Use this review after the Unit 3 diagnostic. It links the nine topics, then gives six questions that each combine two or more.
Big ideas of the unit
- AD is planned spending, C + I + G + NX, at each price level. The wealth, interest rate and exchange rate effects give its slope; other changes in spending shift it. See Topic 3.1.
- Multipliers size the shift. Spending becomes someone’s income, so AD moves by 1 ÷ MPS times a change in spending and MPC ÷ MPS times a change in taxes or transfers. See Topic 3.2.
- Sticky wages make SRAS slope up, so along it more output means more jobs and less unemployment. Changes in costs shift it. See Topic 3.3.
- Flexible wages make LRAS vertical at full-employment output (Yf), set by resources and technology, like a point on the PPC. See Topic 3.4.
- AD meets SRAS in the short run; all three curves meet in the long run. Left of LRAS is a recessionary gap, right of it an inflationary gap. See Topic 3.5.
- The signs tell you the shock. Price level and output in the same direction: AD (demand-pull if AD rises). Opposite directions: SRAS (cost-push and stagflation if SRAS falls). See Topic 3.6.
- Left alone, the economy returns to Yf. Wages adjust and SRAS shifts until AD meets LRAS; an AD shock changes only the long-run price level. See Topic 3.7.
- Fiscal policy closes gaps sooner, but with lags. See Topic 3.8.
- Automatic stabilizers act at once but only soften shocks: tax revenue moves with real GDP, transfers against it. See Topic 3.9.
Key relationships and methods
| Idea | Relationship or method | Topic |
|---|---|---|
| MPC and MPS | ΔC ÷ ΔYd and ΔS ÷ ΔYd; MPC + MPS = 1 | 3.2 |
| Spending multiplier | 1 ÷ MPS, for a change in C, I, G or NX | 3.2 |
| Tax multiplier | −MPC ÷ MPS; transfers work the same way, opposite sign | 3.2, 3.8 |
| Shift or movement? | Price level: along a curve; spending: AD shifts; costs: SRAS shifts | 3.1, 3.3 |
| Equilibrium | Short run: AD = SRAS; long run: also on LRAS (Y = Yf) | 3.5 |
| Output gap | Actual real GDP − Yf (÷ Yf × 100 for a percentage) | 3.5 |
| Shocks | AD: PL and Y same direction; SRAS: opposite directions | 3.6 |
| Self-adjustment | Recessionary gap: wages ↓, SRAS right; inflationary: wages ↑, SRAS left | 3.7 |
| Sizing policy | ΔG = gap ÷ spending multiplier; ΔT = gap ÷ size of tax multiplier | 3.8 |
| Stabilizers | ΔYd = ΔY − ΔT + Δtransfers; ΔC = MPC × ΔYd | 3.9 |
The questions
These are original Marlbridge practice questions, not past exam questions. The rubrics are a suggested Marlbridge rubric, not official scoring. All questions use Valdoria, a fictional country whose currency is the valda (VD); data are fictional, in VD billion at base-year prices. Multipliers use the simple model (constant MPC, saving the only leakage).
Question 1 (multiple choice · mixed)
Valdoria starts in long-run equilibrium with an MPC of 0.75. Investment falls by VD 10 billion at every price level. SRAS slopes upward. What happens in the short run?
- (A) AD shifts left by VD 40 billion; real GDP falls by exactly VD 40 billion and the price level is unchanged.
- (B) AD shifts left by VD 40 billion; real GDP falls by less than VD 40 billion and the price level falls.
- (C) AD shifts left by VD 30 billion, because investment uses the tax multiplier.
- (D) AD shifts left by VD 10 billion; real GDP falls and the price level rises.
Answer and explanation
Answer: (B). Multiplier = 1 ÷ 0.25 = 4, so AD shifts left by VD 40 billion. The surplus at the old price level pushes it down, raising the quantity demanded along the new AD, so output falls by less than the shift.
- (A) would need a horizontal SRAS.
