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ECO 302b Intermediate Macro Spring 2014 Midterm 3 Part I: Answer completely in the spaces provided, or use the back of the page. (30 points total). Show your work. Answers that appear like miracles out of nowhere may not be given credit. 1. An economy is described by the following equations: Desired Consumption Desired Investment Government Purchases Desired Imports Desired Exports Exchange Rate: Real Money Demand Money Supply Full-employment output Foreign Income Foreign real interest rate Price Level Cd = 0.6(Y) -- 200r Id = 24 – 400r G = 30 IMP = 0.1∙Y +20∙e EXP = 19 + (0.1) (Y#) – 20∙e e = 0.4 + 10∙(r – r#) L = 0.5Y - 200r MS = 39 YFE = 100 Y# = 100 r# = .02 P=1 Assume that expected inflation is zero so that money demand depends directly on the real interest rate. a. Write the equation that describes the LM curve. b. Write the equation that describes the desired national savings line as a function of the real interest rate r. (Assume that Y = 90.) c. Write the equation that describes the desired Foreign Lending line as a function of the real interest rate r. (Assume that Y = 90). d. Write the equation that describes the desired net exports line as a function of the real interest rate r. (Assume that Y = 90 and that Y# = 100.) e. Plot (with reasonable accuracy) on a graph the desired foreign lending and desired net export lines. What (approximately) will be the interest rate and current account balance if the product market is in equilibrium when Y = 90? f. Suppose in the economy above, Y = 90, but then foreign interest rates suddenly rise to r# = .04. Show the effects of the rise in foreign interest rates using the FLd and NXd diagram and the IS-LM diagram. g. Although the exchange rate has been floating in the past, the government does not want the exchange rate to change suddenly, and intervenes in the foreign exchange market to maintain the exchange rate at the original level. Therefore the central bank intervenes in the foreign exchange market to prevent the exchange rate from changing. Assuming this intervention is NOT STERILIZED, show the effects of the intervention using the FLd and NXd diagram and the IS-LM diagram Part II: Select the best answer for each of the following questions and mark it clearly on the page. (3 points each) 1. For an open economy, the real interest rate which sets desired national savings equal to desired investment determines where: a. b. c. d. e. desired net exports will be equal to zero. desired foreign lending will be equal to zero. the product market will be in equilibrium. the asset market will be in equilibrium. the foreign exchange market will be in equilibrium. 2. If the exchange rate of the euro to the US dollar is 1 euro = USD 1.50, and a Big Mac costs USD 5 in the USA and 4 euros in the EU, the real exchange rate of the euro is: a. b. c. d. e. 1.20 0.8 6 2.67 0.67 3. A Keynesian economy (with a fixed price level) with floating exchange rates has a current account deficit. In order to bring the CA to zero but keep the equilibrium output constant, the country should use: a. b. c. d. e. expansionary fiscal policy and expansionary monetary policy. contractionary fiscal policy and expansionary monetary policy. contractionary fiscal policy and contractionary monetary policy. expansionary fiscal policy and contractionary monetary policy. none of the above. 4. The NXd line will shift to the right if: a. b. c. d. e. domestic income rises. foreign income falls. foreign interest rates rise. desired national savings rises. desired domestic investment shifts to the left. 5. A country has an upward-sloping SRAS curve and an open economy. The short-run level of output is below full-employment, and the country has a current account surplus at the level of output where the product and asset markets are in equilibrium. If the country uses expansionary fiscal policy to increase output, the domestic real interest rate will _____, the foreign exchange value of its currency will _____, and the current account balance will _____. a. b. c. d. e. increase decrease increase decrease increase decrease increase increase decrease increase decrease decrease decrease increase increase 6. According to the efficiency wage model, employers choose a wage rate in order to maximize the productivity per dollar spent on wages. The model also implies: (i) unemployed workers cannot always obtain jobs by offering to work at a wage slightly lower than the wage currently paid to existing workers. (ii) an increase in labor supply might not change full-employment output. (iii) there may be involuntarily unemployed workers even when the labor market is working as well as we can expect. a. b. c. d. e. only (i) is true. only (ii) is true. only (iii) is true. only (i) and (iii) are true. (i), (ii), and (iii) are all true. 7. In the days of the gold standard, every big discovery of gold led to an expansion of the money supply. The business cycle expansions that followed the gold discoveries cannot be explained by the _____ theory, but can be explained by the _____ theory. a. b. c. d. e. Keynesian classical (market-clearing) reverse causation Keynesian reverse causation reverse causation reverse causation classical (market-clearing) classical (market-clearing) misperceptions 8. According to the misperceptions model (if firms and individuals have rational expectations), then increases in the money supply that are anticipated by workers and firms will cause: a. b. c. d. e. a temporary rise in output but not employment. a permanent rise in output and employment. no change in output or employment. a temporary rise in employment but not output. a permanent rise in employment but not output. 