14.02 Principles of Macroeconomics Quiz # 1, Answers

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1 4. Priniples of Maroeonois Quiz #, Answers Part I.. False. The GDP deflator is the ratio of noinal to real GDP it is a easure of the overall prie level of the eonoy. The CPI is the ost of a given list of goods and servies onsued y a typial uran dweller. So, in fat they are not ased on the sae asket of goods. Moreover, the GDP deflator is a Paashe index while the CPI is a Laspeyres index. This eans that the weights used in the index are different. A Paashe index uses the urrent year, while the Laspeyres index uses the ase year. Even if the askets of GDP and the CPI were very siilar, if the weights hange in tie, we an expet a differene etween the CPI and the deflator of GDP.. True. Gross National Produt (GNP) is the arket value of the goods and servies produed y laor and property supplied y residents of the ountry. Gross Doesti Produt is the arket value of the goods and servies produed y laor and property loated in the ountry. Although Honda is owned y Japanese itizens, it eploys U.S. workers, so part of its value added is in fat generated y U.S. fators, hene it does inrease U.S. GNP. However, it does not inrease Japanese GDP, sine its value added is produed inside the frontier of the U.S. 3. True. Marginal propensity to onsue is the effet on onsuption of an additional dollar in disposale inoe. Autonoous spending is the aount of deand that an eonoy will have with no inoe, in other words, that does not depend on inoe. If the arginal propensity to onsue inreases, the ultiplier inreases, additional autonoous spending will have a greater opounded effet in the equiliriu of the goods arket. 4. Unertain. Proportional inoe taxes hange the ultiplier. A progressive tax struture will ake the ultiplier fall at greater levels of inoe. However, onsider an eonoy where we pass fro a flat rate t, to a struture of rates t<t<t, suh that t is ative when <* and t is ative otherwise. Progressive taxes will tend to itigate the effet of

2 positive shoks to autonoous spending. The effet of Negative shoks on the other hand, ould e less itigated than efore. 5. False. The udget defiit is the exess of governent expenditures over governent spending. An exogenous variale is a variale that is not explained y the odel ut rather is taken as given. An exogenous shok to exports will lower the equiliriu output of the eonoy. If governent spending I exogenous and the tax rate is fixed, we should expet the governent defiit to inrease as the governents tax olletion falls. 6. False. The tax on ATM transations does not hange the deand for oney. Rather, it inreases the proportion of oney held as urreny. This dereases the oney ultiplier, and therefore, the oney supply for a given level of Central Bank oney. The fall in oney supply leads to a left-ward shift in the LM urve, and an inrease in the equiliriu interest rate and a derease in equiliriu output. 7. True. The oney ultiplier is the inrease in the supply of oney resulting fro the inrease of a unit of high powered oney. High powered oney or entral ank oney is the oney issued y the entral ank, the oins and ills. It is also known as the onetary ase. If anks deide to hold less reserves per dollar, they will e in effet reating ore oney in the eonoy as they grant ore withdrawal rights over a saller aount of onetary ase. 8. False. The oney deand is a funtion that desries the aount of oney that is deanded in the eonoy at every interest rate level. The aount of oney is the equiliriu aount of oney eing held y individuals. If governent expands spending and does issue oney, it will still have an effet on the oney arket. Sine equiliriu output will inrease, the deand for oney will expand and the interest rate will rise. With a fixed and exogenous supply of oney, the aount of oney eing held y individuals ould not hange despite the inrease in the oney deand. Part II.. The IS in this eonoy will e:

3 3 ( ) A i slope the IS urve represents the oinations of interest rate levels and output that are onsistent with equiliriu in the goods arket.. The LM in this eonoy will e: M i slope the LM urve represents the oinations of interest rate levels and output that are onsistent with equiliriu in the oney arket. 3. Equiliriu output in the noral year will e: * M A inreased oney supply will inrease the equiliriu level of *. Inreased oney supply lowers interest rates as wealth oves fro the ond arket to the oney arket. The fall in interest rates akes investent inrease, hene pushing up the equiliriu level of output. 4. It is fairly ovious that ( ) M A W and hene ultiplier * W

4 5. The inrease in oney deand aused y the war sare, akes interest rates rise for every level of output. The LM oves to the left and upwards. The IS is unaffeted and so are the slopes of oth urves. The inrease in interest rates ake investent fall as people ove away fro onds towards oney. The fall in investent akes equiliriu output fall due to the war sare. 6. An inrease in the ultiplier will ake the differene in the two output levels greater. Graphially the reason is that the IS urve is flatter so that shifts in the LM urve (suh as those aused y hanges in ) will have a larger ipat. Coneptually, the hanges in are hanges in the oney deand that generate hanges in the interest rate and hene in investent. The ultiplier tells us how uh of an effet on equiliriu output this hange in investent deand should have. The effet of the flutuation of oney deand is lown up if the ultiplier is higher. 7. Coneptually a proportional tax will diinish the ultiplier. We have argued in 6 why a saller ultiplier should diinish the differene etween the two equiliriu levels of output. Matheatially, the flutuation of the eonoy an e shown to e: * W ( t) When the war sare oes, taxes will autoatially fall so that onsuption does not fall so uh as it would otherwise. 8. The slope of the LM does not hange. The new IS urve an e shown to e: i A' ( ) g ( *) so that when *, the new IS is the sae as the old one. For >*, the new IS will have higher interest rate levels for eah level of output eause a higher deand fro governent purhases will have to e opensated with a saller deand for investent whih an only e aused with higher interest rates. For <*, there the new IS urve will have saller interest rate levels for eah level of output eause lower governent spending will open spae for an inreased investent 4

5 deand that an only e generated with lower interest rates. The new IS will e flater than the old one. 9. With a steeper IS urve the effets of shifts of the LM will e larger. The reason is that every tie that interest rates are inreased y the war sare and investent deand falls, the deand fro governent purhases autoatially inreases to opensate. 5

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