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Name: Section Number: First Prelim ECON 102 – Professor Steven Kyle February 28, 2008 PART I: Multiple Choice/Fill-In. 10 points (each question is worth ½ point). 1. Suppose the consumption function were defined as: C = 300 + 0.85(Y-T). What is the MPS? a) b) c) d) 0.85 1.85 0.15 300 Answer: C 2. When your aunt attended Cornell in 1980, she paid $300 for rent. Coincidentally, you now live in the same apartment in which she lived, and pay $500 for rent. Suppose that the CPI in 1980 was 150, and in 2008 is 200. a) In real terms, you're paying more than your aunt b) In real terms, you're paying less than your aunt c) In real terms, you're paying the same amount d) It cannot be determined from the information given Answer: A 3. Suppose a 17 year-old worker is fired from his full-time job. If he is available for work, made specific efforts to find work exactly five weeks ago, and has been volunteering without pay for four hours a week at a local soup kitchen, then he is considered: a) b) c) d) Unemployed Employed, but not at work Not in the labor force None of the above Answer: C 4. If real GDP has increased, then we can conclude that: a) b) c) d) Everybody in the economy is better off Price levels are higher There is more unemployment None of the above Answer: D 5. Which price index includes the prices of intermediate goods? a) b) c) d) Producer price index Consumer price index Housing price index All of the above Answer: A Name: Section Number: First Prelim ECON 102 – Professor Steven Kyle February 28, 2008 6. When the Federal Reserve sells a government bond, the money supply is: a) b) c) d) Decreased Increased Not affected First decreased, then increased Answer: A 7. Which of the following would NOT increase GDP in 2008? a) b) c) d) Michelle’s birth in a private hospital on Feb. 22, 2008 Amy’s purchase of a share of Microsoft stock on Dec. 31, 2008 Brea’s purchase of a new Ford Taurus on Mar. 19, 2008 ILR’s purchase of new computers for its offices on Jan. 1, 2008 Answer: B 8. To stimulate economic growth, the government decides to increase government expenditures and cut taxes at the same time. This economic policy would be described as: a) b) c) d) Income Policy Fiscal Policy Monetary Policy Financial Policy Answer: B 9. The new U.S. president decides to increase personal income taxes by $200 billion in 2009. What effect would this have on the equilibrium level of output if (1 – MPS) is 0.60 and the goods market is assumed to be independent from the money market? a) b) c) d) Decrease output by $200 billion Decrease output by $120 billion Decrease output by $124 billion Decrease output by $300 billion Answer: D 10. If a U.S. firm located in China exports clothes to Germany, which of the following is correct? a) b) c) d) The clothes should be included in U.S. GDP The clothes should be included in China’s GNP The clothes purchases induce a leakage from the German spending stream All of the above Answer: C Name: Section Number: First Prelim ECON 102 – Professor Steven Kyle February 28, 2008 11. Suppose the Federal Reserve wants to restrict the money supply. Then it could do so by: a) b) c) d) e) f) Buying 3-month Treasury bills Decreasing the required reserve ratio Purchasing 30-year Treasury bonds Decreasing the discount rate None of the above All of the above Answer: E 12. Suppose the U.S. government decreases government expenditures by $300 billion, and simultaneously decreases taxes by $300 billion. Then the effect on the equilibrium level of output when the MPC is 0.7, and the goods market is assumed to be independent from the money market, is: a) b) c) d) An increase of $210 billion A decrease of $1 trillion A decrease of $300 billion An increase of $600 billion Answer: C 13. If aggregate output is greater than planned aggregate expenditure, then which of the following adjustments to equilibrium will occur: a) b) c) d) There will be an unplanned inventory increase and firms will reduce production There will be an unplanned inventory decrease and firms will reduce production There will be an unplanned inventory increase and firms will increase production There will be an unplanned inventory decrease and firms will increase production Answer: A 14. Saving and Wealth are: a) b) c) d) Stock and flow variables, respectively Flow and stock variables, respectively Both individually stock and flow variables Both neither stock nor flow variables Answer: B 15. If the federal government enacts an expansionary fiscal policy by decreasing taxes, then we would expect: a) b) c) d) The demand for money to decrease and the interest rate to decrease The supply of money to increase and the interest rate to decrease The demand for money to increase and the interest rate to increase None of the above Answer: C Name: Section Number: First Prelim ECON 102 – Professor Steven Kyle February 28, 2008 16. If the Federal Reserve initiates a contractionary monetary policy through open market operations, then we would expect: a) b) c) d) The demand for money to decrease and the interest rate to decrease The supply of money to increase and the interest rate to increase The quantity of money in the hands of the public to decrease and the interest rate to increase The supply of money to decrease and the interest rate to decrease Answer: C 17. Suppose exports and imports are zero. Then planned aggregate expenditure minus government purchases equals ____aggregate consumption plus planned investment____ 18. The money multiplier multiplied by the required reserve ratio equals __1__ 19. The price of bonds goes: a) Up whenever stock prices go up b) Up when an increase in inflation is expected c) Up when an increase in risk becomes apparent d) Up when the Federal Reserve uses open market operations to increase the money supply Answer: D 20. True/False: Investment tends to respond negatively to decreases in the interest rate Answer: False PART II. Short Answer. 10 points (each question is worth 2 points). Answer each question and make a drawing if requested. You must show your work to receive full credit. 1. Briefly discuss some of the problems that arise with a price index that uses a fixed-weight procedure. Structural changes in the economy may make fixed weights inappropriate for different time periods. No accounting for supply shifts in the economy (i.e., substitution effects). 