- (C) Investment is spending: use the spending multiplier.
- (D) ignores the multiplier, and a fall in AD lowers the price level.
Question 2 (multiple choice · mixed)
Valdoria is in long-run equilibrium. Workers and firms come to expect higher inflation, and new wage contracts raise costs. AD and resources do not change, and there is no policy. Which describes the short run and the long run?
- (A) Short run: price level up, real GDP down. Long run: the higher price level shifts AD left until unemployment is back at the natural rate.
- (B) Short run: price level up, real GDP down. Long run: LRAS shifts left, and the lower output becomes the new Yf.
- (C) Short run: price level up, real GDP up, unemployment down. Long run: real GDP returns to Yf at a higher price level.
- (D) Short run: price level up, real GDP down, unemployment up. Long run: falling wages shift SRAS back, and the economy returns to its original price level and Yf.
Answer and explanation
Answer: (D). Higher wage costs shift SRAS left: stagflation. Unemployment above the natural rate then pushes nominal wages down, and SRAS shifts back until it meets AD on LRAS, neither of which has moved.
- (A) Self-adjustment shifts SRAS, not AD.
- (B) LRAS shifts only with resources or technology.
- (C) describes a rise in AD.
Question 3 (constructed response · mixed)
Full-employment output is VD 680 billion, the natural rate of unemployment is 5.0%, each VD 20 billion change in output moves unemployment by 1 percentage point, and the MPC is 0.8.
| Price level | 96 | 100 | 104 | 108 | 112 |
|---|---|---|---|---|---|
| AD₁ | 720 | 700 | 680 | 660 | 640 |
| SRAS₁ | 640 | 660 | 680 | 700 | 720 |
(a) Show that Valdoria is in long-run equilibrium. (b) Business optimism raises investment. SRAS does not change, and the new short-run equilibrium price level is 108. Find the new real GDP, the size of the (parallel) shift in AD, and the rise in investment that caused it. (c) Calculate the inflation rate and the unemployment rate. Name the type of inflation and output gap. (d) Explain why real GDP rose by less than the shift in AD. (e) Draw a correctly labelled AD–AS graph showing the change.
Worked solution and suggested Marlbridge rubric
(a) AD₁ = SRAS₁ = 680 at a price level of 104. Output equals Yf, so the crossing is on LRAS and unemployment is 5.0%.
(b) SRAS₁ gives VD 700 billion at 108, so AD₂ passes through (700, 108). AD₁ gave 660 there, so AD shifted right by 700 − 660 = VD 40 billion. AD₂: 760, 740, 720, 700, 680. Multiplier = 1 ÷ 0.2 = 5, so ΔI = 40 ÷ 5 = VD 8 billion.
(c) Inflation = 4 ÷ 104 × 100 = 3.85%. Output is 20 above Yf, so unemployment is 4.0%. Demand-pull inflation; positive (inflationary) gap of 20.
(d) At 104, AD₂ is 720 but firms supply 680: a shortage of 40, so the price level rises. Through the wealth, interest rate and exchange rate effects, quantity demanded falls along AD₂ from 720 to 700; output rises by 20, not 40.
(e) Axes “Price level” and “Real GDP”; vertical LRAS at 680 through E₁ (104); AD₂ right of AD₁, crossing SRAS₁ at E₂ (108, 700), right of LRAS.
| Point | What earns it |
|---|---|
| 1 | Equilibrium 104 and 680, on LRAS |
| 1 | Real GDP 700, read from SRAS₁ at 108 |
| 1 | Shift of 40 (700 − 660) and ΔI = 8 using the multiplier of 5 |
| 1 | Inflation 3.85% and unemployment 4.0% |
| 1 | Demand-pull inflation, positive gap |
| 1 | Rising price level lowers quantity demanded along AD₂ |
| 1 | Labelled graph with E₂ above and right of E₁, right of LRAS |
Total: 7 points. Accept values carried forward. Multiplying 40 by 5 in (b) earns no point; “AD shifts left as prices rise” earns no point in (d).
