Name: __________________________ Date: _____________

1. The circular flow model shows that households use income for:
A) consumption, saving, and factor payments.
B) consumption, taxes, and factor payments.
C) taxes, saving, and factor payments.
D) consumption, taxes, and saving.

2. In the circular flow diagram, firms receive revenue from the _____ market, which is
used to purchase inputs in the _____ market.
A) goods; financial
B) factor; financial
C) goods; factor
D) factor; goods

3. In the circular flow model, households receive income from the _____ market and save
through the _____ market.
A) goods; financial
B) factor; financial
C) goods; factor
D) factor; goods

4. In the long run, the level of national income in an economy is determined by its:
A) factors of production and production function.
B) real and nominal interest rate.
C) government budget surplus or deficit.
D) rate of economic and accounting profit.

5. An economy's factors of production and its production function determine the

economy's:
A) labor-force participation rate.
B) budget surplus or deficit.
C) population growth rate.
D) output of goods and services.

Page 1
 6. The two most important factors of production are:
A) goods and services.
B) labor and energy.
C) capital and labor.
D) saving and investment.

7. Unlike the real world, the classical model with fixed output assumes that:
A) capital and labor are fully utilized.
B) all capital is fully utilized, but some labor is unemployed.
C) all labor is fully employed, but some capital lies idle.
D) some capital lies idle, and some labor is unemployed.

8. A production function is a mathematical relationship between:

A) factor prices and the marginal product of factors.
B) factors of production and factor prices.
C) factors of production and the quantity of output produced.
D) factor prices and the quantity of output produced.

9. The production function feature called “constant returns to scale” means that if we:
A) multiply capital by z1 and labor by z2, we multiply output by z3.
B) increase capital and labor by 10 percent each, we increase output by 10 percent.
C) increase capital and labor by 5 percent each, we increase output by 10 percent.
D) increase capital by 10 percent and increase labor by 5 percent, we increase output
by 7.5 percent.

10. If an increase of an equal percentage in all factors of production increases output of the
same percentage, then a production function has the property called:
A) constant marginal product of labor.
B) increasing marginal product of labor.
C) constant returns to scale.
D) increasing returns to scale.

11. If bread is produced using a constant returns to scale production function, then if the:
A) number of workers is doubled, twice as much bread will be produced.
B) amount of equipment is doubled, twice as much bread will be produced.
C) amounts of equipment and workers are both doubled, twice as much bread will be
produced.
D) amounts of equipment and workers are both doubled, four times as much bread will
be produced.

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12. The neoclassical theory of distribution:
A) was developed by Karl Marx.
B) is rejected by most economists today.
C) shows that the national income of an economy is not equal to total output.
D) is a theory of how national income is divided among the factors of production.

13. The price received by each factor of production is determined by:

A) demand for output and supply of factors.
B) demand for factors and supply of output.
C) demand and supply of output.
D) demand and supply of factors.

14. The assumption that the factor's supply is fixed will imply that the factor's
A) supply curve is horizontal.
B) supply curve is vertical.
C) supply curve slopes up to the right.
D) demand curve slopes up to the right.

15. A firm's economic profit is:

A) the price of output minus the wage minus the rental price of capital.
B) revenue minus costs.
C) revenue plus capital costs.
D) the price of output minus labor costs.

16. A competitive firm chooses the:

A) price at which to sell the product produced.
B) wage to pay labor.
C) quantity of labor and capital to employ.
D) rental price to pay capital.

17. The marginal product of labor is:

A) output divided by labor input.
B) additional output produced when one additional unit of labor is added.
C) additional output produced when one additional unit of labor and one additional
unit of capital are added.
D) value of additional output when one dollar's worth of additional labor is added.

Page 3
18. A competitive, profit-maximizing firm hires labor until the:
A) marginal product of labor equals the wage.
B) price of output multiplied by the marginal product of labor equals the wage.
C) real wage equals the real rental price of capital.
D) wage equals the rental price of capital.

19. The real wage is the return to labor measured in:

A) dollars.
B) units of output.
C) units of labor.
D) units of capital.

20. The marginal product of capital is:

A) output divided by capital input.
B) additional output produced when one additional unit of capital is added.
C) additional output produced when one additional unit of capital and one additional
unit of labor are added.
D) the value of additional output when one dollar's worth of additional capital is
added.

21. The real rental price of capital is the price per unit of capital measured in:
A) dollars.
B) units of output.
C) units of labor.
D) units of capital.

22. The real wage will increase if:

A) the supply of labor increases.
B) the productivity of labor increases.
C) the price of output increases.
D) the supply of capital decreases.

23. An increase in the supply of capital will:

A) increase the real rental price of capital.
B) decrease the real rental price of capital.
C) increase the productivity of capital.
D) increase the marginal product of capital.

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24. In the classical model, what adjusts to eliminate any unemployment of labor in the
economy?
A) the average price level
B) the interest rate
C) the real rental price of capital
D) the real wage

25. The neoclassical theory of distribution explains the allocation of:

A) output between goods and services.
B) output among consumption, investment, and government spending.
C) income among factors of production.
D) income between saving and investment.

26. Assuming that all firms maximize profits, economic profit is zero if:
A) all factors are paid their marginal products and the law of diminishing returns is
valid.
B) all factors are paid their marginal products, and there are constant returns to scale.
C) no firms are competitive.
D) all factors are paid their marginal products.

