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Final Exam
Economics 4020(001)-Fall 2008
Answer any two out of the following three questions (40 points in total, 20 points each):
1. The Economy in the Short Run: the IS-LM Model
Answer the following sub-questions:
(a) Draw a graph describing an economy in the short run. In your graph, show the IS
curve, the LM curve, the equilibrium interest rate and income, and label both axes
correctly.
(b) Explain the meaning of the IS curve and the LM curve and discuss why the IS
curve and the LM curve have the slope/shape they typically have.
(c) Now suppose the economy is in recession and the government/central bank
attempts to use expansionary macroeconomic policies to stimulate the economy.
Economists are debating whether fiscal policy or monetary policy is likely to be
more effective. According to Real World Macro, article 3.1, Professor Fazzari
studied alternative factors that could have impact on investment. What are
Fazzari’s findings? Suppose Fazzari’s findings are correct, draw a new graph
showing the economy in the short run, with your IS curve and LM curve having
the slope/shape that is consistent with Fazzari’s findings.
(d) Given Fazzari’s findings, is fiscal policy or monetary policy likely to be more
effective? In your second graph, show the effect of the policy which you believe
is more effective. Indicate the new equilibrium interest rate and income. Explain
why your preferred policy is more effective than the alternative policy in pulling
the economy out of recession (discuss the underlying economic processes in your
explanation).
2. The Open Economy in the Short Run: the Mundell-Fleming Model
Answer the following sub-questions:
(a) Draw a graph describing a small open economy with fixed exchange rate. In your
graph, show the fixed exchange rate, the IS* curve, the equilibrium income, and
label both axes correctly (do not draw LM* curve at this point).
(b) Now suppose in this economy with fixed exchange rate, the central bank sets
money supply at greater than money demand. In your graph, add a LM* curve
that reflects this monetary policy. What will happen next in this economy?
Discuss the process through which the money market returns to equilibrium.
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(c) Draw another graph describing a small open economy with floating exchange rate.
In your graph, show the IS* curve, the LM* curve, the equilibrium exchange rate
and income, and label both axes correctly.
(d) Now suppose the government wants to use expansionary fiscal policy to increase
the level of income. In your graph (for floating exchange rate), show the effect of
this expansionary fiscal policy and the new equilibrium exchange rate and income.
Explain why the equilibrium exchange rate and income have changed (or not
changed) in the way you show in your graph (discuss the underlying economic
processes in your explanation).
3. From Keynesianism to Neoliberalism, and What Will Be the Next?
Based on your reading of Professor Pollin’s article (Real World Macro, article 7.2),
discuss why John Maynard Keynes believed that free market capitalism was
fundamentally unstable.
In the post-WWII period, social democratic capitalism was implemented in many
countries. However, by the 1970s, both Keynesianism and social democratic capitalism
were in serious crisis. According to Pollin, what factors/problems had contributed to the
downfall of social democratic capitalism?
Since then a new consensus in mainstream macroeconomics has emerged. It
argues that in the “long run” macroeconomic policies are ineffective and the capitalist
market itself can adjust to return to long run equilibrium. Discuss why the current
mainstream macroeconomics (as is elaborated by Mankiw’s textbook, chapter 13)
believes that in the long run, without government intervention, a capitalist market
economy will always gravitate towards either full employment or natural rate of
unemployment (no graph is required, just explain the underlying reasoning).
According to Professor Pollin, the contemporary mainstream macroeconomics
belongs to the neoliberal intellectual doctrine. In light of the current economic crisis,
what do you see as the future intellectual/economic trend? Will neoliberalism reinvent
itself and survive the current crisis (if yes, how)? Will there be a revival of
Keynesianism and social democratic capitalism (if yes, how could they manage not to
repeat the 1970s crisis)? Anything else you would like to suggest?
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