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Econ 302 Spring 2007 Midterm 3 Name____________________________ SID # ___________________________ Part I: Answer the following questions in the space provided, or on the back of the page(s) if necessary. Cd = 40 + (0.5)·[Yc –T] –100·r Tc = 20 Id = 40 – 400·r G = 20 Xd = 0.2·(P#/P)·Y#/enom IMPd = 0.2·Yc·(P/P#)·enom MS = 100 L(Y, r) = 25 + 0.5·Yc – 500·r enom = 0.5 + 8·r – 8·r# In the equations above, P#, Y#, and r# represent the foreign price level, income, and real interest rate, respectively. Assume initially that P# =1, Y# = 100, and r# = .04, and that P = 2, and Yc = 100 1. Below is a graph of the MS-MD diagram, at current prices and incomes. For Yc taking on the values of 80 and 120, sketch out the effects in the MS-MD diagram, and use the information to plot out the country's LM curve. MS/P real interest rate .09 .05 .01 L(Y=100, r) 30 50 70 M/P page 1 2. Below are the desired national savings – desired investment lines, assuming that Yc = 100. Plot the difference between Snd and Id and use the information to plot the desired foreign lending line. Snd = 100r real interest rate .10 .06 .02 Id = 40 – 400r 2 32 40 S, I 8 3. Assuming that Yc = 100, sketch out the desired NX curve, assuming that the country is using a flexible exchange rate system. 4. Using this information, sketch out the open economy IS curve, and find the point on the AD curve corresponding to a price level of 2. 5. Suppose the economy is at full-employment, but the government wants to bring the current account balance closer to zero (keeping output at approximately full-employment.) What should it do? page 2 Part II: the exam. Instructions: Select the best answer for each question, and record it on 1. Country A and Country B trade extensively with each other, and B fixes the exchange rate between its currency and the currency of Country A. When Country A uses expansionary monetary policy, A’s domestic interest rate falls. Because of the fixed exchange rate, this is most likely to cause Country B to: a. b. c. d. e. use contractionary monetary policy, shifting its LM and AD curves to the left. use contractionary fiscal policy, shifting IS and AD curves to the left. use expansionary fiscal policy, shifting LM and AD to the right. use expansionary monetary policy, shifting LM and AD to the right. use expansionary monetary policy, shifting IS and AD to the right. 2. A firm with a downward-sloping demand curve for its product will choose not to change its price following a shift in the demand curve for its product when: a. b. c. d. e. the firm is a perfect competitor. the firm’s marginal revenue is above its marginal cost. the firm’s gain in profit from re-setting its price is less than the menu cost. the firm’s average cost per unit of output is equal to the price. the firm’s marginal cost is greater than its marginal revenue. 3. With flexible exchange rates, the open economy IS curve is ______ than the closed-economy IS curve (all else equal), because as domestic real interest rates rise, the exchange rate ______ causes net exports to __________. a. b. c. d. e. flatter appreciation flatter depreciation steeper depreciation steeper appreciation none of the above. rise fall rise fall 4. Expansionary fiscal policy would cause the desired foreign lending line to shift to the _____ . This would also cause a ______ in the open economy IS curve. a. b. c. d. e. right left right left left movement along movement along shift to the right shift to the left shift to the right page 3 5. In an open economy, the product market is in equilibrium when: a. b. c. d. e. desired foreign lending equals desired investment. desired national savings equals desired net exports. the current account balance equals zero. the current account balance plus the capital account balance equals zero. none of the above. 6. A small country with a ______ exchange rate will find that expansionary _____ policy is more effective in stimulating aggregate demand than expansionary ________ policy. a. b. c. d. e. fixed fiscal fixed monetary flexible fiscal flexible trade none of the above. monetary fiscal trade monetary 7. Appreciation of the domestic currency makes exports ______ expensive for foreign buyers and imports _______ expensive for domestic buyers, thus ______ total demand faced by the country’s domestic producers. a. b. c. d. e. more less increasing more less decreasing less more increasing less more decreasing none of the above. 8. The costs to society of a small increase in unemployment are _______ the costs of a small increase in inflation. An activist Keynesian central banker would therefore be likely to use the Phillips Curve trade-off to choose: a. b. c. d. e. greater than greater than smaller than smaller than equal to to reduce the current account deficit to lower unemployment below the natural rate to depreciate the currency to stimulate exports to raise interest rates to reduce inflation stable prices and the natural rate of unemployement page 4 9. Critics of activist management of the economy claim that if people have rational expectations about the level of inflation, the result of the government’s attempts to choose an attractive trade-off along the Phillips Curve will be: a. b. c. d. e. higher inflation and lower unemployment. higher inflation and no effect on unemployment. higher current account deficits and lower unemployment. lower inflation and higher unemployment. higher interest rates and lower unemployment. 