27. According to Euler's theorem, if competitive firms pay each factor its marginal product
and the production function has constant returns to scale, the sum of all factor payments
will equal:
A) total investment.
B) total saving.
C) total profits.
D) total output.

28. Accounting profit is:

A) economic profit minus the return to capital.
B) equal to economic profit.
C) economic profit plus the return to capital.
D) equal to the economic return to capital.

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29. According to the neoclassical theory of distribution, if firms are competitive and subject
to constant returns to scale, total income in the economy is distributed:
A) only to the labor used in production.
B) partly between labor and capital used in production, with the surplus going to the
owners of the firm as profits.
C) equally between the labor and capital used in production.
D) between the labor and capital used in production, according to their marginal
productivities.

30. According to the neoclassical theory of distribution, total output is divided between
payments to capital and payments to labor depending on their:
A) supply.
B) equilibrium growth rates.
C) relative political power.
D) marginal productivities.

31. What determines the ratio of the wage to rental rate of capital in a competitive,
profit-maximizing economy with constant returns to scale?
A) the quantity of economic profits earned by firm owners
B) the interest rate
C) the ratio of public saving to private saving
D) the marginal productivity of labor relative to the marginal productivity of capital

32. With a Cobb–Douglas production function, the share of output going to labor:
A) decreases as the amount of labor increases.
B) increases as the amount of labor increases.
C) increases as the amount of capital increases.
D) does not depend on the amount of labor in the economy.

33. If output is described by the production function Y = AK0.2L0.8, then the production
function has:
A) constant returns to scale.
B) diminishing returns to scale.
C) increasing returns to scale.
D) a degree of returns to scale that cannot be determined from the information given.

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34. If Y = AK0.5L0.5 and A, K, and L are all 100, the marginal product of capital is:
A) 50.
B) 100.
C) 200.
D) 1000.

35. Since 1960, the U.S. ratio of labor income to total income has:
A) been about 2.5 to 1.
B) remained relatively steady.
C) increased steadily.
D) decreased steadily.

36. If the production function describing an economy is Y = 100 K.25L.75, then the share of
output going to labor:
A) is 25 percent.
B) is 75 percent.
C) depends on the quantities of labor and capital.
D) depends on the state of technology.

37. In a Cobb–Douglas production function, the marginal product of labor will increase if:
A) the quantity of labor increases.
B) the quantity of capital increases.
C) capital's share of output increases.
D) average labor productivity decreases.

38. In a Cobb–Douglas production function, the marginal product of capital will increase if:
A) the quantity of labor increases.
B) the quantity of capital increases.
C) labor's share of output increases.
D) average capital productivity decreases.

Page 7
39. According to Goldin and Katz, the increasing income inequality of recent decades is the
result of:
A) increases in the rates of skill-biased technological advancement and educational
attainment.
B) decreases in the rates of skill-biased technological advancement and educational
attainment.
C) an increase in the rate of skill-biased technological advancement and a slowdown
in educational advancement.
D) a decrease in the rate of skill-biased technological advancement and an increase in
the rate of educational advancement.

40. Skill-biased technological change ______ the demand for high-skilled workers, while a
slowdown in the pace of educational advancement reduces the supply of skilled
workers. If we observed both of these phenomena, we would expect _____ wages for
skilled workers.
A) increases; higher
B) increases; lower
C) decreases; higher
D) decreases; lower

41. For much of the twentieth century, skill-biased technological change ______ the
demand for high-skilled workers, while the increase in the pace of educational
advancement increased the supply of skilled workers. Because educational advancement
_______ skill-biased technological change, we should expect _____ wages for skilled
workers.
A) increased; outpaced; higher
B) increased; outpaced; lower
C) decreased; slowed down; higher
D) decreased; slowed down; lower

42. Estimates by Goldin and Katz indicate that the financial returns of a year of college
_____ between 1980 and 2005.
A) increased
B) decreased
C) did not change
D) were negative

Page 8
43. According to the neoclassical theory of distribution, in an economy described by a
Cobb–Douglas production function, workers should experience high rates of real wage
growth when:
A) real interest rates are high.
B) real interest rates are low.
C) labor productivity is growing rapidly.
D) capital's share of income is growing rapidly.

44. Assume that an economy is described by a Cobb–Douglas production function. If

average labor productivity is growing rapidly:
A) labor's share of total income will be increasing.
B) labor's share of total income will be decreasing.
C) workers will experience high rates of real wage growth.
D) economic profits will be positive.

45. In a closed economy, the components of GDP are:

A) consumption, investment, government purchases, and exports.
B) consumption, investment, government purchases, and net exports.
C) consumption, investment, and government purchases.
D) consumption and investment.

46. The demand for output in a closed economy is the sum of:
A) public saving and private saving.
B) the quantity of capital and labor and production technology.
C) consumption, investment, and government purchases.
D) government purchases and transfer payments minus tax receipts.

47. Disposable personal income is defined as income after the payment of all:
A) taxes.
B) interest.
C) loans.
D) social insurance contributions.

48. A consumption function shows the relationship between consumption and:

A) income.
B) personal income.
C) disposable income.
D) taxes.

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49. Consumption depends ______ on disposable income, and investment depends ______
on the real interest rate.
A) positively; positively
B) positively; negatively
C) negatively; negatively
D) negatively; positively

50. The marginal propensity to consume is:

A) expected to be between zero and one.
B) equal to disposable income divided by consumption.
C) the amount by which consumption changes when wealth increases by one dollar.
D) normally assumed to increase as taxes increase.

