Luiggi Donayre Summer 2009 Department of Economics Economics 104 Washington University Session 2. Exam 3

Luiggi Donayre Summer 2009 Department of Economics Economics 104 Washington University Session 2 Exam 3 Name (Print Clearly!) This is a 115 point exam. There are 25 multiple choice questions worth 2 points each and 3 short answer questions worth a total of 50 points. At the end, there are 15 extra multiple choice questions worth 15 points. Make sure you read every alternative for the multiple choice questions carefully before writing the letter of the alternative you think is best in the blank. Take your time with the multiple choice questions; they require careful thought. Write legibly in the space provided for the short answer questions. Your score may be lower if your answer cannot be easily read. Be concise and use sound economic reasoning, not just common sense. Make a special effort to be clear in your writing; the grade you receive on the questions depends in part on how well you communicate. Important Note: You may use your calculator on this exam. You may not refer, however, to any saved information in your calculator. Accessing any inappropriate information, in your calculator or from any other source, is a serious breech of academic integrity and will be treated as such. GOOD LUCK! Multiple Choice Short Answer #1 Short Answer #2 Short Answer #3 Bonus Questions Total Score /50 /18 /22 /10 /15 /100 1

MULTIPLE CHOICE (2 points each): Write the letter of the alternative that best answers the question in the blank. Make sure you read all four alternatives before making your choice. B 1. Molly needs her wisdom teeth taken out. She goes to visit Dr. Maggie, a Canadian dentist. Then, Molly s payments to Dr. Maggie for her services will a. increase exports, increasing net exports. b. increase imports, reducing net exports. c. reduce exports, reducing net exports. d. reduce imports, increasing net exports. D 2. Julie, an Italian citizen, opens a restaurant in Chicago. Her expenditures a. increase U.S. net capital outflow and have no affect on Italian net capital outflow. b. increase U.S. net capital outflow and increase Italian net capital outflow. c. increase U.S. net capital outflow, but decrease Italian net capital outflow. d. decrease U.S. net capital outflow, but increase Italian net capital outflow. B 3. Domestic saving must equal domestic investment in a. both closed and open economies. b. closed, but not open economies. c. open, but not closed economies. d. neither closed nor open economies. C 4. Suppose the world has only two countries: Benmark and Chailand. Domestic residents of Benmark purchased $50 billion of assets from Chailand and Chailand purchased $30 billion of from Benmark. What would the net capital outflows of both countries be? a. $50 billion for Benmark and $30 billion for Chailand b. $30 billion for Benmark and $50 billion for Chailand c. $20 billion for Benmark and -$20 billion for Chailand d. -$20 billion for Benmark and $20 billion for Chailand B 5. The exchange rate is 1.5 Bosnian markas per U.S. dollar. The price of a refrigerator in Bosnia is 1,200 markas while in the U.S. it is $1,000. The real exchange rate is a. 9/5 b. 5/4 c. 4/5 d. None of the above are correct. D 6. The nominal exchange rate is about 2 Aruban florin per dollar. If a basket of goods in the United States costs $40, how many florins must a basket of goods in Aruba cost for purchasing power parity to hold? a. 20 florin b. 40 florin c. 60 florin d. 80 florin A 7. The Republic of Saranya has national savings of $80 billion, government expenditures of $40 billion, domestic investment of $60 billion, and net capital outflow of $20 billion. What is its demand for loanable funds? a. $80 billion b. $60 billion c. $40 billion d. $120 billion 2

B 8. In the open-economy macroeconomic model, a higher U.S. real exchange rate makes a. U.S. goods more expensive relative to foreign goods and reduces the quantity of dollars supplied. b. U.S. goods more expensive relative to foreign goods and reduces the quantity of dollars demanded. c. foreign goods more expensive relative to U.S. goods and reduces the quantity of dollars supplied. d. foreign goods more expensive relative to U.S. goods and reduces the quantity of dollars demanded. C 9. Trade policies a. affect a country's overall trade balance, but affect all firms and industries the same. b. affect a country's overall trade balance, but affect some firms or industries differently than others. c. do not affect a country's overall trade balance, but affect some firms or industries differently than others. d. do not affect either a country's overall trade balance or specific firms or industries. C 10. When a country experiences capital flight its currency a. appreciates and net exports rise. b. appreciates and net exports fall. c. depreciates and net exports rise. d. depreciates and net exports fall. D 11. Which of the following would not be a consequence of an increase in the U.S. government budget deficit? a. U.S. interest rates rise. b. U.S. net capital outflow falls. c. The U.S. supply of loanable funds shifts left. d. The real exchange rate of the U.S. dollar depreciates. C 12. Which is the following is not true about the marginal propensity to consume (MPC)? a. Theoretically, someone could have an MPC greater than 1. b. The MPC is the reciprocal of the marginal propensity to save. c. The MPC refers to the amount of consumption that will be spent from each dollar of income. d. The fundamental psychological law implies that the MPC is greater than zero. A 13. As the price level falls a. people will want to buy more bonds, so the interest rate falls. b. people will want to buy fewer bonds, so the interest rate falls. c. people will want to buy more bonds, so the interest rate rises. d. people will want to buy fewer bonds, so the interest rate rises. A 14. The sticky-wage theory of the short-run aggregate supply curve says that when the price level rises more than expected, a. production is more profitable and employment rises. b. production is more profitable and employment falls. c. production is less profitable and employment rises. d. production is less profitable and employment falls. 3

