Answer each question. For full credit, provide an explanation or show work.

Transcription

1 Econ Instructor Wei Gao Spring 2010 Final Answer each question. For full credit, provide an explanation or show work. 1) Consider the market for cars. Show graphically what happens and explain using economic intuition under each of the following cases. (Do each case separately, each part is worth 3 points. Total is 6 points.) a) The US economy gets out of recession. More people find jobs and people get big wage raise. Solution: As income increase, the demand for car increases. With higher demand, car prices go up. With higher car prices, supply of cars goes up. B S A D b) The price of oil skyrockets. Solution: Oil and cars are complements. Oil price goes up. Demand for oil goes down. Demand for cars also goes down. With lower demand for cars, price of cars falls. As car price falls, supply of cars falls. A S B D 1

2 2. Are the following included in NGDP? If not, why? If yes, where(consumption, investment, government purchases, or net export)? Assume that each of the transactions is carried out during the year. (Each part is worth 2 points. Total is 6 points) a) You buy share stocks in Google. Solution: No. This is transfer of ownership. b)siu buys an old building in downtown Carbondale so as to acquire additional office space. Solution: No. Old building is not built this year. c)pinch Penny CEO s paycheck Solution: No. Paychecks in private sectors are not included. 3. The taxes have been high in the past years. People are complaining about it. The government decides to cut taxes. If the government also wants to keep the interest rate low, what should the government increase government spending or decrease it? Explain. (6 points) Solution: If government cut taxes, the supply of funds goes down. Interest rate will rise. The government need to decrease government spending, thus to increase the supply of funds. This will keep the interest rate low. 2

3 4. The data shows that inflation has been very low in recent months. People don t know how Fed s policy will affect inflation rate in the future. Suppose inflation rate will remain low for a couple of years. Is this good news for graduates with large amount of student loans? Explain. (6 points) Solution: real interest rate=nominal interest rate-inflation. If inflation is high, borrowers pay back less purchasing power. If inflation is low, borrowers pay back more purchasing power. This is bad news for them. 5. You buy a piece of property for $100,000 in 2000 and sell it for $118,000 in The CPI in 2000 was 150 but is 165 in Was your real return positive or negative? (No credit will be given for an answer without any work or explanation accompanying it. 5 points) Solution: Your real return is positive. Your money increased by 18% whereas prices only increased by 10%(165 is 10% more than 150). You can also do this problem by converting the 118,000 into its year 2000 equivalent: Year 2000 equivalent= $ 118,000(150/165)=$107, which is greater than $100, Explain why many people believe that it will spur the investment in the economy if households spend less and save more. (6 points) Solution: If households spend less and save more, the supply of funds goes up. This lowers interest rate and spurs investment. 7. Inflation in China has been high in the last decade. Suppose the Chinese government wants to lower the inflation without changing real interest rate. (Total is 10 points) 3

4 a) What combination of monetary and fiscal policy should it conduct to achieve these goals? (5 points) Solution: If the Fed reduces supply of funds, then interest rate goes up. The higher interest rate lowers consumption and investment and so AD falls. Price level throughout the economy (inflation rate0 falls. At the same time, the Congress cuts government spending or raises taxes. This will increase the supply of funds. Interest rate falls. As government spending goes down, AD falls. Inflation falls. Monetary policy drives up interest rate. However, fiscal policy drives down interest rate. This combination will keep real interest rate unchanged. b) What is the downside of these policies? That is, what negative effects will occur? (3 points) Solution: Output level is decreased. A recession might occur. c) What will happen to nominal interest rate? ( 2 points) Real interest rate remains unchanged. However, inflation is low now. So nominal interest rate is lower. 8. Suppose households and businesses care about interest rate very much when they make consumption and investment decisions. A small increase in interest rate will drive down consumption and investment a lot. A small decrease in interest rate will lead to a big increase in consumption and investment.(total is 10 points) a) What does this imply about the effectiveness of monetary policy in its ability to change output levels in the economy? (5 points) Solution: monetary policy will be very effective. The Fed change the interest rate a little bit, C and I changes a lot. Thus output changes a lot. 4

5 b) What does this imply about the effectiveness of fiscal policy in its ability to change output level in the economy? (5 points) Solution: fiscal policy is not very effective. If the government raises G, the supply of funds in the fund market falls. Interest rate goes up. C and I fall a lot. So AD won t increase very much with increase in G but huge decrease in C and I. Thus output won t change much. 9. Suppose the economy is in a recession. (Total is 10 points) a) Explain how the self-correction mechanism would eventually lift the economy out of recession.(5 points) Solution: With a weak economy, inputs are idle since there is low demand for them. Hence, input prices will fall. Eventually, they fall far enough that firms profitability increase again and they expand production, returning output back to normal. The SRAS curve shifts right to get the economy back to normal. b) If the Federal Reserve did not want to rely on the self-correction mechanism, what would it do to try to lift the economy out of the recession? (5 points) Solution: The Fed should expand the supply of funds so as to reduce interest rates. With lower interest rates, consumption and investment increase thereby raising AD. 10. You observe rising inflation but falling unemployment. Do you think that an increase in financial wealth thereby raising household consumption or a fall in oil price to be most consistent with these observations? Explain. (8 points) Solution: Falling unemployment means rising output. Therefore, output and inflation are both high which is probably caused by an increase in AD such as an increase in consumption. 11. Consider an open market purchase by the Federal Reserve. (Total is 12 points) a) Is interest rate more likely to go up or down? Explain. (3 points) 5

6 Solution: The Fed buys bonds from the public. The public have more funds to make deposits. The supply of funds goes up. Interest rate falls. b) Is the CF (capital flow) more likely to go up or down? Explain. (3 points) Solution: With a lower interest rate, more wealth leaves the country and less wealth flows in. CF increases. c) If the value of the dollar against other currencies-that is, the exchange rate, more likely to go up or down? Explain. (3 points) Solution: As wealth leaves the country, the demand for dollars goes down. Exchange rate, the value of dollar goes down. d) Is the NX(net export) more likely to go up or down? Explain. (3 points) Solution: As exchange rate goes down, US goods are less expensive. US exports goes up. Meanwhile, foreign goods are more expensive. US imports goes down. Thus NX increases. 12. The U.S has been running trade deficits for the last 30+ years. Briefly explain the cause of these trade deficit.(5 points) A trade deficit occurs when NX is negative. NX=output-domestic spending. Hence, a trade deficit occurs when spending in a country exceeds output. The U.S. has been running a trade deficit because spending is greater than output. 13. Consider a financial catastrophe that lowers the supply of funds in the economy. ( Total is 10 points) a) What happens to output and inflation? (4 points) Solution: With lower supply of funds, interest rate goes up. With higher interest rate, C and I fall. With decrease in C and I, AD falls. As AD falls, output and inflation fall. 6

7 b) Suppose the government has three goals. The first one is to restore output to its initial level. The second goal is to restore inflation to its initial level. The third goal is to restore interest rate to its initial level. Do you think an expansionary fiscal policy is able to achieve the three goals at the same time? Explain. ( 6 points) Solution: No. Expansionary fiscal policy increases G but decreases T. Thus AD increases. Output and inflation can get back to normal. But as G goes up and T goes down, supply of funds goes down. Interest rate will go up further. Therefore, expansionary fiscal policy cannot return real interest rate to their initial level. 7