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King’s University College
FINAL EXAMINATION
December 2009
Economics 2220A -570
Duration: 3 hours
Examination Aids allowed:
Non-programmable Calculator
Instructions
Write your answer on the booklet.
The question sheets have 12 pages altogether, including this cover page.
This exam has the total of 100 points assigned for the correct answers.
Write your name and student number below.
Name: ____________________
Student Number: __________________
Marks: ____________________
Part I. (subtotal 22%) Answer all the questions.
1. (4%) Suppose that there is only the goods market in the economy. Suppose also that exante the planned Aggregate Output (YS) is larger than the planned Aggregate
Expenditures(AE) in the current period. For example, ex-ante YS = $ 700 Billions and AE =
$ 650 Billions.
In the Keynesian- Cross Diagram with the relevant AE and other curves, illustrate and
explain the current situation, and what will happen to the National Income(Y) of the next
period.
From Midterm Test
2.(8%) Answer the following questions. The following 3 sub-questions of 1), 2) and 3) are all
related to each other, and they progress from question 1) to 2) and finally to 3): Brief verbal
explanation is necessary with well-indicated (with all the appropriate indications) graphs. In
drawing graphs, exact correspondence between the important points of the two panels is
required for full marks.
1)(2%)Suppose that there are the goods and money markets in the economy. Graphically derive the
LM curve from a normally shaped, or downward-sloping, real money demand curve and the
standard money supply curve.
Money Supply-Demand Setting
i
LM Curve
i
Page 2 out of 12
Y
m
2)(3%)First, draw the above graphs once again in the following panels(as the following question is
a continuation/cumulation of the above question);
Now, illustrate what will happen to the graphs, and thus to the equilibrium Y and i when
due to financial market instability the real money demand, which is unrelated to interest
rate or income, increases(random monetary shock). Suppose that the IS curve is normal
with a negative slope.
Money Supply-Demand Setting
LM Curve(s) and IS curve
3)(3%) First, draw the above graphs from question 2) once again on the following panels.
Now, on the graphs, newly illustrate and indicate what will happen to both panels and
thus to the equilibrium Y and i if the monetary authorities are engaged in the ‘interest
rate pegging policy’ in response to the aforementioned ‘random increase in real money
demand’. Assume that the IS curve is downward sloping.
Clearly indicate whether the authorities should either increase or decrease the nominal money
supply for the interest pegging policy.
Money Supply-Demand Setting
LM Curve(s) and IS cuve
Page 3 out of 12
3.(5%)Suppose that there are the goods and money markets in the economy, and the IS-LM
model is applicable. Suppose that the real money demand is perfectly elastic with respect to
interest rate and currently the economy is stuck in recession. By using the relevant/correct
shapes of IS-LM curves(no needs to derive the LM curve from the corresponding md curve),
illustrate and explain the degrees of effectiveness of monetary policy and fiscal policy
respectively in getting out of recession (you answer whether monetary policy is effective/not
effective; fiscal policy is effective/not effective, and explain).
4. (5%) Suppose that the economy has the following model:
Good Market
C = C0 + c1(Y-T); T = T0+ t1 Y; I = I0 - bi; G = G0; X-M=O
Money Market
ms= MS/P ; md = L(i,Y) = KY –hi +u
What is the mathematical expression for the equilibrium national income in this model?
Explain what will happen to the fiscal policy multiplier when the elasticity of investment with
respect to interest rate approaches zero?
Page 4 out of 12
Part II. Answer all the questions.
1.(21%)Suppose that the initial price level is P1, and then the price level rises to P2. There are 3
sub-questions. Question 1) is a basis for question 2) and question 3). However, suppose that
questions 2) and 3) are alternative, not cumulative: What may happen is either question 1) +
question 2), or question 1) + question 3).
1)
In the Four Panel graph of the Price-Income, the Nominal Wage-Level of Employment,
and the Aggregate Production Curve, and the Keynesian Cross Diagram of YS=Y, derive
the Classical Aggregate Supply Curve, and the Keynesian Aggregate Supply Curve
respectively.
Kevin: Most people would draw the following 2 graphs in one. It is fine. In fact, it may be
better as it contrasts the Classical and Keynesian models.
YS
YS
N
Y
W
2
AS W*
(w)
Ns(P
1)
P1
W*1
Y
P2
Nd(P1)
P
N*
2
1
Y*
Note that along this AS curve the real wage is constant but money wage is not: at point 1
Page 5 out of 12
(W)
P2
E’
Fixed
W*
N1*
N2*
P1
Y1
Y2
Page 6 out of 12
3) First repeat all the drawings that you have done for the previous question 1). Now suppose that
now, instead of technical innovation, simply money wage rises. Show clearly which curve(s) shifts
in the first place, and then indicate/illustrate what will happen to the various curves, including the
Keynesian and Classical AS curves, drawn in your answer to the above question 1).
Technical Innovation
There are two effects: 1) first, technical innovation shifts the Aggregate Production Curve
outward(dotted line); 2) technical innovation increases the Marginal Product of labor and
thus increases(shift) the Aggregate Labor Demand Curve to the right (red line).
