These are original Marlbridge practice questions, not past exam questions. All questions use Valdoria and Kestria, fictional countries whose currency is the valda (VD); all data are fictional, and the MPC given in each question applies only to that question. The rubrics are a suggested Marlbridge rubric to help you check your work; they are not an official scoring guideline. Assumptions: the simple multiplier model applies (constant MPC, saving is the only leakage); in the calculations the price level is treated as constant; values are in billions of valdas.
Question 1 (multiple choice · foundation)
Valdoria’s real GDP is below full-employment output. Which action is an example of expansionary fiscal policy?
- (A) The government raises unemployment benefits.
- (B) The government raises the income tax rate.
- (C) The central bank lowers its policy interest rate.
- (D) The government cuts spending on new hospitals.
Answer and explanation
Answer: (A). Unemployment benefits are transfer payments. Raising them increases disposable income, so consumption and AD rise.
- (B) lowers disposable income and shifts AD left: that is contractionary.
- (C) is a central bank action, so it is monetary policy, not fiscal policy.
- (D) lowers government spending, a component of AD: that is contractionary.
Question 2 (multiple choice · core)
Kestria has a recessionary gap of VD 60 billion. Its MPC is 0.6. Assuming the price level is constant, what is the minimum increase in government spending that would close the gap?
- (A) VD 24 billion
- (B) VD 36 billion
- (C) VD 40 billion
- (D) VD 150 billion
Answer and explanation
Answer: (A). MPS = 0.4, so the spending multiplier = 1 ÷ 0.4 = 2.5. ΔG = 60 ÷ 2.5 = VD 24 billion. Check: 24 × 2.5 = 60.
- (B) multiplies the gap by the MPC (60 × 0.6). The MPC is not the multiplier.
- (C) divides by the size of the tax multiplier (0.6 ÷ 0.4 = 1.5). That gives the tax cut needed, not the spending increase.
- (D) multiplies the gap by the multiplier instead of dividing, which would overshoot hugely.
Question 3 (multiple choice · core)
Why does a VD 10 billion increase in government purchases raise aggregate demand by more than a VD 10 billion cut in personal income taxes?
- (A) Government purchases enter AD in full in the first round, while households save part of a tax cut before spending the rest.
- (B) A tax cut lowers the price level, which reduces aggregate demand.
- (C) Government purchases also shift the LRAS curve to the right.
- (D) Households spend all of a tax cut, but firms save part of any extra government purchases.
Answer and explanation
Answer: (A). G is a component of AD, so it raises AD directly by the full VD 10 billion in round 1. A tax cut raises disposable income, and households spend only the MPC of it; the rest is saved. That is why the spending multiplier is larger in size than the tax multiplier.
- (B) is wrong on both counts: a tax cut shifts AD right, and a change in the price level moves along AD rather than shifting it.
- (C) confuses a demand-side policy with a change in capacity. In this topic, fiscal policy works through AD.
- (D) reverses the logic. Households save part of a tax cut; government purchases are spending by definition.
Question 4 (multiple choice · core)
Valdoria’s government decides in January to fund a large road-building programme to fight a recession. Construction begins 18 months later, after the economy has already returned to full employment. What is the most likely result?
- (A) The spending closes the recessionary gap exactly as planned.
- (B) The spending pushes real GDP above full-employment output and adds to inflationary pressure.
- (C) The spending shifts SRAS to the left and causes a recession.
- (D) The spending has no effect, because government spending only affects AD during recessions.
Answer and explanation
Answer: (B). Because of the decision and implementation lags, the extra AD arrives when there is no gap left to close. AD shifts right from full employment, creating an inflationary gap.
- (A) ignores the timing. The gap has already closed, so there is nothing for the policy to close.
- (C) confuses the curves. Government spending shifts AD, not SRAS.
- (D) is false. Spending is part of AD at any stage of the business cycle.
Question 5 (calculation · core)
Valdoria’s real GDP is VD 885 billion and its full-employment output is VD 840 billion. The MPC is 0.9.
(a) Identify the type of output gap and its size. Should fiscal policy be expansionary or contractionary? (b) Calculate the spending multiplier and the tax multiplier. (c) Calculate the change in government spending that would close the gap. (d) Calculate the change in taxes that would close the gap instead, and explain why it differs from (c). (e) Calculate the change in transfer payments that would close the gap.
Worked solution and suggested Marlbridge rubric
(a) Real GDP is above Yf by 885 − 840 = VD 45 billion: an inflationary gap. Policy should be contractionary.
(b) MPS = 0.1. Spending multiplier = 1 ÷ 0.1 = 10. Tax multiplier = −0.9 ÷ 0.1 = −9.
(c) ΔG = −45 ÷ 10 = −VD 4.5 billion: cut spending by VD 4.5 billion.
(d) Tax change = 45 ÷ 9 = +VD 5 billion: raise taxes by VD 5 billion. A tax rise cuts disposable income by 5, but households cut spending by only 0.9 × 5 = VD 4.5 billion in the first round, because part of the fall is absorbed by lower saving. So a larger tax change is needed than a spending change.
