Economics 259 Final Exam Fall 2014

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1 Economics 259 Final Exam Fall 2014 Name: Before beginning the exam, please verify that you have 10 pages with 27 questions in your exam booklet. The exam is worth 100 points. Good luck. Multiple Choice (each 3 points) Identify the letter of the choice that best completes the statement or answers the question. 1. If domestic saving exceeds domestic investment, then net exports are and net capital outflows are. a. negative; negative b. negative; positive c. positive; negative d. positive; positive e. positive; either positive or negative 2. According to the theory of liquidity preference, tightening the money supply will nominal interest rates in the short run, and according to the Fisher effect, tightening the money supply will nominal interest rates in the long run. a. increase; increase b. increase; decrease c. decrease; decrease d. decrease; increase e. increase; have no effect on 3. Long-run growth in real GDP is determined primarily by, while short-run movements in real GDP are associated with. a. variations in labor-market utilization; technological progress b. money supply growth rates; changes in velocity c. technological progress; variations in labor-market utilization d. changes in velocity; money supply growth rates e. technological progress; technological progress 4. On two occasions in the 1970s: a. world oil prices rose rapidly, inflation was high, and the unemployment rate was high. b. world oil prices rose rapidly, inflation was moderate, and the unemployment rate was high. c. world oil prices rose rapidly, inflation was high, and the unemployment rate was moderate. d. oil prices rose rapidly, but the Fed used monetary policy to curb inflation. e. world oil prices rose rapidly, inflation was moderate, and the unemployment rate was low.

2 5. If the nominal interest rates in the United States and Canada are 8 percent and 12 percent, respectively, the real interest rates are the same, and the real exchange rate is fixed, then the market's expectation about the number of Canadian dollars to be received for a U.S. dollar a year from now will be that it will: a. remain unchanged. b. decrease by 8 percent. c. decrease by 4 percent. d. increase by 5 percent. e. increase by 4 percent. 6. The index of leading economic indicators (LEI) compiled by the Conference Board includes 10 data series that are used to forecast economic activity about in advance. a. one month b. two months c. six to nine months d. one to two years e. five to ten years 7. A difference between the economic long run and the short run is that: a. the classical dichotomy holds in the short run but not in the long run. b. monetary and fiscal policy affect output only in the long run. c. demand can affect output and employment in the short run, whereas supply is the ruling force in the long run. d. prices and wages are sticky in the long run only. e. prices are sticky in the long run only, while wages are sticky in the short run only 8. If Congress passed a tax increase at the request of the president to reduce the budget deficit, but the Fed held the money supply constant, then the two policies together would generally lead to income and a interest rate. a. lower; lower b. lower; higher c. no change in; lower d. no change in; higher e. higher; lower 9. According to the Taylor rule, when real GDP is above its natural level, the nominal federal funds rate should be, and when inflation is below 2 percent, the nominal Federal funds rate should be. a. raised; raised b. lowered; lowered c. lowered; raised d. raised; lowered e. left unchanged; lowered 2

3 10. 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 MPC 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. e. tax cuts affect interest rates, but government spending does not 11. A liquidity trap occurs when: a. banks have too much currency and close their doors to new customers. b. the central bank mistakenly prints too much money, generating hyperinflation. c. when nobody wants to hold cash. d. dams and locks are built to prevent flooding. e. interest rates fall so low that monetary policy is no longer effective. 12. Assume that a war reduces a country's labor force but does not directly affect its capital stock. Then the immediate impact will be that: a. total output will rise, but output per worker will fall. b. both total output and output per worker will fall. c. both total output and output per worker will rise. d. total output will fall, but output per worker could either rise or fall. e. total output will fall, but output per worker will rise. 13. Which of the facts about the business cycles is incorrect? a. fluctuations in investment tend to be larger than fluctuations in GDP b. fluctuations in investment tend to be smaller than fluctuations in GDP c. fluctuations in consumption tend to be smaller than fluctuations in GDP d. fluctuations in consumption tend to be smaller than fluctuations in investment e. changes in the rate of unemployment typically lag changes in GDP growth 14. Stagflation occurs when prices and output. a. fall; remains unchanged b. fall; falls c. fall; increases d. rise; falls e. rise; remains unchanged 15. During the recession of , which new tool of monetary policy has the Federal Reserve adopted? a. TARP b. originate and distribute model c. SIV d. quantitative easing e. LIBOR 3

4 16. Who was the president of the New ork Fed during the 2008 financial crisis? a. Ben Bernanke b. Alan Greenspan c. Tim Geithner d. Henry Paulson e. Lloyd Blankfein 17. Which of the following financial institutions was bailed out during the 2008 financial crisis because it was deemed too big to fail? a. Goldman Sachs b. Merryl Lynch c. Lehman Brothers d. Barclay s Capital e. American Insurance Group Short Answers 18. The Great Recession (8 points) List and explain macroeconomic shocks associated with the 2008 recession in the United States. Show the shocks in the IS-LM diagram as well. r LM1 IS1 4

