UNIVERSITY OF MIAMI Principles of Macroeconomics (ECO 212) Answer Key to the Third Sample Midterm Professor Adrian Peralta-Alva

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1 UNIVERSITY OF MIAMI Principles of Macroeconomics (ECO 212) Answer Key to the Third Sample Midterm Professor Adrian Peralta-Alva Section I. Multiple-choice questions (80 points total). Clearly mark what you consider is the best answer to each one of the following problems 1. Assume wages are relatively fixed. Under these conditions, GDP is determined by the interaction of the short-run aggregate supply (SAS) and the Aggregate Demand (AD). Consider a situation where equilibrium GDP is higher than potential output. If nothing else changes, as time goes by A) short-run aggregate supply curve will shift rightward as the money wage rate falls. B) long-run aggregate supply curve will shift leftward as the money wage rate rises. C) short-run aggregate supply curve will shift leftward as the money wage rate rises. D) long-run aggregate supply curve will shift leftward as the money wage rate falls. C. WHEN WAGES ARE FIXED THERE IS A POSITIVELY SLOPED SAS, AND GDP IS GIVEN BY THE INTERSECTION OF AD AND SAS. IF GDP IS HIGHER THAN POTENTIAL THAT MEANS THAT THE INTERSECTION OF SAS AND AD IS TO THE RIGHT OF POTENTIAL OUTPUT. THIS ALSO MEANS THAT THE ECONOMY IS PRODUCING MORE GDP THAN WHAT PREVAILS WHEN THE LABOR MARKET IS IN EQUILIBRIUM. EMPLOYMENT MUST THEN BE HIGHER THAN EQUILIBRIUM. THIS CAN ONLY OCCUR IF REAL WAGES ARE LOWER THAN EQUILIBRIUM. THIS SHORT RUN EQUILIBRIUM IS UNSTABLE SINCE THE LABOR MARKET WILL GO BACK TO EQUILIBRIUM. AS WAGES INCREASE TOWARDS EQUILIBRIUM FIRMS HIRE LESS WORKERS AND PRODUCE LESS. THUS SAS SHIFTS TO THE LEFT. 2. The most important factor that may trigger an economic slowdown according to the real business cycle theory is A) changes in the quantity of money. B) unexpected changes in aggregate demand. C) a slowdown in the growth rate of Total Factor Productivity. C. 1

2 3. The real business cycle theory is unrealistic because, according to such theory, a recession can only occur when total factor productivity goes down. A) True. B) False. B. A SLOWDOWN IN TFP GROWTH MAY CAUSE AN ECONOMIC RECESSION. YET, A SLOWDOWN DOES NOT MEAN TFP GOING DOWN. 4. The following figure illustrates the behavior of the growth rates of both, TFP (labeled RBC impulse in the figure) and GDP. By definition, a 1% change in TFP translates directly into a 1% change in GDP. In the data, TFP and GDP growth are positively related. However, it is clear that movements in TFP are not strong enough to account for the observed movements in GDP. Hence, a theory for business cycles based on the idea that changes in TFP are behind the Business Cycle is a failure. The previous conclusion is: A) True. B) False because TFP also has a direct impact on employment and investment, which also affect GDP. Hence, a 1% movement in GDP translates in more than a 1% movement in GDP. B. 2

3 Use the data in the following table to answer questions In the short-run macroeconomic equilibrium, the price level is and the level of real GDP is billion. A) 100; $600 B) 110; $700 C) 120; $600 D) 130; $600 B. SHORT RUN MACRO EQUILIBRIUM IS, BY DEFINITION, THE PRICE LEVEL AT WHICH SAS AND AD INTERSECT. HERE THAT OCCURS WHEN PRICE LEVEL EQUALS Assuming no changes in aggregate demand or longrun aggregate supply, in the longrun macroeconomic equilibrium, the price level is and the level of real GDP is billion. A) 100; $600 B) 110; $700 C) 120; $600 D) 130; $600 C. LONG RUN EQUILIBRIUM IS, BY DEFINITION, THE PRICE LEVEL AT WHICH LAS AND AD INTERESECT. HERE THAT OCCURS AT A PRICE LEVEL OF In the short run, the economy is in A) a full-employment equilibrium and prices will not change. B) an above full-employment equilibrium and prices will rise. C) an above full-employment equilibrium and prices will fall. D) a below full-employment equilibrium and prices will fall. B. THE SITUATION HERE IS EXACTLY WHAT QUESTION 1 DESCRIBES. SAS WILL SHIFT AND AS IT DOES THE PRICE LEVEL GOES UP. IT IS ENOUGH TO SEE THAT THE LONG RUN EQUILIBRIUM HAS PRICES HIGHER THAN THE SHORT RUN, AND TO KNOW THAT THE ECONOMY HAS TO GO TOWARDS ITS LONG RUN EQUILIBRIUM (IF NO OTHER CHANGES OCCUR). 3

