AA Economics Theories 4 — Questions and Answers
Question 1: Which theory predicts that real exchange rates adjust to equalize the purchasing power of currencies across countries?
- Interest rate parity
- Purchasing power parity (PPP) (Correct answer)
- Balance of payments theory
- Mundell-Fleming model
Correct answer: Purchasing power parity (PPP)
PPP holds that exchange rates should reflect relative price levels so that a basket of goods costs the same in different currencies.
Question 2: Behavioral economics challenges classical theory by arguing that human decision-making is often:
- Perfectly rational and self-interested
- Subject to biases, heuristics, and bounded rationality (Correct answer)
- Driven entirely by long-run self-interest
- Unaffected by social norms
Correct answer: Subject to biases, heuristics, and bounded rationality
Kahneman and Tversky showed that cognitive biases cause systematic departures from the rational actor model.
Question 3: In the Solow growth model, the 'steady state' is reached when:
- Population stops growing
- Investment exactly offsets depreciation and population growth (Correct answer)
- Technology advances at a constant rate
- Government spending equals tax revenue
Correct answer: Investment exactly offsets depreciation and population growth
At steady state, new capital investment just replaces worn-out capital and equips new workers, so capital per worker stops changing.
Question 4: The theory of comparative advantage suggests that trade benefits all countries if each specializes in goods where it has:
- Absolute lowest production cost
- Lowest opportunity cost relative to other goods (Correct answer)
- Most advanced technology
- The largest labor force
Correct answer: Lowest opportunity cost relative to other goods
David Ricardo showed that specializing in goods with relatively lower opportunity costs allows all trading partners to consume more.
Question 5: Supply-side economics, popularized in the 1980s, primarily advocates for:
- Increased government spending during recessions
- Tax cuts and deregulation to stimulate production (Correct answer)
- Strict money supply controls
- Higher minimum wages to boost consumer spending
Correct answer: Tax cuts and deregulation to stimulate production
Supply-siders argue that lower taxes and reduced regulation improve incentives to work, invest, and produce, shifting aggregate supply outward.
Question 6: The concept of 'crowding out' in macroeconomics refers to:
- Monopolies preventing new market entrants
- Government borrowing raising interest rates and reducing private investment (Correct answer)
- Imports displacing domestic production
- Central bank purchases reducing bond yields
Correct answer: Government borrowing raising interest rates and reducing private investment
When government borrows heavily, higher interest rates discourage private borrowing and investment, partially offsetting fiscal stimulus.
Question 7: Which model links a country's interest rates, exchange rates, and capital flows under a fixed exchange rate regime?
- IS-LM model
- Mundell-Fleming model (Correct answer)
- Harrod-Domar model
- Solow-Swan model
Correct answer: Mundell-Fleming model
The Mundell-Fleming model extends IS-LM to an open economy, showing that under fixed rates, monetary policy loses its effectiveness.
AA Economics Theories 4
Which theory predicts that real exchange rates adjust to equalize the purchasing power of currencies across countries?