51. If the consumption function is given by C = 500 + 0.5(Y – T), and Y is 6,000 and T is
given by T = 200 + 0.2Y, then C equals:
A) 2,500.
B) 2,800.
C) 3,500.
D) 4,200.

52. If the consumption function is given by the equation C = 500 + 0.5Y, the production
function is Y = 50K0.5L0.5, where K = 100 and L = 100, then C equals:
A) 1,000.
B) 2,500.
C) 3,000.
D) 5,000.

53. If the consumption function is given by C = 150 + 0.85Y and Y increases by 1 unit, then
C increases by:
A) 0.15 units.
B) 0.5 units.
C) 0.85 units.
D) 1 unit.

54. If the consumption function is given by C = 150 + 0.85Y and Y increases by 1 unit, then
saving:
A) decreases by 0.85 units.
B) decreases by 0.15 units.
C) increases by 0.15 units.
D) increases by 0.85 units.

Page 10
55. If the consumption function is given by C = 150 + 0.85(Y – T) and T increases by 1 unit,
then saving
A) decreases by 0.85 units.
B) decreases by 0.15 units.
C) increases by 0.15 units.
D) increases by 0.85 units.

56. Assume that the consumption function is given by C = 150 + 0.85(Y – T) and the tax
function is given by T = t0 + t1Y. If t0 increases by 1 unit, then consumption:
A) decreases by 0.85 units.
B) decreases by 0.15 units.
C) increases by 0.15 units.
D) increases by 0.85 units.

57. Assume that the consumption function is given by C = 150 + 0.85(Y – T), the tax
function is given by T = t0 + t1Y, and Y is 5,000. If t1 decreases from 0.3 to 0.2, then
consumption increases by:
A) 85.
B) 425.
C) 500.
D) 525.

58. Assume that the consumption function is given by C = 200 + 0.7(Y – T), the tax function
is given by T = 100 + t1Y, and Y = 50K0.5L0.5, where K = 100 and L = 100. If t1 increases
from 0.2 to 0.25, then consumption decreases by:
A) 70.
B) 140.
C) 175.
D) 250.

59. Assume that the consumption function is given by C = 200 + 0.7(Y – T), the tax function
is given by T = 100 + 0.2Y, and Y = 50K0.5L0.5, where K = 100. If L increases from 100
to 144, then consumption increases by:
A) 560.
B) 840.
C) 1,120.
D) 2,120.

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60. Private investment goods as measured in GDP are purchased by:
A) business firms alone.
B) households alone.
C) business firms and households.
D) business firms, households, and governments.

61. Total investment in the United States averages about ______ percent of GDP.
A) 10
B) 15
C) 20
D) 25

62. Other things equal, an increase in the interest rate leads to:
A) a decrease in the quantity of investment goods demanded.
B) no change in the quantity of investment goods demanded.
C) an increase in the quantity of investment goods demanded.
D) sometimes an increase and sometimes a decrease in the quantity of investment
goods demanded.

63. When economists speak of “the” interest rate, they mean:

A) the rate on 90-day Treasury bills.
B) the Fed Funds rate.
C) the “prime” rate on mortgage loans.
D) no particular interest rate; it's usually an innocuous assumption since real interest
rates tend to move up and down together.

64. Assume that a firm wants to build a factory that will cost $5 million. It believes that it
can get a return of $600,000 in one year and then can sell the used factory for its
original cost. The rate of return on this investment would be:
A) 6 percent.
B) 12 percent.
C) 18 percent.
D) 30 percent.

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65. Assume that a firm is considering building a factory that will cost $5 million. It believes
that it can get a profit from this factory of $600,000 per year for many years. The
interest rate at which the firm can borrow money is 15 percent. After evaluating whether
it should build the factory, the firm decides that it should:
A) not build because the rate of return on the factory is only 6 percent.
B) not build because the rate of return on the factory is only 12 percent.
C) build because the rate of return on the factory is 30 percent.
D) build because the rate of return on the factory is 35 percent.

66. The nominal interest rate is the:

A) rate of interest that investors pay to borrow money.
B) same as the real interest rate.
C) rate of inflation minus the real rate of interest.
D) real rate of interest minus the rate of inflation.

67. The real interest rate is the:

A) rate of interest actually paid by consumers.
B) rate of interest actually paid by banks.
C) rate of inflation minus the nominal interest rate.
D) nominal interest rate minus the rate of inflation.

68. Assume that the investment function is given by I = 1,000 – 30r, where r is the real rate
of interest (in percent). Assume further that the nominal rate of interest is 10 percent and
the inflation rate is 2 percent. According to the investment function, investment will be:
A) 240.
B) 700.
C) 760.
D) 970.

69. The investment function slopes ______ because there are ______ investment projects
that are profitable as the interest rate decreases.
A) upward; fewer
B) upward; more
C) downward; fewer
D) downward; more

Page 13
70. The government purchases component of GDP includes all of the following except:
A) federal spending on goods.
B) state and local spending on goods.
C) federal spending on transfer payments.
D) federal spending on services.

71. If government purchases exceed taxes minus transfer payments, then the government
budget is:
A) balanced.
B) in deficit.
C) in surplus.
D) endogenous.

72. All of the following actions increase government purchases of goods and services except
the:
A) federal government's sending a Social Security check to Betty Jones.
B) federal government's sending a paycheck to the president of the United States.
C) federal government's buying a Patriot missile.
D) city of Boston's buying a library book.

