Exam #2 Review Questions (Answers) ECNS 303 October 31, 2011

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1 Exam #2 Review Questions (Answers) ECNS 303 October 31, ) For Ch. 9 and 10: Review your Ch. 9 and 10 notes, Quiz #6, and any practice problems that were assigned for Ch ) Exogenous vs. Endogenous variables The following equation describes our IS model. Describe the variables r, T, Y, and G as either exogenous or endogenous. Y = C(Y-T) + I(r) + G. Endogenous: Y and r Exogenous: T and G 3.) Ch. 11, problem 1 (all parts)

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4 4.) Ch. 11, problem 3 (all parts)

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9 5.) Ch. 11, problem 8 (all parts)

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11 6.) Movement along the IS curve vs. shifts in the IS curve Consider the Keynesian Cross model of the market for goods and services. If changed, which variable(s) result in movement along the IS curve. If changed, which variable(s) result in shifts in the IS curve. (For practice, go through your answers graphically). A change in the interest rate, r, results in movement along the IS curve. If the interest rate, say, increases, then we will have a decrease in investment (b/c investment represents the cost of borrowing). This decrease in investment will cause the PE curve in the Keynesian Cross model to shift down. The IS curve plots the two equilibrium combinations of (r 1, Y 1 ) and (r 2. Y 2 ). If we have a change in either of the fiscal policy variables, G or T, then we know the IS curve will shift. In these cases, the IS curve shifts because we are examining changes in fiscal policy holding the interest rate constant. 7.) AS models The goal of our Aggregate Supply models is to show that some market imperfection causes the output of the economy to deviate from its natural level. More specifically, the AS supply models we study show that output deviates from its natural level when the price level deviates from the expected price level. The following equation describes this relationship: Y = Y nat + α(p EP) where Y is output, Y nat is the natural level of output, P is the price level, EP is the expected price level, and α indicates how much output responds to unexpected changes in the price level. To obtain this relationship, what must we assume about firm behavior that is different from the previous models in this course. Here, firms have a level of price setting power. In our previous models we have maintained the assumption that all firms are price takers. 8.) Two theories of aggregate supply Explain the two theories of aggregate supply. On what market imperfection does each theory rely? What do the theories have in common? The first model is the sticky-price model. The market imperfection in this model is that prices in the goods market do not adjust immediately to changes in demand conditions the goods market does not clear instantaneously. If the demand for a firm s goods falls, some respond by reducing output, not prices. The second model is the imperfect information model. This model assumes that there is imperfect information about prices, in that some suppliers of goods confuse changes in the price level with changes in relative prices. If a producer observes the nominal price of the firm s good rising, the producer attributes some of the rise to an increase in relative price, even if it is purely a general price increase. As a result, the producer increases production.

12 In both models, there is a discrepancy between what is really happening and what firms think is happening. In the sticky-price model, some firms expect prices to be at one level and they end up at another level. In the imperfect-information model, some firms expect the relative price of their output has changed when it really has not. 9.) Phillips curve The Phillips curve states that the inflation rate depends on what forces? Describe the equation for inflation. The Phillips curve states that the inflation rate depends on the following three forces: -Expected inflation -The deviation of unemployment from the natural rate. -Supply shocks. The equation for the Phillips curve can be written as follows: π = Eπ β(u u n ) + v where π is inflation, Eπ is expected inflation, u is unemployment, u n is the natural rate of unemployment, v is a supply shock, and β is a parameter measuring the response of inflation to cyclical unemployment.