UGBA 101B Macroeconomic Analysis Professor Steven Wood. Exam #2 ANSWERS

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1 Name: SID : UGBA 101B Macroeconomic Analysis Professor Steven Wood Summer 2008 Exam #2 ANSWERS Please sign the following oath: The answers on this test are entirely my own work. I neither gave nor received any aid while taking this test. I will not discuss the questions on this test until after 6:00 p.m. on July 3, Signature Any test turned in without a signature indicating that you have taken this oath will be assigned a grade of zero. Graph Instructions When drawing diagrams, the following rules apply: 1. Completely, clearly and accurately label all axes, lines, curves, and equilibrium points. 2. The original diagram and any equilibrium points MUST be drawn in black or pencil. 3. The first change in any variable, curve, or line and any new equilibrium points MUST be drawn in red. 4. The second change in any variable, curve, or line and any new equilibrium points MUST be drawn in blue. 5. The third change in any variable, curve, or line and any new equilibrium points MUST be drawn in green. Do NOT open this test until instructed to do so. Good Luck Summer 2008 (Exam #2) UGBA 101B 1 of 12

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3 A. Multiple Choice Questions. Circle the letter corresponding to the best answer. (3 points each; total of 45 points.) 1. An adjustable rate loan is a loan where the interest rate you pay adjusts as the central bank changes interest rates. Compared to the US, Britain has a much more substantial proportion of adjustable rate loans. So one would expect: a. A steeper IS curve in the UK. b. A steeper IS curve in the US. c. A steeper LM curve in the UK. d. A steeper LM curve in the US. 2. Suppose the Federal Reserve cuts interest rates below 1%. This drastic measure leads to fear and panic among households and investors about the information the FED might have about the economy. We could analyze this by: a. A shift to the right of the LM curve. b. A shift to the left of the LM curve. c. A shift to the right of the LM curve and a shift to the left of the IS curve. d. A shift to the left of the LM curve and a shift to the right of the IS curve. 3. According to real business cycle theory, a rise in government expenditures brings about a fall in consumption because people feel poorer due to the prospects of future tax increases. If this theory is correct, then the net effect of a rise in government expenditures would be to cause: a. The IS curve to shift to the right. b. The IS curve to shift to the left. c. The LM curve to shift to the right. d. Either a. or b. 4. Richer households have higher savings rates than poorer households. Suppose that unemployment is at the natural rate of unemployment and government decides to redistribute income from the rich to the poor via taxation. If the central bank wants to stabilize the economy at full-employment output, it should: a. Leave the money supply unchanged. b. Increase the money supply. c. Lower interest rates. d. Raise interest rates. 5. The following combination leads to the HIGHEST interest rates: a. Expansionary fiscal policy and expansionary monetary policy. b. Expansionary fiscal policy and contractionary monetary policy. c. Contractionary fiscal policy and expansionary monetary policy. d. Contractionary fiscal policy and contractionary monetary policy. Summer 2008 (Exam #2) UGBA 101B 3 of 12

4 6. The United States has been running large, persistent current account deficits for two decades. Because the dollar is flexible in foreign exchange markets, each year the U.S. would be expected to have: a. A large, persistent balance of payments deficit. b. A large, persistent balance of payments surplus. c. A large, persistent capital account deficit. d. A large, persistent capital account surplus. 7. A large country imposes capital controls that prohibit foreign borrowing and lending by domestic residents. The country is currently running a capital and financial account surplus. This imposition of the capital controls will cause: a. Net exports to decrease. b. Real domestic interest rates to rise. c. Real world interest rates to rise. d. Desired national saving to fall. 8. A depreciation of the dollar causes: a. An increase in the dollar prices of U.S. exports. b. An increase in the dollar prices of U.S. imports. c. A decrease in the dollar prices of U.S. exports. d. A decrease in the dollar prices of U.S. imports. 9. The U.S. real interest rate rises relative to the British real interest rate. British net exports and the British exchange rate. a. Increase; rises. b. Increase; falls. c. Decrease; rises. d. Decrease; falls. 10. Suppose Japan is currently running a current account surplus. The most effective way of eliminating this current account surplus would be to government purchases and the domestic money supply. a. Increase; increase. b. Increase; decrease. c. Decrease; increase. d. Decrease; decrease. Summer 2008 (Exam #2) UGBA 101B 4 of 12

