflationary or recessionary gap may exist in the long run.
B) actual real GDP is equal to potential real GDP in the long run.
C) no upward or downward pressure on the price level is present at short-run equilibrium.
B is correct. In the short run, real GDP can be less than its full-employment level (a recessionary gap that causes downward pressure on prices) or more than its full-employment level (an inflationary gap that causes upward pressure on prices). In long-run macroeconomic equilibrium, actual real GDP is equal to potential real GDP and there is no upward or downward pressure on the price level.
LOS 14.j: Distinguish between the following types of macroeconomic equilibria: longrun full employment, short-run recessionary gap, short-run inflationary gap, and shortrun stagflation.
Question 14.9: If money wages increase, other things equal, the most likely result is a:
A) long-run inflationary gap.
B) short-run inflationary gap.
C) short-run recessionary gap.
C is correct. An increase in the wage rate decreases short-run aggregate supply, leading to a short-run recessionary gap
LOS 14.k: Explain how a short-run macroeconomic equilibrium may occur at a level above or below full employment
Question 14.10: An economy is in full-employment equilibrium. If the government unexpectedly decreases the tax rate, the economy is most likely to experience:
A) an increase in employment in the short run.
B) a decrease in the price level in the short run.
C) no change in employment in the short run.
A is correct. Short-run equilibrium may occur above full employment, for example as a result of an increase in aggregate demand caused by a decrease in taxes. Both employment and the price level increase in the short run. Above-full employment causes upward pressure on wages that will reduce short-run aggregate supply until, in the long run, output returns to its full-employment level with a still-higher equilibrium price level.
LOS 14.h: Explain causes of movements along and shifts in aggregate demand and supply curves & LOS 14.m: Describe sources, measurement, and sustainability of economic growth
Question 14.11: Long-run aggregate supply is least likely to be affected by changes in the:
A) prices of raw materials inputs.
B) quantity of labor in the economy.
C) level of technology.
A is correct. Long-run aggregate supply is related to the level of technology and the available quantities of labor and capital. If the prices of productive inputs increase, short-run aggregate supply decreases (the SRAS curve shifts to the left), but long-run aggregate supply (potential real GDP) is unaffected
An economy’s sustainable growth rate can be estimated by estimating the growth rate of
labor productivity and the growth rate of the labor force. For example, if Japan’s labor force
is projected to shrink by 1%, while its labor productivity is expected to grow by 2%, then we
would estimate the growth in potential GDP as: –1% + 2% = 1%
LOS 14.n: Describe the production function approach to analyzing the sources of economic growth & LOS 14.o: Distinguish between input growth and growth of total factor productivity as components of economic growth.
Question 14.12: Under the production function approach to modeling economic growth, will growing an economy's amount of physical capital at a constant rate support long-term economic growth at that rate?
A) No, because physical capital depreciates over time.
B) Yes, because output is a positive function of both labor and capital.
C) No, because physical capital exhibits diminishing marginal productivity.
C is correct. A constant growth rate of physical capital will increase output over time, but because capital exhibits diminishing marginal productivity, the economy will grow at a rate that decreases over time.
Production function exhibits diminishing marginal productivity for each individual input, meaning the amount of additional output produced by each additional unit of input declines (holding the quantities of other inputs constant). For this reason, sustainable long-term growth cannot necessarily be achieved simply by capital deepening investment—that is to say, increasing physical capital per worker over time. Productivity gains and growth of the labor force are also necessary for long-term sustainable growth.
READING 15: UNDERSTANDING BUSINESS CYCLES
Question 15.1: A peak in the business cycle is most likely associated with:
A) the highest level of economic output during the cycle.
B) payroll employment turning from positive to negative.
C) decreasing inflation pressure.
A is correct. The peak phase of a business cycle represents the highest level of economic output (real GDP) reached during that cycle. Inflation pressure that built during the expansion may continue into the early part of the contraction that follows the peak. Employment typically does not begin to decline until sometime after the peak.
he business cycle has four phases: expansion (real GDP is increasing), peak (real GDP stops increasing and begins decreasing), contraction or recession (real GDP is decreasing), and trough (real GDP stops decreasing and begins increasing).