Question 4 (constructed response · mixed)
Use Question 3, starting at E₂ (108, VD 700 billion).
(a) With no policy, explain what happens to nominal wages and SRAS as contracts are renewed. (b) Find the long-run price level and the shift in SRAS. Compare long-run real GDP, unemployment and the price level with E₁. (c) Instead, at E₂ the government raises income taxes to reverse the whole shift in AD. Treating the price level as constant, calculate the tax rise. Where does the economy end up? (d) A minister says: “The tax rise is pointless; the economy fixes itself.” Give one argument for the tax rise and one against it. (e) Why is VD 700 billion not lasting growth? What would make it full-employment output?
Worked solution and suggested Marlbridge rubric
(a) Unemployment (4.0%) is below the natural rate and prices have risen 3.85%, so scarce workers win higher nominal wages. Costs rise: SRAS shifts left.
(b) AD₂ = 680 at 112. SRAS₁ gave 720 there, so SRAS shifts left by VD 40 billion. Real GDP (680) and unemployment (5.0%) match E₁, but the price level is (112 − 104) ÷ 104 × 100 = 7.69% higher.
(c) Tax multiplier = −0.8 ÷ 0.2 = −4. Tax rise = 40 ÷ 4 = VD 10 billion. AD returns to AD₁, so the economy returns to E₁: 104 and VD 680 billion.
(d) For: it avoids the price level rising to 112 and a slow adjustment. Against: lags. If wages have already risen when the tax takes effect, output is pushed below Yf.
(e) LRAS is still at 680; output of 700 relies on wages lagging prices. Only more resources or better technology would shift LRAS right.
| Point | What earns it |
|---|---|
| 1 | Scarce workers and lost purchasing power push nominal wages up |
| 1 | Higher wages shift SRAS left |
| 1 | Long-run price level 112; SRAS left by 40 |
| 1 | Same output and unemployment as E₁, price level 7.69% higher |
| 1 | Tax rise of 10, returning to 104 and 680 |
| 1 | One argument for and one against (such as lags), each explained |
| 1 | Temporary boom distinguished from a rise in capacity (LRAS shift) |
Total: 7 points. “LRAS shifts left to close the gap” earns no point. Dividing the output gap (20) instead of the AD shift (40) gives 5 and earns no point in (c).
Question 5 (constructed response · mixed)
Valdoria’s real GDP is VD 760 billion, full-employment output is VD 800 billion, and the MPC is 0.75.
(a) Find the gap in VD billion and as a percentage of Yf, and compare unemployment with the natural rate. (b) Calculate the increase in government spending, and the tax cut, that would each close the gap. Why is the tax cut larger? (c) When the recession began, national income fell by VD 40 billion in the first round. Income tax takes 20% of income, and the budget deficit grew by VD 10.5 billion although no tax or benefit law changed. Calculate the automatic changes in tax revenue and in transfer payments. Why is this not discretionary policy? (d) Calculate the first-round changes in disposable income and consumption, and compare with an economy whose taxes and transfers do not respond to income. (e) Why did the stabilizers act sooner than the policy in (b) could?
Worked solution and suggested Marlbridge rubric
(a) 760 − 800 = −VD 40 billion (−5.00%): recessionary, with unemployment above the natural rate.
(b) Multipliers 4 and −3. ΔG = 40 ÷ 4 = VD 10 billion; tax cut = 40 ÷ 3 = VD 13.33 billion. G is spent in full in round one; a quarter of a tax cut is saved first.
(c) Tax: 0.2 × (−40) = −VD 8 billion. The deficit rose by 10.5, so transfers rose by 10.5 − 8 = +VD 2.5 billion. Rates and benefit rules did not change, so this is not discretionary.
(d) ΔYd = −40 + 8 + 2.5 = −29.5. ΔC = 0.75 × (−29.5) = −VD 22.125 billion, against 0.75 × (−40) = −30 with no automatic response.