C 15. The misperceptions theory of the short-run aggregate supply curve says that if the price level is higher than people expected, then some firms believe that the relative price of what they produce has a. decreased, so they increase production. b. decreased, so they decrease production. c. increased, so they increase production. d. increased, so they decrease production. D 16. An increase in the price level and a reduction in output would result from a. an increase in the money supply. b. an increase in government expenditures. c. a fall in stock prices. d. bad weather in farm states. B 17. When the interest rate increases, the opportunity cost of holding money a. increases, so the quantity of money demanded increases. b. increases, so the quantity of money demanded decreases. c. decreases, so the quantity of money demanded increases. d. decreases, so the quantity of money demanded decreases. C 18. Suppose that the Federal reserve is concerned about the effects of rising stock prices on the economy. What could it do? a. buy bond to raise the interest rate b. buy bonds to lower the interest rate c. sell bonds to raise the interest rate d. sell bonds to lower the interest rate B 19. In the economy of Mountain Drew, when income is $100, consumer spending is $60. The value of the multiplier for this economy is 3. It follows that, when income is $101, consumer spending is a. $60.60. b. $60.67. c. $61.33. d. $63.00. A 20. Which of the following illustrates how the investment accelerator works? a. An increase in government expenditures increases aggregate spending so that Gas-n-Go decides to modernize its gas stations. b. An increase in government expenditures increases the interest rate so that Gas-n-Go decides to modernize its gas stations. c. An increase in government expenditures increases the interest rate so that the demand for stocks and bonds issued by Gas-n-Go rises. d. An increase in government expenditures decreases the interest rate so that Gas-n-Go decides to modernize its gas stations. A 21. During recessions, automatic stabilizers tend to make the government's budget a. move toward deficit. b. move toward surplus. c. move toward balance. d. not necessarily move the budget in any particular direction. 4

D 22. Which of the following policies would Keynes's followers support when an increase in business optimism shifts the aggregate demand curve away from long-run equilibrium? a. increasing the money supply. b. increasing government expenditures. c. raising taxes. d. None of the above is correct. D 23. A movement to the right along a given short-run Phillips curve could be caused by a. an increase in the natural rate of unemployment or expansionary monetary policy. b. expansionary monetary policy, but not an increase in the natural rate of unemployment. c. an increase in the natural rate of unemployment or a contractionary monetary policy. d. contractionary monetary policy, but not an increase in the natural rate of unemployment. A 24. If inflation expectations rise, the short-run Phillips curve shifts a. right, so that at any inflation rate unemployment is higher in the short run than before. b. left, so that at any inflation rate unemployment is higher in the short run than before. c. right, so that at any inflation rate unemployment is lower in the short run than before. d. left, so that at any inflation rate unemployment is lower in the short run than before. D 25. A favorable supply shock will cause a. unemployment to rise and the short-run Phillips curve to shift right. b. unemployment to rise and the short-run Phillips curve to shift left. c. unemployment to fall and the short-run Phillips curve to shift right. d. unemployment to fall and the short-run Phillips curve to shift left. 5