LOS 15.b: Describe how resource use, housing sector activity, and external trade sector
activity vary as an economy moves through the business cycle.
Question 15.2: An unexpected increase in businesses' inventory-to-sales ratios is most likely to occur as an economy:
A) reaches a trough.
B) enters a contraction phase.
C) approaches the peak of an expansion
C is correct. At the end or peak of an expansion, economic activity begins to slow, sales are less than planned, and excess inventory accumulates, increasing inventory-to-sales ratios. To reduce inventory-to-sales ratios to desired levels, firms decrease production, which is one of the causes of a contraction.
Inventories are an important business cycle indicator. Firms try to keep enough inventory on
hand to meet sales demand but do not want to keep too much of their capital tied up in
inventory. As a result, the ratio of inventory to sales in many industries trends toward a
normal level in times of steady economic growth.
When an expansion is approaching its peak, sales growth begins to slow, and unsold
inventories accumulate. This can be seen in an increase in the inventory-sales ratio above its
normal level. Firms respond to an unplanned increase in inventory by reducing production,
which is one of the causes of the subsequent contraction in the economy.
Question 15.3: Data for a manufacturing industry indicate that inventories of work in progress are increasing faster than sales. This is most likely to indicate that:
B) inventory is becoming obsolete.
C) firms expect demand to increase.
C is correct. An increase in work-in-progress inventory relative to sales is likely to result from firms increasing production because they expect an increase in demand. An increase in finished goods inventories relative to sales would be more likely to indicate a decrease in demand that may be caused by obsolete inventory or a business cycle peak.
LOS 15.c: Describe theories of the business cycle
Question 15.4: The national government has undertaken a plan to combat a recession that includes a fiscal stimulus package. The school of economic thought most likely to support this action is the:
B is correct. The Keynesian school of macroeconomics believes that increasing the money supply or increasing government spending (such as with a stimulus package) will increase real GDP and combat recession. Monetarists believe economic growth is best supported through a policy of steady and predictable money supply increases. The neoclassical school of thought believes that economic cycles will correct themselves through a rapid adjustment of the prices of key productive inputs that restores the economy to full employment.
Question 15.5: A business cycle theory developed by applying utility theory and budget constraints to macroeconomic models is most closely associated with which school of economic thought?
B) New Classical.
C) New Keynesian.
B is correct. Real business cycle theory, which derives from applying utility theory and budget constraints to macroeconomic models, is associated with the New Classical school.
LOS 15.i: Interpret a set of economic indicators and describe their uses and limitations & LOS 15.d: Describe types of unemployment and compare measures of unemployment
Question 15.6: Reasons why the unemployment rate is a lagging indicator of the business cycle least likely include:
A) discouraged workers who begin seeking work.
B) action lag in the implementation of unemployment insurance.
C) high costs to employers of frequently hiring or firing employees.
B is correct. Unemployment insurance is an example of an automatic stabilizer that is not subject to the action lag of discretionary fiscal policy tools. One reason why the unemployment rate is a lagging indicator is the fact that employers are slow to lay off employees early inrecessions and slow to add employees early in expansions, because frequent hiring and firing has high costs. Another reason is thatearly in expansions, more discouraged workers (who are not counted as unemployed because they are out of the labor force) may begin seeking work (thereby re-entering the labor force) than the number of new jobs that are available, which increases the unemployment rate.
Short-term fluctuations in the participation ratio can occur because of changes in the number of discouraged workers, those who are available for work but are neither employed nor actively seeking employment. The participation rate tends to increase when the economy expands and decrease during recessions. Discouraged workers who stopped seeking jobs during a recession are motivated to seek work again once the expansion takes hold and they believe their prospects of finding work are better.
This movement of discouraged workers out of and back into the labor force causes the unemployment rate to be a lagging indicator of the business cycle. Early in an expansion
when hiring prospects begin to improve, the number of discouraged workers who re-enter the
labor force is greater than the number who are hired immediately. This causes the unemployment rate to increase even though employment is expanding. To gauge the current state of the labor market, analysts should include other widely available indicators such as the number of employees on payrolls.
