These are original Marlbridge practice questions, not past exam questions. All questions use Valdoria, a fictional country whose currency is the valda (VD); all data are fictional and in billions of valdas. The rubrics are a suggested Marlbridge rubric to help you check your work; they are not an official scoring guideline. Assumptions: a change in investment caused by interest rates is multiplied by the spending multiplier; calculated policy sizes are the minimum needed, because part of any AD shift raises the price level. Where a question asks you to draw a graph, sketch it on paper.
Question 1 (multiple choice · foundation)
Valdoria’s real GDP is below full-employment output and unemployment is above the natural rate. Which combination of policies is most likely to restore full employment?
- (A) Raise taxes and lower the central bank’s policy rate
- (B) Increase government spending and lower the central bank’s policy rate
- (C) Cut government spending and raise the central bank’s policy rate
- (D) Increase transfer payments and sell government bonds on the open market
Answer and explanation
Answer: (B). A recessionary gap needs AD to rise. More government spending and a lower policy rate both shift AD to the right.
- (A) mixes a contractionary fiscal action (higher taxes) with an expansionary monetary one, so the effect on AD is uncertain.
- (C) is contractionary on both sides; it would widen the recessionary gap.
- (D) pairs expansionary fiscal policy with an open market sale, which is contractionary monetary policy. The two work against each other.
Question 2 (multiple choice · core)
Valdoria’s government cuts taxes at the same time as the central bank raises its policy rate. Which of the following must be true in the short run?
- (A) Aggregate demand increases.
- (B) Real output is unchanged.
- (C) The nominal interest rate increases.
- (D) The price level decreases.
Answer and explanation
Answer: (C). The central bank pushes the interest rate up, and the tax cut raises income and money demand, which also pushes it up. Both forces act the same way, so the rise is certain.
- (A) is uncertain. The tax cut shifts AD right but the rate rise shifts it left; the net effect depends on their sizes.
- (B) assumes the two policies exactly cancel. They might, but nothing makes this certain.
- (D) is also uncertain, because the direction of the AD shift is unknown.
Question 3 (multiple choice · core)
Valdoria’s MPC is 0.8. The government increases spending by VD 6 billion. At the same time, the central bank raises its policy rate, and planned investment falls by VD 2 billion. What is the net shift in aggregate demand?
- (A) An increase of VD 4 billion
- (B) An increase of VD 20 billion
- (C) An increase of VD 30 billion
- (D) An increase of VD 40 billion
Answer and explanation
Answer: (B). Spending multiplier = 1 ÷ 0.2 = 5. Fiscal shift = 5 × 6 = +30. Monetary shift = 5 × (−2) = −10. Net shift = 30 − 10 = +VD 20 billion.
- (A) subtracts the two actions without multiplying them: 6 − 2 = 4.
- (C) counts only the fiscal action and ignores the fall in investment.
- (D) adds the fall in investment instead of subtracting it: 5 × (6 + 2) = 40.
Question 4 (multiple choice · core)
Valdoria has an inflationary gap. The government raises taxes and the central bank raises its policy rate. Which option correctly describes the short-run effects on the price level and the nominal interest rate?
- (A) Price level decreases; interest rate increases
- (B) Price level decreases; interest rate is uncertain
- (C) Price level is uncertain; interest rate increases
- (D) Price level increases; interest rate is uncertain
Answer and explanation
Answer: (B). Both policies are contractionary, so AD shifts left and the price level falls (or rises less than it would have). The rate rise pushes the interest rate up, but the tax rise lowers income and money demand, which pushes it down. The net effect on the interest rate is uncertain.
- (A) ignores the fall in money demand caused by the tax rise.
- (C) is the pattern for policies pushing in opposite directions, not the same direction.
- (D) gets the direction of the price level wrong: contractionary policy lowers AD.
Question 5 (calculation · core)
Valdoria’s real GDP is VD 870 billion and full-employment output is VD 840 billion. The MPC is 0.6.
(a) Identify the type and size of the output gap. (b) Calculate the spending multiplier and the tax multiplier. (c) The central bank raises its policy rate and investment falls by VD 6 billion. Calculate the shift in AD. (d) Calculate the minimum cut in government spending that, together with the monetary action, would close the gap. Then calculate the tax increase that would do the same job instead.
Worked solution
(a) 870 > 840: an inflationary gap of VD 30 billion.
(b) MPS = 0.4. Spending multiplier = 1 ÷ 0.4 = 2.5. Tax multiplier = −0.6 ÷ 0.4 = −1.5.
(c) 2.5 × (−6) = −VD 15 billion.
(d) AD must fall by a further 30 − 15 = VD 15 billion. Spending cut = 15 ÷ 2.5 = VD 6 billion. Tax increase = 15 ÷ 1.5 = VD 10 billion.
Check. −15 + 2.5 × (−6) = −30, and −15 + (−1.5 × 10) = −30. The tax rise must be larger than the spending cut because the tax multiplier is smaller in size.