SHORT ANSWER QUESTIONS. Read all parts of each question carefully and answer in the space provided. Use clear economic reasoning and make sure you write legibly. 1. (18 points) Sarah L. has just been elected as the president of North Kodrea, a small, open economy. Initially, both the government budget and trade are balanced. a) (8 points) Given the level of foreign debt in North Kodrea, Sarah L. decides to reduce government expenditure, while keeping tax revenue at the previous level. Use the appropriate diagrams to determine the effects of her decision on the real interest rate, the quantity of loanable funds, and net capital outflow. If the government budget is initially balanced, then T G = 0. By reducing G and keeping T unchanged, the government generates a budget surplus, increasing public savings. Hence, national savings increase, which shifts the supply curve in the LF market from S 1 to S 2. At the previous interest rate, r 1, there is an excess supply of LF, so the interest rate falls to clear the market. As the interest rate falls, the quantity demanded of loanable funds increases until the new equilibrium is reached at r 2. The lower interest rate makes domestic assets (from North Kodrea) less attractive and foreign assets more attractive. Therefore, NCO increases and there is a movement along the NCO curve until the new higher- level of equilibrium. b) (6 points) After realizing that North Kodrea is, in fact, an open economy, Sarah L. seeks Katie, her Minister of Foreign Affairs. She is concerned her decision could cause a trade deficit and asks Katie what the effects of lower government expenditure will be on North Kodrea s real exchange rate and net exports. Use the appropriate diagram to help Katie determine the effects of Sarah L. decision on the mentioned variables. Should Sarah L. be concerned about a trade deficit? The higher NCO increases the supply curve in the FC market from S 1 to S 2. The exchange rate falls to clear the market. As the exchange rate falls, North Kodrean goods become relatively cheaper and other countries demand more of them, increasing North Kodrean exports and reducing their imports. In the end, their net exports increase, and this is reflected in a movement along the demand curve, from E 1 to E 2. Hence, if the initial 6

situation was a trade balance, the higher net exports represent a trade surplus. Sarah L. should not be concerned about a trade deficit. Quantity of local currency c) (4 points) Explain how the exchange rate adjusts to clear the foreign currency market. Is this movement in the exchange rate consistent with the movement in the interest rate from part (a)? What is the relationship between these two variables (that is, if interest rates decrease, what happens to exchange rates)? Because of the lower interest rate (given the budget surplus and subsequent higher national savings), foreign assets become more attractive for residents in North Kodrea. Hence, they need more foreign currency (FC) to buy foreign assets. They supply more of their local currency in the FC market to be able to buy foreign assets. This increases the supply of local currency in the FC market and shifts S 1 to S 2. At the original exchange rate, E 1, there is an excess supply of local currency. For people to demand this excess of local currency, its price must go down. Hence, the exchange rate falls until the market is cleared, at E 2. As the exchange rate falls, the quantity demanded of local currency increases, reflected in a movement along the curve from E 1 to E 2. 2. (22 points) Qingland, a new, independent state has been recently established. Nonetheless, things seem not to start smoothly in this country. Due to its recent creation, investors consider it a risky place. a) (5 pts.) Not too long after that, the stock market crashes in Qingland. Starting from a situation of long-run equilibrium, use the AD-SRAS-LRAS diagram to determine the short-run equilibrium after the stock market crash. What happens to the price level and GDP? 7

If the stock market crashes in Qingland, real wealth falls and economic agents feel poorer. They consume less, which reduces aggregate demand and shifts the AD curve downwards/leftwards from AD 1 to AD 2. At the initial price level, there is an excess supply of goods, so some firms reduce their price so people can buy more of those excess supplied goods. As the price falls down, the quantity demanded increases along the demand curve until the market clears in the short-run, at point B. So prices and output fall down. b) (3 pts.) Why is it possible that real GDP deviates from its long-run trend if the long-run theory studied in class states that real variables do not change when nominal variables do? In the long run, the classical dichotomy notion holds and so, nominal variables do not affect real variables. Prices will adjust to whatever level they need to adjust so that the aggregate market clears. However, because of market imperfections (e.g., sticky wages and prices and misperceptions), some firms will not be able to adjust their prices in the short-run. Because some prices can t adjust, some relative prices (which are real variables) will be affected in the short-run, originating changes in real GDP. c) (7 pts.) Ezequiel, president of the Central Bank of Qingland (CBQ), is concerned about this short-run equilibrium. He firmly believes that policymakers should act so as to eliminate deviations of real GDP from its long-run trend. If he wants to shift AD to stabilize real GDP, what OMO should he perform? Use the AD- SRAS-LRAS diagram to show how, starting from the short-run equilibrium from part (b), the CBQ can help the economy return to its long-run trend. Explain. Because the AD curve has shifted downwards, the government can stabilize the economy and induce output to return to its long-run level by increasing the AD curve again. The CBQ can buy bonds and, by doing so, will increase the money supply. The higher money supply reduces the interest rate and increases consumption and investment and, consequently, output. So, from the short-run equilibrium at point B, the increase in the money supply shifts the AD upwards again, until the economy goes back to its original long-run equilibrium at point A. At this point, output returns to the potential level and prices go up to the original level. 8

