FINAL EXAM. Name Student ID 1. C 2. B 3. D 4. B 5. B 6. A 7. A 8. D 9. C 10. B 11. C 12. B 13. A 14. B 15. C

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1 FINAL EXAM Name Student ID Instructions: The exam consists of three parts: (1) 15 multiple choice questions; (2) three problems; and (3) two graphical questions. 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 1. C 2. B 3. D 4. B 5. B 6. A 7. A 8. D 9. C 10. B 11. C 12. B 13. A 14. B 15. C 1. Suppose that the government is considering two tax cuts, one temporary and one permanent. Each cut will give each taxpayer the same amount in the first year. The permanent-income hypothesis predicts that: A) each tax cut will lead to the same amount of consumption in the first year. B) the temporary tax cut will lead to more extra consumption in the first year. C) the permanent tax cut will lead to more extra consumption in the first year. D) the temporary tax cut will lead to no extra consumption at all in the first year. 2. In Irving Fisher's two-period model, if the consumer is initially a saver and the interest rate increases, and first-period consumption decreases, then we can conclude that the income effect: A) was greater than the substitution effect. B) was less than the substitution effect. C) exactly offset the substitution effect. D) and the substitution both decreased consumption. 3. In the Solow growth model with population growth and technological change, the breakeven level of investment must cover: A) depreciating capital. B) depreciating capital and capital for new workers. C) depreciating capital and capital for new effective workers. D) depreciating capital, capital for new workers, and capital for new effective workers. Page 1

2 4. In a small open economy with a floating exchange rate, if the government adopts an expansionary fiscal policy, in the new short-run equilibrium: A) income and the exchange rate will both rise. B) the exchange rate will rise, but income will remain unchanged. C) income will rise, but the exchange rate will remain unchanged. D) both income and the interest rate will rise. 5. An interpretation of why the IS curve slopes downward and to the right is that as income rises, national saving rises, and this increase drives the interest rate: A) down, thereby decreasing investment. B) down, thereby increasing investment. C) up, thereby decreasing investment. D) up, thereby increasing investment. 6. If the proceeds of all loans are deposited somewhere in the banking system and if rr denotes the reserve-deposit ratio, then the total money supply is: A) reserves divided by rr. B) 1/rr. C) reserves times rr. D) reserves divided by (1 rr). 7. According to the sticky-price model, other things being equal, the greater the proportion, s, of firms that follow the sticky-price rule, the the in output in response to an unexpected price increase. A) greater; increase B) smaller; increase C) greater; decrease D) smaller; decrease 8. If the real exchange rate is high, foreign goods: A) and domestic goods are both relatively expensive. B) and domestic goods are both relatively cheap. C) are relatively expensive and domestic goods are relatively cheap. D) are relatively cheap and domestic goods are relatively expensive. 9. If capital lasts an average of 25 years, the depreciation rate is percent per year. A) 25 B) 5 C) 4 Page 2

3 D) In a small open economy, if domestic saving exceeds domestic investment, then the extra saving will be used to: A) make loans to the government. B) make loans to foreigners. C) repay the national debt. D) repay loans to the Federal Reserve. 11. Ricardian equivalence refers to the same impact of financing government: A) whether by printing money or raising taxes. B) in the long run as in the short run. C) whether by debt or taxes. D) in an open economy as in a closed economy. 12. Open-market operations are: A) Commerce Department efforts to open foreign markets to international trade. B) Federal Reserve purchases and sales of government bonds. C) Securities and Exchange Commission rules requiring open disclosure of market trades. D) Treasury Department purchases and sales of the U.S. gold stock. 13. The Lucas critique argues that because the way people form expectations is based on government policies, economists predict the effect of a change in policy without taking changing expectations into account. A) partly; cannot B) only partly; can C) in no way; can D) in no way; cannot 14. If capital grows at 3 percent per year and labor grows at 1 percent per year, and capital's share is 1/3 while labor's share is 2/3, if there is no technological progress and the neoclassical assumptions hold, the growth rate of output will be: A) 1-1/3 percent per year. B) 1-2/3 percent per year. C) 3 percent per year. D) 2-1/3 percent per year. Page 3

4 15. The increase in income in response to a fiscal expansion in the IS-LM is: A) always less than in the Keynesian-cross model. B) less than in the Keynesian-cross model unless the LM curve is vertical. C) less than in the Keynesian-cross model unless the LM curve is horizontal. D) less than in the Keynesian-cross model unless the IS curve is vertical. Problems [40 points total] 1. [12 points total]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) [3 points] What is the marginal product of capital in this situation? MPK = 0.3 Y/K = 0.3/3 = 0.1 B) [3 points] If the economy is in a steady state, what must be the saving rate? (Hint: notice savings must provide for the gross growth of capital necessary to cover depreciation and growth.) sy = (δ + n + g)k; s = ( )K/Y = = 0.21 C) [3 points] If the economy decides to achieve the Golden Rule level of capital and actually reaches it, what will be the marginal product of capital? Golden rule: (δ + n + g) = MPK. Hence, MPK = 0.07 D) [3 points] What must the saving rate be to achieve the Golden Rule level of capital? MPK = 0.3 Y/K. Hence, 0.07/0.3 = Y/K. From B) s = 0.07 K/Y = /0.07 = 0.3 Page 4