73. Government transfer payments:

A) are included as part of government purchases, G.
B) can be viewed as negative tax payments, T.
C) are received as payment for inputs in the factor market.
D) do not affect the level of public or private saving.

74. In examining the impact of fiscal policy, it is assumed that:

A) consumption, investment, and the interest rate are endogenous variables.
B) consumption, investment, and the interest rate are exogenous variables.
C) government purchases, taxes, and interest rates are endogenous variables.
D) government purchases, taxes, and interest rates are exogenous variables.

75. In a classical model with fixed factors of production and flexible prices, the amount of
consumption spending depends on _____ , the amount of investment spending depends
on _____, and the amount of government spending is determined _____.
A) the interest rate; disposable income; by tax revenue
B) the real wage; the real rental price of capital; by factor prices
C) labor's share of output; capital's share of output; by the interest rate
D) disposable income; the interest rate; exogenously

Page 14
76. In the classical model with fixed output, the supply and demand for goods and services
are balanced by:
A) government spending.
B) taxes.
C) fiscal policy.
D) the interest rate.

77. The demand for the economy's output:

A) is always equal to the supply, regardless of the interest rate.
B) may be computed provided that we know disposable income.
C) is equal to consumption, investment, and government purchases.
D) is determined by government purchases and taxes.

78. In the classical model with fixed income, if the demand for goods and services is less
than the supply, the interest rate will:
A) increase.
B) decrease.
C) remain unchanged.
D) either increase or decrease, depending on whether consumption is greater or less
than investment.

79. In the classical model with fixed income, if the demand for goods and services is greater
than the supply, the interest rate will:
A) increase.
B) decrease.
C) remain unchanged.
D) either increase or decrease, depending on whether consumption is greater or less
than investment.

80. In the classical model with fixed income, if the interest rate is too low, then investment
is too ______, and the demand for output ______ the supply.
A) high; exceeds
B) high; falls short of
C) low; exceeds
D) low; falls short of

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81. In the classical model with fixed income, if the interest rate is too high, then investment
is too ______, and the demand for output ______ the supply.
A) high; exceeds
B) high; falls short of
C) low; exceeds
D) low; falls short of

82. National saving refers to:

A) disposable income minus consumption.
B) taxes minus government spending.
C) income minus consumption minus government purchases.
D) income minus investment.

83. Public saving:

A) is always positive.
B) is the overall level of household wealth held in government bonds.
C) is decided by the Federal Reserve.
D) depends on the government's tax collections relative to its expenditures.

84. In a closed economy, Y – C – G equals:

A) national saving.
B) private saving.
C) public saving.
D) financial saving.

85. In a closed economy, private saving equals:

A) Y – C – G.
B) Y – T – C.
C) Y – I – C.
D) Y – T.

86. The factor that makes national saving equal investment, in equilibrium, is:
A) the interest rate.
B) private saving.
C) public saving.
D) fiscal policy.

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87. Private saving is:
A) income minus consumption minus government spending.
B) disposable income minus consumption.
C) disposable income minus government spending.
D) taxes minus government spending.

88. Public saving is:

A) income minus consumption minus government spending.
B) disposable income minus consumption.
C) disposable income minus government spending.
D) government revenue minus government spending.

89. National saving is:

A) private saving.
B) public saving.
C) private saving plus public saving.
D) private saving minus public saving.

90. If disposable income is 4,000, consumption is 3,500, government purchases is 1,000,

and taxes minus transfers are 800, national saving is equal to:
A) 300.
B) 500.
C) 700.
D) 1,000.

91. If income is 4,800, consumption is 3,500, government spending is 1,000, and taxes
minus transfers are 800, private saving is:
A) 300.
B) 500.
C) 1,000.
D) 1,300.

92. If income is 4,800, consumption is 3,500, government purchases is 1,000, and taxes
minus transfers are 800, public saving is:
A) –200.
B) 200.
C) 500.
D) 1,800.

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93. In equilibrium, total investment equals:
A) private saving.
B) public saving.
C) national saving.
D) household saving.

94. The demand for loanable funds is equivalent to:

A) national saving.
B) private saving.
C) public saving.
D) investment.

95. The supply of loanable funds is equivalent to:

A) national saving.
B) private saving.
C) public saving.
D) investment.

96. The supply and demand for loanable funds determine the:
A) real wage.
B) real rental price of capital.
C) real interest rate.
D) nominal interest rate.

97. If saving exceeds investment demand and consumption is not a function of the interest
rate:
A) the demand for loans exceeds the supply of loans.
B) the interest rate will fall.
C) the interest rate will rise.
D) saving will fall.

98. In the classical model with fixed income, if households want to save more than firms
want to invest, then:
A) the interest rate rises.
B) the interest rate falls.
C) output increases.
D) output falls.

Page 18
 99. When the demand for loanable funds exceeds the supply of loanable funds, households
want to save ______ than firms want to invest, and the interest rate ______.
A) more; rises
B) more; falls
C) less; rises
D) less; falls

100. Assume that equilibrium GDP (Y) is 5,000. Consumption (C) is given by the equation C
= 500 + 0.6Y. In addition, assume G=0. In this case, equilibrium investment is:
A) 1,500.
B) 2,000.
C) 2,500.
D) 3,000.

101. Assume that equilibrium GDP (Y) is 5,000. Consumption (C) is given by the equation C
= 500 + 0.6(Y – T). Taxes (T) are equal to 1,000. Government spending is 600. In this
case, equilibrium investment is:
A) 600.
B) 1,100.
C) 1,500.
D) 2,200.