(e) The rules already exist, so they act as soon as incomes change. Discretionary policy must wait through recognition, decision and implementation lags.
| Point | What earns it |
|---|---|
| 1 | Gap −40 (−5.00%), unemployment above the natural rate |
| 1 | ΔG = 10 and tax cut = 13.33 |
| 1 | Part of a tax cut is saved before it is spent |
| 1 | Tax −8 and transfers +2.5 |
| 1 | Not discretionary: unchanged rules, no new decision |
| 1 | ΔYd = −29.5 and ΔC = −22.125, compared with −30 |
| 1 | Stabilizers avoid recognition, decision and implementation lags |
Total: 7 points. Multiplying the gap by the multiplier earns no point in (b).
Question 6 (constructed response · mixed)
Valdoria is in long-run equilibrium at a price level of 100 and full-employment output of VD 600 billion. A sharp, temporary rise in world oil prices moves short-run equilibrium to a price level of 106 and real GDP of VD 580 billion.
(a) Draw a correctly labelled AD–AS graph showing the initial equilibrium and the effect of the oil price rise. Label PL₁, PL₂, Y₂ and Yf. (b) Explain why SRAS shifts but LRAS does not. (c) State the inflation rate, the effect on unemployment and the term for this combination. (d) The MPC is 0.8. Treating the price level as constant, calculate the rise in government spending that would close the gap. Why would real GDP rise by less than the shift in AD? (e) Compare the outcome soon after the policy in (d) with the long run under no policy.
Worked solution and suggested Marlbridge rubric
(a) Axes “Price level” and “Real GDP”; vertical LRAS at 600; AD and SRAS₁ cross on it at PL₁ = 100. SRAS₂ lies left, crossing AD at PL₂ = 106 and Y₂ = 580.
(b) Oil is an input for almost every firm, so costs rise at every output level: SRAS shifts left. The rise is temporary and destroys no resources or technology, so capacity and LRAS are unchanged.
(c) 6.0% inflation; unemployment rises above the natural rate; stagflation (cost-push inflation).
(d) Gap = −20; multiplier 5; ΔG = 20 ÷ 5 = VD 4 billion. Along SRAS₂ the shift raises the price level, which lowers the quantity demanded, so output rises by less than 20.
(e) With policy, output returns towards Yf sooner, but the price level rises above 106. With no policy, high unemployment pushes wages down and the oil shock fades, so SRAS shifts back to 100 and VD 600 billion, after a long spell of high unemployment.
| Point | What earns it |
|---|---|
| 1 | Graph: SRAS left, PL₂ above PL₁, Y₂ left of Yf |
| 1 | Higher input costs shift SRAS left |
| 1 | LRAS unchanged: no change in resources or technology |
| 1 | 6.0%, unemployment up, stagflation |
| 1 | ΔG = 4 |
| 1 | Output rises by less because the price level rises |
| 1 | Higher price level with policy against PL 100 and Yf, after slow adjustment, without it |
Total: 7 points. Shifting AD left in (a) earns no graph point.
How did you do?
- Q1, Q3(b) or Q5(b): multipliers. Use the Topic 3.1 checklist and Topic 3.2 checklist.
- Q2 or Q6(b): shifting SRAS or LRAS. Use the Topic 3.3 checklist and Topic 3.4 checklist.
- Q3(a), (b), (c) or (e): equilibrium and gaps. Use the Topic 3.5 checklist.
- Q3(d), Q6(a) or (c): short-run shocks. Use the Topic 3.6 checklist.
- Q4(a), (b), (e) or Q6(e): self-adjustment and LRAS. Use the Topic 3.7 checklist.
- Q4(c), (d), Q5 or Q6(d): fiscal policy and stabilizers. Use the Topic 3.8 checklist and Topic 3.9 checklist.
If several topics still feel shaky, go back to the Unit 3 diagnostic and follow its “Your next step” table.