I.

True/False question
1. An increase in capital increases productivity only if it is purchased and operated by domestic residents.
2. According to economists, a collection of valuable jewels is not money.
3. Real GDP fluctuates from year to year but is always below potential GDP.
4. If the money prices of resources changes, the SAS curve shifts.
5. Other things the same, another unit of capital will increase output by more in a poor country than in a rich
country.
6. Other things the same, if banks decide to hold a smaller part of their deposits as excess reserves, the money
supply will fall
7. According to the quantity theory of money, in the long run, an increase in the quantity of money does not change
real GDP but raises the price level.
8. The long-run aggregate supple curve is vertical because at full employment prices are stable.
9. A rise in the price level changes aggregate demand because firms increase their investment when prices are higher
Answer
1. False. An increase in capital can enhance productivity regardless of whether it is purchased and operated by
domestic or foreign residents. Capital accumulation, such as investing in machinery, technology, or infrastructure,
contributes to economic growth and productivity. However, the effectiveness of capital depends on factors like its
quality, maintenance, and utilization, rather than the nationality of its owners
2. True. According to economists, a collection of valuable jewels is not considered money. Money serves as a
medium of exchange, a unit of account, and a store of value. While jewels may have value, they lack the universal
acceptance and functionality that define money
3. False. Real GDP can be below potential GDP when the economy is overheated, or can be below potential GDP
when the economy is in recession, and when the economy is operating at its full potential, Real GDP equals potential
GDP.

4. True.
 If the money prices of resources increase => SRAS curve shift tho the leff
 If the money prices of resources decrease => SRAS curve shift tho the right

5. True. Because of
  Diminishing Marginal Returns: As a country accumulates more capital, the additional benefit from each new
unit diminishes. In poor countries with limited capital, adding more capital significantly boosts productivity
due to critical gaps.
 Catch-Up Effect: Poor countries often have lower initial levels of capital and technology. When they invest in
additional capital, they can experience rapid growth due to the “catch-up effect.” Rich countries, already
closer to their production possibilities frontier, see smaller gains from additional capital.
 Infrastructure and Absorptive Capacity: Poor countries may lack infrastructure and skilled labor to fully
utilize capital. When they invest in infrastructure alongside capital, the impact on productivity is more
pronounced.
6. False. When banks decide to hold a smaller part of their deposits as excess reserves, it means they have more
funds available to lend out. As a result, the money supply would not fall; instead, it would increase due to increased
lending capacity. Every time a dollar is deposited into a bank account, the bank’s total reserves increase. While the
bank keeps some of it as required reserves, it loans out the excess reserves, effectively creating new money and
increasing the money supply

7. True. According to the quantity theory of money, in the long run, money is neutral, meaning it does not affect real
GDP, but it does affect the price level. Essentially, if the amount of money in an economy doubles , price levels will
also double. This means consumers would pay twice as much for the same amount of goods and services

8. True. The long-run aggregate supply (LRAS) curve is vertical because, in the long run, prices are flexible and
adjust to changes in demand and supply. When the economy reaches full employment, any increase in aggregate
demand (AD) only leads to higher prices without affecting output. Thus, the LRAS curve represents potential output
at full employment, where prices remain stable regardless of demand fluctuations

9. False. A rise in the price level does not directly change aggregate demand (AD) due to firms increasing
investment. Instead, it affects aggregate supply. When prices rise, firms may adjust their production levels, impacting
the short-run aggregate supply (SRAS) curve. Higher prices can lead to cost-push inflation, reducing real output and
shifting the SRAS curve leftward. Changes in AD are influenced by factors like consumer spending, government
expenditure, investment and net exports, rather than just price levels

