Download Economics 259 Final Exam – Spring 2014 Name: Before beginning

Economics 259
Final Exam – Spring 2014
Name: ________________________________
Before beginning the exam, please verify that you have 8 pages with 25 questions in your
exam booklet. The exam is worth 100 points. Good luck.
Multiple Choice (each 3 points)
Identify the letter of the choice that best completes the statement or answers the question.
1. In 2013, the GDP of the United States totaled about:
a. $16 trillion
b. $16 billion.
c. $140 billion.
d. $14 trillion.
e. $1.6 billion
2. Inflation targeting is a monetary policy rule that requires the central bank to adjust _____ in
order to attain the desired inflation rate.
a. a price index
b. the velocity of money
c. nominal GDP
d. the money supply
e. its inside lag
3. According to the IS-LM model, if Congress raises taxes but the Fed wants to hold income
constant, then the Fed must ______ the money supply.
a. decrease
b. increase
c. first increase and then decrease
d. first decrease and then increase
e. not change
4. When bond traders for the Federal Reserve seek to increase interest rates, they ______ bonds,
which shifts the ______ curve to the left.
a. buy; both IS and LM
b. buy; IS
c. buy; LM
d. sell; IS
e. sell; LM
5. In the long run, the level of national income in an economy is determined by its:
a. government budget surplus or deficit.
b. rate of economic and accounting profit.
c. real and nominal interest rate.
d. factors of production and production function.
e. money supply growth rate
6. Which of the following is one of the fiscal programs the US Treasury adopted during the
Great Recession?
a. quantitative easing
b. TARP
c. SIV
d. “originate and distribute”
e. New Deal
7. The total income of everyone in the economy adjusted for the level of prices is called:
a. a recession.
b. an inflation.
c. real GDP.
d. a business fluctuation.
e. nominal GDP
8. If the government wants to raise investment but keep output constant, it should:
a. adopt a loose monetary policy but keep fiscal policy unchanged.
b. adopt a loose monetary policy and a loose fiscal policy.
c. adopt a loose monetary policy and a tight fiscal policy.
d. keep monetary policy unchanged but adopt a tight fiscal policy.
e. adopt a tight monetary policy and a loose fiscal policy.
9. If a liquidity trap does exist, then ______ policy will not be effective in increasing income
when interest rates reach very ______ levels.
a. monetary; low
b. monetary; high
c. fiscal; high
d. fiscal; low
e. fiscal; negative
10. According to the IS-LM model, when the government increases taxes and government
purchases by equal amounts:
a. income, the interest rate, consumption, and investment are unchanged.
b. income and the interest rate rise, whereas consumption and investment fall.
c. income and the interest rate fall, whereas consumption and interest rise.
d. income, the interest rate, consumption, and investment all rise.
e. Income, consumption, and the interest rate rise, whereas investment falls.
11. The lag between the time that economic stimulus is needed and the time that a tax cut is
passed by Congress is an example of a:
a. monetary inside lag.
b. monetary outside lag.
c. fiscal outside lag.
d. fiscal inside lag.
e. monetary dependency lag.
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12. Policies that stimulate or depress the economy without any deliberate policy change are
called:
a. leading indicators.
b. time-inconsistent policies.
c. rational expectations policies.
d. TARPs.
e. automatic stabilizers.
13. Which of the Wall Street investment banks was the first one to run into troubles during the
Great Recession?
a. Lehman Brothers
b. Merrill Lynch
c. Bear Sterns
d. Goldman Sachs
e. JPMorgan Chase
14. Which of the facts about the business cycles is incorrect?
a. fluctuations in investment tend to be larger than fluctuations in GDP
b. fluctuations in investment tend to be smaller than fluctuations in GDP
c. fluctuations in consumption tend to be larger than fluctuations in GDP
d. fluctuations in consumption tend to be the same as fluctuations in investment
e. changes in the rate of unemployment typically lag changes in GDP growth
15. Most economists believe that prices are:
a. not dependent on time.
b. flexible in the short run but many are sticky in the long run.
c. sticky in both the short and long runs.
d. flexible in both the short and long runs.
e. flexible in the long run but many are sticky in the short run.
16. The currencies of countries with high inflation rates relative to the United States have tended
to ______, and the currencies of countries with low inflation rates relative to the United
States have tended to ______ against the US dollar.
a. appreciate; appreciate
b. appreciate; depreciate
c. depreciate; depreciate
d. depreciate; appreciate
e. either depreciate or appreciate; either depreciate or appreciate
17. In the Solow growth model, the steady-state level of output per worker would be higher if the
______ increased or the ______ decreased.
a. saving rate; depreciation rate
b. population growth rate; depreciation rate
c. depreciation rate; population growth rate
d. population growth rate; saving rate
e. depreciation rate; saving rate
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18. Which of the following is the best example of frictional unemployment?
a. Helen is seeking a job as a nurse, but the high union wages in the industry have
limited the number of jobs available.
b. Celeste is willing to work at the going wage, but there are no jobs available.
c. Bobby searches for a new job after voluntarily moving to Chicago
d. Oliver is willing to work for less than the minimum wage, but employers cannot hire
her.
e. Martha is a student and wants to find a part-time seasonal job in the mall helping with
packaging holiday gifts.