102. Assume that equilibrium GDP (Y) is 5,000. Consumption (C) is given by the equation C
= 500 + 0.6Y. Investment (I) is given by the equation I = 2,000 – 100r, where r is the
real interest rate, in percent. In addition, assume that G=0. In this case, the equilibrium
real interest rate is:
A) 2 percent.
B) 5 percent.
C) 10 percent.
D) 20 percent.

103. Assume that equilibrium GDP (Y) is 5,000. Consumption (C) is given by the equation C
= 500 + 0.6(Y – T). Taxes (T) are equal to 600. Government spending is equal to 1,000.
Investment is given by the equation I = 2,160 – 100r, where r is the real interest rate, in
percent. In this case, the equilibrium real interest rate is:
A) 5 percent.
B) 8 percent.
C) 10 percent.
D) 13 percent.

Page 19
104. According to the model developed in Chapter 3, when government spending increases
without a change in taxes:
A) consumption increases.
B) consumption decreases.
C) investment increases.
D) investment decreases.

105. According to the model developed in Chapter 3, when taxes decrease without a change
in government spending:
A) consumption and investment both increase.
B) consumption and investment both decrease.
C) consumption increases and investment decreases.
D) consumption decreases and investment increases.

106. According to the model developed in Chapter 3, when government spending increases
and taxes increase by an equal amount:
A) consumption and investment both increase.
B) consumption and investment both decrease.
C) consumption increases and investment decreases.
D) consumption decreases and investment increases.

107. According to the model developed in Chapter 3, when government spending increases
but taxes stay the same, interest rates:
A) increase.
B) are unchanged.
C) decrease.
D) can vary.

108. According to the model developed in Chapter 3, when taxes are increased but
government spending is unchanged, interest rates:
A) increase.
B) are unchanged.
C) decrease.
D) can vary wildly.

109. In a closed economy with fixed output, when government spending increases:
A) private saving decreases.
B) private saving increases.
C) public saving decreases.
D) public saving increases.

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110. In the neoclassical model with fixed income, if there is a decrease in government
spending with no change in taxes, then public saving ______ and private saving ______.
A) increases; increases
B) increases; does not change
C) decreases; increases
D) decreases; does not change

111. Crowding out occurs when an increase in government spending ______ the interest rate
and investment ______.
A) increases; increases
B) increases; decreases
C) decreases; increases
D) decreases; decreases

112. The reduction in investment brought about by the increase in the interest rate caused by
increased government spending is called:
A) a budget deficit.
B) fiscal policy.
C) the identification problem.
D) crowding out.

113. In the classical model with fixed income, an increase in the real interest rate could be
the result of:
A) an increase in government spending.
B) a decrease in government spending.
C) a decrease in desired investment.
D) an increase in taxes.

114. In the classical model with fixed income a decrease in the real interest rate could be the
result of:
A) an increase in government spending.
B) an increase in desired investment.
C) an increase in taxes.
D) a decrease in taxes.

Page 21
115. In the classical model with fixed income, a reduction in the government budget deficit
will lead to a:
A) higher real interest rate.
B) lower real interest rate.
C) higher level of output.
D) lower level of output.

116. When government spending increases and taxes are increased by an equal amount,
interest rates:
A) increase.
B) remain the same.
C) decrease.
D) can vary wildly.

117. In the neoclassical model with fixed income, if there is a decrease in taxes with no
change in government spending, then public saving ______ and private saving ______.
A) increases; increases
B) increases; decreases
C) decreases; increases
D) decreases; does not change

Page 22
118. Exhibit: Saving, Investment, and the Interest Rate 1

The economy begins in equilibrium at point E, representing the real interest rate r1 at
which saving S1 equals desired investment I1. What will be the new equilibrium
combination of real interest rate, saving, and investment if the government cuts
spending, holding other factors constant?
A) point A
B) point B
C) point C
D) point D

Page 23
119. Exhibit: Saving, Investment, and the Interest Rate 1

The economy begins in equilibrium at point E, representing the real interest rate r1 at
which saving S1 equals desired investment I1. What will be the new equilibrium
combination of real interest rate, saving, and investment if the government cuts taxes,
holding other factors constant?
A) point A
B) point B
C) point C
D) point D

Page 24
120. Exhibit: Saving, Investment, and the Interest Rate 1

The economy begins in equilibrium at point E, representing the real interest rate r1 at
which saving S1 equals desired investment I1. What will be the new equilibrium
combination of real interest rate, saving, and investment if the government increases
spending, holding other factors constant?
A) point A
B) point B
C) point C
D) point D

Page 25
121. Exhibit: Saving, Investment, and the Interest Rate 1

The economy begins in equilibrium at point E, representing the real interest rate r1 at
which saving S1 equals desired investment I1. What will be the new equilibrium
combination of real interest rate, saving, and investment if the government raises taxes,
holding other factors constant?
A) point A
B) point B
C) point C
D) point D

122. Use the model developed in Chapter 3 and assume that consumption does not depend on
the interest rate. Holding other things constant, when the government lowers taxes on
business investment, thus increasing investment demand, the quantity of investment:
A) increases and the interest rate rises.
B) is unchanged and the interest rate rises.
C) and the interest rate are both unchanged.
D) decreases and the interest rate rises.

123. When there is a fixed supply of loanable funds, an increase in investment demand
results in:
A) a higher interest rate.
B) a lower interest rate.
C) an increase in investment.
D) a decrease in investment.

