Principles of Macroeconomics November 11th, Answer Key Midterm 2

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1 EC132.01(02) Serge Kasyanenko rinciples of Macroeconomics November 11th, 2005 I. Multiple Choice Section (30 points). Select one correct answer. Answer all questions. 1. A stable inflation can be achieved when unemployment is equal to the: A) frictional unemployment B) structural unemployment C) cyclical unemployment D) NAIRU 2. Raising the discount rate, if effective, tends to: A) expand the money supply and lower interest rates. B) expand the money supply and raise interest rates. C) contract the money supply and raise interest rates. D) contract the money supply and lower interest rates. E) do none of the above. 3. According to Okun's Law, 3 percent growth in potential GD for each of 3 years during which actual GD did not grow should be associated with: A) a 4.5-point reduction in unemployment. B) a 4.5-point increase in unemployment. C) a 5.2-point increase in unemployment. D) no change in unemployment. E) a 4.5-point reduction in the rate of inflation 4. When world interest rates increase, an open economy would tend to experience: A) an increase in exchange rates, an increase in investment, and an increase in net exports. B) an increase in exchange rates, a decrease in investment, and an increase in net exports. C) a decrease in exchange rates, an increase in investment, and an increase in net exports. D) a decrease in exchange rates, a decrease in investment, and an increase in net exports. E) a decrease in exchange rates, a decrease in investment, and a decrease in net exports. 5. Answer Key Midterm 2 This is a closed-book exam - you may not use your notes and textbooks. Calculators are not allowed. lease read instructions and questions carefully and attempt to answer all sections. You have 50 minutes to complete the exam. Good luck! The nominal fixed rate of interest on your car loan is 10 percent. When inflation accelerates from 2 percent to 4 percent the real rate of interest on your car loan is: A) 6 percent B) 8 percent C) 12 percent D) 10 percent 6. If the Fed sells government bonds to the public then: A) commercial banks will have excess reserves. B) demand deposits will expand. C) commercial banks will reduce the amount of loans they issue. D) people will have more cash in their pockets - 1 -

2 7. An economy can expect to move from one short-run hillips curve to a lower short-run curve if: A) the rate of inertial inflation rises. B) worker's anticipations about inflation are diminished. C) the rate of unemployment is pushed above the NAIRU. D) fiscal policy increases aggregate demand in the face of a recession. 8. The political theories of the business cycle: A) focus on foreign money investments in the United States. B) focus on labor's wage bargaining and union elections C) focus on bank money and credit. D) focus on the declaration of war for an economic boom. 9. If there are no demand or supply shocks: A) actual inflation should decline to near zero. B) actual inflation will decline below the expected rate. C) actual inflation will rise above the expected rate. D) actual inflation will be responsive only to changes in policy. E) actual inflation should remain at the expected rate. 10. A policy to reduce inertial inflation form 6 percent to 4 percent will cost the government: A) 4 percent increase in unemployment and 8 percent decline in GD. B) 4 percent decline in unemployment and 8 percent increase in GD. C) 3 percent increase in unemployment and 7 percent increase in GD. D) 2 percent increase in unemployment and 4 percent decline in GD. E) 4 percent increase in unemployment and 8 percent increase in GD

3 II. True/False Section (20 points) Answer any two 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) FALSE The balance of international payments holds when a country with the current account deficit has a deficit of financial accounts. The balance of international payments holds when a country with the current account deficit has a surplus of financial accounts. 2. (True/False) FALSE Okun's law implies that the rate of unemployment declines as potential output grows. Okun's law implies that the rate of unemployment declines as the actual output grows faster than the potential output. 3. (True/False) FALSE The long-run hillips Curve is a straight, horizontal line showing that a stable inflation rate can only be maintained by ever rising unemployment rates. The long-run hillips Curve is a straight, vertical line showing that a stable inflation rate can only be maintained with a minimum unemployment rate which is NAIRU. 4. (True/False) FALSE A reduction in the reserve requirement would eventually reduce the money supply, but it would be undertaken only in exceptional circumstances because it would have an enormous effects on the financial markets. A reduction in the reserve requirement would eventually increase the money supply since banks have higher amount of excess reserves

4 III. Definitions (20 points) Answer one question only. rovide 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) Frictional Unemployment, (iii) Structural Unemployment, (iii) NAIRU (non accelerating inflation rate of unemployment): (i) Frictional Unemployment results from the continuing voluntary movement of people between regions and jobs. (ii) Structural Unemployment is a result of the mismatch between the supply of and the demand for workers. NAIRU is the minimum rate of unemployment consistent with the constant inflation rate and is equal to the sum of frictional and structural unemployments. 2. (i) Reserve Requirements, (ii) Demand Deposits, (iii) Money Supply Multiplier: (i) Reserve Requirements the fraction of demand deposits the commercials banks are required to keep as their reserves. (ii) Demand Deposits is a component of narrow money supply. These are the funds deposited in banks and on which you can write checks. Money Supply Multiplier the ratio of the new demand deposits to the increase in reserves. Money Supply Multiplier = 1/Required Reserves Ratio - 4 -