Short Answers
19. Money and Inflation (10 points) In New Zealand, the velocity of money is constant. Real
GDP grows at 2% per year, the money supply grows at 5% per year and the real interest rate
in New Zealand is 2.5%.
a. What are the values of the inflation rate (π) and the nominal interest rate (i) in New
Zealand?
b. Suppose that the central bank of New Zealand wants to reduce inflation. Which
instruments (three of them) of the monetary policy can the central bank of New
Zealand use? Briefly explain how the central bank would use each instrument.
c. What is a benefit of a moderate rate of inflation? Describe how it works.
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20. IS-LM and AD-AS in the Long run (10 points) A major shopping store-chain Target
experiences a security breach where a significant amount of consumers’ credit card data is
stolen. As a response, people limit their use of credit cards and resort to using cash.
Assume that the United States is a closed economy that was at the full employment output
before this shock and that initially the US does not respond with either active fiscal or
monetary policy.
a. Use the IS-LM model below to illustrate graphically how income and interest rates
change in response to the increased demand for cash in the short-run. Does income
increase/decrease/remain unchanged? How about interest rates? (Label the initial
equilibrium A and the new short-run equilibrium B)
b. What happens to aggregate demand as a consequence of the increase in demand for
cach? Show on the AD-AS graph below how the economy moves from the initial
equilibrium to the short-run equilibrium after the increase. (Label the initial
equilibrium A and the new short-run equilibrium B)
c. Use the AD-AS graph from part (b) to show the how the economy moves from the
short-run equilibrium to the long-run equilibrium when prices are allowed to adjust.
What happens to income and prices? How about interest rates? (Label the short-run
equilibrium B and the new long-run equilibrium C)
r
LM1
r1
IS1
Y
P
Y
LRAS
P1
SRAS1
AD1
5
Y
Y
d. Show graphically how income, interest rates, and prices evolve over time as a
consequence of the increase in demand for cash.
Y
r
t0
time
P
t0
time
t0
e. If, however, policymakers do not want to wait for the economy to adjust after the
increase in demand for cash and want to bring income and interest rates back to the
original levels right away, what type of a policy could they employ?
21. The Great Recession of 2008-10 (10 points) Use the IS-LM diagram to explain the events
associated with the current recession in the United States. Make sure you include both the
initial shock(s) and policy response(s). Explain the events in words.
r
LM1
IS1
Y
6
time
Choose one of the following two questions (8 points):
22. FDI Flows (8 points) Solow model predicts that capital will flow from countries that are
abundant with capital to countries where capital is scarce. The United States is a country with
one of the highest stocks of capital per worker. Given what the Solow model predicts, how
can you explain the graph from the Economist?
23. Policy (8 points) In the early 1980s, the U.S. government cut taxes and ran a budget deficit
while the Fed pursued a tight monetary policy. What effect should this policy mix have on
interest rate and investment?
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Choose one of the following two questions (8 points):
24. Policy and Crowding Out (8 points) Explain why government budget deficits crowd out
private investment spending in a closed economy, but crowd out net exports in a small open
economy. Assume prices are flexible and that factors of production are fully employed in
both economies. Assume there is perfect capital mobility for the small open economy.
25. Solow Model (8 points) Suppose that Egypt (E) and Latvia (L) are exactly alike in every
respect except that the rate of population growth is higher in Egypt than in Latvia. Which
country will have the higher level of output per worker in the steady state? Illustrate
graphically.
Extra Credit
If you have not missed more than one class since the last exam, you can answer the question
below and earn 3 points extra credit.
26. All of the following are considered major functions of money except as a:
a. unit of account.
b. medium of exchange.
c. store of value.
d. way to display wealth.
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Key
1. A
2. D
3. B
4. E
5. D
6. B
7. C
8. C
9. A
10. B
11. D
12. E
13. C
14. A
15. E
16. D
17. A
18. C
19.a. The setup gives us the following information: %ΔY = 2%, %ΔM = 5%, and r = 2:5%. To
find the rate of inflation, we use the quantity equation in percent change:
%ΔM + %ΔV = %ΔP + %ΔY
5% + 0% = %ΔP + 2%
%ΔP = 3%
where %ΔM is the growth of money supply, %ΔP is the rise in prices (inflation), and %ΔY is the
change in real output. So, inflation is π = 3%. Now we have to use the Fisher equation to find the
nominal rate of interest:
i=r+π
i = 2.5% + 3%
i = 5.5%
19.b. To reduce inflation, the central bank can use three tools.
i. Open market operations are sales and purchases of government bonds by the Federal Reserve.
