Macroeconomic Theory and Policy — Mock Test

20 Multiple-Choice Questions with Answers and Explanations

Economics Department Study Guide

Table of Contents
Unit 1 — Introduction to Macroeconomics...............................................................................................1
Unit 2 — National Income Accounting........................................................................................................1
Unit 3 — Aggregate Demand and Equilibrium Income (Two- and Three-Sector Models,
IS-LM)......................................................................................................................................................................... 1
Unit 4 — Derivation of the Aggregate Demand Curve (Variable Price).......................................1
Unit 5 — Monetary and Fiscal Policy Analysis........................................................................................1
Unit 6 — Aggregate Supply Analysis............................................................................................................1
Unit 7 — Open Economy Macroeconomics...............................................................................................1

Instructions: Each question has four options (A–D). Select the single best answer. The
correct answer and a short explanation follow each question.
Unit 1 — Introduction to Macroeconomics
Question 1. Which statement correctly distinguishes macroeconomics from
microeconomics?
A) Microeconomics studies the economy as a whole, while macroeconomics studies
individual firms
B) Macroeconomics is concerned with the aggregate behaviour of the economy —
output, employment, and the price level — while microeconomics studies individual
units such as a household, firm, or industry
C) Macroeconomics assumes resources are always fully employed, while
microeconomics studies unemployment
D) The two fields use entirely unrelated mathematical tools and share no common
concepts
Answer: B
Explanation: Macroeconomics looks at the economy in aggregate — total output, the
general price level, and total employment — and asks why these magnitudes change over
time. Microeconomics focuses on individual economic units (a household, firm, or single
industry/market) and the allocation of resources among alternative uses, typically
presuming full employment of resources.

Question 2. If an economy’s actual output is currently below its potential output, this
situation is described as:
A) A positive output gap, signalling overheating and rising inflation
B) A negative output gap, signalling idle capacity and unemployment above the natural
rate
C) Hyperinflation
D) A balanced budget
Answer: B
Explanation: The output gap is the difference between actual and potential output. When
actual output falls short of potential, the gap is negative — resources (especially labour)
are underemployed. A positive output gap is the opposite case, where actual output
exceeds potential and inflationary pressure tends to build.
Unit 2 — National Income Accounting
Question 3. If a country’s GNP is birr 500 billion and its Net Factor Income from abroad
(NFI) is birr 20 billion (i.e., residents earn more abroad than foreigners earn domestically),
what is its GDP?
A) Birr 520 billion
B) Birr 500 billion
C) Birr 480 billion
D) Birr 20 billion
Answer: C
Explanation: GDP = GNP − NFI = 500 − 20 = birr 480 billion. Because GNP measures
income earned by residents wherever in the world it is earned, while GDP measures output
produced within the country’s borders, a positive NFI (residents earn more abroad than
foreigners earn domestically) means GNP exceeds GDP by exactly that amount.

Question 4. Under the expenditure approach to measuring GNP, which of the following is
correctly classified?
A) A household’s purchase of a new car is part of Gross Private Domestic Investment
(I)
B) An increase in unsold inventory held by a firm is part of Consumption (C)
C) Government transfer payments (e.g., pensions) are included directly in Government
Purchases (G)
D) An increase in unsold inventory held by a firm is counted as part of Gross Private
Domestic Investment (I)
Answer: D
Explanation: The expenditure approach is GNP = C + I + G + (X − M). A household’s car
purchase is consumption (C), not investment. Government transfer payments (pensions,
subsidies) are excluded from G, since G counts only purchases of goods and services.
Changes in business inventories — including unsold output — are treated as part of gross
private domestic investment (I), since unsold output is, in effect, “purchased” by the firm
itself (added to its stock).

