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Final Exam
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1)
Using IS-LM diagram illustrate each of the following effects and explain in words what
happens to i) unemployment, iii) interest rate:
a)
(5%) Consumer confidence increases
This causes an outward shift in IS curve (Consumption increases). If there is no liquidity trap
(i.e., the LM curve is not horizontal), then the interest in this economy will increase. If the
LM curve is not vertical then the output (GDP) will increase as well.
b)
(5%) Exchange rate decreases (value of domestic currency depreciates)
This causes an outward shift in the IS curve and the discussion is identical to the one in part
a. Exchange rate decrease causes imports to decline and exports to increase, improving trade
balance
c)
(5%) The Fed purchases US Treasury Bills
This causes an increase in the nominal money supply. Such a change (assuming inflation
remains constant) causes an outward shift in the LM curve. If the IS curve is downward
sloped, an increase in the money supply will result in lower interest rate and higher
employment.
2)
(10%) Using AD&AS diagram demonstrate long-run and short run effects of an
increase in consumer confidence on the economy that initially starts in the long-run
and short-run equilibrium. In words explain the impact on unemployment and
inflation.
The diagram was presented in the last class lecture. The Aggregate Demand increases as
consumption increases. This causes a short-run equilibrium to move along the short-run AS
curve. The result is over-employment and inflation. The long run adjustment will be in the form
of an increase in the wage rate and other input prices, causing the short-run AS curve to shift up.
In the long run, the level of employment will drop back to its long-run level (the starting level in
this problem), while inflation will increase further.
3)
(10%) If an economy operates on a floating exchange rate, and if it
experiences a recession, which policy (fiscal or monetary) would you
recommend and why? (not required, since we didn’t finish the open economy
section. But it would be nice if you could answer this question.
With a floating exchange rate you would recommend monetary policy, because an increase in
money supply (or a reduction in the interest rate) will lead to the depreciation of the domestic
currency, further strengthening the outcome of the policy through the improvement in the trade
balance. Note that the fiscal policy would not be very effective, because the open economy effect
will work against the goals of the policy, reducing the efficiency of such policy.
4)
(10%) Should the government be concerned with the falling stock market?
Why or why not? In many countries there exist provisions for stabilizing
stock markets, for instance, trading can be temporarily halted if a stock, or
index, loses certain percentage in value. These provisions may not be 100%
successful, however, it is also possible for the government to simply step in
and buy shares in order to prevent the prices from dropping any further.
Should the government do this? Please justify each of your answers.
The government should be concerned with the stock market. The stock market plays a number of
important roles in our economy. It makes it easier to obtain investment for firms, hence a falling
stock market will likely increase the costs of obtaining financial capital for firms (example of this
is the NASDAQ index in the US during 1999-2001, where many internet based firms were driven
out of existence because they could no longer count on the sale of stock as a source of financial
capital. More importantly, the stock market acts as a barometer of the future productivity of the
economy, which in turn determines spending and investment decisions today. The stock market in
an economy where a large number of consumers have invested their savings into the stock market
can create a wealth effect. In part this is what we saw during the late 1990’s and that wealth effect
spilled into a number of other markets, as consumers were more willing to borrow money to
finance their current consumption because they saw their savings increase every day as the stock
market kept going up. A sharp decrease in the stock values can cause a negative wealth effect and
even cause an economy to enter into a recession. Thus the government should clearly be
concerned. Should they do something about it? In my opinion, yes, but not directly. Direct
involvement into the stock market will cause moral hazard in investors’ behavior. Consider the
following argument: many politicians blame the IMF for reassurances of financial crisis. The
argument is very simple, the IMF attempts to resolve a financial crisis by providing loans to an
economy in trouble so that it stabilizes its exchange rate regime. If such an argument is correct,
then the implication is simple, the international investor is capable of recapturing some of his
losses. This creates moral hazard in behavior of the investor, just like any insurance would. The
argument would be identical in the context of the domestic stock market.
5) (5%) Classical economists argued that recession cannot be a lengthy phenomena,
yet in the XX century we saw recessions that lasted years. Which argument did
Keynes use to explain this phenomenon and why?
The argument is very simple: sticky wages and prices. The lag of adjustment on the
part of input prices creates a relationship between CPI and the level of output. Just
recall the simple profit function with one input described in class and you would be
able to see that if PPI is fixed and CPI is decreasing, unemployment will be on the
rise.
6)
(5%) Define and explain the drawbacks of fiscal policy
These include (by the way all of them are listed in your class slides): open economy
effect, direct and indirect crowding out effects, time lags (decision, recognition, and
effect). Explanation for each is:
Open economy effect occurs when fiscal policy through interest rate change affects
the exchange rate making relative prices (foreign versus domestic) change and hence
changes the trade balance. An example of that is a fiscal expansion that results in a
significant increase in government borrowing. If that borrowing results in a rise in the
interest rate, then an increase in domestic interest rate (while interest rates in other
economies remain constant), causes an increase in foreign investment, which in turn
causes an appreciation in the domestic currency. Such currency appreciation can
worsen trade balance, as foreign goods become cheaper, while domestically produced
goods become more expansive abroad.
Indirect crowding out refers to the impact of interest rate change that can follow
domestic fiscal policy, on the domestic private consumption and domestic private
investment. Since, both of those components of the GDP are decreasing functions of
the interest rate.
Direct crowding out is simply a situation where the government provision of a good
or service reduces the demand for private providers of that good or service, hence,
the public sector expansion causes a reduction in the private sector production.
7)
Below is a list of economic variables:
i. Business inventories
ii. Wage rate
iii. Unemployment rate
iv. Productivity growth
v. Exchange rate
vi. Foreign currency reserves of the central bank
Which of these would you choose and why in order to predict
a)
(5%) future inflation
definitely wage rate and productivity growth. Exchange rate. (you can also make case for
unemployment and business inventories if you like)
b)
(5%) if recession is coming
Business inventories is a must. Productivity growth is also good. Unemployment is a lagging
variable, hence should not be chosen to predict future recession!
TRUE/FALSE (EXPLAIN!)
7)
(10%) An increase in domestic interest rate will always increase the nominal
value of foreign exchange (appreciate the value of domestic currency)
The word always makes this question false! What if this increase is accompanied by an equal or
larger increase in the foreign country?!
8)
(10%) If consumer confidence increases and the economy is at full employment
then we should anticipate an increase in inflation.
The answer to this is yes, because firms are forced to compete for inputs causing an increase in
the input prices, while an already at full employment level labor will post relatively (relative to
wage gains) productivity growth.
9)
(5%) A recession that affects a particular region of a country can be more
successfully corrected by a locally used and directed monetary policy, rather than by a locally
directed fiscal policy. FALSE, there is no such thing as a local monetary policy.
10)
(5%) If Canada experiences a higher rate of inflation than the US, then, Ceteris
Paribus, the value of the US dollar should increase in terms of Canadian dollars (both countries
employ floating exchange rate).
Yes, the statement is true, since Canadian prices increase faster than US prices, Canadians will
start buying more US goods, hence they will demand more US dollars and that will cause an
appreciation in the value of the USD
11)
(5%) If CPI is rising faster than PPI then the profitability of businesses is
expected to increase. Conditional answer is true. If the rise is CPI is not a result of a shrinking
output due to some external shock, then this change in CPI given the smaller rise in PPI should
positively impact the profitability of businesses.