Use this review after the Unit 5 diagnostic. It shows how the seven topics fit together, then gives six questions that each combine topics.
Big ideas of the unit
- Short run first, long run second. Ask what a policy does now (AD, output, unemployment) and what is left once wages, prices and capital have adjusted.
- Policies can be combined. Same direction gives a certain change in AD; opposite directions give a certain change in the interest rate. See Topic 5.1.
- The Phillips curve is the AD–AS story on new axes. An AD shift is a movement along the SRPC; an SRAS shift moves the SRPC the opposite way; the LRPC stands at the natural rate. See Topic 5.2.
- There is no long-run trade-off. Unemployment below the natural rate lasts only until wages and expectations catch up; then the SRPC shifts and only inflation is higher.
- Lasting inflation is a monetary event. With stable velocity and output at full employment, money growth beyond real growth becomes inflation, and money is neutral for real output. See Topic 5.3.
- Deficits are flows; the debt is a stock. Every deficit is borrowed and adds to the debt, and interest on the debt uses funds that have other uses. See Topic 5.4.
- Borrowing has a price. Government borrowing raises the real interest rate and crowds out private investment: a smaller AD shift and slower capital growth. See Topic 5.5.
- Growth means capacity, per person. It is measured as the growth rate of real GDP per capita and comes from capital per worker, human capital and technology. See Topic 5.6.
- Policy can raise growth. Infrastructure, skills, research and supply-side incentives shift LRAS and the PPC out, often after a short-run AD effect. See Topic 5.7.
Key relationships and methods
| Idea | Relationship or method | Topic |
|---|---|---|
| Closing a gap | Push AD against the gap; multiply each action by its own multiplier, then add | 5.1 |
| Multipliers | Spending and investment 1 ÷ MPS; taxes −MPC ÷ MPS; transfers MPC ÷ MPS | 5.1 |
| Gaps on the Phillips curve | Left of LRPC: inflationary; right of LRPC: recessionary | 5.2 |
| Shocks | Demand: along the SRPC; supply: SRPC shifts (SRAS left → SRPC right); natural rate change: LRPC shifts | 5.2 |
| Equation of exchange | M × V = P × Y, so P = MV ÷ Y and V = nominal GDP ÷ M | 5.3 |
| Growth-rate form | Inflation ≈ %ΔM + %ΔV − %ΔY | 5.3 |
| Budget balance and debt | Balance = T − (G + transfers + interest); debt at end = debt at start + deficit | 5.4 |
| Crowding out | Deficit → demand for loanable funds right (or supply left) → real r up → private investment down | 5.5 |
| Growth | Real GDP per capita = productivity × (employed ÷ population); growth = PPC out, LRAS right | 5.6, 5.7 |
The questions
These are original Marlbridge practice questions, not past exam questions. The rubrics are a suggested Marlbridge rubric, not official scoring. Valdoria and Kestria are fictional countries using the valda (VD); all data are fictional. Only the stated changes happen. Interest-driven changes in investment use the spending multiplier, and policy sizes are the minimum needed.
Question 1 (multiple choice · mixed)
Valdoria is in long-run equilibrium with a balanced budget. A long strike at its only oil refinery raises firms’ fuel costs for several months. No new policy is passed. Which describes the short-run effects?
- (A) The SRPC shifts right; unemployment benefits rise automatically, pushing the budget towards deficit.
- (B) A movement down and to the right along the SRPC; unemployment benefits rise automatically, pushing the budget towards deficit.
- (C) The SRPC shifts right; the budget stays balanced because no new policy was passed.
- (D) The SRPC shifts left; unemployment benefits fall, pushing the budget towards surplus.
Answer and explanation
Answer: (A). Higher costs shift SRAS left, so unemployment and inflation both rise: the SRPC shifts right. More people claim benefits and real incomes fall, so the budget moves towards deficit with no new law. These are automatic stabilizers.
- (B) A supply shock shifts the SRPC; only demand shocks move the economy along it.
- (C) Automatic stabilizers change the budget without any new decision.
- (D) SRAS shifting left moves the SRPC right, and unemployment rises.
Question 2 (multiple choice · mixed)
For many years Valdoria’s central bank lets the money supply grow by 10% a year. Velocity is constant and full-employment real GDP grows by 4% a year. Which describes the long run?
- (A) Inflation of about 6%, with unemployment at the natural rate and real growth still about 4%
- (B) Inflation of about 10%, with unemployment kept below the natural rate
- (C) Inflation of about 6%, with real growth raised to about 10%
- (D) Inflation of about 14%, with the LRPC shifted right
Answer and explanation
Answer: (A). Inflation ≈ 10 − 4 = 6% (exactly 1.10 ÷ 1.04 − 1 = 5.77%). Real growth comes from real resources, so it stays about 4%. The LRPC is vertical: unemployment returns to the natural rate whatever the inflation rate.
- (B) ignores real growth, and no inflation rate holds unemployment below the natural rate for ever.
- (C) Money is neutral in the long run; it cannot raise real growth.
- (D) adds real growth instead of subtracting it, and money growth does not change the natural rate.