Question 5. An economy’s nominal GNP rises by 8% over a year, while its real GNP rises by
only 2%. What does this imply?
A) The economy experienced 2% inflation and 8% real growth
B) The GNP deflator rose by approximately 6 percentage points, indicating most of the
nominal increase reflects price increases (inflation) rather than real growth
 C) The economy is in a recession
D) Real and nominal GNP must always move by the same percentage
Answer: B
Explanation: Real GNP strips out price changes, so a 2% rise in real GNP represents the
actual increase in the physical volume of output. The gap between the 8% nominal increase
and the 2% real increase (roughly 6 percentage points) reflects the rise in the GNP
deflator — i.e., inflation. Most of the nominal growth in this example is therefore due to
rising prices, not genuine output growth.
Unit 3 — Aggregate Demand and Equilibrium Income (Two- and Three-Sector
Models, IS-LM)
Question 6. If the marginal propensity to consume (MPC) is 0.75, what is the marginal
propensity to save (MPS)?
A) 0.75
B) 1.75
C) 0.25
D) 0
Answer: C
Explanation: Since disposable income is either consumed or saved, MPC + MPS = 1.
Therefore MPS = 1 − MPC = 1 − 0.75 = 0.25.

Question 7. In a simple two-sector (closed) economy, the MPC is 0.8. If autonomous

investment increases by birr 20 billion, by how much does equilibrium income (Y)
increase?
A) Birr 20 billion
B) Birr 16 billion
C) Birr 100 billion
D) Birr 4 billion
Answer: C
Explanation: The simple multiplier is 1/(1−MPC) = 1/(1−0.8) = 1/0.2 = 5. The change in
equilibrium income is ΔY = multiplier × ΔI = 5 × 20 = birr 100 billion.

Question 8. In the three-sector model with a lump-sum tax, why is the (absolute value of
the) tax multiplier smaller than the government-spending multiplier, for an equal-sized
change in G or T?
A) Because taxes only affect the government’s budget, not households
B) Because an increase in G enters aggregate expenditure directly and fully, whereas a
change in T affects expenditure only indirectly — through its effect on disposable
income and hence consumption, scaled by the MPC
C) Because the tax multiplier is always positive while the spending multiplier is always
negative
D) Because taxes are collected only once per year while spending occurs continuously
Answer: B
Explanation: The government-spending multiplier is 1/(1−c), while the tax multiplier is
−c/(1−c). A birr-for-birr change in G changes aggregate expenditure by the full amount
immediately; a birr-for-birr change in T changes disposable income by the full amount,
but consumption (and hence expenditure) changes only by c times that amount (the MPC).
Since 0 < c < 1, the tax multiplier’s magnitude (c/(1−c)) is always smaller than the spending
multiplier’s magnitude (1/(1−c)).

Question 9. If government spending (G) and lump-sum taxes (T) both increase by birr 50
billion (a “balanced-budget” change), what is the resulting change in equilibrium income,
according to the balanced-budget multiplier?
A) Birr 0 — the changes cancel out exactly
B) Birr 50 billion — an increase equal to the spending increase
C) Birr 250 billion, assuming MPC = 0.8
D) A decrease of birr 50 billion
Answer: B
Explanation: The balanced-budget multiplier equals the sum of the spending multiplier
[1/(1−c)] and the tax multiplier [−c/(1−c)], which simplifies to (1−c)/(1−c) = 1. A
simultaneous, equal increase in G and T therefore raises equilibrium income by exactly the
amount of the increase — birr 50 billion — regardless of the value of MPC.

Question 10. The IS curve slopes downward in (interest rate, income) space primarily
because:
A) Higher income causes higher interest rates directly, with no role for investment
B) A higher interest rate reduces planned investment, which (via the multiplier)
reduces the equilibrium level of income consistent with goods-market equilibrium
C) The IS curve represents the money market, where higher income requires higher
interest rates
D) Government spending always falls when interest rates rise
Answer: B
Explanation: The IS curve traces combinations of (r, Y) for which planned injections (I + G)
equal planned leakages (S + T) in the goods market. Since investment I(r) falls as r rises, a
higher interest rate reduces injections, requiring a lower equilibrium income (with
correspondingly lower saving/taxes) to restore goods-market equilibrium — hence the
downward slope. (The LM curve, not the IS curve, represents money-market equilibrium.)