Suggested mark points (4): 1 for the inflationary gap of VD 30 billion; 1 for both multipliers; 1 for the −VD 15 billion shift; 1 for both the VD 6 billion spending cut and the VD 10 billion tax rise. Accept values carried forward from an earlier error.
Question 6 (constructed response · core)
Valdoria is in a short-run equilibrium with a recessionary gap.
(a) Draw a correctly labelled AD–AS graph showing the current short-run equilibrium. Label real output Y₁, the price level PL₁ and full-employment output Yf. (b) Identify one fiscal policy action and one monetary policy action that the government and central bank could take together to close the gap. (c) On your graph, show the effect of the combined policy if it closes the gap exactly. Label the new price level PL₂. (d) Assume the fiscal action alone is carried out. Using a correctly labelled money market graph (limited reserves), show the effect on the nominal interest rate. Explain. (e) The central bank wants the nominal interest rate to stay where it was before the fiscal action. Identify the open market operation it should carry out.
Worked solution and suggested Marlbridge rubric
(a) Axes: price level (vertical) and real GDP (horizontal). Downward-sloping AD₁, upward-sloping SRAS, vertical LRAS at Yf. AD₁ and SRAS cross at Y₁, to the left of Yf, at PL₁.
(b) Fiscal: increase government spending, or cut taxes, or raise transfer payments. Monetary: lower the policy rate (for example, lower the interest rate paid on reserves, or buy government bonds).
(c) AD shifts right to AD₂, crossing SRAS on the LRAS line at Yf. The new price level PL₂ is higher than PL₁.
(d) Graph: nominal interest rate (vertical) and quantity of money (horizontal); vertical MS; downward-sloping MD shifts right from MD₁ to MD₂. The nominal interest rate rises. The fiscal action raises real output and the price level, so households and firms need more money for transactions, which increases money demand.
(e) An open market purchase of government bonds. It increases reserves and the money supply, shifting MS right until the interest rate returns to its original level.
| Point | What earns it |
|---|---|
| 1 | Correctly labelled AD–AS graph with Y₁ to the left of Yf and PL₁ shown |
| 1 | One correct expansionary fiscal action and one correct expansionary monetary action |
| 1 | AD shifts right to meet SRAS at Yf, with PL₂ above PL₁ |
| 1 | Correctly labelled money market graph with MD shifting right and a higher interest rate |
| 1 | Explains the rise in money demand using higher income or price level |
| 1 | Open market purchase |
In (b), “expansionary fiscal policy” with no specific action does not earn the point. In (e), “increase the money supply” alone earns the point only if the method (buying bonds) is named.
Question 7 (constructed response · stretch)
Valdoria’s MPC is 0.75. Worried about inflation, the central bank raises its policy rate, which reduces investment by VD 5 billion. In the same month, the government cuts taxes by VD 5 billion.
(a) Calculate the shift in AD caused by each action and the net shift. (b) State the effect of the policy mix on the nominal interest rate. Explain. (c) A commentator says, “The two actions are the same size, so they cancel out.” Explain why the commentator is wrong about AD. (d) Calculate the tax cut that would have exactly offset the monetary action’s effect on AD.
Model answer and suggested Marlbridge rubric
(a) Spending multiplier = 4; tax multiplier = −3. Monetary: 4 × (−5) = −VD 20 billion. Fiscal: −3 × (−5) = +VD 15 billion. Net = −VD 5 billion: AD falls slightly.
(b) The nominal interest rate rises. The central bank’s action raises it directly, and the tax cut raises disposable income and spending, which increases money demand and adds upward pressure. Both effects point the same way, so the rise is certain.
(c) The two changes have different multipliers. A fall in investment is a fall in spending, so its whole value starts the multiplier process (multiplier 4). A tax cut raises disposable income, but households save part of it (MPS 0.25), so only VD 3.75 billion of first-round spending results (multiplier 3). The contractionary effect is larger, so AD falls.
(d) The tax cut must raise AD by VD 20 billion: 20 ÷ 3 = VD 6.67 billion.
| Point | What earns it |
|---|---|
| 1 | Both shifts (−20 and +15) and the net −VD 5 billion |
| 1 | Interest rate rises |
| 1 | Explains that both actions push the interest rate up (policy rate and money demand) |
| 1 | Explains the different multipliers, linked to saving part of a tax cut |
| 1 | VD 6.67 billion |
Accept a net shift carried forward into (c) if the reasoning about different multipliers is correct.
How did you do?
- Q1, Q6(b) wrong: re-read “Choosing the direction: match the gap” in the study guide.
- Q2, Q4 or Q7(b) wrong: revisit “What a combined policy does” and its summary table.
- Q3, Q5 or Q7(a), (d) wrong: work through Worked examples 1 and 2 again, multiplying each action before adding.
- Q6(a), (c)–(e) wrong: study Figures 1 and 2 and “Showing the interest rate on a money market graph”.
Then tick off the topic checklist.