5 11. Suppose country A does a lot of trade with country B. Country A is at its potential output while country B is below its potential output. Then a substantial rise in the personal saving rate in country B will ultimately cause: a. The DAD curve in country A to shift to the right. b. The DAD curve in country A to shift to the left. c. The DAD curve in country A to shift to the right and the SAS curve in country A to shift up. d. The DAD curve in country A to shift to the left and the SAS curve in country A to shift down. 12. If interest rates become more sensitive to rising inflation, then: a. The SAS curve will shift upward faster. b. The DAD curve will be flatter. c. The DAD curve will be steeper. d. The DAD curve will shift further to the right. 13. In the DAD-SAS model, a rightward shift of the DAD curve leads to permanently higher inflation because: a. Of supply shocks. b. Economic output is greater than full-employment output. c. Economic output is less than full-employment output. d. Inflationary expectations have permanently changed. 14. Standard economic theory says that a recession will have no effect on productivity. An alternative theory suggests that a recession can increase productivity permanently because it forces inefficient firms out of business. If this alternative theory is correct, then an unfavorable DAD shock will cause: a. Inflation to fall more quickly and end up lower than under the standard theory. b. Inflation to fall more slowly and end up higher than under the standard theory. c. Inflation to fall more slowly and end up lower than under the standard theory. d. Inflation to fall more quickly and end up higher than under the standard theory. 15. Suppose that the Federal Reserve has underestimated full-employment output. Then efforts by the central bank to stabilize the economy at what it thinks is full-employment output will result in: a. Disinflation. b. High inflation c. Accelerating inflation. d. Deflation. Summer 2008 (Exam #2) UGBA 101B 5 of 12

6 B. Answer ALL of the following questions (35 points each; total of 105 points.) 1. IS LM Model. Congratulations! You have just been appointed Governor Schwarzenegger s budget director. The state unemployment rate is above its natural rate of unemployment while the government is running an actual budget deficit of $20 billion and a structural budget deficit of $10 billion. Assume that the economy can be described by the Keynesian model and that Ricardian equivalence does not hold. The state constitution requires the Governor to present a balanced budget. Schwarzenegger has decided to try to eliminate the deficit by cutting government spending by $10 billion and increasing tax rates to generate $10 billion in additional tax revenues. a. Based only on this information, use an IS-LM diagram with a Budget line to accurately and clearly show: i. The California economy s initial short-run equilibrium (in black), ii. The short-run effect on California s output, the real interest rate, the actual budget balance, and the structural budget balance from these changes in spending (in red) and tax rates (in blue). r LM0 r0 r1 IS2 IS1 IS0 Y1 Y0 Y* Y T - G Change in ABB < $20 billion. < $0 billion > -$20 billion -$20 billion BB2 BB1 BB0 +$10 billion Change in SBB = $20 billion. $0 billion -$10 billion Summer 2008 (Exam #2) UGBA 101B 6 of 12