Question 11. Along the LM curve, why does a higher level of income (Y) require a higher
interest rate (r) for money-market equilibrium to be maintained?
 A) Higher income directly increases the money supply
B) Higher income raises the transactions/precautionary demand for money; with a
fixed money supply, the interest rate must rise to reduce speculative money demand
by an offsetting amount
C) The LM curve has nothing to do with the demand for money
D) Higher income always reduces the demand for money
Answer: B
Explanation: Money demand is md = k(Y) + h(r), where k(Y) (transactions/precautionary
demand) rises with Y, and h(r) (speculative demand) falls with r. If the real money supply
(ms) is fixed, a rise in Y that increases k(Y) must be offset by a fall in h(r) — which requires
a rise in r — to keep total money demand equal to the fixed supply. This positive
relationship between Y and r along money-market equilibrium points gives the LM curve
its upward slope.
Unit 4 — Derivation of the Aggregate Demand Curve (Variable Price)
Question 12. If the nominal money supply (Ms) is fixed at birr 700 million and the price
level falls from P = 7 to P = 5, what happens to the real money supply, and what is its effect
on the LM curve?
A) The real money supply falls from 100 to about 71, shifting LM to the left
B) The real money supply rises from 100 to 140, shifting LM to the right (equivalent to
a monetary expansion)
C) The real money supply is unaffected by changes in P
D) The LM curve shifts only if the nominal money supply itself changes
Answer: B
Explanation: The real money supply is Ms/P. At P = 7, Ms/P = 700/7 = 100. At P = 5, Ms/P =
700/5 = 140. A fall in the price level, with nominal Ms unchanged, raises the real money
supply — which has the same effect on the LM curve (shifting it right/downward) as an
increase in the nominal money supply would at a constant price level.

Question 13. Why does the Aggregate Demand (AD) curve slope downward?
A) Because firms produce less when prices fall
B) Because a lower price level raises the real money supply, which lowers the interest
rate (via the LM curve), stimulates investment (via the IS curve), and raises
equilibrium output through the multiplier
C) Because the AD curve is simply a horizontal sum of individual demand curves with
no link to money markets
D) Because government spending automatically falls when prices fall
Answer: B
Explanation: The AD curve’s downward slope reflects a monetary transmission
mechanism: a lower price level (P) increases the real money supply (Ms/P), shifting the
LM curve rightward; this lowers the equilibrium interest rate; the lower interest rate
stimulates investment along the IS curve; and the higher investment raises equilibrium
income via the multiplier. The net result is that lower P is associated with higher
equilibrium Y — a downward-sloping AD curve.
Unit 5 — Monetary and Fiscal Policy Analysis
Question 14. The “crowding-out effect” refers to:
A) The tendency of an expansionary monetary policy to reduce government spending
directly
B) The tendency of an expansionary fiscal policy to raise the interest rate, which
reduces (partially offsets) the increase in private investment and hence in
equilibrium income
C) A situation where exports completely replace domestic consumption
D) The automatic reduction in taxes whenever government spending rises
Answer: B
Explanation: When expansionary fiscal policy (higher G or lower T) shifts the IS curve to
the right, the resulting rise in equilibrium income increases money demand, which — with
a fixed money supply — pushes up the interest rate. This higher interest rate reduces
(crowds out) some private investment that would otherwise have occurred, partially
offsetting the expansionary effect of the fiscal policy on income.

Question 15. Fiscal policy is least effective (crowding out is largest) when the LM curve
is:
A) Perfectly flat (horizontal) — the “liquidity trap” case
B) Steep (approaching vertical) — money demand relatively insensitive to the interest
rate
C) Identical in slope to the IS curve
D) Negatively sloped
Answer: B
Explanation: When the LM curve is steep (money demand is not very sensitive to the
interest rate), a rightward shift of the IS curve (from fiscal expansion) produces a large
increase in the equilibrium interest rate. This large rise in r crowds out a large amount of
private investment, so most of the intended fiscal stimulus is offset — fiscal policy is least
effective in this case. (The opposite extreme — a flat, “liquidity trap” LM curve — is where
fiscal policy is most effective, since the interest rate barely moves and crowding out is
minimal.)