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124. When saving (the supply of loanable funds) increases as the interest rate increases, an
increase in investment demand results in a ______ interest rate and ______ in the
quantity of investment.
A) higher; no change
B) higher; an increase
C) lower; no change
D) lower; an increase

125. Suppose that GDP (Y) is 5,000. Consumption (C) is given by the equation C = 500 +
0.5(Y – T). Investment (I) is given by the equation I = 2,000 – 100r, where r is the real
interest rate, in percent. Government spending (G) is 1,000, and taxes (T) is also 1,000.
When a technological innovation changes the investment function to I = 3,000 – 100r:
A) I rises by 1,000 and r rises by 10 percentage points.
B) I rises by 1,000 and r is unchanged.
C) I is unchanged and r rises by 10 percentage points.
D) I is unchanged and r rises by 15 percentage points.

126. Exhibit: Saving, Investment, and the Interest Rate 2

The economy begins in equilibrium at point E, representing the real interest rate r1 at
which saving S1 equals desired investment I1. What will be the new equilibrium
combination of real interest rate, saving, and investment if there is a technological
innovation that increases the demand for investment goods?
A) point A
B) point B
C) point C
D) point D

Page 27
127. Exhibit: Saving, Investment, and the Interest Rate 2

The economy begins in equilibrium at point E, representing the real interest rate r1 at
which saving S1 equals desired investment I1. What will be the new equilibrium
combination of real interest rate, saving, and investment if there is a tax law change that
makes investment projects less profitable and decreases the demand for investment
goods (but does not change the amount of taxes collected in the economy)?
A) point A
B) point B
C) point C
D) point D

128. If increased immigration raises the labor force, the neoclassical theory of distribution
predicts that:
A) the real wage will rise, and the real rental price of capital will fall.
B) both the real wage and the real rental price of capital will fall.
C) both the real wage and the real rental price of capital will rise.
D) the real wage will fall, and the real rental price of capital will rise.

129. If an earthquake destroys some of the capital stock, the neoclassical theory of
distribution predicts that:
A) the real wage will rise, and the real rental price of capital will fall.
B) both the real wage and the real rental price of capital will fall.
C) both the real wage and the real rental price of capital will rise.
D) the real wage will fall, and the real rental price of capital will rise.

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130. If a technological advancement increases productivity, the neoclassical theory of
distribution predicts that:
A) the real wage will rise, and the real rental price of capital will fall.
B) both the real wage and the real rental price of capital will fall.
C) both the real wage and the real rental price of capital will rise.
D) the real wage will fall, and the real rental price of capital will rise.

131. An example of decreasing returns to scale is when capital and labor inputs:
A) both increase 10 percent and output increases 5 percent.
B) both increase 10 percent and output increases 10 percent.
C) both increase 5 percent and output increases 10 percent.
D) do not change and output increases 5 percent.

132. An example of increasing returns to scale is when capital and labor inputs:
A) both increase 10 percent and output increases 5 percent.
B) both increase 10 percent and output increases 10 percent.
C) both increase 5 percent and output increases 10 percent.
D) do not change and output decreases 5 percent.

133. If the productivity of farmers has risen substantially over time because of technological
progress, and workers can move freely between being farmers and barbers, the
neoclassical theory of distribution predicts that the real wages of:
A) both barbers and farmers should have remained constant over time.
B) both barbers and farmers should have risen over time.
C) farmers should have risen while the real wage of barbers should have remained
constant.
D) barbers should have risen while the real wage of farmers should have remained
constant.

134. The government raises lump-sum taxes on income by $100 billion, and the neoclassical
economy adjusts so that output does not change. If the marginal propensity to consume
is 0.6, private saving:
A) rises by $40 billion.
B) rises by $60 billion.
C) falls by $60 billion.
D) falls by $40 billion.

Page 29
135. The government raises lump-sum taxes on income by $100 billion, and the neoclassical
economy adjusts so that output does not change. If the marginal propensity to consume
is 0.6, public saving:
A) rises by $100 billion.
B) rises by $60 billion.
C) falls by $60 billion.
D) falls by $100 billion.

136. The government raises lump-sum taxes on income by $100 billion, and the neoclassical
economy adjusts so that output does not change. If the marginal propensity to consume
is 0.6, national saving:
A) rises by $100 billion.
B) rises by $60 billion.
C) falls by $60 billion.
D) falls by $100 billion.

137. The government raises lump-sum taxes on income by $100 billion, and the neoclassical
economy adjusts so that output does not change. If the marginal propensity to consume
is 0.6, investment:
A) rises by $100 billion.
B) rises by $60 billion.
C) falls by $60 billion.
D) falls by $100 billion.

138. Assume that an increase in consumer confidence raises consumers' expectations of

future income and thus the amount they want to consume today for any given level of
disposable income. This shift, in a neoclassical economy, will:
A) lower investment and raise the interest rate.
B) raise investment and lower the interest rate.
C) lower both investment and the interest rate.
D) raise both investment and the interest rate.

139. In a neoclassical economy, assume that the government lowers both government
spending and taxes by the same amount. This causes:
A) investment to fall and the interest rate to rise.
B) investment to rise and the interest rate to fall.
C) investment and the interest rate to both fall.
D) investment and the interest rate to both rise.

Page 30
140. In a neoclassical economy, assume that the government lowers both government
spending and taxes by $100 billion. If the marginal propensity to consume is 0.6,
investment will:
A) rise by $100 billion.
B) rise by $60 billion.
C) rise by $40 billion.
D) not change.

