Final Exam. Name: Student ID: Section:

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1 Final Exam Name: Student ID: Section: Instructions: The exam consists of three parts: (1) 15 multiple choice questions; (2) three problems; and (3) one graphical question. Please answer all questions in the space provided in this exam. You may use scratch paper but do not turn it in as it will not be graded. Please budget your time appropriately. Good Luck! Multiple Choice [ 30 points 2 points each] Place your multiple-choice answers here Starting from the natural rate of output, an unexpected monetary contraction will cause output and the price level to in the short run, and in the long run the expected price level will, causing the level of output to return to the natural rate. A) increase; increase B) increase; decrease C) decrease; decrease D) decrease; increase 2. The basic aggregate supply equation implies that output exceeds natural output when the price level is: A) low. B) high. C) less than the expected price level. D) greater than the expected price level. 3. In a steady state with population growth and technological progress: A) the real rental price of capital is constant and the real wage grows at the rate of technological progress. B) the real rental price of capital grows at the rate of technological progress and the real wage is constant. C) both the real rental price of capital and the real wage grow at the rate of technological progress. D) both the real rental price of capital and the real wage are constant. Version 1 Page 1

2 4. If consumption is given by C = (Y - T) and investment is given by I = r, then the formula for the IS curve is: A) Y = T - 25r + G. B) Y = 1,600-3T - 100r + 4G. C) Y = T - 25r - G. D) Y = 1, T - 100r - 4G. 5. An increase in government spending raises income: A) and the interest rate in the short run, but leaves both unchanged in the long run. B) in the short run, but leaves it unchanged in the long run, while lowering investment. C) in the short run, but leaves it unchanged in the long run, while lowering consumption. D) and the interest rate in both the short and long runs. 6. According to the sticky-wage model, when the price level is less than the expected price level, workers get a real wage than expected, and workers are hired than expected. A) lower; more B) lower; fewer C) higher; more D) higher; fewer 7. In the IS-LM model, a decrease in the interest rate would be the result of a(n): A) increase in the money supply. B) increase in government purchases. C) decrease in taxes. D) increase in money demand. 8. The assumption of adaptive expectations for inflation means that people will form their expectations of inflation by: A) taking all information into account using the best economic model available. B) asking the opinions of experts. C) basing their opinions on recently observed inflation. D) flipping a coin. Page 2

3 9. Inflation inertia is represented in the aggregate supply and aggregate demand model by continuing upward shifts in the: A) aggregate demand curve. B) short-run aggregate supply curve. C) long-run aggregate supply curve. D) aggregate demand and short-run aggregate supply curves. 10. Assume that an economy has the Phillips curve π = π (u ). Then the natural rate of unemployment is: A) 0.5. B) C) D) If people's expectations of inflation are formed rationally rather than based on adaptive expectations and if policymakers make a credible policy move to reduce inflation, then the costs of reducing inflation will be traditional estimates of the sacrifice ratio. A) much higher than B) much lower than C) exactly equal to D) approximately two percent greater than 12. John Taylor's rule for targeting the federal funds rate proposes increasing the federal funds rate as inflation and as the GDP gap. A) increases; widens B) increases; narrows C) decreases; widens D) decreases; narrows 13. The model of aggregate demand and aggregate supply is consistent with short-run monetary and long-run monetary. A) neutrality; neutrality B) nonneutrality; nonneutrality C) neutrality; nonneutrality D) nonneutrality; neutrality Page 3

4 14. A supply shock includes all of the following events except: A) a change in the minimum wage. B) the repeal of government controls on prices. C) the passage of an investment tax credit. D) a decrease in worldwide oil prices. 15. If MPC = 0.75 (and there are no income taxes but only lump-sum taxes) when T decreases by 100, then the IS curve for any given interest rate shifts to the right by: A) 100. B) 200. C) 300. D) 400. Page 4

5 Analytical Questions [ 45 points 5 points each correct part] Please answer in the space provided. 1. Assume that a country's production function is Y = AK.3 L.7. The ratio of capital to output is 3, the growth rate of output is 3 percent, and the depreciation rate is 4 percent. Capital is paid its marginal product. a. What is the marginal product of capital in this situation? (Hint: The marginal product of capital may be computed using calculus by differentiating the production function and using the capital-output ratio or by using the fact that capital's share equals MPK multiplied by K divided by Y.) b. If the economy is in a steady state, what must be the saving rate? (Hint: The saving rate multiplied by Y must provide for gross growth of (δ + n + g)k, where δ is the depreciation rate.) c. If the economy decides to achieve the Golden Rule level of capital and actually reaches it, what will be the marginal product of capital? d. What must the saving rate be to achieve the Golden Rule level of capital? Page 5

6 2. Let the symbol π stand for the rate of inflation, with π e the expected inflation rate, both measured in percent. The letter u is the unemployment rate and u n is the natural rate of unemployment. Suppose the short-run Phillips curve u = u n - α (π - π e ) applies in a certain economy. The Fed's loss function L(u,π) = u + γ π 2. The analysis in the appendix to textbook Chapter 14 shows that if the Fed minimizes its loss function under the assumption that π e is fixed and rational private agents know this, the expected inflation rate will be π e = α /2γ, and this will also be the inflation rate the government chooses. a. Suppose that α = 0.5 and γ = What are the expected and actual inflation rates? b. Suppose α = 0.5 and γ = In this case, does the Fed have greater or lesser relative distaste for inflation than in part a? What are the expected and actual inflation rates with γ = 0.50? Why do they differ from the inflation rates in part a? Page 6

7 3. Assume that an economy is described by the IS curve Y = 3, G - 2T - 150r and the LM curve Y = 2 M/P + 100r [or r = 0.01Y (M/P)]. The investment function for this economy is 1,000-50r. The consumption function is C = (2/3)(Y - T). Long-run equilibrium output for this economy is 4,000. The price level is 1.0 and M = 1,200. a. Assume that government spending is fixed at 1,200. The government wants to achieve a level of investment equal to 900 and also achieve Y = 4,000. What level of r is needed for I = 900? What levels of T and M must be set to achieve the two goals? What will be the levels of private saving, public saving, and national saving? (Hint: Check C + I + G = Y.) b. Now assume that the government wants to cut taxes to 1,000. With G set at 1,200, what will the interest rate be at Y = 4,000? What must be the value of M? What will I be? What will be the levels of private, public, and national saving? (Hint: Check C + I + G = Y.) c. Which set of policies may be referred to as tight fiscal, loose money? Which set of policies may be referred to as loose fiscal, tight money? Which policy mix most encourages investment? Page 7

8 Graphical Questions[ 25 points total 5 points each correct part] 1. Consider the following graph y = x R 2 = Change in Inflation Output Gap where the Change in inflation is measured as the difference between the current inflation rate and last period s inflation rate and the Output Gap is measured as the percent deviation of real output from potential output. (a) What does is the name of the dashed line depicted in the figure? (b) Suppose inflation last period was 3% (use 3 rather than 0.03) and that output currently exceeds potential by 10%. What would inflation be today? (c) Suppose that output next period returns to its potential level. What will be the inflation rate of equilibrium? (d) Explain why this inflation rate differs from 3%. What is going on? (e) Suppose last period s inflation is 4%, output is at potential, and there is an oil shock of size 2% (i.e., current inflation becomes 2% higher than without the shock). What will be the inflation rate of equilibrium next period? What can the monetary authority do? What is the likely consequence of this policy choice for next period s output? Explain. Page 8