Econ 98- Chiu Spring 2005 Final Exam Review: Macroeconomics

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1 Disclaimer: The review may help you prepare for the exam. The review is not comprehensive and the selected topics may not be representative of the exam. In fact, we do not know what will be on the exam. We try to make our answers complete, but we cannot guarantee their correctness. Use at your own risk and use good judgment. The answers are very extensive. You will run out of time on the exam if you try to write so much. I just want you to understand the big picture. SUGGESTED SOLUTIONS 1. OPEC raises oil prices drastically without warning. Show graphically the effects on the aggregate supply curve. Label AS 2. Label the economy s new equilibrium output (Y 2 ) and price level (P 2 ). Label AD 0, AS 0, Y 0, P 0 as your initial conditions. You must explain the adjustment process. Assume that oil is a major input in all outputs. The increase in the price of oil pushes price level to rise at every level of output. Hence, the AS curve shifts left. At Y o (assuming output does not change in the very short-run), the economy suffers a sharp rise in price level from P o to P 1. The increase in price level raises money demand because the economy wants more money to purchase the same amount of output (Y o ). If we assume a money supply target, then interest rates (r) rises. P P 1 P 2 P o AS 2 AS o The increase r raises the cost of borrowing and the rate of return on dollar assets. Planned investment spending (I) falls and net exports (NX) fall. PAE falls as a consequence, hence output falls via the multiplier effect. We are shifting along the AD 0 curve. Y 2 Y o AD o Y In addition, the higher price level reduces the real wealth of the economy. Savings increases and consumption falls. PAE falls as a consequence, hence output falls via the multiplier effect. We are shifting along the AD 0 curve. The drop in output (caused by the interest effect and wealth effect) reduces the demand for inputs. The decline in input prices causes a decline in price level which offsets some but NOT the entire initial rise in price level. We are shifting along the AS 2 curve. The new equilibrium is at P 2 and Y 2. Notice that our new equilibrium faces a higher price level and lower output than before OPEC raised oil prices. Page 1 of 8

2 2. Consumers are fervent about the bright economic future. Show graphically the effects on the AD-AS model. Label your initial conditions with subscript 0 and your new equilibrium with subscript 2. You must explain the adjustment process. Assume the boost in consumer confidence raises autonomous consumption spending (i.e. the part of consumption spending that is independent of disposable income). An increase in autonomous consumption increases PAE which raises income which raises disposable income which raises consumption which raises income via the multiplier effect. P P 2 P o AS o AD 2 Output rises at every price level. Hence AD shifts right. If price level did not change (in the very short-run, P o ), then output increases from Y o to Y 1. The Y o Y 2 Y 1 AD o Y increase in output raises the demand for inputs. The increase in the price of inputs spills over to higher price levels. We are shifting along the AS o curve. The increase in price level raises money demand because the economy wants more money to purchase more output (Y 1 ). If we assume a money supply target, then interest rates (r) rises. The increase r raises the cost of borrowing and the rate of return on dollar assets. Planned investment spending (I) falls and net exports (NX) fall. PAE falls as a consequence, hence output falls via the multiplier effect which offsets some but not the entire initial increase in output. We are shifting along the AD 2 curve. The new equilibrium is at P 2 and Y 2. Notice that our new equilibrium faces a higher price level and higher output than before the consumer confidence boost. Page 2 of 8

3 3. The economy is in dire despair due to high unemployment. Congress raises government spending in order to stimulate the economy. Assume the Fed maintains a money supply target. Draw the money market model showing the effects of expansionary fiscal policy on interest rates. Label subscript 0 for before the fiscal policy and subscript 1 for after the fiscal policy. Explain the relationship between output and interest rates. G up PAE up Y up Yd up C up Y up via the multiplier The increase in output raises Md (shift right) because there is more output to purchase in the economy. If the Fed maintains a money supply target, then Ms does not change. At r o, Md>Ms, so the economy wants to hold more money than the amount of money circulating in the economy. The economy sells bonds in order to exchange a non-money asset (bond) for money. The selling of bonds shifts the supply of bonds to the right which lowers the price of bonds. A decrease in the price of bonds raises the rate of return on bonds. Interest rate rises to r 1 such that Md 1 =Ms. Hence an increase in output raises interest rates (assuming a money supply target). r Ms r 1 r 0 Md 0 Md 1 M Page 3 of 8