In terms of the fractional-reserve banking model, when the Fed sells bonds to the public, it
collects dollars from the public and this decreases money supply M.
ii. Reserve requirements are Fed's regulations that require banks to hold a minimum portion of
all deposits. When the Fed increases the reserve requirement, banks can make less loans and
“create” less money from each deposit. This decreases the money supply (M).
iii. The discount rate in the interest rate that the Fed charges on loans it makes to banks. When
banks borrow from the Fed, their reserves increase, allowing them to make more loans and
\create" more money. When the discount rate is increased, this reduces banks' willingness to
borrow from the Fed and this decreases the money supply.
19.c. A benefit of a moderate rate of inflation comes from the fact that nominal wages never
decrease. It is hard to decrease nominal wages in the real world and it is even expected to keep
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increasing nominal wages with time as workers remain on the same job. Persistent increase in
nominal wages would lead to an increase in real wages if there was no inflation and this would
cause unemployment (recall structural unemployment due to wages higher than the equilibrium
value). Thus, to neutralize the effect of increased nominal wages, moderate inflation is necessary
and welcome from the macroeconomic standpoint.
20.a. An increase in demand for cash is a negative shock to the LM curve, which shifts the LM
curve to the left (1). Consequently, income decreases from Y1 to Y2 and the interest rates increase
from r1 to r2. The country finds itself at point B in the short-run.
r
LM2
3
B
r2
LM1
r1
r3
A C
1
IS1
Y2
P
Y =Y1
Y
LRAS
C
A
P1
P2
3
SRAS1
B
SRAS2
2
AD2
Y2
Y = Y1
AD1
Y
20.b. As the LM curve shifts to the right, the AD curve shifts to the left as well (2). Since the
price is fixed in the short-run, the price level remains at P1. The economy moves from point A to
point B.
20.c. The economy finds itself in the short-run equilibrium below the natural rate of output: Y2 <
Y1 (point B). Because aggregate demand is lower than the long-run aggregate supply at the price
level P1, there will be a downward pressure on the price level. Over time, prices can change and
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they adjust. Therefore, prices fall over time and eventually reach level P2. At that point, the
economy is in the long-run equilibrium (point C). Income increases from Y2 to Y1 and prices
decrease from P1 to P2. Since prices decrease, the supply of real money balances increases (↑
M/P) and the LM curve shifts right (3). Consequently, interest rates decrease and come back to
their original level.
20.d.The increase in demand for cash does not have real effects in the long-run. Both output and
real interest rates return to the their original levels in the long run. Prices remain permanently
lower as a consequence of the increase in demand for cash.
Y
r
t0
time
P
t0
time
t0
20.e. Policymakers would employ an expansionary monetary policy, such as an increase in the
money supply. This would push the LM curve back and bring both income and interest rates to
the same level as before the increase in demand for cash.
21. Shocks:
Demand: fall in housing prices, decline in the stock market, fall in both consumer and producer
confidence  shift of the IS curve to the left.
Supply: an increase in the price of oil and a decrease in bank lending  shift of the LM curve to
the left (decreased lending leads to lower M and higher oil prices lead to higher P, which means
that M/P decreases).
The effect of both of these shocks was a decrease in total income (output).
Monetary response was a large increase in the money supply and a cut in the discount rate, which
both pushed the LM curve back right. Moreover, the Fed started a process of quantitative easing
where it was buying securities from and lending directly to investment banks and firms.
Fiscal response included tax cuts both for households and businesses and a dramatic increase in
government spending, both of which pushed the IS curve to the right.
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time
LM2
r
LM1
IS2
IS1
Y
22. Solow model predicts that capital will flow from countries that are abundant with capital to
countries where capital is scarce. As the United States is a country with one of the highest stocks
of capital per worker, capital should flow from the US to countries that are capital scarce.
However, for this to be true, MPK needs to be larger in countries that are scarce with capital. If
the US and some other capital scarce country were exactly the same except that capital is more
abundant in the US, MPK in the US would be lower and capital would flow to a the country that
is capital scarce. But, we know that if Y = AKαL 1-α = Akα then MPK = Ak α-1 = A/k 1-α. Hence,
if k is higher, MPK is lower, everything else constant. But, if A is lower in a capital scarce
country, it could be that MPK is still higher in a capital abundant country. Some estimates
suggest that A in capital scarce countries is indeed much lower than in the US, which would
mean that although the US is a capital abundant country, its MPK is still high, which means that
capital will flow to the US. The question is why A would be lower in capital scarce countries and
many answers point to the composition of institutions in capital scarce (poorer) countries is very
weak so that the return on capital (MPK) turns out to be very low.
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23. The policy mix in the early 1980s consisted of an expansionary fiscal policy and a
contractionary monetary policy. Such a policy mix shifts the IS curve to the right and the LM
curve to the left, hence the real interest rate rises and investment falls.
24. In a closed economy, an increase in the budget deficit reduces national saving and increases
the interest rate, which crowds out (decreases) private investment. In a small open economy, the
budget deficit reduces national saving, thus decreasing net capital outflow (S - I), which
increases the real exchange rate. The increase in the real exchange rate crowds out (decreases)
net exports.
25.
26. D
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