Final Examination ECON 4020/ SPRING 2005 Instructor: Dr. M. Nirei 1:30 3:20 pm, April 28, Part I (45 points; Mark your answers in a SCANTRON)

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1 Final Examination ECON 4020/ SPRING 2005 Instructor: Dr. M. Nirei 1:30 3:20 pm, April 28, 2005 Name: Part I (45 points; Mark your answers in a SCANTRON) (1) The GDP deflator is equal to: a. the ratio of nominal GDP to real GDP b. the ratio of real GDP to nominal GDP c. real GDP minus nominal GDP d. nominal GDP minus real GDP (2) The value added on an item produced means: a. a firm s profit on the item sold b. the value of the labor inputs in the production of an item c. the value of firm s output less the value of its costs d. the value of firm s output less the value of the intermediate goods that the firm purchases (3) If GDP (measured in billions of current dollars) is $5,465, consumption is $3,657, investment is $741, and the government purchases are $1,098, then net exports are: a. $131 b. -$131 c. $31 d. -$31 (4) The real interest rate is the: a. rate of interest actually paid by the consumers b. rate of interest actually paid by the banks c. rate of inflation minus the nominal interest rate d. nominal interest rate minus the rate of inflation (5) The reduction in investment brought about by the increase in the interest rate caused by increased government spending is called: a. a budget deficit b. monetary policy c. the identification problem d. crowding out

2 (6) In the classical model with fixed income, if the demand for goods and services is less than the supply, the interest rate will: a. increase b. decrease c. remain unchanged d. either increase or decrease, depending on whether consumption is greater than or less than investment (7) According to the Fisher effect, the nominal interest rate moves one-for-one with changes in the: a. Inflation rate b. Expected inflation rate c. Ex ante real interest rate d. Ex post real interest rate (8) In a small open economy, starting from a position of balanced trade, if the government increases domestic government purchases, this produces a tendency toward a: a. Trade surplus b. Trade deficit c. Budget surplus d. Stagflation (9) If the number of dollars per yen rises, this is called a(n): a. Appreciation of the dollar b. Appreciation of the yen c. Increase in the terms of trade d. Decrease in the terms of trade (10) The value of net exports is also the value of: a. Net investment b. Net saving c. National saving d. The excess of national saving over domestic investment (11) When the real exchange rate rises (i.e. appreciates) : a. Exports will decrease but imports will be unaffected b. Imports will decrease but exports will be unaffected c. Exports will increase but imports will decrease d. Imports will increase but exports will decrease

3 (12) To reduce the money supply, the Federal Reserve: a. Buys government bonds b. Sells government bonds c. Creates demand deposits d. Destroys demand deposits (13) If there are 100 transactions in a year and the average value of each transaction is $10, then if there is $200 of money in the economy, transaction velocity per year is a. 0.2 b. 2 c. 5 d. 10 (14) The natural rate of unemployment is: a. The average rate of unemployment around which the economy fluctuates b. About 15% of the labor force c. A rate that never changes d. The transition of individuals between employment and unemployment (15) Unemployment caused by the time it takes workers to search for a job is called: a. Insider unemployment b. Voluntary unemployment c. Frictional unemployment d. Efficiency unemployment (16) If s is the rate of job separation, f is the rate of job finding, and both rates are constant, then the unemployment rate is approximately: (Answer: C) a. b. c. d. f s + f f + s f s s + f s + f s (17) The Solow growth model describes:

4 a. How output is determined a. The static allocation of economy s output b. How savings, population growth, and technological progress affect output over time c. How unemployment is created (18) The major force of economic growth of income per person is: a. Productivity growth b. Money supply growth c. Employment growth d. Import growth (19) In the face of an adverse supply shock, an accommodating monetary policy would result in: a. Permanently higher output level b. Permanently lower price level c. Permanently lower output level d. Permanently higher price level (20) According to the quantity equation, if the velocity of money and the supply of money are fixed, and the price level increases, then the quantity of goods and services purchased: a. Increases b. Decreases c. Does not change d. May either increase or decrease (21) The IS-LM model takes: a. National income as exogenous b. The price level as exogenous c. The interest rate as exogenous d. National income and the price level as exogenous (22) According to the Keynesian-cross analysis, if MPC stands for marginal propensity to consume, then a rise in taxes of T will: a. Decrease equilibrium income by T b. Decrease equilibrium income by T /( 1 MPC) c. Decrease equilibrium income by ( T )( MPC) /(1 MPC) d. Not affect equilibrium income at all (23) The effect of tax-cut in the IS-LM model will be :