4 4. The economy is in dire despair due to high unemployment. Congress raises government spending in order to stimulate the economy. Assume the Fed maintains an interest rate target. Draw the Keynesian-cross model showing the effects of the initial surge in government spending with a subscript 1. Show the crowding-out effects with a subscript 2. G up PAE up Y up Yd up C up Y up via the multiplier PAE shifts up from PAE 0 to PAE 1 due to the fiscal policy. However the initial surge in output raises Md which raises r (assuming Ms target). An increase in r raises the cost of borrowing and the rate of return on dollars. I falls and NX falls. PAE falls to PAE 2. Y falls via the multiplier which offsets some of the initial increase in Y. An increase in r decreases NX because dollars earn a higher rate of return than foreign exchange (assuming r us >r foreign ). This causes a decrease in the demand for foreign exchange and increase in the supply for foreign exchange. The price of foreign exchange falls and the dollar appreciates. If prices are constant, then the appreciation of the dollar lowers NX. Notice that an increase in government spending crowds out investment spending and net exports (if the Fed uses a money supply target), but output still is above Y 0. PAE Y=PAE PAE 1 PAE 2 PAE 0 Yo Y2 Yf=Y1 Y Page 4 of 8

5 5. Explain why the closed-economy government spending multiplier is SMALLER with a money supply target than interest rate target. The closed-economy government spending multiplier is smaller than (1/(1- mpc)) if the Fed maintains a money supply target. Because when G goes up, PAE goes up, Y goes up due to the multiplier effect. But when Y goes up, Md goes up because the economy demands more money to spend their additional income, when Md goes up, then r goes up. A higher interest rate reduces investment spending and reduces PAE and reduces Y. We call this the crowding-out effect. Hence Y increases by LESS THAN the increase in G times the multiplier. Page 5 of 8

6 6. Assume flexible exchange rates. Argentina is currently in a recession. Suppose Argentina s central bank engages in expansionary monetary policy in an effort to bring Argentina out of its recession. Will US imports from Argentina rise or fall? Explain by describing the impact of Argentina s expansionary monetary policy on the exchange rate between dollars and pesos, and the effect of this change in exchange rate on US imports from Argentina. The central bank buys bonds which increases the demand for bonds and raises the price of bonds. The lowered rate of return on bonds decreases the interest rate. A decreased Argentinean interest rate makes peso denominated assets relatively less attractive than dollar assets (assume r a <r us ). Dollar denominated assets are relatively more attractive than peso denominated assets. Argentineans want to buy dollar assets and Americans want to buy dollar assets as well. D peso down and S peso up. The relative price of the peso (P peso ) falls. The dollar appreciates because $1 can buy more peso than before. The peso depreciates because 1 peso can buy fewer dollars than before. If prices are constant, then Argentina s goods are relatively cheaper than American goods and services. Americans will import more from Argentina. Page 6 of 8

7 7. Explain why monetary policy could be more effective than fiscal policy in an open economy. Monetary policy could be more effective than fiscal policy in an open economy because the interest rate effect on investment spending is positively correlated with the interest effect on net exports. Assume the Fed wants to stimulate the economy by expanding the money supply target. The FOMC buys bonds which raises the price of bonds, lowers the rate of return on bonds, and lowers the interest rate. r down cost of borrowing down I up PAE up Y up via the multiplier r down rate of return on dollar assets down dollar assets are relatively less attractive than foreign assets (which is the same thing as saying foreign assets are relatively more attractive than dollar assets) Americans want to buy foreign assets and Foreigners want to buy their own assets D fx up and S fx down P fx up dollar depreciates NX up PAE up Y up via the multiplier Fiscal policy lacks the extra boost from NX (even if the Fed is an interest rate target). If the Fed was a money supply target, then expansionary fiscal policies push the interest rate up which crowds out investment spending and NX. Page 7 of 8

8 8. A US resident purchases a British stock. What is the effect on US assets abroad (increase or decrease)? What is the effect on the foreign assets in the US (increase or decrease)? What is the effect on the US capital account? Net wealth position of the United States? What is the only way a country s net wealth position can change? US assets abroad Foreign assets in the US Change in KA Change in CA Change in net wealth position Increase Increase None None None The American takes her dollars and exchanges them for British pounds. She uses the British pounds to buy the British stock. The dollars are deposited into a US Bank. US assets abroad = assets from abroad owned by Americans. In our example, the British stock is from Britain. The person who owns the British stock is American. Hence US assets abroad increased! Foreign assets in the US = assets held inside the US but owned by foreigners. In our example, the dollars are owned by the British. However, the dollars must be deposited into a US bank because British banks do not accept deposits of dollars. Hence foreign assets in the US increased! Mnemonic device: The word before assets denotes ownership. The word after assets denotes where the asset is from or held. An increase in US assets abroad and increase in foreign assets in the US cancel each other out in the capital account. Hence no change in the capital account. If there is no change in the capital account, then there is no change in the current account because KA = -CA. CA is the net wealth position of the country. Hence there is no change in the net wealth position. The only way to change the net wealth position of the United States is to change the current account. An increase in the current account raises the net wealth position. A decrease in the current account lowers the net wealth position. One way to raise our current account (and our net wealth position) is to EXPORT MORE GOODS & SERVICES TO THE REST OF THE WORLD! Page 8 of 8