d) (7 pts.) After observing this situation, Sarah S., a prominent economist from Qingland, talks to Ezequiel. Sarah S. strongly advocates letting the economy get back to its long-run equilibrium by itself. What reasons could she have to think the Government shouldn t stabilize the economy? If she would have had the chance to be in charge, she would have let the economy adjust over time. Explain how the economy would have naturally returned to its long-run trend without any stabilization policies by means of the AD-SRAS-LRAS diagram (start from the short-run equilibrium found in part (b), ignoring what you did in part (c)). Sarah S. could oppose stabilization policies on the premises that they (monetary actions) affect the economy with a lag (or it could take time to implement them, in the case of fiscal policies) and could hurt the economy 9

more than they could heal it. Moreover, if the economy is in recession, automatic stabilizers will increase G (since claims for unemployment insurance and welfare increase) and lower taxes will increase people s disposable income. If she had let the economy return to its long-run equilibrium by itself, the lower price level in the short-run equilibrium at point B would have reduced the price level people expected in the future. So, the lower expected price level would reduce production costs, (increasing) shifting the SRAS curve from AS 1 to AS 2. As firms adjust their prices downwards, the quantity demanded falls and moves along the AD 2 curve from B to C. In the end, output returns to its long-run level and prices fall down. 3. (10 points) Consider the mathematical version of the model for aggregate demand: Y = AD = C + I + G + X M (1) C = a + by (2) I = d + ey (3) where b represents the marginal propensity to consume, e represents the investment accelerator, and a,d > 0. a) (3 pts.) We have assumed that net exports are exogenous. However, that is not necessarily the case. Explain why economists usually assume that imports depend positively on domestic income (that is, the variable Y ). Integrate the dependence of imports on domestic income into the mathematical version of the aggregate demand model (hint: Keep X exogenous. Then, you need to come up with an equation for M that depends on Y, just like the equations for C and I). If people have higher income, they will demand more goods, both domestically and internationally produced. Hence, the higher the level of income, the higher the demand for foreign goods and the higher the level of imports. To integrate this dependence of M on Y, we can formulate a very simple import function, much in the same way as the consumption and investment functions seen in class: M = f + gy where f is the level of autonomous imports, and g is the marginal propensity to import (that is, if income increased in 1 dollar, the part of that dollar that would be destined to consume imported goods). b) (4 pts.) Using the equation for M you came up with in part (a) and equations (1)-(3), solve for the equilibrium level of Y, as a function of the exogenous variables and parameters (hint: make sure to substitute equations (2), (3) and the equation for M into (1)). In equilibrium, aggregate supply must equal aggregate demand: Y = C + I + G + X - M = (a+by) + (d+ey) + G + X (f+gy) Solving for Y: Y (1 b e + g) = (a + d + G + X f) 10

Then, in equilibrium: 1 Y* ( a d G X f ) 1 b e g c) (3 pts.) What is the multiplier? How does a larger value of the variable that captures the relationship between imports and domestic income change the multiplier? Explain the economic process in words. 1 The multiplier is given by. A larger marginal propensity to import reduces the multiplier 1 b e g because, if people consume more imported goods when their income increases, the aggregate demand will not increase as much as if they only consumed locally produced goods (as part of the higher income goes abroad). 11