Question 16. Monetary policy is most effective at raising output when the IS curve is:
A) Vertical (investment completely insensitive to the interest rate)
B) Flat — investment is highly sensitive to changes in the interest rate
C) Identical to the LM curve
 D) Upward-sloping
Answer: B
Explanation: An expansionary monetary policy shifts the LM curve to the right, lowering
the equilibrium interest rate. If the IS curve is flat (investment highly responsive to r), even
a small fall in r generates a large increase in investment and hence in equilibrium income
— making monetary policy highly effective. If the IS curve is steep (investment
unresponsive to r), the same fall in r produces little change in investment or income,
making monetary policy weak.
Unit 6 — Aggregate Supply Analysis
Question 17. The Keynesian Aggregate Supply (AS) curve, derived under the assumption
of a fixed money wage and diminishing marginal productivity of labour, has which overall
shape as output rises from very low levels toward full employment?
A) Vertical throughout its entire range
B) Downward-sloping throughout
C) Flat (perfectly/highly elastic) at low output, then upward-sloping, then vertical at
full-employment output (Yf)
D) A simple straight line with constant positive slope at all output levels
Answer: C
Explanation: At low output, idle resources allow output to expand with little or no price
increase (a flat/elastic segment). As the economy approaches full employment, diminishing
returns to labour raise unit costs, so the curve becomes upward-sloping. Once full
employment (Yf) is reached, output cannot increase further regardless of price, so the
curve becomes vertical at Yf. This three-segment shape is the hallmark of the Keynesian AS
curve.

Question 18. Once the economy reaches the vertical segment of the AS curve (output =
Yf), an increase in aggregate demand will primarily result in:
A) A proportional increase in real output with no change in prices
B) An increase in the price level (inflation) with little or no increase in real output
C) A decrease in the price level
D) An increase in unemployment
Answer: B
Explanation: On the vertical segment of the AS curve, the economy is already at full
employment (Yf) — there are no additional resources to increase real output further. Any
further increase in aggregate demand can therefore only bid up prices, resulting in
inflation without a corresponding increase in real output.
Unit 7 — Open Economy Macroeconomics
Question 19. Under a fixed exchange rate with perfect capital mobility, an
expansionary fiscal policy will:
A) Be completely ineffective, because the money supply automatically contracts
B) Be highly effective — the resulting capital inflow forces the central bank to expand
the money supply to defend the peg, reinforcing the fiscal expansion (no crowding
out)
C) Cause the domestic currency to float freely
D) Have no effect on the interest rate or capital flows
Answer: B
Explanation: Expansionary fiscal policy shifts the IS curve rightward, which would push the
domestic interest rate above the world rate. With perfect capital mobility, this attracts a
large capital inflow, creating upward pressure on the domestic currency. To maintain the
fixed exchange rate, the central bank must buy foreign currency (sell domestic currency),
which expands the domestic money supply — shifting the LM curve right until the
interest rate returns to the world rate. The result is a full multiplier effect on income with
no crowding out, making fiscal policy highly effective under these conditions.

Question 20. Under a flexible exchange rate with perfect capital mobility, an
expansionary monetary policy tends to be highly effective mainly because:
A) It directly increases government spending
B) The resulting fall in the domestic interest rate causes the currency to depreciate,
which boosts net exports and shifts the IS curve rightward, reinforcing the increase
in output
C) It has no effect on the exchange rate
D) It causes an automatic increase in taxes
Answer: B
Explanation: An expansionary monetary policy shifts the LM curve to the right, lowering
the domestic interest rate below the world rate. With perfect capital mobility, this triggers
a capital outflow, causing the domestic currency to depreciate. The cheaper domestic
currency makes exports more competitive and imports more expensive, increasing net
exports — which shifts the IS curve to the right as well. This reinforcing effect on the IS
curve (in addition to the LM shift) is why monetary policy is particularly powerful under
flexible exchange rates with high capital mobility — the mirror image of fiscal policy’s
strength under fixed exchange rates (Question 19).