Answer: A). There is a flatter IS curve in the high MPC economy. Original LM LM after increase in M. IS curve for low MPC economy

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1 4.02 Quz Solutons Fall 2004 Multple-Choce Questons (30/00 ponts) Please, crcle the correct answer for each of the followng 0 multple-choce questons. For each queston, only one of the answers s correct. Each queston counts 3/00 ponts. ) Consder two economes that are dentcal, wth the excepton that one has a hgh margnal propensty to consume (MPC) and one has a low MPC. If the money supply s ncreased by the same amount n each economy, the hgh MPC economy wll experence A) A larger ncrease n output and a smaller decrease n the nterest rate. B) A smaller ncrease n output and a smaller decrease n the nterest rate. C) A larger ncrease n output and a larger decrease n the nterest rate. D) A smaller ncrease n output and a larger decrease n the nterest rate. E) None of the above. A). There s a flatter IS curve n the hgh MPC economy. Orgnal LM LM after ncrease n M S IS curve for low MPC economy IS curve for hgh MPC economy 2) Whch of the followng polcy optons would smultaneously ncrease nterest rates and decrease output? A) The Federal Reserve Board sells bonds through open market operatons. B) The federal government ncreases ts defense purchases. C) The Federal Reserve Board expands the money supply. D) The federal government ncreases the tax rate. E) Actons descrbed n both A) and D). Answer A). Sellng bonds reduces the money supply n the economy. The lower money supply results n a hgher nterest rate and lower output level (.e., an upward shft n the

2 LM curve); nvestment unambguously declnes. Opton C always ncreases nvestment, whle optons B and D have uncertan mplcatons for nvestment. 3) Suppose an economy s runnng a government budget defct. Assume that C = c 0 + c (-T). Whch one of the followng wll cause ths defct to become larger? A) Expansonary monetary polcy. B) An ncrease n exports. C) A decrease n equlbrum GDP. D) A decrease n taxes. E) A decrease n government purchases. D). A government budget defct means that T-G<0. Therefore, lower taxes wll mply lower revenues for the government and a hgher government budget defct. 4) If the nterest rate s hgher n the US than n the UK, then A) The dollar s expected to apprecate wth respect to the pound. B) The pound s expected to apprecate wth respect to the dollar. C) The nterest rate n the US s expected to ncrease. D) The nterest rate n the US s expected to decrease. E) Uncertan. B). Uncovered nterest rate party mples that: e e e ( + US ) E = t + US UK E ( + US ) = ( + UK ) E t +. So f ( + ) > ( + ), then t+ has to be Et ( + UK ) E t E t greater than. So, we expect the dollar to deprecate, or the pound to apprecate wth respect to the dollar. 5) Consder a small economy where the total populaton s 0,000. The sze of the labor force s 8,000, whle the number of people employed s 7,000. What s the unemployment rate n ths economy? A) 0% B) 2.5% C) 20% D) 30% E) 37.5% B). Gven the labor force of 8,000 people, 000 people are unemployed. Thus the unemployment rate s (,000/8,000)*00 = 2.5%. The number of people n the entre populaton s rrelevant for ths queston. 2

3 6) Assume that C = c 0 + c (-T). Suppose that taxes ncrease and money supply ncreases n such a way that output s constant n equlbrum (assume c <). These polcy changes wll produce A) An ncrease n nvestment and a decrease n prvate consumpton. B) An ncrease n nvestment and a decrease n government spendng. C) An ncrease n nvestment and an ncrease n prvate savng. D) A decrease n nvestment and an ncrease n publc savng. E) Uncertan. A). In equlbrum, s constant and decreases (IS moves to the left and LM shfts down). Recall that nvestment, gven by I(,), depends negatvely on the nterest rate. So, as the nterest rate decreases, nvestment ncreases. Also, we know that: C=c 0 + c (-T), and prvate savng s gven by -T-C = (- c )(-T)- c 0. Therefore, because T ncreases, prvate consumpton and prvate savng both decrease. (G s constant, T-G ncreases.) So, B) s ncorrect because government spendng s constant; C) s ncorrect because prvate savng decreases; and D) s ncorrect because nvestment ncreases and publc savng decreases. 7) In 2000, the nomnal GDP growth of a country was 8% and the real GDP growth was 4%. What was the rate of nflaton for ths country? A) - 4% B) 2% C) 4% D) 8% E) 2% C). Nomnal GDP growth = real GDP growth + nflaton. Thus, nflaton = 8% - 4% = 4%. 8) Suppose the Unted States has no exports. The only mports of the US are 200 Mercedes Benz cars worth US$50,000 each from Germany. Germany has no mports and only exports those 200 cars to the US. Nether the US nor Germany trade wth any other countres or engage n any transactons wth other countres. Whch one of the followng statements must be true? A) The US has a captal account defct. B) Germany has a current account defct. C) Germans are buyng US assets. D) The exchange rate of US Dollars per Euros (the currency n Germany) s bgger than. E) None of the above. C). The US has a current account defct. In order to fnance the current account defct, they need to have a captal account surplus. Snce the US doesn t engage n any 3