10. In an open economy, the product market equilibrium with a current account balance equal to zero is attained automatically by: a. exchange rate appreciation or depreciation sufficient to bring desired net exports equal to zero. b. domestic real interest rate changes will reverse the capital flow that finances the current account deficit, forcing the deficit back to zero. c. changes in domestic output will induce changes in imports sufficient to bring desired net exports equal to zero. d. changes in the domestic price level will make the country’s export products either more or less attractive in foreign markets, and set desired net exports equal to zero. e. nothing makes the current account balance automatically zero. 11. Suppose a (Keynesian) country with a flexible exchange rate system has a high current account deficit. The type of policies that would tend to reduce the current account deficit would be (ignore effects on domestic output): (i) (ii) (iii) (iv) expansionary fiscal policy expansionary monetary policy contractionary fiscal policy contractionary monetary policy a. b. c. d. e. only (i) is true. only (iii) is true. both (ii) and (iii) are true. both (iii) and (iv) are true. both (i) and (ii) are true. page 5 12. An open economy with flexible exchange rate and excess supply of goods requires a ______ fall in real interest rates to achieve a product market equilibrium (compared to a closed economy) because the fall in domestic interest rates also causes the domestic currency to _______ , which would stimulate net exports. a. b. c. d. e. larger appreciate larger depreciate smaller appreciate smaller depreciate none of the above labor productivity w0 wage The graph above applies to the next two questions. 13. In the graph above, a firm will pay a wage of w0 because: a. b. c. d. e. wage w0 gives the firm the highest attainable level of productivity. the firm will find no workers available at lower wages. the quantity of labor supplied will equal the quantity of labor demanded at w0. the firm has social objectives besides trying to minimize the cost of production. the wage w0 minimizes the cost of production for the firm. 14. Suppose it becomes more difficult for employers to monitor or observe directly the effort or productivity of employees. This would be shown in the diagram above as a shift to the _______ of the effort-wage line. The result would be__________ . a. b. c. d. e. left higher wages but less unemployment in equilibrium right lower wages and less unemployment in equilibrium right higher wages and more unemployment in equilibrium left higher wages and more unemployment in equilibrium none of the above. page 6 15 Country A and Country B trade extensively with each other and maintain flexible exchange rates. When Country A uses expansionary fiscal policy, Country A’s domestic real interest rate rises. The rise in A’s interest rate also causes in Country B: a. b. c. d. e. a shift to the right of NXd, IS, and AD due to the depreciation of B’s currency. a shift to the left of NXd, IS, and AD due to the rise in B’s domestic interest rate. a shift to the right of the FLd, which will cause the IS and AD to shift to the left. a shift to the left of the LM and AD curves. a shift to the left of FLd, and a shift to the right of IS and AD. 16. Country A and Country B trade extensively with each other and maintain flexible exchange rates. When Country A uses expansionary monetary policy, Country A’s domestic real interest rate falls. The fall in A’s interest rate also causes in Country B: a. b. c. d. e. a shift to the right of NXd, IS, and AD due to the appreciation of B’s currency. a shift to the left of NXd, IS, and AD due to the appreciation in B’s currency. a shift to the left of the FLd, which will cause the IS and AD to shift to the right. a shift to the left of the LM and AD curves. a shift to the left of FLd, and a shift to the right of IS and AD. 17. According to the Friedman-Phelps (expectations augmented) version of the Phillips curve, when there is an increase in the amount of inflation expected by workers, there is a: a. b. c. d. e. shift to the right of the labor supply curve. shift to the left of the Phillips curve. shift to the left of the SRAS. shift to the right of the AD curve. none of the above. 18. If a central bank is maintaining a fixed exchange rate and finds itself spending international reserves to uphold the value of its currency, then the need to maintain the fixed exchange rate requires: a. making fiscal policy more expansionary so that desired foreign lending increases. b. making fiscal policy less expansionary in order to raise interest rates. c. the central bank to raise interest rates and make monetary policy less expansionary. d. the central bank to lower interest rates and make monetary policy more expansionary. e. making monetary policy more expansionary so that extra money can be used to buy back international reserves. page 7 19. A country with a fixed exchange rate has a ________ desired net exports curve than if it had a flexible exchange rate. Therefore the _______ curve is _________ than it would be with a flexible exchange rate. a. b. c. d. e. steeper IS steeper LM flatter LM steeper IS none of the above. flatter flatter steeper steeper 20. Country A and Country B trade extensively with each other, and B fixes the exchange rate between its currency and the currency of Country A. When Country A uses expansionary fiscal policy, A’s domestic interest rate rises. Because of the fixed exchange rate, this is most likely to cause Country B to: a. b. c. d. e. use contractionary monetary policy, shifting its LM and AD curves to the left. use contractionary fiscal policy, shifting IS and AD curves to the left. use expansionary fiscal policy, shifting LM and AD to the right. use expansionary monetary policy, shifting LM and AD to the right. use expansionary monetary policy, shifting IS and AD to the right. Extra Credit (1 point) Why do cyclones of the southern hemisphere spin in the opposite direction of cyclones (hurricanes) of the northern hemisphere? page 8