5 19. IS-LM and AD-AS in the Long run (10 points) Costa Rica is a closed economy that finds itself at the full employment output. However, the Costa Rican government is running a large budget deficit and would like to decrease it. More specifically, the Costa Rican government reduces its spending on some social services. Please use the graphs on the next page to answer graphical questions. a. If you consider the IS-LM framework, which curve shifts when government expenditure is decreased? Is the horizontal shift of this curve more than, less than, or equal to the change in government expenditure ( G)? Explain. b. Use the IS-LM model on the next page to illustrate graphically how income and interest rates change in response to decreased government expenditure in the short-run. Does income increase/decrease/remain unchanged? How about interest rates? (Label the initial equilibrium A and the new short-run equilibrium B) c. What happens to aggregate demand when government spending is decreased? Show on the AD-AS graph on the next page how the economy moves from the initial equilibrium to the short-run equilibrium after a decrease in G. (Label the initial equilibrium A and the new short-run equilibrium B) d. Use the AD-AS graph from part (c) to show the how the economy moves from the short-run equilibrium to the long-run equilibrium when prices are allowed to adjust. What happens to income and prices? How about interest rates? (Label the short-run equilibrium B and the new long-run equilibrium C) 5

6 r LM1 r1 IS1 P LRAS P1 SRAS1 AD1 e. Show graphically how income, interest rates, and prices evolve over time as a consequence on a decrease in government expenditure. r P t0 time t0 time t0 time 6

7 20. Inflation Expectations (7 points) During the Great Depression money supply fell by 25%, but the price level also fell by 25%, so the effect on the LM curve should be neutral. However, the LM curve shifted leftward dramatically due to expectations of lower prices. Explain how inflation expectations can influence the LM curve and, consequently, real interest rates (Hint: think about the effect of inflation expectations on money demand). 21. Thriftiness (6 points) Two countries, Thriftia and Spendia, are the same in every respect except that the rate of saving is higher in Thriftia than in Spendia. In which country will the standard of living be higher? Illustrate graphically. The standard of living will be higher in. 7

8 Choose one of the following two questions (6 points): 22. Unemployment (6 points) Changes in economic policies will frequently have an impact on the unemployment rate. Explain whether each of the policy changes described is likely to: 1) affect frictional or structural unemployment and 2) increase or decrease the measured unemployment rate. a. The government reduces the number of weeks of unemployment insurance that unemployed workers can receive. b. The government raises the minimum wage. c. The government increases spending on job-training programs. 23. Inflation (6 points) Consider two countries, Sweden and Denmark. In Sweden new arrangements for making payments, such as credit cards and ATMs, have been enthusiastically adopted by the population thereby reducing the proportion of income that is held as real money balances. Over this period no such changes occurred in Denmark. If the rate of money growth and the growth rate of real GDP were the same in Sweden and Denmark over this period, then how would the rate of inflation differ between the two countries? Carefully explain your answer. 8

9 Choose one of the following two questions (6 points): 24. Liquidity Trap (6 points) Explain how monetary policy may be useless as a response to a negative shock to the IS curve. What may need to happen to the interest rate to get the economy back to the full employment output? Why may this be impossible? 25. Policy (6 points) For each of the following policies indicate whether the policy is i) a monetary or a fiscal policy, ii) an active or a passive policy, and iii) a policy by rules or with discretion: a. the central bank follows a policy of allowing the money supply to grow at a constant 4 percent per year; b. a government follows a policy of keeping government spending over a calendar year equal to government revenue over the calendar year; c. the central bank uses judgment to adjust the growth of the money supply based on expectations of what will happen to output and inflation over the next five years; d. the central bank follows a policy of adjusting the money supply according to a formula based on deviations of unemployment from the natural rate of unemployment. 9

10 Choose one of the following two questions (6 points): 26. Neoclassical Theory of Distribution (6 points) Use the neoclassical theory of distribution to predict the impact on the real wage and the rental price of capital of each of the following events: a. a wave of immigration increases the labor force. Real wage rate (w) Real rental rate of capital (r) b. an earthquake destroys some of the capital stock. Real wage rate (w) Real rental rate of capital (r) c. a technological advance improves the production function. Real wage rate (w) Real rental rate of capital (r) 27. Policy and Crowding-out (6 points) Explain why government budget deficits crowd out private investment spending in a closed economy, but crowd out net exports in a small open economy. Assume prices are flexible and that factors of production are fully employed in both economies. Assume there is perfect capital mobility for the small open economy. Extra Credit If you have not missed more than one class since the last exam, you can answer the question below and earn 3 points extra credit. 28. In 2013, the GDP of the United States totaled about: a. $16 billion. b. $140 billion. c. $14 trillion. d. $1.6 billion e. $16 trillion. 10

11 Key A 1. D 2. B 3. C 4. A 5. E 6. C 7. C 8. A 9. D 10. B 11. E 12. E 13. B 14. B 15. D 16. C 17. E 18. Shocks: Demand: fall in housing prices, decline in the stock market, fall in both consumer and producer confidence shift of the IS curve to the left. Supply: an increase in the price of oil and a decrease in bank lending shift of the LM curve to the left The effect of both of these shocks was a decrease in total income (output). r LM2 LM1 IS2 IS1 11