4 fnancal transactons wth other countres, havng a captal account surplus mples that Germans are buyng US assets. In fact, f there s no statstcal dscrepancy, Germany needs to buy $00 mllon more n US assets than the US s buyng n German assets. These $00 mllon are lke a loan from Germany to the US, and the US uses ths money to buy the Mercedes Benzes. 9) Suppose that nvestment (I) n the goods market s not responsve to the nterest rate (that s, I does not depend on the nterest rate at all). Then A) The IS curve s a vertcal lne and monetary polcy s very effectve n rasng output. B) The IS curve s a horzontal lne and monetary polcy s very effectve n rasng output. C) The IS curve s a vertcal lne and monetary polcy does not affect output n the IS-LM model. D) The IS curve s a horzontal lne and monetary polcy does not affect output n the IS-LM model. E) The IS curve stll has a negatve slope, but monetary polcy monetary polcy does not affect output n the IS-LM model. C). If we assume that C = c 0 + c (-T) and I = b 0 + b b 2, then aggregate demand s gven by Z = c 0 + c (-T) + b 0 + b b 2 + G. In equlbrum Z =. Solvng for n equlbrum, we get = [c 0 - c T + b 0 - b 2 + G] - c - b Solvng ths for so that we can see the equaton for the IS curve n the (,) space, we get = [c - c T + b 0 + G] - c - b 0 b 2 b 2 Now, the assumpton that nvestment s not responsve to the nterest rate s equvalent to sayng that b 2 = 0. ou can see that ths mples that the slope of the IS curve s nfnte and that the ntercept s also nfnte. Thus, the IS curve s a vertcal lne. Monetary polcy leads to shfts n the LM curve, however, these shfts do not change output at all snce the equlbrum pont always remans on the vertcal IS curve. IS LM 0 LM * 4

5 0) An ncrease n the money supply and a drop n consumer confdence wll lead to A) A decrease n output wth an ambguous effect on the nterest rate. B) An ncrease n output and a decrease n the nterest rate. C) A decrease n output and an ncrease n the nterest rate. D) An ambguous effect on output and an ncrease n the nterest rate. E) An ambguous effect on output and a decrease n the nterest rate. E). A drop n consumer confdence mples a decrease n c 0 (and therefore, a drop n C.) The IS curve wll shft left and the LM curve wll shft down. LM 0 LM 0 LM LM 0 0 IS IS 0 0 Fg. Fg. 2 For a relatvely large shft out of the LM curve, output can ncrease (as shown n Fgure ). For a relatvely small shft out of the LM curve, gven the same shft n the IS curve, output can decrease (as shown n Fgure 2). 5

6 Free Response Queston I (50/00 ponts) The Republc of Keynesa s a closed economy and obeys our short-run IS-LM model. Assume t starts out n equlbrum n both the goods market and the money market. Keynesa s economy s descrbed by the followng set of equatons: Goods market: C = c 0 + c (-t), where C s consumpton; s ncome; t represents a proportonal tax; and c 0 and c are postve constants I = b 0 b, where I s nvestment; s the nterest rate; and b 0 and b are postve constants G = G, where G s a postve constant Money market: M d = P(m 0 + m m 2 ), where M d s money demand; P s the prce level; m 0 (a postve constant) represents exogenous changes to M d ; and m and m 2 are also postve constants Let M s represent money supply. Combne the goods market equatons to derve an expresson for as a functon of (.e. derve the IS curve). Gve the defnton of the IS relaton. (7 ponts) = C + I + G = c 0 + c (-t) + b 0 b + G ( -c (-t)) = c 0 + b 0 b + G c 0 + b 0 + G b = c ( t) c ( t) Defnton of the IS curve: the IS curve gves all the combnatons of and that cause the market for goods and servces to clear (.e. to be n equlbrum). 2. Use the money market equatons to express as a functon of (.e. derve the LM curve). Gve ntuton for why the LM curve slopes upward/downward. (7 ponts) M s = M d M s /P = m 0 + m m 2 = m 2 s (m M ) + m 0 P m 2 The LM curve s upward-slopng ( = m m 2 > 0 ). 6

