Real GDP $5000 $6000 GDP Growth =( )/5000=0.2 E) 20%

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1 EC132.01(02) Serge Kasyanenko Principles of Macroeconomics October 07th, 2005 I. Multiple Choice Section (30 points). Select one correct answer. 1. Value added is measured as the: A) difference between a firm's sales and its purchases of materials and services from other firms. B) difference between net and gross investment. C) additional output the economy produces when it is at full employment. D) additional consumer goods produced when the economy moves from war-time to peace-time. E) increase in corporate profits from one year to the next. 2. Disposable income includes: A) corporate taxes. B) undistributed corporate profits. C) depreciation. D) dividend payments. E) none of the above. 3. You are given the following information: Year Nominal Price Index (1990=1) Answer Key - Midterm 1 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! What was the growth rate of the real from 1995 to 2000? A) 5% B) -2% C) 0% D) 12% E) 20% Real $5000 $6000 Growth =( )/5000=0.2 E) 20% 4. A shift in the AS function could not be caused by which of the following? A) A change in input prices. B) A decreased supply of oil or energy. C) The breakdown of OPEC. D) An increase in the price level. E) All of the above. 5. A decrease in the MPC means that: A) purchases by consumers will absorb a smaller share than before of any further increases in the output. B) purchases by consumers will absorb a larger share than before of any further increases in the output. C) a smaller share of the total resources will now be needed to satisfy investment demands. D) a larger share of the total resources will now be needed to satisfy consumer demands. E) there will now be a smaller MPS. page 1 of 7

2 Disposable Government Consumption Investment Income Purchases What is the marginal propensity to consume? A) 0.70 B) 0.80 C) 0.85 D) 0.75 E) What is the value of expenditure multiplier? A) 4.0 B) 3.5 C) 5.0 D) 4.5 E) How much will households consume if government increase government purchases by $100? A) $3500 B) $3300 C) $3400 D) $3100 E) $ For questions 6-8 use the following information: equilibrium: =TE Households consume $4000 when the disposable income is $4000 and $4300 when the disposable income is $4400. How much will they consume if income is equal to $2000? A) $2200 B) $2000 C) $2500 D) $1500 E) $ The Multiplier Model assumes: A) zero unemployment. B) flexible prices. C) horizontal short-run AS. D) upward-sloping aggregate supply. E) all of the above. MPC=ΔC/ΔDI ΔC=400 ΔDI=500 MPC=400/500=0.8 ME=1/(1-MPC) MPC=0.8 ME=1/(1-0.8)=1/0.2=5 ME=5 TE=C+I+G ME=5 ΔG=100 which implies that Δ=ME *ΔG=5 *100=500 thus ΔDI=500, yet ΔC=MPC * ΔDI = 0.8 * 500=400 and since previous equilibrium consumption was 2900 consumption in the new equilibrium is C=2900+ΔC= =3300 (1) MPC=ΔC/ΔDI ΔC= =300 ΔDI= =400 MPC=300/400=0.75 (2) ΔDI= =-2000 thus ΔC=-2000 *0.75=-1500 C= =2500 page 2 of 7

3 II. True/False Section (15 points) For each question provide a short explanation (no more than 1-2 sentences) of your answer. Use equations if necessary 1. (True/False) TRUE Potential output is influenced by the availability of inputs but not by the level of wages. Changes in the level of wages shift only the short-run aggregate supply. 2. (True/False) FALSE An increase in personal taxes has the same effect on consumption as it does on disposable income. An increase in personal taxes reduces consumption only by the amount of this increase multiplied with the marginal propensity to consume: ΔDI=-ΔT but ΔC=-MPC * ΔT 3. (True/False) FALSE The life-cycle hypothesis theorizes that consumption is very unstable through a person's life. The life-cycle hypothesis assumes that people prefer to smooth consumption over their life term, thus consumption tends to be stable. page 3 of 7