141. In a neoclassical economy, if consumption increases as the interest rate decreases, then a
$10 billion rise in government spending would:
A) still crowd out exactly $10 billion of investment.
B) crowd out between zero and $10 billion of investment.
C) not crowd out any investment.
D) crowd out more than $10 billion of investment.

142. Assume that the production function is Cobb–Douglas with parameter a = 0.3. If capital
and labor are paid their marginal products, they receive the shares of income:
A) 0.3 and 0.3.
B) 0.7 and 0.7.
C) 0.3 and 0.7.
D) 0.7 and 0.3.

143. Assume that the production function is Cobb–Douglas with parameter a = 0.3. In the
neoclassical model, if the labor force increases by 10 percent, then output:
A) increases by about 10 percent.
B) increases by about 7 percent.
C) increases by about 3 percent.
D) does not increase since the new workers are unemployed.

144. In an economy with flexible prices, competitive factor markets, and fixed supplies of the
factors of production, graphically illustrate the impact of a change in immigration policy
in a country that permits a huge influx of foreign workers into the labor market, ceteris
paribus. Be sure to label the axes, the curves, the initial equilibrium values, the direction
the curve's shift, and the terminal equilibrium values. Explain in words how the
equilibrium values of labor, the real wage, saving, investment, and the real interest rate
change.

Page 31
145. Assume that the production function is given by Y = AK0.5L0.5, where Y is GDP, K is
capital stock, and L is labor. The parameter A is equal to 10. Assume also that capital is
100, labor is 400, and both capital and labor are paid for their marginal products.
a. What is Y?
b. What is the real wage of labor?
c. What is the real rental price of capital (the amount of output paid per unit of capital)?

146. Assume that GDP (Y) is 6,000. Consumption (C) is given by the equation C = 600 +
0.6(Y – T). Investment (I) is given by the equation I = 2,000 – 100r, where r is the real
rate of interest, in percent. Taxes (T) are 500, and government spending (G) is also 500.
a. What are the equilibrium values of C, I, and r?
b. What are the values of private saving, public saving, and national saving?
c. If government spending rises to 1,000, what are the new equilibrium values of C, I, and r?
d. What are the new equilibrium values of private saving, public saving, and national saving?

147. Assume that GDP (Y) is 5,000. Consumption (C) is given by the equation C = 1,000 +
0.3(Y – T). Investment (I) is given by the equation I = 1,500 – 50r, where r is the real
interest rate, in percent. Taxes (T) are 1,000, and government spending (G) is 1,500.
a. What are the equilibrium values of C, I, and r?
b. What are the values of private saving, public saving, and national saving?
c. Now assume there is a technological innovation that makes business want to invest more. It
raises the investment equation to I = 2,000 – 50r. What are the new equilibrium values of C,
I, and r?
d. What are the new values of private saving, public saving, and national saving?

148. Assume that GDP (Y) is 5,000. Consumption (C) is given by the equation C = 1,200 +
0.3(Y – T) – 50r, where r is the real interest rate, in percent. Investment (I) is given by
the equation I = 1,500 – 50r. Taxes (T) are 1,000, and government spending (G) is
1,500.
a. What are the equilibrium values of C, I, and r?
b. What are the values of private saving, public saving, and national saving?
c. Now assume there is a technological innovation that makes business want to invest more. It
raises the investment equation to I = 2,000 – 50r. What are the new equilibrium values of C,
I, and r?
d. What are the new values of private saving, public saving, and national saving?

Page 32
149. a. Suppose a government moves to reduce a budget deficit. Using the long-run model of the
economy developed in Chapter 3, graphically illustrate the impact of reducing a
government's budget deficit by reducing government purchases. Be sure to label the axes, the
curves, the initial equilibrium values, the direction curves shift, and the terminal equilibrium
values.
b. State in words what happens to (i) the real interest rate; (ii) national saving; (iii) investment;
(iv) consumption; and (v) output.

150. a. Suppose a government moves to reduce a budget deficit. Using the long-run model of the
economy developed in Chapter 3, graphically illustrate the impact of reducing a
government's budget deficit by increasing (lump-sum) taxes on household income. Be sure
to label the axes, the curves, the initial equilibrium values, the direction curves shift, and the
terminal equilibrium values.
b. State in words what happens to (i) the real interest rate; (ii) national saving; (iii) investment;
(iv) consumption; and (v) output.

151. a. Suppose a government education program succeeds in getting households to save more (you
may interpret this as a downward shift in the consumption function). Using the long-run
model of the economy developed in Chapter 3, graphically illustrate the impact of the higher
saving rate by households. Be sure to label the axes, the curves, the initial equilibrium
values, the direction curves shift, and the terminal equilibrium values.
b. State in words what happens to (i) the real interest rate; (ii) national saving; (iii) investment;
(iv) consumption; and (v) output.

152. a. Suppose there is a technological breakthrough that increases the productivity of all capital
and, consequently, increases the demand for investment. Assuming factors of production are
fixed, use the long-run model of the economy developed in Chapter 3 to graphically
illustrate the impact of the increased investment demand. Be sure to label the axes, the
curves, the initial equilibrium values, the direction curves shift, and the terminal equilibrium
values.
b. State in words what happens to (i) the real interest rate; (ii) national saving; (iii) investment;
(iv) consumption; and (v) output.