9. The main difference between Keynesian theory and classical theory is that Keynesian theory does not rely on adjustment of prices being able to quickly generate a market equilibrium in the: a. b. c. d. e. product market capital market asset market labor market money market 10. Compared to effect it would have in a closed economy, the use of expansionary fiscal policy in an open economy with floating exchange rates would produce a ____ shift in the AD curve because __________. a. bigger exports b. smaller exports c. smaller exports d. bigger exports e. bigger depreciation of the domestic currency will increase net the appreciation of the domestic currency will decrease net the depreciation of the domestic currency will increase net the appreciation of the domestic currency will increase net there will be no appreciation of the domestic currency 11. The desired net exports line in a floating exchange rate economy is ______ because a rise in domestic real interest rates causes: a. downward-sloping exports. b. vertical c. upward-sloping domestic products d. horizontal exports. e. none of the above. depreciation of the domestic currency and higher net no change in net exports higher foreign income that increases demand for less demand for products and therefore lower net 12. If country A has an open economy and floating exchange rates, it’s use of expansionary monetary policy will (for a given level of country A’s income) cause in country B: a. b. c. d. e. a shift to the right of the LM curve and a shift to the right of the AD curve. a shift to the left of the IS curve and a shift to the left of the AD curve. a shift to the right of the IS curve and a shift to the right of the AD curve. a shift to the left of the FL line and a shift to the left of the AD curve. a shift to the right of the NX line and a shift to the left of the AD curve. Productivity (effort) 100% Wage 13. Above is the degree of effort (or productivity) a typical employee might offer according to the wage paid. The employer wants to pay wage W1 because that wage maximizes the value of output per dollar spent on wages. Suppose the government passes new labor market regulation making it more difficult to fire a worker for being unproductive – the employer needs greater proof than before of the worker’s lack of effort. The effect of this regulation would be: a. the effort line would shift to the left, resulting in a higher wage and higher employment. b. the effort line would shift to the right, resulting in a higher wage and lower employment. c. the effort line would shift to the right, resulting in a lower wage and higher employment. d. the effort line would shift to the left, resulting in a lower wage and higher employment. e. none of the above. Profits Π* P* Price 14. The graph above shows how a firm’s profits respond to a change in the firm’s price. Suppose the firm’s “perfect” price is P* at which it would earn a profit of π* If the firm incurs a small menu cost mc in order to carry out a change in prices, the firm will choose to keep prices constant as long as: a. The difference between the current price P and the perfect price P* is less than mc. b. The difference between the current price P and the perfect price P* is greater than mc. c. The difference in profits at the current price and the profits from the perfect price is less than mc. d. The difference in profits at the current price and the profits from the perfect price is greater than mc. e. profits are greater than mc. 15. The Phillips Curve relationship between inflation and unemployment is what would result if the SRAS were _____ and the AD curve was _____. a. b. c. d. e. upward-sloping and stable upward-sloping and unstable vertical and unstable vertical and stable horizontal and stable unstable stable stable unstable unstable 16. According to the Friedman-Phelps expectations-augmented Phillips curve, a rise in the natural rate of unemployment would cause: a. b. c. d. e. unanticipated inflation to rise. a decrease in average labor productivity. interest rates to rise. the Phillips curve to shift to the right. the LM curve to shift to the left. 17. Suppose a country with a fixed exchange rate system wants to preserve the fixed exchange rate by buying or selling its currency in the foreign exchange market without having these transactions affect the money supply. The country undertakes a second transaction to return the money supply to its original level. This second transaction is called _____, and it involves buying or selling _____ assets. a. b. c. d. e. intervention appreciation sterilization open market operations speculation foreign foreign domestic liquid borrowed 18. Both classical and Keynesian economists agree that the long-run Phillips Curve is: a. b. c. d. e. unstable. dependant on expected inflation downward-sloping vertical over the natural rate of unemployment upward-sloping 19. A country that operates a fixed exchange rate system promises that its central bank will ____ intervene in the foreign exchange market to ____ international reserve assets when the quantity supplied of its currency is greater than quantity demanded. This intervention also has the effect of causing the money supply to _____. a. b. c. d. e. always always never never always buy sell buy sell buy increase decrease increase increase decrease 20. A country that uses a fixed exchange rate system finds that expansionary fiscal policy has ____ effect on aggregate demand than it would have under a floating exchange rate system. The use of expansionary monetary policy has _____ effect than it would have under a floating exchange rate system. a. b. c. d. e. a larger a larger a smaller a smaller the same less more more less an equal Part III. Extra Credit (1 point each). Do not waste time on these until you are finished with the rest of the exam! 1. Below are pictures of my dog and 4 famous swindlers – Robert Vesco, Jay Gould, Bernie Madoff, and Charles Keating. Which is which? a. b. c. d. e. (1) dog; (2) Vesco; (3) Gould; (4) Madoff; (5) Keating (1) Keating; (2) dog; (3) Vesco; (4) Gould; (5) Madoff (1) dog; (2) Madoff; (3) Keating; (4) Vesco; (5) Gould (1) dog; (2) Gould; (3) Madoff; (4) Keating; (5) Vesco (1) Vesco; (2) Gould; (3) Madoff; (4) Keating; (5) dog 2. Which is funniest? (Option receiving the most votes is correct.) a. b. c. d. stool sample herbivore step ladder big fan