a) Write down the output (RGDP) and price level of the Wonderland economy in 2010.

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1 Sample Questions for the New Topics 1) In 2009 Wonderland economy was prospering at full employment with high level of consumer confidence. The economy s output level was $12 billion (measured as real GDP at 1998 prices) and the price index was steady at 110 (Base year 1998=100). The aggregate supply and aggregate demand curve of Wonderland was estimated empirically and is given in the figure below. SRAS P AD In 2010 consumer confidence in Wonderland economy increases along with the stock market indices. This causes investment and consumer spending to go up. This in turn causes aggregate demand (AD) to increase by $2 billion. The Aggregate Demand Curve for 2010 consistent with the data given above. Econometric data on consumption pattern of Wonderland consumers indicate an MPC of 0.9. Moreover autonomous consumption is 4. a) Write down the output (RGDP) and price level of the Wonderland economy in Output = Price level= b) How would you describe the state of the Wonderland economy? RGDP c) Mark the GDP gap on your graph. What is the magnitude of the GDP gap? d) What is the necessary decrease in Aggregate Demand to go back to full employment output level? e) What are the policy options are available to the government if it decides to pursue contractionary fiscal policy to achieve the necessary decrease in the aggregate demand? f) Calculate the value of the government spending multiplier. g) Calculate the necessary decrease in government spending which would bring the wonderland economy to full employment output level? h) List two of the three adverse effects of expected chronic inflation.

2 2) In 2009 Wonderland economy was prospering at full employment with high level of consumer confidence. The economy s output level was $12 billion (measured as real GDP at 1998 prices) and the price index was steady at 110 (Base year 1998=100). The aggregate supply and aggregate demand curve of Wonderland was estimated empirically and is given in the figure below. P SRAS AD RGDP In 2010 consumer confidence fell and stock market indices dropped dramatically. Investment and consumer spending dropped to historically low levels. This caused aggregate demand (AD) to decrease by $ billion. The Aggregate Demand Curve for 2010 consistent with the data given above. Econometric data on consumption pattern of Wonderland consumers indicate an MPC of 0.9. The reserve requirement ratio in Wonderland is 0.2. Federal Reserve Chairman Ben Pan and other members of the FOMC decide to fight recession by stimulating investment. They order the Fed's bond traders to buy $120 million worth of treasury bonds from the public increasing the money in circulation. a) Write down the output (RGDP) and price level of the Wonderland economy in Output = Price level= b) How would you describe the state of the Wonderland economy in 2010? c) Mark the GDP gap on your graph. What is the magnitude of the GDP gap? d) Write down the three monetary policy options that are available to the Fed to fight recession in Wonderland e) If the reserve requirement ratio in Wonderland is 0.2, calculate the money multiplier in Wonderland economy.

3 f) What will be the effect of open market purchase of $120 million worth of bonds on the money supply (M1)? Please indicate the shift in the Money supply on the money market diagram below based on your calculation of the increase in M1. Interest Rate (i) 10 9 M S Interest Rate (i) I M d Quantity of Money (billions) Investment (billions) g) Using the money market diagram determine the effect of this increase in money supply on the prevailing interest rates. h) Firms in Wonderland soon realize the reduced interest rates for borrowing. They respond by buying new machinery and equipment and constructing new plants for production. This increases investment expenditures by the firms in Wonderland. Using the graph given above find the increase in investment spending. i) Assume the MPC in Wonderland economy is Calculate the investment spending multiplier. j) Calculate the increase in the aggregate demand due to the increase in investment spending that you found in (i).

4 1) Consider Wonderland s economy. Suppose Wonderland s central bank pursues a contractionary monetary policy by selling government bonds to the public. Wonderland economy s currency is called Wonderdollar. Which of the following would be the result of this policy on the Wonderdollar exchange rate? a. Wonderdollar would appreciate b. Its currency would gain value against other currencies. c. Demand for Wonderdollar would increase d. All of the above 2) If you go to the bank and notice that a dollar buys more Mexican pesos than it used to, then the dollar has a. appreciated. Other things the same, the appreciation would make Americans less likely to travel to Mexico. b. appreciated. Other things the same, the appreciation would make Americans more likely to travel to Mexico. c. depreciated. Other things the same, the depreciation would make Americans less likely to travel to Mexico. d. depreciated. Other things the same, the depreciation would make Americans more likely to travel to Mexico. 3) If the exchange rate is 125 yen = $1, a bottle of rice wine that costs 2,500 yen costs a. $20. b. $25. c. $22. d. None of the above is correct. 4) Exchange rates are 120 yen per dollar, 0.8 euro per dollar, and 10 pesos per dollar. A bottle of beer in New York costs dollars, 1,200 yen in Tokyo, 7.2 euro in Munich, and 50 pesos in Cancun. Where are the most expensive and the cheapest beer in that order? a. Cancun, New York b. New York, Tokyo c. Tokyo, Cancun d. Munich, New York 5) The nominal interest rate is 3.5 percent and the inflation rate is 2 percent. What is the real interest rate? a. 7 percent b. 5.5 percent c percent d. 1.5 percent ) The costs of changing price tags and price listings are known as a. inflation-induced tax distortions. b. relative-price variability costs. c. shoeleather costs. d. menu costs. 7) At the Federal Reserve, a. the nation s monetary policy is made by the Federal Open Market Committee, which meets twice a year. b. the nation s monetary and fiscal policies are made by the Federal Open Market Committee, which meets twice a year. c. the nation s monetary policy is made by the Federal Open Market Committee, which meets about every six weeks. d. the nation s monetary and fiscal policies are made by the Federal Open Market Committee, which meets about every six weeks.

5 8) The Federal Reserve does all except which of the following? a. It controls the supply of money. b. It acts as a lender of last resort to banks. c. It makes loans to large business firms. d. It tries to ensure the health of the banking system. 9) When the Fed buys government bonds, a. the money supply increases and the federal funds rate increases. b. the money supply increases and the federal funds rate decreases. c. the money supply decreases and the federal funds rate increases. d. the money supply decreases and the federal funds rate decreases. 10) The discount rate is the interest rate that a. banks charge one another for loans. b. banks charge the Fed for loans. c. the Fed charges banks for loans. d. the Fed charges Congress for loans. 11) The federal funds rate is the interest rate that a. banks charge one another for loans. b. banks charge the Fed for loans. c. the Fed charges banks for loans. d. the Fed charges Congress for loans. 12) To increase the money supply, the Fed can a. buy government bonds or increase the discount rate. b. buy government bonds or decrease the discount rate. c. sell government bonds or increase the discount rate. d. sell government bonds or decrease the discount rate. 13) If the reserve ratio is 5 percent, then the money multiplier is a. 25. b. 20. c d ) Which of the following is not a tool of monetary policy? a. open market operations b. changing reserve requirements c. changing the discount rate d. increasing the government budget deficit For the previous topics (topics covered in Midterm 1-3) please review Midterm 1-3 along with the Practice Tests 1-3 and the extra credit test.