Question 3 (constructed response · mixed)
Kestria starts the year with a debt of VD 900 billion. It collects VD 400 billion in taxes and spends VD 330 billion on goods and services, VD 76 billion on transfers and VD 36 billion in interest. It borrows any deficit. In its loanable funds market (VD billion, r = real interest rate in %), private demand is Qd = 500 − 25r and supply is Qs = 150 + 45r. Last year the budget was balanced.
(a) Calculate the budget balance, and the balance before interest. (b) Calculate the debt at the end of the year, and interest as a percentage of tax revenue. (c) Calculate the real interest rate before and after the government borrows the deficit. (d) Calculate the private investment crowded out and the extra saving. (e) Draw a correctly labelled loanable funds graph showing (c). (f) The same crowding out happens each year for four years. Explain the long-run effect on Kestria’s growth.
Worked solution and suggested Marlbridge rubric
(a) Spending = 330 + 76 + 36 = 442. Balance = 400 − 442 = −42, a deficit of VD 42 billion. Before interest: 400 − 406 = −6.
(b) Debt = 900 + 42 = VD 942 billion. Interest is 36 ÷ 400 × 100 = 9.00% of revenue, money that cannot fund other uses.
(c) Before: 500 − 25r = 150 + 45r, so 350 = 70r and r = 5% (Q = 375). After: 542 − 25r = 150 + 45r, so 392 = 70r and r = 5.6% (Q = 402).
(d) Private investment = 500 − 25(5.6) = 360, down from 375: VD 15 billion crowded out. Saving rises from 375 to 402: VD 27 billion. Check: 15 + 27 = 42.
(e) Axes “Real interest rate” and “Quantity of loanable funds”. D₁ shifts right to D₂ (or S shifts left, not both); r rises from 5% (r₁) to 5.6% (r₂).
(f) After four years the capital stock is 4 × 15 = VD 60 billion smaller. Less capital per worker slows productivity growth: LRAS shifts right by less and real GDP per capita grows more slowly.
| Point | What earns it |
|---|---|
| 1 | Deficit of 42, including transfers and interest |
| 1 | Debt of 942 and interest of 9% of revenue |
| 1 | r = 5% before and 5.6% after |
| 1 | Crowding out of 15 and extra saving of 27 |
| 1 | Labelled graph: one curve shifted, higher r₂ marked |
| 1 | Lower investment means a smaller capital stock (60) |
| 1 | Less capital per worker slows productivity: LRAS shifts right by less |
Total: 7 points. Accept values carried forward. In (e), shifting both curves earns no point.
Question 4 (constructed response · mixed)
Valdoria’s real GDP is VD 870 billion and full-employment output is VD 900 billion. Unemployment is 6.5% (natural rate 5.0%), the labour force is 30 million, inflation is 1% and the MPC is 0.9.
(a) Identify the gap, and calculate the number of people cyclically unemployed. (b) The government raises purchases by VD 2 billion. Calculate the shift in AD, and the minimum rise in investment the central bank’s action must cause to close the gap. State the monetary action in a limited-reserves system. (c) Draw a correctly labelled Phillips curve graph showing the starting point A and the effect of the policy mix, labelled B. (d) Explain why the effect of the mix on the nominal interest rate is uncertain. (e) Instead, the government acts alone, borrowing to raise purchases by VD 3 billion. Using the loanable funds market, explain why this may not close the gap.
Worked solution and suggested Marlbridge rubric
(a) A recessionary gap of 900 − 870 = VD 30 billion. Cyclical unemployment = 0.015 × 30 million = 0.45 million.
(b) Multiplier = 1 ÷ 0.1 = 10. AD shift = 10 × 2 = +VD 20 billion. Remaining 10 ÷ 10 = VD 1 billion of investment. The central bank should buy government bonds (an open market purchase) to lower interest rates.
(c) Axes “Inflation rate” and “Unemployment rate”. Downward-sloping SRPC; vertical LRPC at 5%. A at 6.5% and 1%, to the right of the LRPC. B is up and to the left along the same SRPC, at 5%, with higher inflation.
(d) The bond purchase lowers the rate, but higher income and prices raise money demand, which raises it. The net effect depends on sizes.
(e) Borrowing shifts the demand for loanable funds right, so the real interest rate rises and private investment falls. The net AD shift is less than 10 × 3 = VD 30 billion, so the gap may stay partly open.
| Point | What earns it |
|---|---|
| 1 | Recessionary gap of 30 and 0.45 million cyclically unemployed |
| 1 | AD shift of 20 and investment rise of 1 |
| 1 | Open market purchase |
| 1 | Labelled axes, SRPC and LRPC at 5%, A to the right of the LRPC |
| 1 | B up and to the left along the same SRPC |
| 1 | Uncertain rate: lower from the purchase, higher from money demand |
| 1 | Higher real r crowds out investment, so the AD shift is smaller than 30 |
Total: 7 points. In (c), shifting the SRPC earns no point for B.