7 b. Provide a brief economic explanation of the changes you showed in your diagram above as well as the adjustment process that the economy undergoes with respect to economic output, the real interest rate, the actual budget balance, and the structural budget balance. Be sure to compare the level of these 4 variables between the initial and final short-term equilibrium situations. The California economy is initially in short-term equilibrium with economic output at Y0 and the real interest rate at r0. We know that Y0 < Y* because the unemployment rate is above its natural rate of unemployment. In addition, the actual budget balance at Y0 is a deficit of $20 billion while the structural budget balance at Y* is a deficit of $10 billion. Two events now happen. First, government spending is reduced by $10 billion. This shifts the IS curve to the left from IS0 to IS1 and reduces economic output. Lower economic output reduces the demand for money. Given that the money supply is fixed, this causes the real interest rate to decrease. Lower real interest rates stimulate some additional interest-sensitive spending and limit the decline in economic output. In addition, the budget balance line shifts higher by $10 billion when measured at the fullemployment output level. This increases the structural budget balance by $10 billion but increases the actual budget balance by less than $10 billion because of the decline in economic output. Second, tax rates are increased to generate $10 billion of additional revenue at Y*. Higher tax rates reduce disposable income. Consumer spending falls by the change in disposable income times the marginal propensity to consume. This shifts the IS curve to the left from IS0 to IS1 and reduces economic output. Lower economic output reduces the demand for money. Given that the money supply is fixed, this causes the real interest rate to decrease. Lower real interest rates stimulate some additional interest-sensitive spending and limit the decline in economic output to Y1. This leftward shift of the IS curve and decline in economic output are smaller than that caused by the reduction is government spending because part of the higher taxes are paid out of desired saving rather than desired spending. In addition, the budget balance line rotates higher by $10 billion when measured at the fullemployment output level. This increases the structural budget balance by $10 billion but increases the actual budget balance by less than $10 billion because of the decline in economic output. Economic output has fallen from Y0 to Y1, the real interest rate has declined from r0 to r1, the structural budget balance has increased from a deficit of $10 billion to a surplus of $10 billion, and the actually budget deficit has improved from a deficit of $20 billion (but by less than $20 billion) so that an actual budget deficit remains. [ Because economic output declines, both absolutely and relative to full-employment output, employment would also drop and the unemployment rate would rise. ] Summer 2008 (Exam #2) UGBA 101B 7 of 12

8 2. Open Economy IS LM Model. The U.S. and China are major trading partners. Suppose that both economies were in general equilibrium in 2006 with a flexible exchange rate but that the change in economic output from domestic events is greater than from international events. Assume that both economies can be described by the Keynesian model and that Ricardian equivalence does not hold. In 2007, the U.S. economy experienced a significant decline in home building activity. Also in 2007, the Chinese government increased government spending substantially. In the U.S. the Federal Reserve reacted immediately to these events to keep the economy at its full-employment level. a. Based only on this information, use a 2-country, open economy IS LM diagram with a Foreign Exchange Market diagram (for the Chinese renminbi) to accurately and clearly show: i. The initial general equilibrium situation in both countries (in black), ii. The short-run effects on output and the real interest rates in both the U.S. and China and on the supply and demand for the Chinese renminbi (in red and blue as needed). U.S. China r Y* LM 0 r Y* LM 0 LM 3 r 0 r 1 r 3 r 0 IS1 1 IS 2 IS0 0 IS 0 IS Y 0 Y Y 0 Y 1 Y $/Renminbi Foreign Exchange Market S RMB0 S RMB2 S RMB1 e nom2 e nom0 e nom1 D RMB0 D RMB2 Summer 2008 (Exam #2) UGBA 101B 8 of 12

