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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