Earlier, we noted that firms tend to be slow to hire or lay off workers at business cycle turning points. This also causes the unemployment rate to lag the business cycle. The effect can also be seen in data on productivity, or output per hour worked.
LOS 15.d: Describe types of unemployment and compare measures of unemployment
Question 15.7: When individuals are unemployed because they do not have perfect information concerning available jobs, this is:
A) natural unemployment.
B) structural unemployment.
C) frictional unemployment.
C is correct. Frictional unemployment exists because workers and employers do not have perfect information and must expend time and resources on search activities.
Frictional unemployment results from the time lag necessary to match employees who seek work with employers needing their skills. Frictional unemployment is always with us as employers expand or contract their businesses and workers move, are fired, or quit to seek other opportunities.
Structural unemployment is caused by long-run changes in the economy that eliminate some jobs while generating others for which unemployed workers are not qualified. Structural unemployment differs from frictional unemployment in that the unemployed workers do not currently have the skills needed to perform the jobs that are available.
Cyclical unemployment is caused by changes in the general level of economic activity. Cyclical unemployment is positive when the economy is operating at less than full capacity and can be negative when an expansion leads to employment temporarily over the full employment level.
LOS 15.f: Explain the construction of indexes used to measure inflation & LOS 15.g: Compare inflation measures, including their uses and limitations
Question 15.8: An analyst who is interested in the core inflation rate should most appropriately examine a price index:
A) for wholesale goods.
B) that uses hedonic pricing.
C) that excludes food and energy.
C is correct. Core inflation refers to prices excluding food and energy, which tend to exhibit higher price volatility than most other goods and services. Hedonic pricing refers to adjusting a price index for improvements in the quality of goods.
LOS 15.f: Explain the construction of indexes used to measure inflation
Question 15.9: Which of the following statements most accurately describes the difference between headline inflation and core inflation?
A) Core inflation does not include food and energy prices.
B) Headline inflation is a better measure of the underlying trend in prices.
C) Core inflation refers to producer prices
A is correct. Core inflation excludes food and energy and is thus a better measure of the underlying trend in prices.
Headline inflation refers to price indexes for all goods. Core inflation refers to price indexes that exclude food and energy. Food and energy prices are typically more volatile than those of most other goods. Thus, core inflation can sometimes be a more useful measure of the underlying trend in prices.
LOS 15.h: Distinguish between cost-push and demand-pull inflation.
Question 15.10: Which of the following factors would least likely result in demand-pull inflation? An increase in:
A) the quantity of money.
C) energy prices.
Demand-pull inflation can result from any factor that increases aggregate demand, including increases in the money supply, increases in exports, and increases in government purchases. Increases in the prices of productive inputs would result in cost-push inflation as aggregate supply decreases.
LOS 15.i: Interpret a set of economic indicators and describe their uses and limitations.
Question 15.11: Pat Bannerman is analyzing economic indicators to form an opinion on whether an economic contraction has ended. Which of the following turning points should Bannerman most appropriately interpret as a coincident indicator suggesting economic growth is entering the early stage of a new expansion?
A) Real personal income has begun increasing.
B) The unemployment rate has begun decreasing.
C) Building permits for new houses have begun increasing
A is correct. Real personal income is a coincident indicator with turning points that tend to coincide with business cycle turning points. The unemployment rate is a lagging indicator, here suggesting an expansion has been underway for some time. Building permits are a leading indicator because builders may seek permits in anticipation of an economic expansion that has not begun yet.
Leading indicators: Average weekly hours in manufacturing; initial claims for unemployment insurance; manufacturers’ new orders for consumer goods; manufacturers’ new orders for non-defense capital goods ex-aircraft; Institute for Supply Management new orders index; building permits for new houses; S&P 500 equity price index; Leading Credit Index; 10-year Treasury to Fed funds interest rate spread; and consumer expectations.
Coincident indicators: Employees on nonfarm payrolls; real personal income; index of
industrial production; manufacturing and trade sales.
Lagging indicators: Average duration of unemployment; inventory-sales ratio; change
in unit labor costs; average prime lending rate; commercial and industrial loans; ratio of
consumer installment debt to income; change in consumer price index.