25  Quick quiz: 12 conceptual questions

Reveal each answer only after you commit to one. Be honest — guessing without thinking is worse than thinking and being wrong.

Q1. CPI uses base-year quantities and current-year prices. Does this overstate or understate inflation, and why?

Overstates. Consumers substitute away from goods whose prices have risen, but Laspeyres holds quantities fixed at the (cheaper-substitute-not-yet-bought) base-year basket. The IGDPDI (Paasche) does the opposite and underestimates.

Q2. A discouraged worker stops looking for a job. What happens to (a) U, (b) LF, (c) the unemployment rate $u$?

(a) U falls (they're no longer counted as unemployed). (b) LF falls by the same amount. (c) $u$ falls. This is why measured unemployment can drop in a bad economy — it's a bad signal of labor-market improvement.

Q3. MPC = 0.80. The government wants to raise $Y^*$ by 200. By how much must it raise $\overline{G}$?

$K_G = 1/(1-0.80) = 5$. $\Delta\overline{G} = 200/5 = $ 40.

Q4. Same MPC. Same target. By how much must it cut $\overline{T}$? Why is this number bigger in absolute value than the $G$ answer?

$K_T = -0.80/0.20 = -4$. $\Delta\overline{T} = 200/(-4) = $ −50. Bigger because some of a tax cut is saved (the round-one $1-c$ portion). The spending instrument is more powerful per dollar.

Q5. Same MPC. Use the balanced-budget combination to close the gap. By how much do $\overline{G}$ and $\overline{T}$ each rise?

$K_{BB} = 1$. So $\Delta\overline{G} = \Delta\overline{T} = $ 200. Verify: $\Delta Y^* = 200 \cdot 5 + 200 \cdot (-4) = 1000 - 800 = 200$. ✓ Deficit unchanged.

Q6. The Fed sells $50 of bonds (OMO sale). $rrr = 25\%$. What is $\Delta M^S$? Does $r^*$ rise or fall?

$K_S = 4$. $\Delta M^S = 4 \cdot (-50) = $ −$200. $M^S$ shifts left, so $r^*$ rises.

Q7. A 10-year bond has $FV = \$1{,}000$ and trades at $\$700$. What's the implied yield $r$?

$r = (1000/700)^{1/10} - 1 = (1.4286)^{0.1} - 1 \approx 1.0363 - 1 = $ 3.63%.

Q8. The market interest rate jumps from 3% to 8%. What happens to the price of an existing bond (issued when rates were 3%)?

Falls. The old bond pays 3% but new bonds pay 8%. Nobody will pay full face value for a 3% bond when they could buy a new 8% one. Price drops until yield-to-maturity matches 8%.

Q9. US inflation runs at 6%/year. UK inflation is 2%/year. What does PPP say happens to the dollar relative to the pound over time?

The dollar depreciates by roughly 4%/year against the pound. The country with higher inflation always sees its currency weaken, in proportion to the inflation differential.

Q10. US interest rates rise to 8%. UK stays at 4%. What happens to the dollar via the capital-flow channel?

The dollar appreciates. Higher US rates attract foreign capital. UK investors sell £ for $ to buy US assets. Demand for $ rises; supply of £ rises. $E_{\$/£}$ falls (fewer $ per £). Note this is the OPPOSITE direction from the inflation effect — keep them straight.

Q11. A country fixes its exchange rate. The central bank tries to ease (boost $M^S$). What actually happens to $M^S$ and $Y$?

The easing causes capital outflows that would depreciate the currency. To prevent depreciation, the central bank must sell FX reserves and buy back its own currency, which contracts $M^S$ back. Net: $M^S$ barely moves; the FX channel is dead; only a partial interest-rate channel operates. Monetary policy is muted under fixed ER.

Q12. A country wants free capital flow, a fixed exchange rate, and independent monetary policy. Why can't it have all three?

The trilemma. Free capital + fixed ER means the central bank must always intervene to defend the peg, which means it can't independently set $M^S$. Free capital + independent monetary policy means the ER must float, which means it can't be fixed. Fixed ER + independent monetary policy means capital must be controlled (or the peg breaks under speculative attack). Pick two; lose the third.

25.1 Score yourself

11–12 right: you’re ready. 8–10: review the chapters for the questions you missed. 5–7: re-read everything, then come back. 0–4: you have time. Start with the chapter that covers your weakest area.

25.2 Want more?

The Full exam is 30 questions, timed-style, with detailed solutions.