Practice Final Exam Economics 503 Fundamentals of Economic Analysis 2:30-5:30PM

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1 Name Student ID Practice Final Exam Economics 503 Fundamentals of Economic Analysis 2:30-5:30PM Write all of your answers on this white exam paper. Do not hand in the blue books. Multiple Choices (2 points each) 1. We observe in microeconomics that, while in macroeconomics : a. the supply curve is more elastic in the short run than the long run; the short-run aggregate supply curve is more elastic than the long-run aggregate supply curve. b. The supply curve is more elastic in the long run than the short run; the short-run aggregate supply curve is more elastic than the long-run aggregate supply curve. c. the supply curve is more elastic in the short run than the long run; the long-run aggregate supply curve is more elastic than the short-run aggregate supply curve. d. The supply curve is more elastic in the long run than the short run; the long-run aggregate supply curve is more elastic than the short-run aggregate supply curve. B 2. You read an analysis that says that the Japanese yen is overvalued relative to the US dollar. This would imply that a. Japan s real exchange rate is above 1; Japan s PPP converted GDP is larger than its exchange rate converted GDP. b. Japan s real exchange rate is above 1; Japan s PPP converted GDP is smaller than its exchange rate converted GDP. c. Japan s real exchange rate is below 1; Japan s PPP converted GDP is larger than its exchange rate converted GDP. d. Japan s real exchange rate is below 1; Japan s PPP converted GDP is smaller than its exchange rate converted GDP. D Unfortunately, we did not get a chance to cover this material. 1

2 3. The U.S. Federal Reserve announces that it is raising its target interest rate. We would then observe that a. The Federal Reserve would engage in an open market sale; the HKMA would engage in a foreign currency purchase. b. The Federal Reserve would engage in an open market sale; the HKMA would engage in a foreign currency sale. c. The Federal Reserve would engage in an open market purchase; the HKMA would engage in a foreign currency purchase. d. The Federal Reserve would engage in an open market purchase; the HKMA would engage in a foreign currency sale. B 4. The demand and supply for a product both increase (i.e. both curves shift out). Which of the following statements is true: a. the equilibrium price of the product must increase; the equilibrium quantity of the product must increase. b. the equilibrium price of the product may or may not increase; the equilibrium quantity of the product must increase. c. the equilibrium price of the product must increase; the equilibrium quantity of the product may or may not increase. d. the equilibrium price of the product may or may not increase; the equilibrium quantity of the product may or may not increase. B 5. Which of the following transactions would be included as part of the expenditure method of calculating GDP in Japan. a. a German expatriate sells a used Toyota to his neighbor in Tokyo b. a Japanese fisherman sells fresh fish to a sushi shop in Kyoto c. a Japanese miller sells flour to a bakery in Los Angeles d. a German expatriate buys shares in Toyota Motor Co. e. none of the transactions would be counted. C 2

3 6. Discretionary counter-cyclical fiscal and monetary policy will both take some time to affect the economy. We can say that: a. with fiscal policy the lag occurs before policy is formulated; with monetary policy the lag occurs after the policy is formulated. b. with fiscal policy the lag occurs after policy is formulated; with monetary policy the lag occurs after the policy is formulated. c. with fiscal policy the lag occurs before policy is formulated; with monetary policy the lag occurs before the policy is formulated. d. with fiscal policy the lag occurs after policy is formulated; with monetary policy the lag occurs before the policy is formulated. A Fiscal policy requires a consensus which takes time. Monetary policy is easily adjusted, but it will only works when firms adjust investment. Unfortunately, we did not get a chance to cover this material. 7. Gadgets are a normal good. The supply curve of gadgets is not perfectly elastic. Gadgets are substitutes for widgets. The income of gadget and widget customers goes up by 10%. We should see: a. The price of gadgets rise and the demand curve for widgets shifts out. b. The price of gadgets rise and the demand curve for widgets shift in. c. The price of gadgets fall and the demand curve for widgets shifts out. d. The price of gadgets fall and the demand curve for widgets shift in. A 8. The income of gadget and widget customers goes up by 10%. The supply curve in a market for widgets is perfectly elastic but the supply curve of gadgets is not. Widgets are a luxury good while gadgets are a normal good. Gadgets are substitutes for widgets. a. The equilibrium quantity of widgets increases by more than 10%. b. The equilibrium quantity of widgets increase by less than 10% c. The equilibrium quantity of widgets decrease by less than 10% d. The equilibrium quantity of widgets decrease by more than 10%. A 3