5 2. [10 points total] Assume that the LM curve for a small open economy with a floating exchange rate is given by Y = 200r (M/P), while the IS curve is Y = G 2T + 3NX 200r. The function for NX is NX = e, where e is the exchange rate. The price level (P) is fixed at 1.0. The international interest rate is r * = 2.5 percent. Assume G = 100 and the budget is in equilibrium. A) [3 points] Find the equilibrium level of Y in the small open economy, if M = 100. From the LM curve: Y = (100/1) = 500 B) [4 points] What must be the equilibrium value of NX? From the IS curve: 500 = NX Hence: NX = 500/3 = C) [3 points] What must be the equilibrium exchange rate, e? From the NX relation: 500/3 = e. Hence, e = 1/3 Page 5

6 3. [18 points total] Consider an economy characterized by the following relations: C = (Y T) (1) I e = ( i π ) (2) G = 1,000 T = 900 (3) (4) π = 2% ; π = 3% (5) r = 2% (6) Y = 3,850 (7) i = r + π + α( π π ) + β ( Y Y ); α = 1, β = 0.1 (8) where (1) is the consumption function; (2) is the investment function and where π e = π = 2 ; (3) is government expenditures; (4) is tax revenues; (5) shows that the target for inflation is 2% but that actual inflation is at 3%; (6) shows that the real interest rate targeted by the central bank when inflation is at target and the output gap is zero is 2%; (7) shows that potential output is 3,850; and (8) is the Taylor rule for the central bank. (a) [2 points] Derive the expression for the IS curve with output as a function of the nominal interest rate i. Y = C + I + G Y = (Y 900) (i 2) Y = i Page 6

7 (b) [2 points] Derive the MP curve from expression (8) with the nominal interest rate i as a function of output. i = (3 2) + 0.1(Y 3,850) i = Y (c) [2 points] Derive the equilibrium levels of output and the nominal interest rate. (Note: the solution for the nominal interest rate will already be in percentages. Hence, a value of i = 0.1 does not mean i is 10% but rather 0.1%) Y = ( Y). Hence: Y = 3,900. Plugging this number into the MP relation, i = i = 10% (d) [1 point] What is the output gap? 3, = 50 (e) [1 point] What is the level of investment? I = (10 2) = 100 (f) [1 point] What is the level of consumption? C = ( ) = 2,800 (g) [1 point] What is the level of private saving? S priv = (Y T) C = 3,000 2,800 = 200 (h) [1 point] What is the level of public saving? S pub = T G = = -100 (i) [1 point] What is the level of domestic saving? S = S priv + S pub = 100 (j) [2 points] Without solving the model again, how much more should the central bank raise the nominal interest rate by to achieve potential output? To achieve a reduction of output back to potential, the MP curve has to shift to intersect the IS curve at the point where output is 3,850. Hence, all we need is to solve the IS curve for that level of output = i. Hence i = 10.1% (k) [2 points] Is the public justified in having expectations on inflation at 2%? No, current inflation is 3% If not, what are the consequences of the public updating their expectations? Inflation expectations should be updated to 3% in which case, the real interest rate will drop by 1%, thus stimulating demand further and requiring stricter monetary policy to push output back to its potential level. Page 7

8 (l) [2 points] What policy recommendations can you offer to restore this economy back to equilibrium? There are two policy options. 1) to make monetary policy stricter (say, by changing the coefficient β in the Taylor rule), and/or 2) becoming fiscally more responsible by either raising taxes or lowering government expenditures. Graphical Questions [30 points total/5 bonus points] 1. [14 points total] Based on the following graph, answer the questions that follow it: (1992:1-2003:4) 19 I/Y Ratio y = x R 2 = G/Y Ratio A) [7 points] What economic relationship does this graph display? Crowding out effect. B) [7 points] If government expenditures grow by 1% as a fraction of GDP, what is the change in the fraction of investment to GDP? A reduction of %. Page 8

9 2. [21 points total] Based on the following graph, answer the questions that follow it GDP Growth (in %) y = x R 2 = Change in Unemployment Rate (in %) A) [7 points] What is the name of the economic relationship being depicted in this graph? Okun s Law. B) [7 points] What is the level of output growth if there are no changes in unemployment? 3.4% C) [7 points] Suppose unemployment drops from 6.5% to 4.5%. What will the new growth rate of output be? (-2) = 7.22% Page 9