Foundations of Economics for International Business Supplementary Exercises 3

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1 Foundations of Economics for International Business Supplementary Exercises 3 INSTRUCTOR: XIN TANG Department of World Economics Economics and Management School Wuhan University Fall 2015 These tests are only for your practice, you do NOT have to hand them in. However, all materials in the supplementary tests are also subject to be tested in exams. Check the answers carefully! 1 MULTIPLE CHOICES 1. Over the business cycle, investment spending consumption spending. (A) is inversely correlated with (B) is more volatile than (C) has about the same volatility as (D) is less volatile than 2. When the Federal Reserve reduces the money supply, at a given price level the amount of output demanded is and the aggregate demand curve shifts. (A) greater; inward (B) greater; outward (C) lower; inward (D) lower; outward 3. A short-run aggregate supply curve shows fixed, and a long-run aggregate supply curve shows fixed. (A) output; output (B) prices; prices 1

2 (C) prices; output (D) output; prices 4. If the long-run aggregate supply curve is vertical, then changes in aggregate demand affect: (A) neither prices nor level of output. (B) both prices and level of output. (C) level of output but not prices. (D) prices but not level of output. 5. If the short-run aggregate supply curve is horizontal, then a change in the money supply will change in the short run and change in the long run. (A) only prices; only output (B) only output; only prices (C) both prices and output; only prices (D) both prices and output; both prices and output 6. If the short-run aggregate supply curve is horizontal and the Fed increases the money supply, then: (A) output and employment will increase in the short run. (B) output and employment will decrease in the short run. (C) prices will increase in the short run. (D) prices will decrease in the short run. 7. Starting from long-run equilibrium, if the velocity of money increases (due to, for example, the invention of automatic teller machines) and no action is taken by the government: (A) prices will rise in both the short run and the long run. (B) output will rise in both the short run and the long run. (C) prices will rise in the short run and output will rise in the long run. (D) output will rise in the short run and prices will rise in the long run. 8. A reduction in the demand for money is the equivalent of a(n) in velocity and will shift the aggregate demand curve to the. (A) increase; right (B) increase; left (C) decrease; right (D) decrease; left 2

3 9. Starting from long-run equilibrium, an increase in aggregate demand increases in the short run, but only increases in the long run. (A) output; prices (B) prices; output (C) short-run aggregate supply; long-run aggregate supply (D) the money supply; the natural rate of output 10. If the short-run aggregate supply curve is horizontal, an increase in union aggressiveness that pushes wages and prices up will result in prices and output in the short run. (A) higher; lower (B) lower; higher (C) higher; higher (D) lower; lower 11. The dilemma facing the Federal Reserve in the event that an unfavorable supply shock moves the economy away from the natural rate of output is that monetary policy can either return output to the natural rate, but with a price level, or allow the price level to return to its original level, but with a level of output in the short run. (A) higher; higher (B) higher; lower (C) lower; lower (D) lower; higher 12. Starting from long-run equilibrium, if a drought pushes up food prices throughout the economy, the Fed could move the economy more rapidly back to full employment output by: (A) increasing the money supply, but at the cost of permanently higher prices. (B) decreasing the money supply, but at the cost of permanently lower prices. (C) increasing the money supply, which would restore the original price level. (D) decreasing the money supply, which would restore the original price level. 13. The I S LM model takes as exogenous. (A) the price level and national income (B) the price level (C) national income (D) the interest rate 3

4 14. The variable that links the market for goods and services and the market for real money balances in the I S LM model is the: (A) consumption function. (B) interest rate. (C) price level. (D) nominal money supply. 15. An explanation for the slope of the IS curve is that as the interest rate increases, the quantity of investment, and this shifts the expenditure function, thereby decreasing income. (A) increases; downward (B) increases; upward (C) decreases; upward (D) decreases; downward 16. Based on the Keynesian model, one reason to support spending increases over tax cuts as measures to increase output is that: (A) government spending increases the M PC more than tax cuts. (B) the government-spending multiplier is larger than the tax multiplier. (C) government-spending increases do not lead to unplanned changes in inventories, but tax cuts do. (D) increases in government spending increase planned spending, but tax cuts reduce planned spending. 17. One argument in favor of tax cuts over spending on infrastructure to increase production is that: (A) tax cuts increase the M PC by a larger amount than spending on infrastructure. (B) tax cuts increase planned spending, but spending on infrastructure offsets private spending. (C) the tax multiplier is larger than the government spending multiplier. (D) it takes longer to implement spending on infrastructure than to implement tax cuts. 18. Along an I S curve all of the following are always true except: (A) planned expenditures equal actual expenditures. (B) planned expenditures equal income. (C) the demand for real balances equals the supply of real balances. (D) there are no unplanned changes in inventories. 19. When the LM curve is drawn, the quantity that is held fixed is: 4