153. a. Suppose a government decides to reduce spending and (lump-sum) income taxes by the
same amount. Using the long-run model of the economy developed in Chapter 3, graphically
illustrate the impact of the equal reductions in spending and taxes. Be sure to label the axes,
the curves, the initial equilibrium values, the direction curves shift, and the terminal
equilibrium values.
b. State in words what happens to (i) the real interest rate; (ii) national saving; (iii) investment;
(iv) consumption; and (v) output.

Page 33
154. Consider two competitive economies that have the same quantities of labor (L = 400)
and capital (K = 400), as well as the same technology (A = 100). The economies of the
countries are described by the following Cobb–Douglas production functions:
North Economy: Y = A L.3K.7
South Economy: Y = A L.7K.3
a. Which economy has the larger total production? Explain.
b. In which economy is the marginal product of labor larger? Explain.
c. In which economy is the real wage larger? Explain.
d. In which economy is labor's share of income larger? Explain.

155. Assume that a competitive economy can be described by a constant returns to scale
(Cobb–Douglas) production function and all factors of production are fully employed.
Holding other factors constant, including the quantity of capital and technology,
carefully explain how a one-time, 10-percent increase in the quantity of labor (perhaps
as a result of a special immigration policy) will change each of the following:
a. the level of output produced
b. the real wage of labor
c. the real rental price of capital
d. labor's share of total income

156. Assume that a competitive economy can be described by a constant returns to scale
(Cobb–Douglas) production function, and all factors of production are fully employed.
Holding other factors constant, including the quantity of labor and technology, carefully
explain how a one-time, 50-percent decrease in the quantity of capital (perhaps the
result of war damage) will change each of the following:
a. the level of output produced
b. the real wage of labor
c. the real rental price of capital
d. capital's share of total income

157. Consider a competitive economy in which factor prices adjust to keep the factors of
production fully employed. In addition, the interest rate adjusts to keep the supply and
demand for goods and services in equilibrium. The economy can be described by the
following set of equations:

Y = AKa L(1 – a)
Y=C+I+G
C = C (Y – T)
I = I(r)
Suggest at least two policies that a government could use to increase the equilibrium
quantity of investment in the economy and carefully explain how these policies produce
this result.

Page 34
158. Consider a competitive economy in which factor prices adjust to keep the factors of
production fully employed and the interest rate adjusts to keep the supply and demand
for goods and services in equilibrium. The economy can be described by the following
set of equations:

Y = AKaL(1 – a)
Y=C+I+G
C = C(Y – T)
I = I(r)
How does an increase in government spending, holding other factors constant, affect the
level of:
a. public saving?
b. private saving?
c. national saving?
d. the equilibrium interest rate?
e. the equilibrium quantity of investment?

159. Price flexibility plays a key role in the classical model by ensuring that the markets
reach equilibrium.
a. Explain which price adjusts to bring equilibrium in the labor market. Describe how the price
adjusts when demand exceeds supply in this market.
b. Explain which price adjusts to bring equilibrium in the loanable funds market. Describe how
the price adjusts when supply exceeds demand in this market.

160. Consider a production function for an economy:

Y = 20(L.5K.4N.1)
where L is labor, K is capital, and N is land. In this economy, the factors of production
are in fixed supply with L = 100, K = 100, and N = 100.
a. What is the level of output in this country?
b. Does this production function exhibit constant returns to scale? Demonstrate by example.
c. If the economy is competitive so that factors of production are paid the value of their
marginal products, what is the share of total income will go to land?

161. The production of an economy is explained by a function Y = 20 (L.5K.5), where L is

labor and K is capital with L = 400 and K = 400. Does this economy support constant
returns to scale?

162. After studying the circular flow of dollars in the economy, explain with an example how
saving done by households goes back into the circular flow. In reality, is all household
saving used as investment?

Page 35
163. What effect does advancement in technology have on the equilibrium real rental price
and capital, assuming that the supply of capital is fixed?

164. The government of an economy has increased its spending and its taxes by the same
amount. What is the effect on investment?

Page 36
Answer Key

1. D
2. C
3. B
4. A
5. D
6. C
7. A
8. C
9. B
10. C
11. C
12. D
13. D
14. B
15. B
16. C
17. B
18. B
19. B
20. B
21. B
22. B
23. B
24. D
25. C
26. B
27. D
28. C
29. D
30. D
31. D
32. D
33. A
34. A
35. B
36. B
37. B
38. A
39. C
40. A
41. B
42. A
43. C
44. C

Page 37
45. C
46. C
47. A
48. C
49. B
50. A
51. B
52. C
53. C
54. C
55. B
56. A
57. B
58. C
59. A
60. C
61. B
62. A
63. D
64. B
65. B
66. A
67. D
68. C
69. D
70. C
71. B
72. A
73. B
74. A
75. D
76. D
77. C
78. B
79. A
80. A
81. D
82. C
83. D
84. A
85. B
86. A
87. B
88. D
89. C
90. A

Page 38
 91. B
92. A
93. C
94. D
95. A
96. C
97. B
98. B
99. C
100. A
101. C
102. B
103. D
104. D
105. C
106. B
107. A
108. C
109. C
110. B
111. B
112. D
113. A
114. C
115. B
116. A
117. C
118. B
119. A
120. A
121. B
122. D
123. A
124. B
125. C
126. B
127. A
128. D
129. D
130. C
131. A
132. C
133. B
134. D
135. A
136. B

Page 39
137. B
138. A
139. B
140. C
141. B
142. C
143. B
144.
145.
146.
147.
148.
149.
150.
151.
152.
153.
154.
155.
156.
157.
158.
159.
160.
161.
162.
163.
164.

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