4 Use the following figure to answer question Which of the following factors might have shifted the aggregate demand curve rightward? A) Reduced taxes B) Less investment C) A decrease in government purchases D) Higher money wages A, LOWER TAXES CAUSE PEOPLE TO SPEND MORE. 9. After the aggregate demand curve has shifted permanently to AD1, the new short-run macroeconomic equilibrium is at point A) point a. B) point b. C) point c. D) No point identified with a letter in the figure. B. 10. When the economy is moving to its long-run equilibrium, which curve shifts? A) The LAS curve shifts rightward. B) The LAS curve shifts leftward. C) The SAS curve shifts rightward. D) The SAS curve shifts leftward. D, AGAIN, THIS IS RELATED TO QUESTION ONE. 4

5 11. When controlling the money supply, the Federal Reserve Bank has to take into account that for each dollar it puts in (takes out of) circulation private banks will increase (lower) the money supply by much more than a dollar. Private banks have a multiplier effect on the actions of the FED because B. A) they trade (buy or sale) Treasury bills with the Federal Reserve Bank B) they perform multiple rounds of loans and deposits 12. To increase commercial bank lending the Fed can A) raise the required reserve ratio, lower the discount rate, or sell government securities. B) raise the required reserve ratio, raise the discount rate, or sell government securities. C) lower the required reserve ratio, lower the discount rate, or buy govmt. securities. D) lower the required reserve ratio, raise the discount rate, or buy government securities. C. LOWER RESERVER RATIO ALLOWS BANKS TO LOAN OUT MORE MONEY OUT OF WHAT THEY RECEIVE IN DEPOSITS. A LOWER DISCOUNT RATE MAKES IT CHEAPER TO GIVE LOANS. FINALLY, WHEN THE FED BUYS SECURITIES FROM IT PAYS IN CASH, THUS INTRODUCING MONEY IN THE ECONOMY THAT BANKS WILL THEN LEND. 13. The Fed buys $1 million in U.S. government securities that belonged to Bank ABC directly with the bank. At the same time, Bill Gates opens a checking account at Bank ABC for $1 million. Prior to these transactions, Bank ABC had zero excess reserves. If the required reserve ratio is 15 percent, Bank ABC now has (Note: money received by banks from the sale of securities that belong to the bank are not subject to the reserve requirement) A) $1.7 million in excess reserves. B) $0.85 million in excess reserves. C) $1.15 million in excess reserves. D) $1.85 million in excess reserves. D. EXCESS RESERVES ARE THE RESERVES THE BANK HAS ON TOP OF THE REQUIRED RESERVES. REQUIRED RESERVES AFTER THE BANK S TRANSACTIONS ARE AS FOLLOWS: THE BANK DOES NOT NEED TO HOLD ANY RESERVER FROM SELLING SECURITIES SINCE THEY BELONGED TO THE BANK. THUS, THE FULL $1 MILLION IS EXCESS RESERVES. FROM THE DEPOSIT OF BILL GATES THE BANK MUST KEEP 15%, OR 150,000. THUS, THE TOTAL EXCESS RESERVES ARE 1.85 MILLION. 5

6 14. In the figure above, the graph that best depicts the short-run and long run effects of a permanent increase in consumer expenditures is (In all figures curves with a 1 subscript denote the initial position of the economy, curves with a 2 subscript denote the impact of the change in consumer expenditure.) A) Figure A. B) Figure B. C) Figure C. D) Figure D. C. A PERMANENT INCREASE IN EXPENDITURE SHIFTS AD TO THE RIGHT. SHORT RUN EFFECTS ARE GIVEN BY THE INTERESECTION OF SAS AND AD. LONG RUN EFFECTS TAKE INTO ACCOUNT THAT THE ECONOMY MUST GO TOWARDS ITS LONG RUN EQUILIBRIUM (AND THAT SAS WILL MOVE TO ACHIEVE THAT). FIRST THE ECONOMY GOES TO A HIGHER THAN POTENTIAL OUTPUT EQUILIBRIUM AND THEN THE ECONOMY READJUSTS UNTIL LONG RUN EQUILIBRIUM IS REACHED. 6