7 Intutvely, gven the level of the money supply, f ncome () s hgh, then demand for money wll be hgh (because when output ncreases, there are more transactons n the economy). For money demand to equal money supply, therefore, nterest rates also need to be hgh n order to reduce money demand. (Recall that when nterest rates are hgh, people don t want to hold much money.) The opposte s true when ncome s low: for a gven level of money supply, demand for money s low. So, n order to equlbrate money demand and money supply, nterest rates have to be low to ncrease money demand. 3. Graph the IS and the LM curves on the same dagram, puttng on the vertcal axs and labelng the curves. Label the equlbrum nterest rate and output, 0 and 0, respectvely. (7 ponts) c 0 + b 0 + G b LM A 0 A s M 0 0 m P IS (m ) c 0 +b 0 +G c ( t) Note that the equlbrum s at pont A. Suppose we are at a pont lke A whch s on the LM curve. Even though the money market s n equlbrum, the goods market s not, snce we are off the IS curve. At ths low nterest rate, s too low to clear the goods market, so frms ncrease producton and rses. As ncreases, must rse as well n order to mantan money market equlbrum. So, the economy moves toward the ntersecton pont, A. 4. Suppose the government ncreases ts spendng by G. Whch curve wll shft, f any? Calculate by how much t wll shft and draw a dagram that shows the mpact of ths polcy. (9 ponts) The IS curve wll shft to the rght. Note that the multpler n ths case s /( c (-t)). It tells us that a unt ncrease n government spendng wll ncrease output by /( c (-t)), holdng nterest rate constant. Thus, n our case, the IS curve wll shft out G by. c ( t) 7

8 LM 0 G c ( t) B A A IS 0 2 The new equlbrum s at pont B. Note that t s not at A (.e. output does not ncrease all the way to 2 ), because nterest rates are not constant n the IS-LM model. (See the answer to part 5 for more on ths.) 5. What wll happen to nvestment as a result of the government polcy descrbed n part 4? (ou do not need to calculate anythng, just gve ntuton.) (5 ponts) The ncrease n exogenous government purchases ncreases whch n turn reduces nvestment, I, because the nterest rate enters nto the expresson for I negatvely. Ths decreases the overall postve effect of ncreased government spendng. 6. Suppose that the government decdes to cut taxes nstead of ncreasng spendng. Analyze the effects of ths expansonary fscal polcy usng a dagram. (ou do not need to calculate anythng, just draw the dagram.) (5 ponts) 0 A B LM IS 0 IS curve.) A tax cut s represented n ths model by a reducton n t. Smaller t ncreases C. But note that the IS curve does not shft out n a parallel fashon n ths case. Ths s because t enters nto the slope of the IS equaton. A smaller t tlts the curve, makng t flatter. (Recall from part that, once we rearrange the IS equaton such that s on the left-hand sde, the coeffcent on becomes c ( t), whch s the slope of the b The new equlbrum s at pont B. 8

9 7. Usng the IS-LM model, explan what can be done to offset the changes n the nterest rate caused by ncreased government spendng and, at the same tme, keep output from declnng. (In other words, suggest a way to brng the nterest rate back to the level t was at before the polcy n part 4 took place wthout causng a reducton n output). (0 ponts) Expansonary monetary polcy: 0 = 2 A B C LM 0 LM IS By enactng expansonary monetary polcy, the government can brng nterest rates down, whle at the same tme ncreasng output. The equlbrum s at C. Note that a fscal contracton would also do the job of reducng the nterest rate. However, t would also reduce output. 0 2 (Note that a potental flaw of the IS-LM model s the predcton that monetary polcy s always superor: the Fed should ncrease money supply all the tme because t only leads to hgher output and lower nterest rates. In realty, however, the Fed s careful about ncreasng money supply durng booms, because that would cause nflaton. In ths smple IS-LM framework prces are not determned wthn the model.) 9

10 Free Response Queston II (20/00 ponts) Image and secton of artcle removed due to copyrght reasons. Please see Fed boosts nterest rates a quarter-pont. Central bank says economy has 'reganed some tracton' By Martn Wolk. Chef economcs correspondent. MSNBC. Updated: 6:4 p.m. ET Sept. 24, Ths artcle s avalable at: For the followng 3 questons, please use the nformaton above.. How does the central bank (the Fed n the US) rase the nterest rate? (ou should lmt your answer to no more than two sentences) (6 ponts) When the central bank sells bonds, t removes from crculaton the money t receves n exchange for the bonds. (See pages 72-74) When the money supply decreases, t rases the nterest rate. (Graph s just FI. ou dd not need to draw ths.) 0

11 Interest rate, s s M 2 M 2 M d Money, M 2. When the Fed rases the nterest rate, what happens to the prce of bonds? Why? (ou should lmt your answer to no more than two sentences) (7 ponts) The prce of a one-year bond today s equal to the fnal payment dvded by plus the nterest rate. So, when the nterest rate ncreases, the prce of bond falls. $ 00 $P B = + Å If the fnal payment s $00 (See pages 74-75) 3. If lowerng output was the man objectve of the Fed when t rased the nterest rate, can fscal polcy acheve the same objectve? How? (ou should lmt your answer to no more than two sentences) (7 ponts) es. Contractonary fscal polcy can acheve the same objectve of lowerng output. Fscal contracton occurs when the government ether decreases G (government spendng) or ncreases T (taxes). (Note: Even though the level of output s the same at B and C, equlbrum nterest rate s dfferent.) LM LM 0 LM 0 B A IS 0 B A C IS 0 Monetary Contracton 0 Fscal Contracton