II. Short essay

1. What are the four main ways in which the CPI is an upward-biased measure of the price level?
2. Describe the two things that limit the precision of the Fed’s control of the money supply and explain how each
limits that control
3. What problems arise from the CPI bias?
4. What are fiscal and monetary policies? Do they have an immediate effect on the AD curve or the SRAS curve?
Answer
1. The CPI can be an upward-biased measure of the price level due to the following four main reasons:
 Substitution Bias: The CPI uses a fixed basket of goods and services to calculate price changes, and does not
capture the ability of consumers to substitute away from more expensive goods in response to changes in relative
prices.
Quality Change: Sometimes price increases reflect quality improvements rather than inflation. For example, safer
cars or improved healthcare services may cost more but provide better value. The CPI assumes that the quality of
goods and services remains constant over time, and quality changes may not always be properly captured by
statistical agencies.
New Goods and Technological Advances: The CPI may not accurately account for the introduction of new goods
and technological advances. Additionally, technological advancements can lead to better products at higher prices,
contributing to an upward bias
Outlet-Substitution Bias: The CPI assumes that everyone shops at the same outlets (e.g., retail stores), but
consumer behavior varies. People may shop online, at discount stores, or specialty shops. If price changes differ
across outlets, the CPI may not fully capture these variations, resulting in an upward bias

2. The Federal Reserve (Fed) aims to control the money supply to influence economic conditions. However,
two factors limit its precision:
Currency Holdings by Households: The Fed cannot directly control the amount of currency that households
choose to hold relative to bank deposits. If households decide to hold more currency, banks have fewer reserves,
leading to a decrease in the money supply. Essentially, this limitation arises from individual preferences regarding
cash holdings.
Excess Reserves Held by Banks: The Fed also lacks control over the amount of excess reserves that banks
choose to hold. If banks decide to lend out less of their deposits, the money supply decreases. In other words,
bankers’ decisions regarding excess reserves impact the overall money supply

3. The Consumer Price Index (CPI) is used to measure inflation by tracking changes in the price level of a
market basket of consumer goods and services. However, it faces several issues that can lead to a bias:
Substitution Bias: The CPI uses a fixed basket of goods and services to calculate price changes, and does not
capture the ability of consumers to substitute away from more expensive goods in response to changes in relative
prices.
Quality Change: Sometimes price increases reflect quality improvements rather than inflation. For example, safer
cars or improved healthcare services may cost more but provide better value. The CPI assumes that the quality of
goods and services remains constant over time, and quality changes may not always be properly captured by
statistical agencies.
New Goods and Technological Advances: The CPI may not accurately account for the introduction of new goods
and technological advances. Additionally, technological advancements can lead to better products at higher prices,
contributing to an upward bias
Outlet-Substitution Bias: The CPI assumes that everyone shops at the same outlets (e.g., retail stores), but
consumer behavior varies. People may shop online, at discount stores, or specialty shops. If price changes differ
across outlets, the CPI may not fully capture these variations, resulting in an upward bias.

4. What are fiscal and monetary policies? Do they have an immediate effect on the AD curve or the SRAS
curve?
 Fiscal Policy
 Definition : Fiscal policy refers to the setting of the levels of government spending and taxation by
government policymakers
 Effect on AD curve:
- Expansionary: When the government increases spending (e.g., on infrastructure, education, or
unemployment benefits) and decreases taxes, it shifts the AD curve to the right. This stimulates
 demand for goods and services so the price and real GDP increase. When GDP increases, it makes the
unemployment decreases and the inflation increases.
- Contractionary: Decreasing government spending or raising taxes shifts the AD curve to the left,
reducing overall demand and that causes prices and real GDP to fall. When real GDP decreases,
unemployment will increase and inflation will decrease.
 Effect on SRAS curve: By stabilizing employment and consumption during recessions, fiscal policy indirectly
affects the SRAS curve.
 Monetary Policy
 Definition: Monetary policy involves central banks (like the Federal Reserve in the U.S.) adjusting the money
supply and interest rates.
 Effect on AD curve
- Expansionary: Lowering interest rates increases borrowing and spending, boosting AD.
- Contractionary: Raising interest rates reduces borrowing and spending, leading to a leftward shift in
AD.
 Effect on SRAS curve: Changes in interest rates can affect business investment and production costs,
influencing the SRAS curve.