1.) (10 points) Use the quantity theory of money equation to solve the following problem:

Transcription

1 Exam #2 (ANSWERS) ECNS 303 Name 1.) (10 points) Use the quantity theory of money equation to solve the following problem: Consider the market for bread. Suppose 50 loaves of bread are sold in a year at $1.00/loaf. Further suppose that the quantity of money in the economy is $10. Solve for the transactions velocity of money. Interpret what your answer means. Recall the equation MV = PT If we substitute in the values from above we have $10V = ($1)(50) V = 5 This means that for $50 of transactions per year to take place with $10 of money, each dollar must change hands 5 times per year. 2.) (10 points) Consider the market for real money balances. Now suppose the Fed buys back a large amount of bonds from the public. Show graphically how this impacts the IS-LM model by first working your way through the money market. This answer requires two graphs one for the money market and one for the IS-LM model. Label your graphs (including your axes) or you will lose points!!! -Money mkt.: Supply of real money balances shifts to the right -IS-LM: LM shifts out and to the right

2 3.) (10 points) Consider an increase in taxes. Show how this impacts the IS-LM model by first working your way through the market for goods and services. This answer requires two graphs one for the market for goods and services and one for the IS-LM model. Label your graphs (including your axes) or you will lose points!!! -Mkt. for goods and services: PE shifts down -IS-LM: IS shifts inward 4.) a.) (10 points) Derive the tax multiplier (you knew this was coming!). That is, show mathematically that the following relationship holds ΔY/ΔT = -MPC/(1-MPC) ΔY = -MPC*ΔT MPC 2 *ΔT MPC 3 *ΔT - = ΔT(-MPC MPC 2 MPC 3 - ) => ΔY/ ΔT = -MPC MPC 2 MPC 3 - => ΔY/ ΔT = -MPC(1 + MPC + MPC 2 + ) => ΔY/ ΔT = -MPC/(1 MPC) (by the sum of an infinite geometric series) b.) (5 points) Suppose consumption can be described by the following equation: C = (Y 120) What is the tax multiplier? Interpret your answer. ΔY/ ΔT = -MPC/(1 MPC) = -.25/.75 = -1/3 If we increase taxes by $1, then income falls by $0.33.

3 5.) Consider the economy of Andersonville. a.) (7 points) The consumption function is C = (Y - T). The investment function is I = r. Government spending and taxes are 100 each. Graph the IS curve for this economy (make sure to show where the IS intersects the horizontal and vertical axes). r 5.9 IS Y b.) (7 points) The money demand function in Andersonville is (M/P) d = Y - 50r. Money supply is 400 and the price level is P = 4. Graph the LM curve for this economy for values of r ranging from 0 to 5. 5 r LM Y

4 c.) (6 points) What is the equilibrium interest rate r and the equilibrium level of income in the IS-LM model? r = r => 116.7r = => r* = 2.51 => Y* = ) Determine whether each of the following statements is true or false, and very briefly explain why. If the statement is true, discuss whether monetary and fiscal policy are effective at influencing the level of income in the economy. a.) (5 points) If investment does not depend on the interest rate, the IS curve is vertical. True. If investment does not depend on r, then NOTHING in IS equation depends on r; income must adjust to ensure the quantity of goods produced, Y, equals the quantity of goods demanded, C+I+G. Thus, IS is vertical. Monetary policy has no effect on output, only affects r. Fiscal policy is effective: output increases by full IS shift. b.) (5 points) If money demand does not depend on the interest rate, the IS curve is horizontal. False. IS curve is unaffected as it models the market for goods and services not the money market.

5 7.) One reason unemployment exists is because of wage rigidities. a.) (6 points) Show graphically how real wage rigidities can lead to positive unemployment. Make sure to label your graph or you will lose points! See graph we went through in lecture on minimum wage laws. b.) (4 points) Efficiency wage theory provides an explanation for why real wage rigidities exist. Describe at least two reasons why an employer would pay an efficiency wage to their workers. #1: For poorer countries, efficiency wages may increase nutrition. Healthier workers are more productive. #2: Higher wages reduce turnover. The more a firm pays its workers, the greater is their incentive to stay with the firm. By decreasing turnover, the firm decreases time and money spent hiring and training new workers. #3: Average quality of a firm s work force depends on the age it pays its employees. If a firm decreases its wage, then the best employees may take jobs elsewhere. #4: Higher wages improve worker effort. Firms cannot perfectly monitor their employees work effort and workers decide to work hard or shirk. The higher the wage, the greater the cost to the worker if fired. Here, the efficiency wage induces employees not to shirk..

6 8.) (15 points) Monetary policy and fiscal policy often change at the same time. In the early 1980s, the U.S. government cut taxes and ran a budget deficit while the Fed pursued a tight monetary policy. What effect should this policy mix have on the interest rate and on output? Support your answer with an IS-LM graph. IS shifts out and to the right. LM shifts up and to the left. The interest rate unambiguously increases. Y could increase or decrease depending on the relative magnitudes of the IS and LM curve shifts.