4 9. A feeling of pessimism comes over a closed economy. Households begin to save more for future rainy days and the corporate sector feels that capital investment projects are less profitable. We should expect to see [ a. an increase in the equilibrium real interest rate and an ambiguous impact on equilibrium investment. b. A decrease in the equilibrium real interest rate and an ambiguous impact on equilibrium investment. c. an ambiguous impact on the equilibrium real interest rate and an increase in equilibrium investment. d. an ambiguous impact on the equilibrium real interest rate and a decrease in equilibrium investment.. B 10. All else equal, an increase in the government budget deficit will a. lead to a greater equilibrium increase in the real interest rate in a globalized economy than in a closed economy and lead to a greater equilibrium decline in national savings in a globalized economy than in a closed economy. b. lead to a greater equilibrium increase in the real interest rate in a globalized economy than in a closed economy and lead to a smaller equilibrium decline in national savings in a globalized economy than in a closed economy. c. lead to a smaller equilibrium increase in the real interest rate in a globalized economy than in a closed economy and lead to a greater equilibrium decline in national savings in a globalized economy than in a closed economy. d. lead to a smaller equilibrium increase in the real interest rate in a globalized economy than in a closed economy and lead to a smaller equilibrium decline in national savings in a globalized economy than in a closed economy.. C 4

5 Calculation 1. [3 points] Calculate the elasticity of demand (using the midpoint method) and the marginal revenue for a monopolist facing the following demand curve. Marginal Price Quantity Elasticity Revenue [4 points] The GDP deflator index is 116 in Assuming year 2000 was the base year, what was the average inflation rate over the period ? Assuming constant velocity and a money growth rate of 15%, what was the growth rate of real GDP? The base year deflator was 100, so the growth rate of prices was 16%, P2001 P = =.16. We can say that P M P Y Y M t V = Pt Yt gt = gt + gt =.15 =.16 + gt if money growth was 15% Y g =.01 t 5

6 3. [4 points] HK s GDP is HK$1.4 trillion. The exchange rate with the US dollar is 7.8 HK$ per US dollar. The price of a market basket of typical goods in HK is HK$12,000 and the price of that same market basket of goods in the USA is US$2,000. Calculate the exchange rate converted GDP of HK in US$ and the PPP converted GDP. Calculate the real exchange rate. Is the Hong Kong Dollar overvalued or undervalued? PPP conversion factor is 6. HK GDP per Capita is HK$ In exchange rate converted terms In PPP converted terms is US$33, REX is 1.3 and the HK dollar is undervalued. Unfortunately, we did not get a chance to cover this material. 4. [4 points] The growth of the money supply is always 6.25% and the growth rate of real output is always 2.75%. If velocity is always constant, what is the long run inflation rate? If the average real interest rate is 2.5%, what would be the average nominal interest rate? Inflation rate is 3.5% and nominal interest rate is 6%. 5. [4 points] The base year is The following table shows the hourly wages in 1997 and 2007 along with the CPI for those years. Calculate the wages measured in 2000 dollars. Which is higher in inflation adjusted terms? Wages CPI Real Wages

7 6. [ 5 points] The marginal propensity to consume is.8 and the tax rate is 25% so that disposable income is.75*y. Assume that the marginal propensity to import is zero. a. Calculate the expenditure multiplier. How much would expenditure increase, if government spending increases by 100? Unfortunately, we did not get a chance to cover this material. b. Assume that output increases to match the increase in the expenditure. Calculate the increase in tax collection that occurs as a result of the increase in spending. What is the total impact on the budget deficit that occurs if government spending increases by 100? Unfortunately, we did not get a chance to cover this material. D 7. [4 points] The demand curve in an industry is Q = 10.1 P while the supply curve S is Q =.15 P. Calculate the equilibrium price and quantity P=.15P P= 40 Q = 6 7

8 Short Answer 1. [3 points] From the following table, what is the money multiplier (i.e. the ratio of the M1 money supply to the monetary base) in this economy? Cash 100 Reserves 20 Deposits 600 Money multiplier = (Cash+Deposits)/(Cash+Reserves) = 700/120 = [3 points] The velocity rate is constant over time at V =.5. The growth rate of real GDP is 5% per year and the growth rate of the money supply is 7% per year. Calculate the level of the real inflation tax when Real GDP is HK$1 trillion dollars. Unfortunately, we did not get a chance to cover this material. 3. [3 points] List the 3 roles of money a. Unit of Account b. Medium of Exchange c. Store of Value 8

9 4. [6 points] Americans feel very optimistic and their high animal spirits increase demand in that country. The US Federal reserve follows a policy of countercyclical monetary policy. a. Would the central bank in the USA respond with an open market purchase or an open market sale of government bonds? To raise interest rates, the Fed must shrink money supply. They would need an open market sale. b. Compare the effects of these events on the sales of two firms in Hong Kong. Firm A is a real estate developer which builds residential housing. Firm B is a company that makes watches for sale at the best department stores across the world. Which type of firm is likely to experience the strongest increase in demand as a result of the two events in the US? Explain the difference in 5 sentences or less. The open market sale and the high animal spirits push up interest rates in the USA. This raises interest rates in HK. The high interest rates will have negative impact on borrowing for housing, but is also likely to have negative effects on consumer durable purchases. However, the HK Watch company should also receive some additional demand from the USA export market 5. [3 points] You have information on the income elasticity of demand for three types of goods. Classify the goods by type: normal good, a luxury good or an inferior good? Good Income Type of Good Elasticity of Demand Tomatoes.5 Normal Plums -.5 Inferior Spinach -2.5 Inferior 9

