Principles of Macroeconomics December 17th, 2005 name: Final Exam (100 points)

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1 EC Serge Kasyanenko Principles of Macroeconomics December 17th, 2005 name: Final Exam (100 points) This is a closed-book exam - you may not use your notes and textbooks. Calculators are not allowed. Please read instructions and questions carefully and attempt to answer all sections. You have 50 minutes to complete the exam. Good luck! I. Multiple Choice Section (30 points). Select one correct answer. Answer all questions. 1. Price stability means: A) absolutely no movement of all prices. B) that real GDP cannot climb over time. C) price movements that, on the average, tend to cancel so that the CPI holds steady. D) absolutely no movement in the prices of the goods contained in CPI market basket. 2. Disposable income is equal to: A) national income plus unearned income. B) national income minus both tax payments and unearned income. C) national income minus tax payments. D) national income minus tax payments and plus unearned income 3. An outward shift in the investment demand curve might suggest: A) an increase in business taxation. B) a change towards optimism in the expectations of investors. C) a reduction in the interest rates. D) a decrease in the total output of the economy. E) all of the above. 4. On the basis of the Keynesian model of output determination, when national output is greater than its equilibrium level: A) actual saving is higher than actual investment. B) saving must be negative. C) the economy has more employment than is optimal. D) unwanted inventories will be accumulating. E) more inventories will be depleted because consumption spending is higher than its equilibrium level. 5. The link from monetary policy to changes in real macroeconomic variables is one that: A) depends only upon the sensitivity of demand for money to changes in the interest rate. B) is direct, and works automatically within the walls of American banks. C) depends only upon the sensitivity of investment to changes in the interest rate. D) depends not at all on the interest rate. E) depends upon the sensitivity of both investment and the demand for money to changes in the interest rate. 6. A recent graduate not yet employed but searching for work is considered: A) cyclically unemployed. B) not yet in the labor force. C) structurally unemployed. D) frictionally unemployed

2 7. The multiplier-accelerator theory: A) follows from shocks to the aggregate demand curve. B) suggests that business cycles may be self-generating. C) is related primarily to fluctuations in the automobile industry. D) is one of the political theories of the business cycle. E) is an external theory of business cycles. 8. Let the unemployment rate decline from 6.5% to an observed rate of 5%. Actual GDP must therefore: A) increase by 1.5 percentage points. B) fall by.75 percentage points. C) fall by 3 percentage points. D) fall by 1.5 percentage points. E) increase by 3 percentage points. 9. If the rate of inertial inflation were 6 percent, then you would expect: A) that nominal interest rates would include a 6 percent inflation premium. B) that price inflation would have a tendency to run at somewhere between 6 percent and the NAIRU. C) that wage inflation would run at something less than 6 percent. D) that real interest rates would be maintained somewhere above 6 percent. E) all of the above. 10. A Keynesian would recommend which of the following for an economy with a low level of output in equilibrium? A) A governmentally instituted higher price of oil. B) A rationing of an essential input. C) An increase in government spending. D) None of the above. E) All of the above. 11. An increase in the inertial rate of inflation causes the short run Phillips curve A) to shift up and in. B) to shift down and out. C) to move downward along the long run Phillips curve. D) to shift up and out. 12. The Ricardian view of fiscal policy is that tax changes have no impact on consumption A) the government has a budget surplus. B) households save less when taxes are cut to take advantage of the multiplier and the growing economy. C) the benefits from trade and comparative advantage will pay for the tax cut. D) investment spending changes to counteract the effect of the tax cut. E) households save more when taxes are cut because they realize that the government will have to raise taxes at some point in the future to pay interest on the new loans. 13. Which of the following is a correct, likely sequence? A) M up, i up, I up, GDP up. B) M down, i up, I down, GDP up. C) M up, i down, I up, GDP up. D) M down, i down, I up, GDP up. E) M down, i up, I up, GDP up

