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Midterm Exam 2
Economics 503
Foundations of Economic Analysis
Session 4
Multiple Choice ( ½ point each)
1. Potential GDP equals $100 billion. The economy is currently producing GDP1
which is equal to $90 billion. If autonomous spending increases, then total
expenditure will increase. If the marginal propensity of expenditure is mpex = .8,
then how much must autonomous spending change (holding the price level and
interest rate constant) for the economy to move to potential GDP?
A) -$2 billion
B) $2 billion
C) -$18 billion
D) $18 billion
___________B_______
2. Which of the following is a reason why increases in the price level results in a
decline in aggregate expenditure?
A) Price level increases cause firms and consumers to hold less real balances which
raises the interest rate. Higher interest rates lower consumption and planned
investment expenditures, which lowers aggregate expenditures.
B) Price level increases in the U.S. relative to other countries, raise net exports, which
lowers aggregate expenditures.
C) As the price level rises, government spending falls, which lowers aggregate
expenditures.
D) Price level increases raise real wealth which causes consumption spending and
aggregate expenditures to decline.
_______A___________
3. Suppose the economy is at point A. If investment spending increases in the
economy, where will the eventual long run equilibrium be?
A) A
B) B
C) C
D) D
__________C________
4. Stagflation occurs when
A) inflation falls and GDP falls.
B) inflation rises and GDP falls.
C) inflation falls and GDP rises.
D) inflation rises and GDP rises.
________B__________
Calculation
1. (2 points) The monetary base is $100. The central bank imposes a required
reserves ratio of 20% of demand deposits. The ratio of currency to demand
deposits is fixed at .8. Assuming no excess reserves, calculate the level of cash,
reserves and M1. At what level of reserves would the money supply be equal to
270?
1  C D 1.8

 1.8 . M1 = 180. Reserves = 20, Cash = 80.
R C
1
D
D
If M1 goes to 270, MB must go to 150. Since cash is held on a 4 to 1 basis reserves,
reserves must increase by 10 and go to 30. However, I will accept that reservees will
be used to increase the monetary base, so if the answer is “Reserves go to 70” that
will be fine also.
mm 
2. (2 points) The marginal propensity of consumption is .6; the marginal propensity
of investment is .4; the marginal propensity to import is .25. Government
spending increases by 100. Calculate the increase in equilibrium demand holding
the price level and interest rate constant.
Mpex = .75. Y 
1
1
 E0 
100  400
1  mpex
1  .75
Graphical Questions
3. (2 points) In the Japanese economy, the Finance Ministry cuts corporate tax rates.
Using the AS-AD model, demonstrate the effect that this would have in the shortrun and in the long run after the self-correction process has kicked in.
AS’
P
AS
3
2
1
AD
AD’
Y
4. (2 points) In the Japanese economy, business confidence increases. Using the ASAD model, we know this would lead to a certain short-run equilibrium impact on
P and Y. Suppose the Bank of Japan acts to keep the money supply fixed. Draw a
picture of the money market which shows the impact of these activities on the
equilibrium in this market.
MS
r
r**
MS
P
P
P goes up, real
balances drop.
Y goes up,
money demand
increases. Real
interest rates
rise.
2
r*
1
md´
md
M
P
5. (3 points) In the USA on a given day, customers at a large money center bank
transfer their funds to other banks. This creates a need for that bank to borrow a
large quantity of reserves relative to the amount available. Draw a picture of the
Fed Funds market and the effect of this event, keeping in mind the fact that the
Fed operates a discount window. If the Fed wants to maintain its target, it will
need to issue instructions to its bond traders on implementing defensive
transactions. Should the traders be instructed to implement open market purchases
or open market sales?
iIBR
iLOAN
2
iTGT
1
S
iDEPOSIT
D
Traders should do OPEN MARKET PURCHASE to defend interest rate.
D’