(e) Transfers work like taxes in reverse: cut transfers by VD 5 billion.
| Point | What earns it |
|---|---|
| 1 | Inflationary gap of VD 45 billion and contractionary policy |
| 1 | Multipliers 10 and −9 |
| 1 | Cut G by VD 4.5 billion (direction stated) |
| 1 | Raise taxes by VD 5 billion, with the explanation that part of the tax change affects saving, not spending |
| 1 | Cut transfers by VD 5 billion |
A size without a direction earns no point in (c), (d) or (e). Accept values carried forward from an error in (b).
Question 6 (constructed response · core)
Kestria’s real GDP is below its full-employment output.
(a) Draw a correctly labelled AD–AS graph showing LRAS, SRAS and AD, with the current equilibrium at output Y₁ and price level PL₁. Show full-employment output Yf. (b) Identify one specific fiscal policy action that could close the gap. (c) On your graph, show the effect of your policy in the short run. Label the new price level PL₂. (d) State the effect of your policy on unemployment. (e) Explain one reason why the policy might not have its full effect until much later.
Model answer and suggested Marlbridge rubric
(a) Vertical axis: Price level. Horizontal axis: Real GDP. A vertical LRAS at Yf; AD crossing an upward-sloping SRAS at Y₁, to the left of Yf, at PL₁.
(b) Any expansionary action: increase government spending (for example on schools), cut income taxes, or raise transfer payments.
(c) AD shifts right; the new equilibrium is at a higher output (towards or at Yf) and a higher price level, PL₂ > PL₁.
(d) Unemployment falls (cyclical unemployment falls as output rises towards Yf).
(e) Any one lag, explained: it takes time for official data to show the gap (recognition); the government and legislature must debate and pass the budget (decision); projects must be planned and started, or tax rules changed (implementation); the multiplier rounds take time to spread through the economy (impact).
| Point | What earns it |
|---|---|
| 1 | Correctly labelled axes with a vertical LRAS at Yf and equilibrium Y₁ to its left |
| 1 | A valid expansionary fiscal action (not a central bank action) |
| 1 | AD shifted right, with output higher than Y₁ and PL₂ above PL₁ |
| 1 | Unemployment falls |
| 1 | One lag correctly named or described, with a reason it delays the effect |
A graph that shifts SRAS instead of AD earns no point in (c). “Lower interest rates” in (b) earns no point: that is monetary policy.
Question 7 (constructed response · stretch)
Valdoria has a recessionary gap of VD 48 billion. Its MPC is 0.8.
(a) Calculate the minimum increase in government spending that would close the gap. (b) Calculate the tax cut that would close the gap instead. (c) The government raises spending by VD 6 billion and closes the rest of the gap with a tax cut. Calculate the size of the tax cut. (d) Ignoring any other effects, by how much does each plan in (a), (b) and (c) increase the government’s budget deficit? Which plan adds least to the deficit, and why? (e) Using the AD–AS model, explain why real GDP might rise by less than VD 48 billion even if AD shifts right by VD 48 billion.
Model answer and suggested Marlbridge rubric
(a) Spending multiplier = 1 ÷ 0.2 = 5. ΔG = 48 ÷ 5 = +VD 9.6 billion.
(b) Tax multiplier = −0.8 ÷ 0.2 = −4. Tax cut = 48 ÷ 4 = VD 12 billion.
(c) VD 6 billion of spending raises AD by 6 × 5 = 30. Remaining gap = 48 − 30 = 18. Tax cut = 18 ÷ 4 = VD 4.5 billion.
(d) (a) adds VD 9.6 billion; (b) adds VD 12 billion; (c) adds 6 + 4.5 = VD 10.5 billion. Plan (a) adds least, because every valda of government spending enters AD in the first round, so a smaller amount is needed; with a tax cut, part of each valda is saved.
(e) SRAS slopes upward. As AD shifts right, the economy moves up along SRAS, so part of the extra demand raises the price level instead of real output. Real GDP therefore rises by less than the horizontal shift in AD, and a slightly larger shift would be needed to reach Yf.
| Point | What earns it |
|---|---|
| 1 | VD 9.6 billion increase in G |
| 1 | VD 12 billion tax cut |
| 1 | VD 4.5 billion tax cut in (c), using the remaining gap of VD 18 billion |
| 1 | Deficit increases 9.6, 12 and 10.5, with (a) the smallest and a correct reason |
| 1 | Upward-sloping SRAS means part of the AD shift raises the price level, so output rises by less |
Accept values carried forward from an error in (a) or (b). In (e), “prices rise” with no link to the slope of SRAS or to the split between output and price level earns no point.
How did you do?
- Q1 wrong: re-read “What fiscal policy is” in the study guide.
- Q2, Q5 or Q7(a)–(c) wrong: revisit “Calculating the change needed to close a gap” and Worked examples 1 and 2.
- Q3 or Q7(d) wrong: revisit “Direct and indirect effects on AD”.
- Q6 or Q7(e) wrong: revisit “Matching the policy to the gap”, Figure 1 and the Assumption paragraph.
- Q4 or Q6(e) wrong: revisit “Lags in discretionary fiscal policy”.
Then tick off the topic checklist.