Unit 5: Long-Run Consequences of Stabilization Policies

Original practice questions written to the published framework for this section. No expert has reviewed them, and they are not taken from any official exam. Try each one before you open the answer.

1. Question 1Foundational

   What is the shape of the long-run Phillips curve, and where is it located?

   1. AVertical at the natural rate of unemployment
   2. BDownward sloping through every rate of unemployment
   3. CHorizontal at the central bank's target inflation rate
   4. DUpward sloping above the natural rate of unemployment

   Show answer

   Answer: A. Vertical at the natural rate of unemployment

   In the long run expectations adjust to any steady inflation rate, so unemployment returns to its natural rate no matter how much inflation the economy tolerates. A downward slope is the tempting distractor, but that describes the short-run curve, where the trade-off exists only because wages and expectations have not yet caught up.

   Key insight: The long-run Phillips curve and long-run aggregate supply say the same thing: policy can move prices permanently but not output or unemployment.

2. Question 2Foundational

   What is the term for the reduction in private investment that occurs when heavy government borrowing drives up the real interest rate?

   1. ACrowding out
   2. BCrowding in
   3. CThe multiplier effect
   4. DAutomatic stabilization

   Show answer

   Answer: A. Crowding out

   Government deficits increase the demand for loanable funds, raising the real interest rate and discouraging business investment and interest-sensitive consumption. The multiplier effect is the tempting distractor because it operates on the same fiscal expansion, but it magnifies the increase in aggregate demand while crowding out partly offsets it.

   Key insight: The multiplier and crowding out pull in opposite directions, which is why the net effect of deficit spending is smaller than the multiplier alone predicts.

3. Question 3Intermediate

   According to the quantity theory of money, what happens in the long run if a country's money supply grows much faster than its real output?

   1. AThe price level rises roughly in proportion to the excess money growth
   2. BReal output rises roughly in proportion to the money growth
   3. CThe real interest rate falls permanently
   4. DUnemployment stays permanently below its natural rate

   Show answer

   Answer: A. The price level rises roughly in proportion to the excess money growth

   With velocity and real output relatively stable, extra money chases an unchanged quantity of goods and simply bids up prices. Permanently higher real output is the tempting distractor, but money is neutral in the long run, so printing money changes nominal values rather than the economy's productive capacity.

   Key insight: Sustained inflation is fundamentally a monetary phenomenon: prices rise when money grows faster than the goods it can buy.

4. Question 4Intermediate

   Which change shifts an economy's long-run aggregate supply curve to the right?

   1. AAn increase in the quantity or quality of productive resources
   2. BAn increase in household consumption spending
   3. CAn increase in the money supply
   4. DA decrease in the overall price level

   Show answer

   Answer: A. An increase in the quantity or quality of productive resources

   Long-run aggregate supply is set by resources, technology, and institutions, so more capital, more skilled workers, or better technology raises potential output. An increase in consumption is the tempting distractor, but spending shifts aggregate demand and cannot by itself expand what the economy is capable of producing.

   Key insight: Demand-side policy determines where the economy sits in the short run; only supply-side capacity moves the long-run curve.

5. Question 5Advanced

   Households and firms revise their expectations of future inflation upward. What happens to the short-run Phillips curve?

   1. AIt shifts outward, so any given inflation rate now comes with higher unemployment
   2. BIt shifts inward, so any given inflation rate now comes with lower unemployment
   3. CIt becomes vertical at the current rate of unemployment
   4. DIt does not move, because expectations matter only in the long run

   Show answer

   Answer: A. It shifts outward, so any given inflation rate now comes with higher unemployment

   Workers who expect higher inflation bargain for higher nominal wages, raising business costs and worsening the trade-off the economy faces at every inflation rate. Saying expectations matter only in the long run is the tempting distractor, but expectations are precisely what shifts the short-run curve, and the long-run curve stays fixed at the natural rate.

   Key insight: Expected inflation shifts the short-run Phillips curve, which is why credible central banks work so hard to keep expectations anchored.