5 (A) the nominal money supply. (B) the real money supply. (C) government spending. (D) the tax rate. 20. According to the theory of liquidity preference, if the supply of real money balances exceeds the demand for real money balances, individuals will: (A) sell interest-earning assets in order to obtain non-interest-bearing money. (B) purchase interest-earning assets in order to reduce holdings of non-interest-bearing money. (C) purchase more goods and services. (D) be content with their portfolios. 21. With the real money supply held constant, the theory of liquidity preference implies that a higher income level will be consistent with: (A) no change in the interest rate. (B) a lower interest rate. (C) a higher interest rate. (D) first a lower and then a higher interest rate. 22. A decrease in the real money supply, other things being equal, will shift the LM curve: (A) downward and to the left. (B) upward and to the left. (C) downward and to the right. (D) upward and to the right. 23. Changes in monetary policy shift the: (A) LM curve. (B) planned spending curve. (C) money demand curve. (D) I S curve. 24. Assume that the money demand function is (M/P) d = 2, r, where r is the interest rate in percent. The money supply M is 2,000 and the price level P is 2. If the price level is fixed and the supply of money is raised to 2,800, then the equilibrium interest rate will: (A) drop by 4 percent. (B) drop by 2 percent. (C) drop by 1 percent. (D) remain unchanged. 5

6 2 DATA ANALYSIS In order to answer the following problem, you may wish to read the supplementary material on basic business cycle facts by David Romer on Blackboard. Macroeconomics is a science that tries to explain the phenomena happening around the world of economy as a whole. Motivations to most macroeconomic theories are the phenomena we observed in real life and these observations in principal are provided in the form of data. Hence perhaps the most important skill in analyzing macroeconomic problems is to analyze data. This question provides you with a very primitive intuition of how data analysis is conducted. Some basic data about business cycle are summarized in Figure 1, Table 1 and 2. Figure 1: Real GDP Growth Rate in United States Table 1: Recessions in United States since World War II Year and Quarter of Peak in Real GDP Numbers of Quarters until Trough in Real GDP Change in Real GDP from Peak to Trough 1948: % 1953: % 1957: % 1960: % 1969: % 1973: % 1980: % 1981: % 1990: % Source: Citibase. Based on the information provided above, please answer the following question: 6

7 Table 2: Behavior of the Components of Output in Recessions Component of Output Average Share in GDP Average Share in Fall in GDP in Recessions Relative to Normal Growth Consumptions Durables Non-durables Services Investment Residential Fixed Non-residential Inventories Net Exports Government Purchases Source: Citibase. (a) Historically, economists have attempted to settle a regular cyclical pattern of business cycle in the sense that under a certain period, the fluctuations should exhibit similar magnitude and last for approximately the same length, some early attempts including Kitchin (3 years), Kuznets (20 years) and Kontratiev (50 years). What is your opinion toward this attempt? You may wish to refer to Table 1 (2%) (b) Do the components of output fluctuate at the same volatility? Refer to Table 2 (2%) (c) Are the output movements symmetric? That is to say in equivalence, are the magnitudes of fluctuation the same in expansions and recession? You may wish to refer to Figure 1. (3%) 3 SHORT ANSWERS AND NUMERICAL PROBLEMS 1. Assume that the long-run aggregate supply curve is vertical at Y = 3,000 while the short-run aggregate supply curve is horizontal at P = 1.0. The aggregate demand curve is Y = 2(M/P) and M = 1,500. (a) If the economy is initially in long-run equilibrium, what are the values of P and Y? (b) What is the velocity of money in this case? (c) Suppose because banks start paying interest on checking accounts, the aggregate demand function shifts to Y = (1.5)(M/P). What are the short-run values of P and Y? (d) What is the velocity of money in this case? (e) With the new aggregate demand function, once the economy adjusts to long-run equilibrium, what are P and Y? 7

8 (f) What is the velocity now? 2. You are given the information about the following leading indicators. For each indicator explain whether the information suggests that a recession or expansion should be expected in the future. (a) Average initial weekly claims for unemployment insurance rises. (b) New building permits issued increase. (c) The interest rate spread between the 10-year Treasury note and the 3-month Treasury bill narrows. (d) The Index of Supplier Deliveries falls. 3. Suppose Congress passes legislation that significantly reduces taxes. (a) Use the Keynesian-cross model to illustrate graphically the impact of a reduction in taxes on the equilibrium level of income. Be sure to label: 1) the axes; 2) the curves; 3) the initial equilibrium values; 4) the direction the curve shifts; and 5) the terminal equilibrium values. (b) Explain in words what happens to equilibrium income as a result of the tax cut and the time horizon appropriate for this analysis. 4 SOLUTIONS Multiple Choices: 1 5 B C C D B; 6 10 A D A A A; B A B B D; B D C B B; C B A B. Data Analysis: Please refer to the supplementary material on basic business cycle facts by David Romer on Blackboard. You should be able to form your own comments. Short Answers and Numerical Problems 1. (a) P = 1.0; Y = 3,000 (b) velocity = 2 (c) P = 1.0; Y = 2,250 (d) velocity = 1.5 8

9 (e) P = 0.75; Y = 3,000 (f) velocity = (a) Recession; more workers eligible for unemployment insurance benefits indicate that firms are laying off workers and cutting back on production. (b) Expansion; planned investment is increasing. (c) Recession; future interest rates are not expected to rise, which typically occurs in a recession. (d) Recession; few firms are experiencing slow deliveries, indicating that output and production is slow. 3. (a) As demonstrated in Figure 2. Figure 2: Keynesian Cross (b) The equilibrium level of income increases. This analysis is appropriate in the short run when prices and the interest rate are constant. 9