EC132.01(02) Serge Kasyanenko Principles of acroeconomics Fall 2005 I. ultiple Choice Section (30 points). Select one correct answer. 1. A boycott of British goods by U.S. consumers might result in: A) a depreciation of the dollar relative to the pound. B) a depreciation of the pound relative to the dollar. C) an inflation of the domestic economy of Great Britain. D) another war in the colonies. E) none of the above. name: Answer Key Sample idterm 2 (100 points) 2. Let the unemployment rate climb from 6.5% to an observed rate of 8%. Actual GDP must therefore: A) fall by 3 percentage points. B) fall by 1.5 percentage points. C) fall by.75 percentage points. D) increase by.75 percentage points. E) increase by 1.5 percentage points. 3. An expansion phase of the usual business cycle can be most appropriately represented as: A) an outward shift in the aggregate demand curve. B) a downward shift in the aggregate demand curve. C) an upward shift in the aggregate supply curve. D) a downward shift in the aggregate supply curve. E) a rotation of the aggregate supply curve to a more vertical position. 4. An example of an "internal" theory of the business cycle is: A) sunspots. B) wars and population increases. C) the acceleration principle. D) multiplier reactions to innovational waves. E) none of the above. 5. "Commercial" banks are the main financial institutions: A) that sell life insurance. B) that make loans aiding consumers. C) that store gold. D) that handle trusts. E) that issue demand deposits. 6. A reduction in legal required reserve ratio will tend to: A) reduce the money supply and reduce commercial bank loans. B) reduce the money supply and increase commercial bank loans. C) increase the money supply and increase commercial bank loans. D) increase the money supply and decrease commercial bank loans. E) leave the money supply unaffected. - 1 -
7. If all commercial banks were forced to keep 100 percent reserves on checking and saving accounts: A) no financial institution would make loans. B) multiple money creation would not be possible. C) people could not have the modern convenience of check writing. D) all of the above would be true. E) none of the above would be true. 8. Demand deposits are included as a form of money because: A) the government or central bank authorizes their use. B) there is gold to back them. C) people believe there is gold to back them. D) people can buy goods with them. E) people are ordered to accept them. 9. The money-supply multiplier assumes that: A) all new money is deposited in checking accounts. B) individuals do not retain cash balances. C) banks do not hold excess reserves. D) all of the above. E) none of the above. 10. The real rate of interest is the rate of interest: A) paid on a loan after all other bank fees have been deducted. B) paid on a loan inclusive of all other bank fees and charges. C) banks charge their largest and most credit-worthy customers. D) banks pay on deposits over $100,000. E) found by subtracting the inflation rate from the nominal rate. 11. A Fed open-market purchase: A) increases only banks' liabilities. B) increases only banks' assets. C) increases banks' assets and reduces their liabilities. D) increases banks' assets and liabilities together. E) has no effect banks' balance sheets. 12. The link from monetary policy to changes in real macroeconomic variables is one that: A) depends not at all on the interest rate. B) depends only upon the sensitivity of investment to changes in the interest rate. C) depends only upon the sensitivity of demand for money to changes in the interest rate. D) depends upon the sensitivity of both investment and the demand for money to changes in the interest rate. E) is direct, and works automatically within the walls of American banks. 13. Required reserve ratios: A) exist primarily to ensure that deposits are safe. B) exist to penalize banks that are members of the Federal Reserve System. C) exist primarily to help the Fed control the money supply. D) exist for all of the above reasons. E) exist for none of the above reasons. - 2 -
14. In the official statistics, a worker who is so discouraged that he has stopped looking for employment is counted as: A) unemployed. B) underemployed. C) in the labor force but not employed. D) not in the labor force in exactly the same way as a woman who works exclusively at keeping house. E) none of the above. 15. A reduction in reserve requirements of member banks tends to counter a recession by: A) raising interest rates. B) reducing excess reserves. C) increasing excess reserves. D) decreasing outstanding loans. E) decreasing aggregate demand. - 3 -