Question 5 (constructed response · mixed)
Valdoria is in long-run equilibrium. Its money supply is VD 250 billion, velocity is 4.8 and full-employment real GDP is VD 960 billion. The central bank raises the money supply by 8%.
(a) Calculate the price level before the change and in the long run after it (V and real GDP unchanged). (b) Explain the short-run effect on real output and unemployment, and show it on a Phillips curve graph. (c) Explain the long-run adjustment, and show it on the same graph. (d) The central bank then keeps money growing at 8% a year while real GDP grows 2% a year and V is constant. Estimate the inflation rate, and give the exact figure. (e) Explain why (b) to (d) show that there is no long-run trade-off between inflation and unemployment.
Worked solution and suggested Marlbridge rubric
(a) P = (250 × 4.8) ÷ 960 = 1,200 ÷ 960 = 1.25. New M = 270, so P = (270 × 4.8) ÷ 960 = 1.35, up 8%, the same as M.
(b) More money lowers interest rates and raises spending, so AD shifts right. Output rises above full employment and unemployment falls below the natural rate: a movement up and to the left along SRPC₁, from A to B.
(c) Workers win higher nominal wages, so SRAS shifts left and the SRPC shifts right to SRPC₂. The economy reaches C on the LRPC: unemployment at the natural rate, inflation higher than at A.
(d) Inflation ≈ 8 − 2 = 6%. Exactly: 1.08 ÷ 1.02 − 1 = 5.88%.
(e) Lower unemployment lasted only until wages caught up. In the long run unemployment is at the natural rate at any inflation rate: the LRPC is vertical.
| Point | What earns it |
|---|---|
| 1 | P = 1.25 and 1.35 |
| 1 | AD right, so output up and unemployment down |
| 1 | Movement up along SRPC₁, labelled |
| 1 | Nominal wages rise, so SRPC shifts right |
| 1 | C on the LRPC at a higher inflation rate than A |
| 1 | About 6% (exactly 5.88%) |
| 1 | No trade-off: unemployment returns to the natural rate whatever the inflation rate |
Total: 7 points. In (b), “the SRPC shifts left” earns no point.
Question 6 (constructed response · mixed)
Valdoria has 50 million people, 24 million employed workers and output per worker of VD 45,000; the population does not change. A borrowed-money package adds a research tax credit that raises output per worker by 4%, and childcare subsidies that raise employment to 24.6 million.
(a) Calculate real GDP and real GDP per capita before the package. (b) Calculate real GDP per capita after the package and its growth rate. Name the channel each policy works through. (c) Draw a correctly labelled AD–AS graph showing the long-run effect, and state the matching change on a PPC. (d) Explain why the effect of the package on the price level is ambiguous. (e) Borrowing crowds out some private investment, so output per worker rises only 2%. Calculate the new growth rate and explain the difference.
Worked solution and suggested Marlbridge rubric
(a) Real GDP = 24 million × 45,000 = VD 1,080 billion. Per capita = 1,080 billion ÷ 50 million = VD 21,600.
(b) Output per worker = 46,800; real GDP = 24.6 million × 46,800 = VD 1,151.28 billion; per capita = VD 23,025.60. Growth = 6.60% (1.04 × 1.025 = 1.066). The tax credit works through technology and capital (productivity); childcare works through participation (employed share 48% to 49.2%).
(c) Axes “Real GDP” and “Price level”. LRAS shifts right from Yf₁ to Yf₂. On a PPC, the curve shifts outward.
(d) In the short run the package shifts AD right, pushing the price level up. As capacity grows, SRAS and LRAS shift right, pushing it down. The net effect depends on the sizes.
(e) Output per worker = 45,900; real GDP = VD 1,129.14 billion; per capita = VD 22,582.80; growth = 4.55%. A higher real interest rate cut private investment, so capital per worker and productivity grew less.
| Point | What earns it |
|---|---|
| 1 | VD 1,080 billion and VD 21,600 |
| 1 | VD 23,025.60 and 6.60% |
| 1 | Channels: productivity (tax credit) and participation (childcare) |
| 1 | LRAS right on labelled axes, PPC outward |
| 1 | Price level ambiguous because AD and AS both shift right |
| 1 | 4.55% |
| 1 | Crowding out lowers investment, so capital per worker and productivity grow less |
Total: 7 points. Accept values carried forward. In (c), shifting only AD earns no point.
How did you do?
- Q4(b), (d): policy mixes. Tick off the Topic 5.1 checklist.
- Q1, Q4(c) or Q5(b)–(c), (e): Phillips curves. Use the Topic 5.2 checklist.
- Q2 or Q5(a), (d): money and inflation. Use the Topic 5.3 checklist.
- Q1 or Q3(a)–(b): budget and debt. Use the Topic 5.4 checklist.
- Q3(c)–(f), Q4(e) or Q6(e): crowding out. Use the Topic 5.5 checklist.
- Q6(a)–(c): measuring growth. Use the Topic 5.6 checklist.
- Q6(b), (d): growth policy. Use the Topic 5.7 checklist.
If several topics feel shaky, return to the Unit 5 diagnostic and its “Your next step” table.