4 III. Definitions (15 points) Give a short definition of the following terms (no more than 2-3 sentences). You may use your own words. Try to be clear and concise. Use equations if necessary. 1. Expenditure Multiplier: Expenditure Multiplier is equal to the change in equilibrium output when exogenous spending (either investment or government purchases) increases with one dollar: ME=Δ/ΔI=Δ/ΔG or ME=1/(1-MPC) 2. Opportunity Cost: Opportunity cost of a decision is the value of good or service forgone. 3. Fiscal Policy: Fiscal policy is the use of government purchases and taxation to influence output and employment in the economy. page 4 of 7

5 IV. Graphs (20 points) Use a separate diagram to answer each question. Label all axes, indicate initial equilibrium and show the direction of a change. Label the final state of the economy. If necessary, provide a short description for each graph. 1. Russia increases the world supply of oil as it develops new oil wells. World oil price declines. Show the short run impact on US output and price level. Lower oil price implies lower production costs for US firms. Therefore they increase production - short-run aggregate supply shifts down to the right. In the new equilibrium there are lower prices and higher. P P0 P1 * AS AS' AD 1 2. The federal government initiates substantial tax cuts and increases transfers to the public. Show the short run impact on the US output and price level. P * Lower taxes and higher transfers increase consumption - aggregate demand shifts to the right. In the new equilibrium there are both higher prices and higher. P1 P0 AS AD' AD 1 page 5 of 7

6 V. Essay (20 points) You have two options in this section (Option B is on the last page). Answer one question only. Please provide a clear and concise answer. Use graphs and equations when necessary A) A sharp drop in consumer confidence reduces consumer spending and moves economy into recession. Show the new equilibrium on the AS-AD diagram. What are the objectives of the government in this case? What instruments (consider those we covered in class) can it use to achieve these objectives? 3. The president has a meeting with economic advisors. Some of them support "classical approach" to macroeconomics and some believe in "Keynesian school". What would they say about the instruments you discussed in the previous question? (Claim whether they support or disapprove those measures and explain why.) ii) Classical school: ii) Keynesian school: P P0 P1 R 1 * AS AD AD' Consumption declines and aggregate demand shifts to the left. Output and employment decrease. In this case the government is concerned with output and employment in the economy. The goal of the government policy is to shift the economy closer to the potential output. The government may use fiscal policy instruments - either increase government purchases or reduce taxes to move economy back to the potential. These economists would argue that government's fiscal policy is not going to have any effect on output and employment since they believe that aggregate supply is vertical. They would claim that economy would quickly adjust back to * as prices and wages decline to clear the market. Keynesian school economists, on the contrary, assume that prices and wages are sticky in the short-run. Thus, they would persuade the president to proceed with fiscal policy in order to mitigate the consequences of this recession, achieve lower unemployment and expand output back to its potential. page 6 of 7

7 1. B) As growth prospects improve, investors become more optimistic about the future of the economy - exogenous investment spending increases. Use multiplier model diagram for a closed economy to illustrate the effect of higher investment on output. (Show two alternative approaches, we covered in class, to find equilibrium output.) There two alternative ways to find equilibrium in the multiplier model: (1) equate total expenditure and output: TE=C+I+G= (2) equate savings and investment: S=I TE TE=C+I+ΔI+G S S TE=C+I+G I+ΔI ΔI ΔI I Δ 0 Δ (1) (2) Explain how economy adjusts to a new equilibrium. (Describe how the production side of the economy responses to the higher level of total expenditure.) Firms respond to this increase in the investment spending by expanding their production. As they increase output they hire more workers. When employment increases in the economy, disposable income rises. With higher disposable income households spend more which in turn stimulates firms to increase their output. Firms continue to expand output unless an increase in the disposable income is zero. 3. Would the expansionary effect of the higher investment be the same in the open economy? Explain your answer. This effect will be smaller in the open economy since the expenditure multiplier in the open economy (MO) is lower than the multiplier in the closed economy (M): MO=1(MPS+MPm)<M=1/MPS that is in the open economy a fraction (MPm) of the increase in the disposable income is not channeled to the consumption of domestically produced goods (does not increase domestic demand) but is spent on imports. page 7 of 7