II. True/False Section (20 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 An increase in the discount rate would be a signal of a tightening in the money supply. Higher discount rate reduce the amount of reserves that commercial banks borrow from the Fed and money supply declines. 2. (True/False) FALSE Growth in the labor force is the only identified source of growth in potential GDP. Growth in the labor force is one of the sources of growth in potential GDP. Potential GDP expands due to the technological growth 3. (True/False) TRUE If the Federal Reserve buys bonds, and the sellers prefer to keep the proceeds in currency, then the potential increase in the total money supply will be smaller than if they keep the proceeds in banks. In this case customers keep some of the cash in their pockets and money supply multiplier is smaller (see Problem Set 6, question 2 for more details). 4. (True/False) FALSE If the reserve requirement were 100%, then the money multiplier would equal 0. In this case the money supply multiplier is equal to 1 because banks cannot use their reserves to issue loans but they still accept deposits from the public. - 4 -
III. Definitions (20 points) For every question, give a short definition of all three terms and explain the link between the first two terms and the third one, shown in bold. 1. (i) Open arket Operations, (iii) oney Supply, (iii) Interest Rate: Open arket Operations an instrument of the monetary policy, a process of buying and selling securities by the central bank in the open market. oney Supply a monetary aggregate, used as a medium of exchange and controlled by the central bank. Interest Rate is the price paid for borrowing money. The central bank uses open market operations to change money supply and target interest rates. 2. (i) Nominal Interest Rate, (ii) Inflation Rate, (iii) Real Interest Rate: Nominal Interest Rate is an interest rate on money in terms of money. Inflation Rate a percentage increase in prices. Real Interest Rate measure the return on investments in terms of goods and services and is equal to the difference between the nominal interest rate and inflation. - 5 -
IV. Graphs (15 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. Show the effect of the higher government expenditure on the current account of an open economy. i S+T-G' S+T-G Net export declines and the current account deteriorates i* X' X I 2. Show the effect of the higher reserve requirement on the interest rate in the economy. i I oney supply declines and the interest rate increase. i1 i0 D 3. Show the effect of the higher minimum wage on the number of unemployed workers in the economy. w S Wage increase above market clearing level and unemployment goes up. unemployment wmin w* - 6 - L
V. Essay (15 points) The Fed is concerned with rising unemployment in the economy and is trying to design measures to mitigate economic slowdown. a. Briefly describe what policies the Fed can implement to achieve this target. The Fed may use three instruments to loose monetary policy (increase money supply): 1) open market operations the Fed buys government bonds from the public, 2) discount rate policies the Fed reduce discount rate, 3) reserve requirement ratio the Fed reduces the reserve requirement ratio. b. Choose one of the policies, you suggested in the previous question, and track its effect on the financial system, given that the initial state of the Fed and commercial banks is described as: (Use the same steps as in the problem set) Reserve Requirement 10% Federal Reserve Balance Sheet Balance Sheet of Commercial Banks Assets Liabilities Assets Liabilities Securities 300 Currency 250 Reserves 50 Dem. Dep. 500 Reserves 50 Loans 450 Total 300 Total 300 Total 500 Total 500 Policy description: Instrument Chosen: Size of the Instrument: OPEN ARKET OPERATIONS Buy 5$ of government securities (i) Immediate Change Federal Reserve Balance Sheet Balance Sheet of Commercial Banks Assets Liabilities Assets Liabilities Securities +5 Currency Reserves +5 Dem. Dep. +5 Reserves +5 Loans Total Total Total Total (ii) Final Adjustment Federal Reserve Balance Sheet Balance Sheet of Commercial Banks Assets Liabilities Assets Liabilities Securities 305 Currency 250 Reserves 55 Dem. Dep. 550 Reserves 55 Loans 495 Total 305 Total 305 Total 550 Total 550 Excesses reserves are +4.5$, money supply multiplier is 10 and the banks expand loans with 45$. Demand deposits increase with 50$, thus money supply expands with 50$ - 7 -
c. Using graphs, show the effect of this policy on the interest rates, prices and output. If necessary, provide a short description of your graphs. I. oney supply expands and interest rate declines at the money market: i i0 i1 D II. Lower interest rate induces investment and increase other interest rate sensitive spending. i i0 i1 I I0 I1 I III. Aggregate demand shifts to the right output and employment expands. AS P P1 P0 AD AD' Q0 Q1 Q - 8 -