2. Suppose the goods market in a closed economy with a government is in equilibrium. Using the leakages/injections approach, state the equilibrium condition, and discuss whether the government’s budget must necessarily be balanced. Name: First Prelim ECON 102 – Professor Steven Kyle February 28, 2008 Section Number: It is helpful to note that equilibrium requires that Y = C + I + G. Also, Y ≡ C + S + T. So, stating the equilibrium condition, we have S + T = I + G. This condition does not require a balanced government budget (G = T). 3. Suppose the money market is in equilibrium. Discuss and illustrate graphically how an expansionary monetary policy would affect the quantity of money supplied and demanded, as well as the equilibrium interest rate. MS r MS’ r0 r2 r1 Md’ Md M0 M1 M M We have MS ↑ → r ↓ → I ↑ → Y ↑ → Md ↑ → r ↑. Therefore, the money supply curve would shift to the right, increasing the quantity of money supplied and demanded, and lowering the equilibrium interest rate. Secondarily, the money demand curve would shift to the right, increasing the interest rate by an amount smaller in absolute value than the initial decrease. Thus, the quantity of money supplied and demanded would increase, and the equilibrium interest rate would decrease. 4. Briefly describe the transaction and speculation motives in their relation to money demand. If market interest rates increase, is an individual more or less likely to hold money balances relative to bonds? Transaction motive relates to the need to have money to buy goods and services. Speculation motive relates to the increased desire to hold bonds when interest rates are higher than normal, due to expectations that interest rates will fall in the future. Therefore, as interest rates increase, an individual is less likely to hold money balances. 5. Briefly describe the value-added approach to calculating GDP. Why don’t we use the value of total sales in an economy to measure the level of output that has been produced? Sum the value added at each stage in production. If we use the value of total sales, we double-count intermediate goods when we count their value in final goods. Name: First Prelim ECON 102 – Professor Steven Kyle February 28, 2008 Section Number: PART III. Newspaper Analysis. 10 points (each question is worth 5 points). Answer each question and make a drawing if requested. You must show your work to receive full credit. 1. Read the following excerpt from an article that appeared in the Economist on February 14, 2008: Rushing on by road, rail and air “China's rapid economic growth and equally rapid integration into the global economic system is putting huge strains on its infrastructure. This has led to a spate of spending on transport. Between 2001 and the end of 2005 more was spent on roads, railways and other fixed assets than was spent in the previous 50 years. According to the state media, investment will see doubledigit growth every year for the rest of the decade. Between 2006 and 2010, $200 billion is expected to be invested in railways alone, four times more than in the previous five years.” 1.1 Define (using both words and standard letter abbreviations) planned aggregate expenditure in a closed economy with a government. (1 point) Planned aggregate expenditure is the sum of aggregate consumption, planned investment, and government expenditures. In letters: AE = C + I + G. 1.2 Explain the crowding-out effect. (1 point) The crowding-out effect is the tendency for increases in government purchases to cause a reduction in private investment via the interest rate increases caused by the increase in aggregate expenditure and the resulting shift in the money demand curve to the right. 1.3 Illustrate graphically how China’s response to strains on its public infrastructure will affect the goods market, the money market, and the level of planned (private) investment. Do we observe crowding-out of planned investment? (3 points) We have G ↑ → Y ↑ →Md ↑ → r ↑ → I ↓, therefore crowding-out of private investment does occur. Graphically: Goods Market Money Market 45° line C+I0+G1 C+I1+G1 AE r MS C+I0+G0 r1 MD’ r0 MD Y0 Y2 Y1 Y M0 M Name: First Prelim ECON 102 – Professor Steven Kyle February 28, 2008 Section Number: Planned Investment Schedule r r1 r0 I I1 I0 2. Read the following excerpt from an article which appeared in the Financial Times on February 20, 2008: Jump in prices raises worry of US stagflation “Prices in the US rose at an unexpectedly rapid rate last month, figures showed on Tuesday, raising fears that the world's biggest economy was going through at least a temporary bout of stagflation. The jump in inflation at a time of very weak growth highlights the dilemma facing central bankers and the gamble the Federal Reserve has taken in cutting interest rates aggressively to combat the risk of recession. Economists said stubbornly high inflation would not stop the Fed from cutting interest rates next month, but could affect how far the US central bank would go, and how long it would be prepared to keep rates low.” 2.1 Define stagflation. (1 point) Stagflation occurs when the overall price level rises rapidly during period of recession or high and persistent unemployment. 2.2 Define the discount rate. (1 point) The discount rate is the interest rate that banks pay to the Federal Reserve to borrow from it. 2.3 Suppose the Federal Reserve cuts the discount rate from 6% to 5%. Other things equal, how would we expect commercial banks to respond to this action? (1 point) We would expect banks to increase their borrowing from the Federal Reserve. 2.4 Suppose commercial banks borrow $50 million from the Federal Reserve, and the required reserve ratio is 20%. By how much will the money supply increase due to the increase in excess reserves if we ignore the banks’ interest payments to the Federal Reserve? (2 points) A required reserve ratio of 20% implies a money multiplier of 5. Banks can loan the entire $50 million (since the additional reserves do not come from deposits) and will create an additional $50 million*5 = $250 million. Therefore, the money supply increases by $250 million.