7 15. When the FED performs an open market sale it increases the of T-bills causing T-bill prices to. Thus, an open market sale the implicit interest rate on T-bills. A) Supply; go down; lowers B) Demand; go up; increases C) Demand; go up; lowers D) Supply; go down; increases D. OPEN MARKET SALE MEANS THE FED IS SELLING TBILLS. THUS, THE SUPPLY OF TBILLS GOES UP. A HIGHER SUPPLY LOWERS PRICES. FINALLY, SINCE THE IMPLICIT INTEREST RATE ON TBILLS IS FACE VALUE/PRICE, A LOWER PRICE FOR TBILLS RESULTS IN A HIGHER INTEREST. 16. The short-run costs of an open market sale are (assuming wages do not adjust fast): A) Lower GDP, lower real wages B) Lower GDP C) Lower real wages, inflation D) Inflation with no impact on real wages E) Lower nominal wages with no impact on inflation B. A HIGHER INTEREST (SEE Q 15) SHIFTS AD TO THE LEFT. A NEW SHORT RUN EQUILIBRIUM WITH LOWER GDP AND PRICES EMERGES. LOWER PRICES RESULT IN A HIGHER REAL WAGE. THUS A,C,D,E SAY THINGS THAT ARE NOT TRUE. 17. If the Fed raises the federal funds rate, the quantity of money and the supply of loanable funds. A) increases; increases B) increases; decreases C) decreases; increases D) decreases; decreases D. A HIGHER FED FUNDS RATE MAKES IT MORE COSTLY FOR BANKS TO OPERATE. ON TOP OF THAT THE HIGHER INTEREST PAID BY THE FED CAUSES SOME MARGINAL PRIVATE LOANS TO BE CANCELED SINCE IT BECOMES BETTER FOR BANKS TO GIVE THAT MONEY TO THE FED AND OBTAIN A SAFE RETURN. AS A RESULT THE QUANTITY OF MONEY AND LOANABLE FUNDS GOES DOWN. 18. In order to combat inflation, the Fed will the federal funds rate and as a result, the quantity of loans. A) lower; decreases B) lower; increases C) raise; decreases D) raise; increases C (SAME AS Q 17, IN SOME SENSE). NOTICE THAT HIGHER FUNDS RATE RESULTS IN HIGHER INTEREST RATES WHICH LOWER DEMAND AND THUS PRICES. 7

8 Section II. Essay questions (20 points total). 2. (10 points) Keynesian economists (who think labor markets adjust slowly) generally believe that government fiscal (increasing government expenditure) and monetary policy (lowering interest rates) may be desirable when a negative shock hits aggregate demand because they help smoothing business cycle fluctuations. Classical economists (who believe labor markets adjust quickly) generally disagree. What accounts for this difference in views? (Hint: depart from a long run equilibrium, assume a negative shock lowers aggregate expenditure (AD), and describe what will happen to the economy under the Keynesian and classical points of view). CONSIDER AN ECONOMY THAT IS AT ITS LONG RUN EQUILIBRIUM. THEN A NEGATIVE SHOCK HITS AGGREGATE DEMAND. KEYNESIAN VIEW: IF THE LABOR MARKET ADJUSTS SLOWLY THERE IS A POSITIVELY SLOPED SAS AND GDP IS DETERMINED BY THE SHORT RUN MACROECONOMIC EQUILIBRIUM. IF THE FED LOWERS THE INTEREST RATE THEN AGGREGATE DEMAND MAY NOT GO DOWN AS MUCH AND THUS GDP WILL NOT GO DOWN AS MUCH. CLASSICAL VIEW: IF THE LABOR MARKET ADJUSTS FAST THE ONLY IMPACT OF LOWERING THE INTEREST RATE WILL BE HIGHER PRICES (BUT GDP WILL NOT CHANGE). 8