5 a. Interest rate rises and income falls b. Interest rate falls and income rises c. Interest rate falls and income falls d. Interest rate rises and income rises (24) In a small, open economy with a floating exchange rate, an effective policy to increase equilibrium output is to: a. Increase government spending b. Increase taxes c. Increase the money supply d. Decrease the money supply (25) In a fixed exchange rate system, the monetary policy is: a. Fully effective b. Fully ineffective c. Partially effective d. Partially ineffective (26) The time between a shock to the economy and the policy action responding to that shock is called the: a. Automatic stabilizer b. Time inconsistency of policy c. Inside lag d. Outside lag (27) The fact that traditional method of policy evaluation do not take into account the impact of policy on expectations is known as : a. Stabilization policy b. The political business cycle c. The Lucas critique d. Okun s law (28) Monetary policy rules that target nominal variables would target any of the following except the: a. Price level b. Money supply c. Unemployment rate d. Nominal GDP

6 (29) According to the traditional viewpoint, a tax cut without a cut in government spending would result in: a. Decrease in domestic interest rate and depreciation of domestic currency b. Decrease in domestic interest rate and appreciation of domestic currency c. Increase in domestic interest rate and depreciation of domestic currency d. Increase in domestic interest rate and appreciation of domestic currency (30) According to the theory of Ricardian equivalence, a tax cut that has no plans to reduce government spending results in: a. Increase in public saving and increase in private saving b. Decrease in public saving and increase in private saving c. Decrease in public saving and decrease in private saving d. Increase in public saving and decrease in private saving

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10 Part III (40 points) Choose two topics from below and discuss each of them in one page A. A. Principle of Classical Dichotomy in the long-run equilibrium in reference to the determination of nominal exchange rate by the Fisher effect and to the determination of price level in the quantity theory of money B. Causes and propagation mechanism of the Great Depression of the United States C. Different mechanisms of monetary transmission in a closed economy, in a small open economy under floating exchange rate, and in a small open economy under fixed exchange rate D. Mundell's trilemma and its implication for the U.S. and EU economies E. Lucas critique and the role of expectation on the effects of monetary expansion and of tax cut The classical dichotomy means theoretical separation of nominal and real variables in classical economics, and it implies that nominal variables do not affect real variables. An example of its application is the quantity theory of money, which claims that money supply only affects nominal GDP but does not affect real GDP. Real GDP is determined by economic fundamentals such as technology and endowments of labor and capital in the long run equilibrium, and hence an increase in money supply only affects the price level. Another example is the Fisher effect which claims that inflation rate only affects nominal interest rate but does not affect real interest rate. The real interest rate is determined by fundamentals such as the long-run demand and supply of goods and services, and hence a change in inflation rate affects only the nominal interest rate with leaving the real interest rate unaffected. B. The Great Depression was triggered by a stock price crash, which caused a downward shift of consumption function via worsened consumer confidence. The decreased consumption caused decrease in income as well as deflation. The deflation exacerbated the initial recession in two ways. First, the deflation decreased the nominal revenue of firms and households, and caused difficulty for debtors in repaying their debts. This caused a further shrink in investments and consumption (debt-deflation theory). Secondly, an expectation for further deflation was set in, and caused an increase in ex ante real interest rate, which further decreased investment. The worsened credit positions of debtors caused failure in banking system, which prolonged the depression. C. In a closed economy, an increase in money supply leads to an increase in income in the short run. The transmission mechanism of the money supply to income in this case is

11 that the increased money supply decreases the interest rate in the money market, which in turn increases investment demand. In a small open economy, this transmission mechanism through the investment does not take effect, since the interest rate is fixed at the world level. However, an increase in money supply does cause an increase in income in a small open economy under floating exchange rate. The transmission mechanism here is that an increase in money supply depreciates the currency and increases net export demand. This mechanism is shut down under the fixed exchange rate, however, because the monetary authority will be forced to buy back its increased money supply to maintain the exchange rate. Thus both monetary transmission mechanisms via interest rate and via exchange rate do not take effect in a small open economy under fixed exchange rate. D. Mundell s trilemma states that a policymaker cannot achieve the following three objectives: perfect capital mobility, fixed exchange rate, and autonomous monetary policy. This is because, under the perfect capital mobility, a commitment on a certain level of exchange rate necessarily determines the level of money supply. In the U.S., the capital mobility and monetary policy are achieved, but the exchange rate has to experience fluctuations. In the EU economies where the currency is made common within the region, there is no exchange rate fluctuation (obviously, since they use the common currency), but the central bank of a country cannot control their money supply independently from other central banks. E. Lucas critique points out a possibility that an economic policy may change people s expectation and alter the underlying economic relations which the policymaker intended to exploit. One example is a monetary expansion. Given that the short-run Phillips curve is downward sloping, the central bank can reduce the unemployment rate by raising the inflation. However, if the households and firms expect that the inflation is coming, then the rise in expected inflation rate shifts up the Phillips curve and leaves the unemployment rate unaffected by the monetary expansion. Another example is a tax cut. Given an upward sloping consumption function, an increase in disposable income due to the tax cut will increase consumption. However, if the households expect that the government will raise the tax in future to pay for the increased debt due to the tax cut, then it shifts the consumption function down and offsets the effect of increased disposable income on consumption. (end of Final Exam sheets)