3 14. If the national output declines with $300 bl when the government increases taxes with $100 bl than the MPC for this economy is: A) 1 B) 0.5 C) 2/3 D) 0.4 E) The definition of M1 includes: A) all currencies, both in banks and in the hands of the public. B) coins, currency, and all bank deposits. C) coins, currency, and time deposits. D) coins, currency, and demand deposits. 16. Aggregate demand would tend to be shifted up by: A) open-market purchases by the Fed. B) an increase in interest rates. C) an increase in taxes. D) a decrease in government spending. E) none of these. 17. The most preferred direction for the Phillips curve to shift is: A) up and to the right. B) up and to the left. C) down and to the right. D) down and to the left. E) in the same direction as costs. 18. The aggregate production function relates total national output to: A) inflation and economic growth. B) employment and growth. C) inputs and outputs. D) the production possibilities frontier. E) inputs and technology. 19. The quantity of U.S. dollars demanded by foreigners is likely to rise: A) if there is high inflation in the United States but there is no inflation abroad. B) after foreigners devalue their currencies relative to the dollar. C) the Fed tightens monetary policy. D) if it is anticipated that the dollar will be devalued. E) if the demand for U.S. exports falls. 20. Which of the following is an accurate statement according to the classical model? A) Changes in aggregate demand affect only the price level. B) Policy can have no effect on the level of employment because it cannot change the level of GDP. C) The aggregate supply curve is vertical above potential GDP. D) Prices and wages always respond quickly to clear markets. E) All of the above

4 II. True/False Section (15 points) Answer all questions. Determine whether the statement is true or false. For each question provide a short explanation (no more than 1-2 sentences) of your answer. Use equations if necessary. 1. (True/False) In the multiplier model, the impact of the government spending is substantially different from the impact of private investments. 2. (True/False) An increase in the discount rate would be a signal of a tightening in the money supply. 3. (True/False) Ricardian view of fiscal policy argues that changes in tax rates have an impact upon consumption spending. 4. (True/False) For the existence of equilibrium in the multiplier, the C + I + G + X schedule must have a smaller slope than the slope of the 45-degree line. 5. (True/False) A recession cycle caused by contractionary fiscal policy can be represented in the usual Phillips curve context with an upward shift of the initial Phillips curve

5 III. Definitions (10 points) Answer all questions. Provide a short definition of all three terms and explain the link between the first two terms and the third one, shown in bold. Use equations if necessary. 1. (i) Disposable Income, (iii) Marginal Propensity to Save, (iii) Savings Function: 2. (i) Potential Output, (ii) Structural Deficit, (iii) Cyclical Deficit:

6 IV. Graphs (25 points) Use a separate diagram to answer each question. Label all axes, indicate initial equilibrium and show the direction of a change. Show the final state of the economy. If necessary, provide a short description for each graph. Answer all questions. 1. Show the response the money demand and the interest rate to the decline in the income of households (assume that the money supply is fixed). 2. Use multiplier model for the closed economy to show the effect of a decline in the government purchases on the national output. 3. Use Phillips curve to show the short-run impact of a fall in the unemployment rate. 4. Using AS-AD diagram, show the short-run impact of lower oil prices on the aggregate price level and output. 5. Show the response of Euro/$ exchange rate is the European Central Bank loosens its monetary policy. (Use the demand for and supply of dollars graphs.) - 6 -

7 V. Essay (20 points) 1. You have two options in this section (Option B is on the next page). Answer one question only. Please provide a clear and concise answer. Use graphs and equations when necessary. You may use the back side of the page for your answer, if you need. A [6 points] In a move to stimulate the economy the Fed loosens monetary policy. Describe and illustrate the impact of this policy on the interest rate, investment, prices and output. 2. [3 points] List all option the Fed can use to increase money supply. Are all of them equally likely to be used by the Fed? Explain why. 3. [4 points] What is the cost (trade-offs) of this policy? What graphs do we use to represent this trade-off (plot the graph)? Should we observe this trade-off both in the short-run and long-run (explain why)? 4. [2 points] The Fed actions pushed up the inertial inflation by 1%. Measure the response of output and unemployment. 5. [5 points] What is the name of the theory that links price stability and monetary policy? What are the main assumptions, equations and conclusions of this theory? - 7 -

8 1. B [5 points] The economy enters a period of high unemployment. The government attempts to stimulate output by using the fiscal policy. What are the instruments of the fiscal policy? How should the government use this instruments to achieve the desired change in output? 2. [5 points] Choose one instrument and show its effect on the economy by using both Keynesian Multiplier Model and AS-AD framework. (Your both graphs should accurately reflect the assumptions of the multiplier model.) 3. [5 points] Assume that the actual unemployment rate is 12% and the government wishes to reduce it to 9%. If MPC is equal to 3/4 and the actual output is $1000 what is the necessary size of the fiscal policy instrument to achieve this target? Answer this question for both instruments - taxes and government spending. 4. [5 points] What are the consequences of this fiscal policy for the government budget? Are they going to have any long-term implications for this country? Why? - 8 -