EXTRA MULTIPLE CHOICE QUESTIONS (1 point each). Write the letter of the alternative that best answers the question in the blank. Make sure you read all four alternatives before making your choice. B 1. Other things the same, if a country has a trade deficit and saving rises, a. net capital outflow rises, so the trade deficit increases. b. net capital outflow rises, so the trade deficit decreases. c. net capital outflow falls, so the trade deficit increases. d. net capital outflow falls, so the trade deficit decreases. C 2. If US goods cost 1/5 of one dollar for every kroner Danish goods cost, the real exchange rate would be computed as how many Danish goods per U.S. goods? a. Five b. one fifth the price of the U.S. goods c. the amount of kroner that can be bought with 1/5 of one dollar. d. None of the above is correct. C 3. According to purchasing power parity, if it took 1,000 Korean Won to buy a dollar this year, but it took 1,100 to buy it last year, then the dollar has a. appreciated, indicating inflation was higher in the U.S. than in Korea. b. appreciated indicating inflation was lower in the U.S. than in Korea. c. depreciated indicating inflation was higher in the U.S. than in Korea. d. depreciated indicating inflation was lower in the U.S. than in Korea. D 4. If at a given real interest rate desired national saving would be $50 billion, domestic investment would be $40 billion, and net capital outflow would be $20 billion, then at that real interest rate in the loanable funds market there would be a a. surplus. The real interest rate would fall. b. surplus. The real interest rate would rise. c. shortage. The real interest rate would fall. d. shortage. The interest rate would rise. C 5. Suppose the real exchange rate is such that the market for foreign-currency exchange has a surplus. This surplus will lead to a. an appreciation of the dollar, an increase in U.S. net exports, and so an increase in the quantity of dollars demanded in the foreign exchange market. b. an appreciation of the dollar, a decrease in U.S. net exports, and so a decrease in the quantity of dollars demanded in the foreign exchange market. c. a depreciation of the dollar, an increase in U.S. net exports, and so an increase in the quantity of dollars demanded in the foreign exchange market. d. a depreciation of the dollar, a decrease in U.S. net exports, and so a decrease in the quantity of dollars demanded in the foreign exchange market. A 6. In 2002 it looked like the Argentinean government might default on its debt (which eventually it did). The openeconomy macroeconomic model predicts that this should have a. raised Argentinean interest rates and caused the Argentinean currency to depreciate. b. raised Argentinean interest rates and caused the Argentinean currency to appreciate. c. lowered Argentinean interest rates and caused the Argentinean currency to depreciate. d. lowered Argentinean interest rates and caused the Argentinean currency to appreciate. 12

B 7. Other things the same, if the U.S. price level falls, then a. the supply of dollars in the market for foreign-currency exchange increases, so the exchange rate rises. b. the supply of dollars in the market for foreign-currency exchange increases, so the exchange rate falls. c. the supply of dollars in the market for foreign-currency exchange decreases, so the exchange rate rises. d. the supply of dollars in the market for foreign-currency exchange decreases, so the exchange rate falls. D 8. Other things the same, a decrease in the price level causes real wealth to a. fall, interest rates to fall, and the dollar to appreciate. b. fall, interest rates to rise, and the dollar to depreciate. c. rise, interest rates to rise, and the dollar to appreciate. d. rise, interest rates to fall, and the dollar to depreciate. A 9. Suppose the economy is in long-run equilibrium. If there is a tax cut at the same time that major new sources of oil are discovered in the country, then in the short-run a. real GDP will rise and the price level might rise, fall, or stay the same. b. real GDP will fall and the price level might rise, fall, or stay the same. c. the price level will rise, and real GDP might rise, fall, or stay the same. d. the price level will fall, and real GDP might rise, fall, or stay the same. C 10. Initially, the economy is in long-run equilibrium. Aggregate demand then shifts leftward by $50 billion. The government wants to increase its spending in order to avoid a recession. If the crowding-out effect is always half as strong as the multiplier effect, and if the MPC equals 0.8, then by how much do government purchases have to increase in order to offset the $50 billion leftward shift? a. by $5 billion b. by $10 billion c. by $20 billion d. by $50 billion B 11. The economy is in long-run equilibrium. Suppose that automatic teller machines become cheaper and more convenient to use, and as a result the demand for money falls. Other things equal, we would expect that, in the short run, a. the price level and real GDP would rise, but in the long run they would both be unaffected. b. the price level and real GDP would rise, but in the long run the price level would rise and real GDP would be unaffected. c. the price level and real GDP would fall, but in the long run they would both be unaffected. d. the price level and real GDP would fall, but in the long run the price level would fall and real GDP would be unaffected. B 12. If a central bank increases the money supply, then a. prices, output, and unemployment rise. b. prices and output rise and unemployment falls. c. prices rise and output and unemployment fall. d. prices fall and output and unemployment rise. 13

D 13. According to Friedman and Phelps's analysis of the Phillips curve, a. the unemployment rate will be below its natural rate whenever inflation is negative. b. the unemployment rate will be below its natural rate whenever inflation is positive. c. the unemployment rate will be below its natural rate only if inflation is less than expected. d. the unemployment rate will be below its natural rate only if inflation is greater than expected. A 14. If the sacrifice ratio is 2, reducing the inflation rate from 4 percent to 2 percent would a. cost 4 percent of annual output. b. cost 1 percent of annual output. c. imply that unemployment would rise by 4%. d. imply that unemployment would rise by 1%. A 15. Proponents of rational expectations theory argued that, in the most extreme case, if policymakers are credibly committed to reducing inflation and rational people understand that commitment and quickly lower their inflation expectations, the sacrifice ratio could be as small as a. 0. b. 1. c. 4. d. 5. 14