9 b. Provide a brief economic explanation of the changes you shown in your diagram above. Be sure to compare the level of economic output, the real interest rate, and the exchange rate between the initial general equilibrium and the new short-term equilibrium that exists in each country after these events occur. The U.S. economy began in general equilibrium with economic output at Y 0, which was equal to its full-employment level of output, i.e., Y 0 = Y*, and with the real interest rate at r 0. The Chinese economy also began in general equilibrium with economic output and income at Y 0, which was equal to its full-employment level of output, i.e., Y 0 = Y*, and with the real interest rate at r 0. With flexible exchange rates, the equilibrium exchange rate was equal to its fundamental value at e nom0. In 2007, the U.S. experienced a significant decline in home building activity. This would shift the U.S. IS curve to the left from IS 0 to IS 1, reducing both U.S. economic output and the real interest rate. Also in 2007, China experienced a substantial increase in government spending. This would shift the Chinese IS curve to the right from IS0 to IS1, increase both Chinese economic output and the real interest rate. The increase in Chinese economic output would also increase the Chinese demand for imports or U.S. exports. This would shift the U.S. IS curve to the right from IS1 to IS2. However, because the effect on economic output is larger from domestic events than international events, this rightward shift of the IS curve is smaller than the initial leftward shift from the decline in home building activity. In addition, the Federal Reserve reacted immediately to these events to keep the economy at its full-employment level of output. This required an expansionary monetary policy which shifted the U.S. LM curve to the right from LM 0 to LM 1, decreasing the real interest rate but increasing U.S. economic output back to its full-employment level. After these events, the U.S. economy would be in short-term equilibrium with the same level of economic output at Y 0, which still equaled its full-employment level of output, i.e., Y 0 = Y*, but with a lower real interest rate at r 1. The Chinese economy would be in short-term equilibrium with a higher level of economic output at Y 1, which was greater than its full-employment level of output, i.e., Y 1 > Y* and with a higher real interest rate at r 1. In the foreign exchange market, higher economic output in China increases the demand for imports, increases the supply of renminbi, and shifts the supply curve to the right from S RMB0 to S RMB1, causing the renminbi to want to depreciate. However, a higher real interest rate in China makes renminbi-denominated assets more attractive, increases the demand for renminbi, shifts the demand curve to the right from D RMB0 to D RMB2, and decreases the supply of renminbi, shifts the supply curve to the left from S RMB1 to S RMB2, causing the renminbi to appreciate. The net result is that the foreign exchange value of the renminbi appreciates from e nom0 to e nom2. Summer 2008 (Exam #2) UGBA 101B 9 of 12

10 c. Now suppose that in 2006 China had fixed its currency, the Chinese renminbi, to the U.S. dollar at its fundamental value. The Chinese central bank committed to keeping the exchange rate fixed without sterilizing any foreign exchange intervention. Describe exactly how China s central bank must respond to the events in both the U.S. and China in 2007 in order to maintain a fixed exchange rate at its 2006 level. Also discuss what happens to China s economic output and real interest rate in the short-run assuming that China is successful in maintaining the fixed exchange rate at its 2006 level. If China had fixed the exchange rate in 2006 at its fundamental value at e nom0, this became the official rate. In 2007, events in the U.S. and in China would cause the renminbi to want to appreciate. This indicates that the demand for the Chinese renminbi in the foreign exchange market was greater than the supply of Chinese renminbi in the foreign exchange market, and the currency is undervalued. Therefore, in order to fixed the exchange rate at its 2006 level of e nom0, the Chinese central bank would have to enter the foreign exchange market and buy up the excess dollars that existed at the official rate of e nom0 by increasing its domestic money supply and increasing its foreign official reserves. It would have to do this in every time period. By buying up the excess dollars in the foreign exchange market, the Chinese central bank would be increasing the domestic money supply. Because the central bank was not sterilizing its foreign exchange intervention, this would shift the LM curve to the right, reducing the real interest rate and increasing economic output (which was already above its full-employment level). Maintaining a fixed exchange rate when a favorable demand shock hits the economy (in this case an expansionary fiscal policy) forces an expansionary monetary policy response. This exaggerates the increase in economic output. Summer 2008 (Exam #2) UGBA 101B 10 of 12

