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Selva Demiralp/ Erhan Artuc
Econ 202, Midterm 2
April 24, 2007
 DO NOT open the cover page until you are told to do
so.
 You have 90 minutes.
 DO NOT cheat. If I or one of the proctors suspect that
you are cheating or trying to cheat we will mark your
exam right away and if you get two marks, your test
will be sent to the Dean’s Office.
 You are NOT allowed to ask any questions during the
exam. The questions are clear. If you cannot
understand the question it means you don’t know the
material well enough. You can only ask a question
regarding the dictionary meaning of a word (but we
will not explain technical terms which are the subject
material of this course).
 You are NOT allowed to leave the room during the
exam. If you need to use the restroom, do it before the
test starts.
Name: _________________________________________
Questions 1-3 are based on to the information below, however they are not interdependent and you can solve them separately.
Consider a world in which all goods, services, capital, and money can be transferred
from one country to another without any costs, barriers, tariffs or quotas.
In this world, a large and powerful country called Bullyland invades another country
called Farland, which increases Bullyland’s military spending substantially.
Meanwhile, in another small country called Smalland economists are unpleasantly
surprised by the increase in their real interest rates following this seemingly irrelevant
war in Farland.
1. a) Graphically explain how the war affected real interest rates Smalland? (8 points)
First draw the market for loanable funds for the world economy. Savings decline, and
world interest rate increases.
Next, draw the market for loanable funds for Smalland. They experience an increase
in world interest rates, which increases their trade balance (i.e. NX increases).
b) Predict what will happen to the real exchange rate of Smalland currency against
Bullyland. A verbal answer is sufficient but you can use additional graph(s) if you
think is necessary. (7 points)
Draw the market for the real exchange rate (with S-I and NX). When investment
declines, S-I shifts right, and the real exchange rate declines (depreciation).
Intuitively, as investment declines, the supply of domestic currency increases, Exports
increase, imports decline, and NX increases.
2. Now consider the following production function for Smalland: Y=K0.5L0.5
(Hint: MPL= 0.5 K0.5 / L0.5 and MPK = 0.5 L0.5 / K0.5)
Before the war, total labor supply in Smalland is L=100, and total capital is K=16.
a) State the labor demand and labor supply curves for Smalland mathematically, and
calculate the equilibrium real wage. Next, plot labor supply and demand graphically,
mark the equilibrium point. Finally calculate the equilibrium level of output. (10
points)
Labor demand=MPL=0.5 K0.5 / L0.5 MPL=0.5 (16)0.5 / (100)0.5 =0.2
Real wage=MPL=0.2
Y=K0.5L0.5 =160.51000.5 = 40
Draw the labor market with vertical labor supply curve and downwards sloping labor
demand curve, plot the equilibrium L=100 and real wage=0.2
b) If we know that real interest rates have doubled in Smalland after the war, what
happens to nominal wages? (Hint: Assume that real interest rate is equal to the real
rental rate) Give a numerical answer and illustrate it graphically in the labor market.
Calculate the new level of output consequently. (10 points)
r1=MPK=0.5 L0.5 / K0.5=0.5 (100)0.5 / (16)0.5=5/4
r2=2r1=5/20.5 L0.5 / K0.5=5/2
(0.5).10/ K0.5=5/2K=4
Y=K0.5L0.5 =40.51000.5 = 20
MPL=0.5 K0.5 / L0.5 =(0.5) 40.5/1000.5 =0.1
3. Assume that output and wages decreased in Smalland after the war.
a) Do you think this war will affect job finding (f), and job separation (s) rates? (5
points)
s: ratio of people who move from E to U: increases
f: ratio of people who move from U to E: decreases
b) Show how these rates will determine the equilibrium unemployment rate (u).
Derive the relationship between u, s and f . Do not write the formula only. (5 points)
If the unemployment rate remains constant (i.e. at steady state): fU = sE
Substitute E = L – U into (1):
fU = s(L – U)
Divide both sides by L
f (U/L) = s [1- (U/L)]
(U/L)(f + s) = s
U/L = s / (s + f)
c) Will the unemployment rate increase or decrease? (5 points)
As s↑, U/L↑
As f↓, U/L↑
(
U / L
f
> 0)

s
(s  f) 2
(1)
4) Suppose that you are an economist working for the central bank when
droughts across the country substantially reduce food production.
a. Use the Aggregate Demand-Aggregate Supply model to illustrate graphically
your policy recommendation to accommodate this adverse supply shock,
assuming that your top priority is maintaining full employment in this
economy. Be sure to label the axes, the curves, the initial equilibrium values,
the direction the curves shift, and the final equilibrium values. State in words
your policy recommendation as well as what happens to prices and output as
a combined result of the supply shock and central bank policy. (10 points)
Start with an initial SR and Long run equlibrium and shift SRAS up. The
policy recommendation would be expansionary MP that shifts AD to the
right. Output increases to potential GDP in the short run. Prices increase
due to the price shock in the short run. Prices stay higher permanently.
b.
Would your recommentation change if your top priority was to keep prices
stable ? Explain clearly using graphs as well as verbally as in part a. (10
points)
This time, we would recommend doing nothing. In the long run. The economy will
return to its initial equilibrium level with a decline in the price level and increase in
the level of output.
5) Suppose the government decides to reduce the budget deficit by cutting
government spending.
a. Use the Keynesian-cross model to illustrate graphically the impact of a
reduction in government purchases in equilibrium level of income in the
short run. Be sure to label the axes, the curves, the initial equilibrium values,
the direction the curve shifts and the final equilibrium values. (10 points)
E line shifts down, reducing equilibrium Y.
b.
How does the size of change in government spending compare to the size of
change in income. Explain clearly. (5 points)
∆Y > ∆G
∆Y/∆G = 1/ (1 – mpc) > 1
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c.
Graphically illustrate the impact of this reduction in government purchases in the
loanable funds and IS framework. State in words and explain intuitively what
happens to equilibrium levels of saving, investment, and the interest rate. (10
points)
First, draw the initial equilibrium in the market for loanable funds and the
IS curve side by side.
The decline in G increases S for a given level of income and shifts the S
curve to the right, reducing equilibrium real interest rate. On the right hand
side, IS curve shifts down.
d.
What is the impact of this cut in government spending in the long-run? Simply
explain in words. No graphics are necessary. (5 points)
In the LR, prices decline, output returns to potential GDP.
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