(W)
P2
E
’
Fixed
W*
N1*
N2*
P1
Y1
Y2
Page 7 out of 12
Part III. Answer all the questions:
1. (10%)Suppose that initially the economy is located at the long-run equilibrium and the
national income is at the full employment level: the AD, SAS and LAS curves intersect all at
one point. Now suppose that there occurs a negative supply shock such as ‘oil shocks’. What
will happen to the price level and the national income of the economy in the short-run as well
as in the long-run? Use the regular AD-SAS-LAS curve model for your illustration and
explanation (no needs to draw the labor supply/demand or the aggregate production curves).
Page 8 out of 12
2.(7%) Suppose that initially the economy is located at the long-run equilibrium. Now suppose
that there occurs technical innovation or technological advance. What will happen to the
price level and the national income of the economy in the short-run as well as in the long-run?
Use the regular AD-SAS-LAS curves for your explanation: no need to show any changes in
the labor market condition or the aggregate production curve (Hint: this question is a
continuation from Part II, question 1, sub-question 1) on page 6).
P
LAS0
LAS1
SAS0
SAS1 SAS2
P1869
(100.00)
P1897
(63.40)
Yf1869
(100.00)
-
Yf1897
AD
Y
(299.00)
T
When LAS0 moves to LAS1, SAS0 moves to SAS1 by the same amount
at the same time(note that the intersections of the LAS and
SAS before and after have the same height). That is not the
end of the story.
Note that the SAS moves once again from SAS1 to SAS2: Because
the short-run equilibrium national income given by the
intersection of SAS1 and AD leads to a short-run equilibrium
national income Y (not indicated above: you may do so), and
it is below the new full employment or long-run equilibrium
national income Yf 1987.
In this case, just as we have learned, the SAS should move to
the long-run equilibrium. As SAS moves to the right for this
reason, there is an additional increase in Y and a fall in P.
Page 9 out of 12
3.(20%)Suppose that the economy is located at the long-run equilibrium in the New Classical
model with the AD-Lucas Aggregate Supply-Long Run Aggregate Supply curves. Explain
what the response will be to i)unexpected increase in money supply or unanticipated
expansionary monetary policy; and ii) to expected increase in money supply or fully
anticipated expansionary monetary policy respectively according to the New Classcial model
of macroeconomics.
i)Unanticipated Expansionary Monetary Policy
In the short run, as the increase in Money Supply is
unanticipated or unexpected for the workers or the general
public, then the SAS curve does not move at all in the shortrun. In the long run: Even if the expansionary monetary
policy is unexpected, eventually in the long-run the general
public will figure out the consequent increase in the price
level. Suppose that there is no institutional wage rigidity
in the labour market. As they demand a higher money wage so
as to recover the real wage, the money wage will rise and the
SAS will reflect the wage(labour cost) increase and thus
decrease(shifting to the left or up visually).
LRAS
Page 10 out of 12
ii)Fully Anticipated Expansionary Monetary Policy
1) If the expansionary monetary policy is announced well in
advance and is executed by the monetary authority as
announced, and at the same time, if there is no institutional
money wage rigidity, then there is the Policy Ineffectiveness
Theorem holding once-for-all, i.e., in the short-run as well
as in the long-run. There will be no increase in Y even in
the short-run.
LRAS
Page 11 out of 12
4. (10%)Why did the Great Depression last for such a long period of time between 1929 and
1939 in the U.S.? Explain and illustrate your answer with the standard AD-Short Run ASLong Run AS curve model.. Suppose that initially before the start of the Great Depression the
economy was located at the full employment level. Confine your explanation to class
discussion
P
LAS
SAS
AD193
AD193
AD9192
3
9
Y
Y*
Yf
- puzzling question:
Why SAS did not shift to the right when
<<
P level fell between 1929 and 1933?
The answer lies in the institutional downward rigidity of
money wages that kept the SAS there for a long period of time.
Page 12 out of 12
5. (10%) Answer all the questions:
1)What conditions in the labor market make the difference between the Keynesian world(SAS
curve) and the Classical World(LAS)? Name the three conditions in the labor market for the
classical world where the AS curve is vertical at the full employment level (or the opposites
for the Keynesian world).
This flexibility of money wages and thus the consequent constancy
of real wages belong to the classical world, where i) there is no
information asymmetry between the entrepreneurs and the workers:
There is no money illusion on the part of workers (it goes without
saying that any working, let along successful, entrepreneurs
should NOT have any money illusion at all); ii) there is no
structural rigidity which hinders flexible changes of money wages
in response to a change in price level, particularly of downwards
changes or falls to a falling price level in the case of
recession, such as labour unions, and finally iii) it is in the
long-run – enough of time has passed to make a full adjustment of
money wages to a changing price level.
2)
What was the argument by President Hoover who objected to wage cuts amid the
recession of the time? Why was his argument wrong?
that President Herbert Hoover prevented the money wages from
falling. He believed that policies to keep wage rates high
would maintain workers’ level of purchasing, providing the
“steadier” markets necessary to thwart economic contractions:
In a word, he thought that the falling money wages will
further decrease the (consumption) aggregate demand for the
society.
If money wages had been flexible, the Aggregate Output would
have increase and the price level would fall. This might
have led to a full employment (refer to the graph: Kevin, no
student would draw a graph. This is for your better
understanding only).
Page 13 out of 12
If the money wages had fallen, YSR* would not have stayed
below Yf for such a long period of time:
As money wages fall, the SAS would move to the right. And the
price level should fall and Y should increase.
P
LAS
SAS0
99
SAS1
AD39
AD29
Y
Y f  YSR  YLR
*
*
(This situation did not happen in 1929-1939)
Page 14 out of 12