5 IV. Graphs (15 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. Use demand and supply graphs and the foreign exchange market for dollars to show the impact of the tight monetary policy in US on the price of the US dollar in terms of Euro. Euro/$ Supply of $ Tight monetary policy in US leads to the higher interest rates in US. As a result the demand for US dollars increases as Europeans are willing to invest more in US. Exchange rate appreciates. e1 e0 Demand for $ Demand for $ 2. The Fed buys securities from the public. Use - graphs to show the short-term impact on the price level and output in the US economy. As the Fed buys securities from the public, the money supply expands. Interest rates decline and investment, consumption and net export increase. As a result shifts to the right, output and prices increase. 1 0 Q* $ ' Q0 Q1 3. Use hilips curve to show the short-term cost of the tight monetary policy aimed at the reduction of the inertial inflation. (Hint: plot short and long-run hillips curves; assume that the Fed tightens monetary policy and indicate a short-term increase in unemployment; show the final adjustment of expectations by shifting the short-run hillips curve) inflation ϖ0 ϖ1 Short-run increase in unemployment NAIRU U1 unemployme - 5 -

6 V. Essay (15 points) You have two options in this section (Option B is on the next page). Answer one question only. lease 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 Due to the bad weather conditions the supply of oil declines sharply. As a result of the excess demand, oil prices jump. a. Use - diagram to show the short run impact on prices and output. Are prices going to increase slower or faster? Is it a demand or supply-pull (cost-push) inflation? Why? Is the economy entering a recession or boom because of this shock? Explain. Because the oil is more expensive production cost increases. As a result, short-run shifts up output declines to Q1 and prices will increase to 1. ' Therefore, it is a supply-pull (cost-push) inflation because price grow faster due to the higher production costs. The economy is entering recession since the output declines from its potential level to Q1 and unemployment increases. 1 0 Q1 Q* b. What are the objectives of the government in this case? (Hint: The government might have several conflicting targets in this case.) How will the government respond to this shock using its macroeconomic policies? (Make sure that you provide a reasonable argument for your choice of the policy tool. Remember that the government may mix different policies. The current macroeconomic situation in US may supply you with a hint to answer this question.) In this case the government faces both accelerating inflation and rising unemployment rates. You know that inflation is fought with tight monetary and contractionary fiscal policy while unemployment is reduced with loose monetary and expansionary fiscal policy. So in this case the government has two conflicting objectives inflation and unemployment. The policy adopted by the government thus depends on the relative importance of both goals. If the government believe that inflationary expectations are too high it might use tight monetary policy to lower these expectations. However, tight monetary policy will increase unemployment, therefore, the government might consider to use loose fiscal policy to supplement tight monetary policy and avoid even higher unemployment rate. The conclusion is that the government might find it optimal to signal with tight monetary policy that it is willing to fight inflation and in this way to restrict increasing inflationary expectations. On the other hand it might partially offset the negative effects of the higher oil price and this tight monetary policy with loose fiscal policy

7 a. B The government believes that the economy is overheated, therefore, its objective is to reduce the inertial inflation. How would you represent this economy with the - diagram? (Hint: for this economy the unemployment rate is below NAIRU) 1 B Q* Q0 b. List the two types of policies this government has to fight the inflation. Are both policies equally effective for reducing inflation? Explain briefly. Select one of the possible policy instruments and show on the - diagram its impact on the price level and output. The government may use tight monetary policy (sell securities, increase required reserves ratio and increase discount rate) or contractionary fiscal policy (reduce government purchase or increase taxes) to lower inflation. Due to the different duration of recognition, reaction and effectiveness lags for fiscal and monetary policy both will differ in their efficiency in brining down inflation. For example, it would be hard for the president to get an approval for a tax increase. 1 0 B c. If the Fed uses tight monetary policy (for example sells securities to the public), money supply will decrease and the interest rate will increase. Thus, investment, consumption and net export declines and shifts to the left. Q* Q0 If the government attempts to reduce the inertial inflation by 2% and the GD is 100$, what is the monetary cost (in terms of GD) of this disinflation policy? Will unemployment change? How? (Hint: use the relationship between the inflation and output discussed in class and in the book. ) ' The monetary cost of this disinflation policy is the drop in output due to the lower aggregate demand. You know that if inflation is reduced with 1% output declines with 4%. Thus, if inflation is reduced with 2%, output should decline with 8% or by 8$ if GD was equal to 100$. So, the cost of this disinflation policy is equal to 8$ of lost GD. As the aggregate demand and GD decline, the firms reduce employment and unemployment increases. By Okun's law a 8% drop in output will result in the 4% increase in unemployment Thus this disinflation policy increases unemployment with 4%