Download Week 8 Practice Quiz b Answers - The University of Chicago Booth

QUIZ 4: Macro – Fall 2015
Name: ______________________
Section Registered:
Mail Folder (circle one):
Tue a.m.
Campus
Tue p.m.
Gleacher
Wed a.m.
Exchange Student None
For the entire quiz, make the following assumptions. (1) All consumers are non-liquidity
constrained, non-ricardian PIH, (2) Prices are held fixed unless told otherwise, (3)
expected inflation does not affect money demand (MD), (4) the capital stock (K) is fixed, (5)
all exogenous variables (A, tax rates, government spending, Fed policy, etc.) are fixed unless
told otherwise, (6) we are considering a closed economy (NX=0), and (7) changes in N do
not independently affect investment demand. Finally, assume all changes to exogenous
variables are permanent and unexpected.
Note: For questions 1, 3, and 4, you must circle ALL true answers. Multiple answers
could be true (or not). You should view the answers as a series of True/False questions.
Question 1 (1 point each – 6 points total)
Circle all true answers to the following statement. Assume the substitution effect on labor
supply equals the income effect on labor supply. An unexpected permanent increase in TFP
will:
a. Shift the IS curve to the right.
True – C(.) and I(.) will increase – both of which will shift the IS curve to the right.
b. Shift the labor supply curve to the left.
True – As PVLR goes up, the labor supply curve will shift to the left (this is a mid term
question). How far it shifts to the left will depend on the strength of the income effect
relative to the substitution effect. In this case, it will shift to the left such that the new
equilibrium is back at the original level of N (given labor demand already shifted right).
c. Shift the long run aggregate supply curve to the right
True – as A goes up and N doesn’t change, Y* (LRAS) will shift to the right.
d. Shift the money demand curve to the right.
True – as Y goes up in IS-LM market, money demand will shift right.
e. Shift the aggregate demand curve to the right.
True – as C(.) and I(.) increase, the AD will shift right.
f. Shift the LM curve to the right.
False – the LM curve shifts when M changes (which is fixed in this example) and P
changes (which is fixed in this example)
Question 2 (4 points total)
Define the quantity theory of money. Your answer should include two parts. First, what is
the equation that defines the quantity theory of money (this should be one equation – be
precise). Second, what assumptions turn the equation into the quantity theory? Again, be
specific.
To summarize, your answer should be one equation and at most two other
sentences.
%ΔM + %ΔV = %ΔY + %ΔP
The quantity theory of money imposes that velocity growth is close to zero and that real
GDP growth is 2-3% per year. This creates almost a one to one link between money
growth and price growth (inflation).
Question 3 (1 point each – 5 points total)
Circle all true answers to the following statement. Assume that the income effects on labor
supply (NS) are large relative to the substitution effects on labor supply. An unexpected
permanent increase in government spending (G) will:
a. Shift the Aggregate Demand (AD) curve to the right
True
b. Shift the Labor Supply (NS) curve to the right.
False – changes in G do not affect labor supply
c. Shift the Long Run Aggregate Supply (LRAS) curve to the right.
False – no change in A, K or N*
d. Shift the Money Demand (MD) curve to the right.
True – as IS curve shifts out, Y will increase. An increase in Y will shift Money
Demand to the right.
e. Shift the LM curve to the right.
False – no change in M (which is fixed in this example) or P (which I held fixed
throughout the whole quiz).
Question 4 (1 point each – 5 points total)
For this question, circle all the answers that are true. Also, use the IS-LM framework
developed in class to answer the questions (like we did in the middle of class last week).
Again, assume prices are fixed (and all other quiz assumptions hold). Also, focus on the
demand side of the economy only – i.e., ignore the supply side of the economy. We will
discuss the supply side at the beginning of the class this week.
a. An increase in the required reserve ratio (m) will unambiguously cause real interest
rates (r) to fall and the IS curve to shift to the right.
False – An increase in (m) will cause M to fall (will reduce money multiplier). A fall in
M will shift LM curve left putting upward pressure on interest rates and downward
pressure on Y. Also, the IS curve will NOT shift in this case.
b. An increase in TFP (A) will unambiguously increase both output (Y) and real interest
rates (r).
True – the IS curve will shift right and the LM curve will not shift. Graph it out. Both
Y and r will increase.
c. An increase in government spending (G) will cause the IS curve to shift to the right
and investment (I) to fall.
True – we did this in class last week. I will fall because r increases (crowding out). I(.)
will not change – but total investment will fall because of the interest rate effect.
d. An increase in business confidence will cause real interest rates (r) to rise causing the
effect on total investment (I) to be ambiguous.
False! Y will definitely increases as the IS curve shifts out. Y = C+I+G, and C and G
didn’t change – so, we know I must increase. Moreover, we know that r increased. So,
I(.) increased and r increased. You might think that total I is therefore ambiguous.
But, the only reason that r increased is because money demand went up. The only
reason money demand increased was total I increased. If total I fell, interest rates
would have fallen and then I would have gone up for sure (which is logically
inconsistent).
e. An increase in consumer confidence will have no effect on either the Money Supply
(Ms) or the Money Demand (MD) curves.
False. As C(.) increased, Y will increase. An increase in Y will shift money demand
curve to the right.