12 19.a. Government expenditure enters the equation for the IS curve, so the IS curve shifts when government expenditure is decreased. Also, it shifts to the left by more than the amount of the change in G. It shifts by G * [1/(1 - MPC)]. 19.b. When government expenditure decreases, the IS curve shifts to the left (1). Consequently, income decreases from 1 to 2 and the interest rates increase from r1 to r2. Costa Rica finds itself at point B in the short-run. 19.c. When G is decreased, the IS curve shifts to the left and this means that there is a lower output at any given price. Thus, the AD curve shifts to the left (2). Since the price is fixed in the short-run, the price level remains at P1. The economy moves from point A to point B. r LM1 1 3 LM2 r1 A r2 B C IS1 IS2 2 =1 P LRAS 2 P1 3 B A SRAS1 C SRAS2 AD2 AD1 2 = 1 19.d. The economy finds itself in the short-run equilibrium below the natural rate of output: 2 < 1 (point B). Because aggregate demand is lower than the long-run aggregate supply at the price 12

13 level P1, there will be a downward pressure on the price level. Over time, prices can change and they adjust. Therefore, prices fall over time and eventually reach level P2. At that point, the economy is in the long-run equilibrium (point C). Income increases from 2 to 1 and prices decrease from P1 to P2. Since prices decrease, the supply of real money balances increases ( M=P) and the LM curve shifts right (3). Consequently, interest rates decrease. 19.e. Fiscal policy has real effects in the long-run. Output returns to the natural rate of output in the long-run, but both interest rates and prices remain permanently lower as a consequence of a contractionary fiscal policy. Lower prices do not have any consequences in the long-run (neutrality of money), but lower interest rates lead to higher private investments. 13

14 r P t0 time t0 time t0 time The standard of living will be higher in Thriftia (yt > ys). 22.a. Frictional unemployment is likely to be reduced as unemployed workers take fewer weeks to search for new jobs because of reduced benefits. This process is likely to reduce the measured unemployment rate. 22.b. Structural unemployment will probably increase for those workers with marginal product valued below the higher minimum wage. This policy change is likely to increase the measured unemployment rate. 22.c. Frictional unemployment will be reduced if workers with obsolete skills receive training that prepares them for available jobs. This policy change is intended to reduce the measured rate of unemployment. 23. The rate of inflation would be higher in Sweden. 14

15 There are two ways one can explain this. 1) Since money demand decreases in Sweden, supply of real money balances (M/P) needs to decrease as well (or, better say, growth rates of money demand and money supply need to be the same). To lower (or reduce growth of) M/P, P needs to increase. Since Sweden and Denmark are the same in every other way, P will grow faster in Sweden. 2) According to the quantity theory, if the rates of money growth and real GDP growth are the same, differences in rates of inflation are related to differences in velocity. The faster increase in velocity leads to a higher rate of inflation, holding other factors constant. In Sweden the reduction in the proportion of income held as real balances is the equivalent of a speedup in the rate of velocity and, consequently, a higher rate of inflation in Sweden than in Denmark. 24. If the IS curve shifts to the left a lot, then a necessary shift in the LM curve to bring income back to the full employment output needs to be large as well. It could be that the necessary real interest rate to bring the goods market into equilibrium is negative. However, the problem is that nominal interest rate cannot be negative. Since the nominal interest rate has a zero lower bound, the Fisher equation says that the only way a real interest rate can be negative is if there is inflation (i = r + π). If, however, the economic conditions worsen so that the price level decreases, even if nominal interest rates approach zero, real interest rates will still be positive. This means that there will be no or very minimal lending and hence the name liquidity trap. r LM1 LM2 IS2 IS1 25.a. monetary policy; passive; rule 25.b. fiscal policy; passive; rule 25.c. monetary policy; active; discretion 25.d. monetary policy; active; rule 15

16 26.a. According to the neoclassical theory of distribution, the real wage equals the marginal product of labor. Because of diminishing returns to labor, an increase in the labor force causes the marginal product of labor to fall. Hence, the real wage falls. Since more workers are using the same number of machines, each machine is being used more and its productivity increases. Hence, the real rental rate of capital increases. 26.b. The real rental price equals the marginal product of capital. If an earthquake destroys some of the capital stock (yet miraculously does not kill anyone and lower the labor force), the marginal product of capital rises and, hence, the real rental price rises. Since there are less machines and the same number of workers, each worker works with less intensity (has to share the machine), workers marginal productivity decreases and the real wage rate decreases. 26.c. If a technological advance improves the production function, this is likely to increase the marginal products of both capital and labor. Hence, the real wage and the real rental price both increase. 27. In a closed economy, an increase in the budget deficit reduces national saving and increases the interest rate, which crowds out (decreases) private investment. In a small open economy, the budget deficit reduces national saving, thus decreasing net capital outflow (S - I), which increases the real exchange rate. The increase in the real exchange rate crowds out (decreases) net exports. 28. E 16

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