10 Macroeconomics 6. [3 points] We observe the inflation rate in the US being 2% and the money market interest rate being set at 3%. Assuming that the Federal Reserve sets the interest rate target according to the Taylor rule, would we say that the Federal Reserve believes the economy is in a recession or an expansion. TGT The Taylor rule suggests that i = π +.5 ( π π ) +.5 Output Gap Given an inflation target of 2%, we could say the inflation gap = 0. Then we could write this as.03 = i = Output Gap So that the only explanation is the Fed thinks there is a Output Gap =.03 recession. 7. [2 points] List two costs of high expected inflation a Shoe Leather Costs Inconvenience costs from not holding money. b. Menu Costs Costs of changing price levels 10

11 Graphing Questions Since the mid-1990 s, the United Kingdom has followed a monetary policy of inflation targeting. The way we might think of this policy, the central bank will choose some price level P* and to set monetary policy to keep the equilibrium price level in the economy near P *. When the price level threatens to go above P*, the central bank will raise interest rates and cut interest rates when the price goes below P*. Assume that the economy is in an initial equilibrium where the price level is P * and the output level is equal to potential output. Assume that monetary policy will impact the economy before the self-correcting mechanism activates. 1. [4 points] Use 1 graph to describe what would happen to GDP in the economy when (A) the UK real estate market crashes; and (B) the central bank acts to maintain the price level. Clearly mark (A) the equilibrium after the crash in asset prices occurs and before monetary policy affects the economy; and (B) the equilibrium after monetary policy has an effect. Y P SRAS P * B A AD AD 11

12 2. [4 points] Use 1 graph to describe what would happen to GDP in the economy (A) when the price of oil rises sharply; and (B) the central bank acts to maintain the price level. Clearly mark (A) the equilibrium after the rise in oil prices occurs and before monetary policy affects the economy; and (B) the equilibrium after monetary policy has an effect. A Y P SRAS P * B AD ADʹ 12

13 A series of financial scandals suddenly makes the Australian stock market very attractive (relative to other stock markets around the world) to both Australians and foreign investors. 3. [4 points] Use a graph of the Australian Forex market to demonstrate the impact of these events on the Australian Dollar exchange rate (i.e. the number of Australian dollars needed to buy one US dollar). R Y P Supply 1 Supply R * R ** Demand Supply 2 Demand Q 13

14 4. [4 points] Now, suppose the Reserve Bank of Australia acts to keep the Australian dollar exchange rate stable in the face of these events. Describe the impact of the policy response on Australian money and interest rates using a graph of the Australian money market. i Money Supply Money Supply i* i** Money 14

15 5. [4 points] The demand for watermelons is highest during summer and lowest during winter. Yet, watermelon prices are normally lower in summer than in winter. Use a demand and supply graph to demonstrate how this is possible. Be sure to carefully label the curves in your graph and to clearly indicate the equilibrium summer price and the equilibrium winter price. Winter Summer S D The demand for watermelons is highest in summer which should make the demand higher. Holding supply constant, this would make watermelon prices higher than in winter. However, the supply of watermelons also rises in summer, perhaps more than demand. This makes the equilibrium price of watermelon lower in summer. 15

16 6. [4 points] Draw a graph showing what happened in Japan near the turn of the millennium when the interest rate hit its zero lower bound. i Money Supply i* i** Money 16

17 7. [4 points] We see that real interest rates around the world are going up. Draw a graph of the loanable funds market which shows what this would do to domestic savings, domestic investment, the domestic real interest rate, the domestic capital account and the domestic trade balance. B r W S+KA r W S D AD S* S** D** D* S,r,I,KA 17

18 8. [4 points] Assume that a country is operating at its level of potential output. The central bank, however, overestimates the level of potential output, believing the long run output of the economy to be greater than it is in actuality. Assuming they conduct counter-cyclical monetary policy to fight what they consider to be a recession, draw a graph showing the behavior of this economy in the short-run and the long-run. SRAS C P * A B Y P Est. Y P AD AD The central bank believing that the economy is in a recession will increase the money supply and reduce the real interest rate. This will shift the demand curve out, increasing output. However, they will push the economy above potential output, tightening labor markets and leading the AS curve to shift up leading to an increase in prices and movement back to the real level of potential output. 18

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