11 C. DAD SAS Model. In the early 2000 s, the pace of globalization accelerated. As a result, multinational firms stopped building and investing in production facilities in the United States and opened them in China and India. These firms then imported products and services from China and India in order to sell to their customers in the U.S. Because of lower production costs abroad, imported goods prices in the U.S. fell substantially. In addition, the increase in international competition led to an acceleration in U.S. productivity, where the long-run effects were greater than the short-run effects. Suppose that the U.S. economy was initially in general equilibrium, that it can be described by the Keynesian model, and that Ricardian equivalence does not hold. Assume that all of the events described above happened in Year 1, that the adjustment to long-term equilibrium takes 4 years, and that any demand shocks have a larger effect on output than any inflation (or short-term supply) shocks. a. Based only on this information, use the DAD-SAS model to accurately and clearly show: i. The U.S. economy s initial general equilibrium situation (in black), ii. The short-run effect on U.S. economic output and inflation from each of these changes (in red), iii. The effect on U.S. economic output and inflation during the first 2 years of the adjustment process (in blue and green), and iv. The U. S. economy s final general equilibrium situation (in black). Y 0 * Y 1 * π DAD1 DAD1a DAD0 π0 π1a π1 SAS0 SAS1a SAS1 π2 π3 π5 SAS2 SAS3 SAS5 Y1 Y0 Y. Y2 Y3 Y5 Summer 2008 (Exam #2) UGBA 101B 11 of 12

12 b. Provide a brief economic explanation of the changes you showed in your diagram above as well as the adjustment process that that the economy undergoes with respect to economic output and inflation. Be sure to compare the level of economic output and the inflation rate between the initial and final general equilibrium situations. The economy is initially in general equilibrium with economic output at Y 0 = Y 0 * and with a steady inflation rate of π 0. Four events happen in Year 1 as a result of this acceleration in globalization. First, globalization increased international competitive pressures that led to an acceleration of productivity. This caused inflation to fall from π 0 to π 1a and the SRAS curve to shift down from SRAS0 to SRAS1a. In addition, potential output increased, causing Y* to shift to the right from Y 0 * to Y 1 *. Because the long-run effects were greater than the short-run effects, the rightward shift of the LRAS curve is greater than the effect on economic output of the downward shift of the SRAS curve (along the original DAD curve). Second, globalization caused desired investment to decline as firms stopped building and investing in productive facilities in the U.S. This caused the DAD curve to shift to the left from DAD0 to DAD1a. Third, globalization led to an increase in imports (and likely decline in exports). This also caused the DAD curve to shift to the left from DAD1a to DAD1. Fourth, globalization led to lower prices for imported goods and services. This caused inflation to fall from π 1a to π 1 and the SRAS curve to shift down from SRAS1a to SRAS1. The combination of these events caused economic output to decline [if the shifts in the DAD curve dominated the shifts in the SAS curve]. Economic output will have declined from Y 0 to Y 1 while inflation will have declined from π 0 to π 1. In Year 2, because Y 1 < Y 1 *, inflation will decline from π 1 to π 2 and the SRAS curve will shift down from SRAS1 to SRAS2. Lower inflation increases the purchasing power of the nominal money supply, reduces interest rates, stimulates interest-sensitive spending and increases economic output from Y 1 to Y 2. In Year 3, because Y 2 < Y 1 *, inflation will decline from π 2 to π 3 and the SRAS curve will shift down from SRAS2 to SRAS3. This decline in inflation and downward shift of the SRAS curve will be smaller than in Year 2 because the output gap in Year 2 is smaller than the output gap in Year 1. Lower inflation increases the purchasing power of the nominal money supply, reduce interest rates, stimulate interest-sensitive spending and increase economic output from Y 2 to Y 3. This process continues until the economy returns to general equilibrium with economic output at Y 5, which is also the new, higher full-employment level of output at Y 1 *. The inflation rate will be permanently lower at π 4 (because of the combination of unfavorable demand shocks and favorable supply shock) and the economy will be at a higher potential output level (because of the favorable supply shock). [ Because the full-employment level of output has increased, the level of full-employment employment will also increase while the natural rate of unemployment will be lower. ] Summer 2008 (Exam #2) UGBA 101B 12 of 12