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Izmir University of Economics
Department of Economics
I. Hakan Yetkiner
http://www.hakanyetkiner.com
ECON 202
MACROECONOMIC THEORY
Dr. Yetkiner
18 April 2011
Key to Midterm Exam
1. (15 Points) Calculate the GDP of KingLand, a fictitious economy whose numbers
are listed below. Do so using all three methods (value added approach, income
approach, and expenditure approach). Please do indicate your calculations clearly.
KingLand, year 2010
Farmer King, (private firm)
Corn Sold to Govt
Corn Sold to Singapore
Corn Sold to KingFoodCo, Inc
Payment to workers
Tax on profit
$30
$25
$20
$40
$15
Corn Inventory
Beginning of Year
End of Year
$0
$5
Govt
Taxes
Payment to workers
Purchase of Corn
Purchase of Corn Flakes
Unemployment benefits Paid
$50
$15
$30
$20
$15
KingFoodCo, Inc
Sold Corn Flakes to Consumers
Sold Corn Flakes to Govt
Bought corn from Farmer King
Bought salt from Egypt
Payment to workers
Tax on Profit
Corn Flakes Inventory
Beginning of Year
End of Year
Households
Taxes on wage income
Unemployment benefits
Corn Flakes purchased
VA App:
Farmer Jones
(30+25+20+5) +
FoodCo
(100+20-[20-5]-10
Exp App:
C
I
100 + 10 +
(X-M)
(25-10)
Inc. App.:
Wage Income
(40+20+15) +
G
65 +
Profits
(25+60) +
$100
$20
$20
$10
$20
$15
$10
$15
$10
$15
$100
Govt.
15
= 190
= 190
TA
(15+15)
= 190
The trick here is Corn Inventory. You must think it as sales of Farmer King to
itself. Hence, value added of Farmer King is 30+25+20+5. On the other hand, its
profit is 30+25+20-40=35.
Another point that you must have paid attention is productive government services
of15. It is VA by government!!!!
Grading: 5 points each
1
Izmir University of Economics
Department of Economics
I. Hakan Yetkiner
http://www.hakanyetkiner.com
2. (10 Points) Suppose that the following equations describe the a simple Keynesian
macroeconomy.
C  55  0.9(Y - T) ; T  50  (0.1)Y ;
I  2500  0.055  Y ; G  200  (0.035)Y
Find the multiplier and equilibrium GDP values of this economy.
One may find the multiplier from income-expenditure equality.
Y  55  0.9Y - - 50  (0.1)Y 2500  (0.055)  Y  200  (0.035)  Y 
Y  2755  0.9Y  50 - (0.1)Y (0.09)  Y 
Y  2800  (0.9)Y 
Y  (0.9)Y  2800 
(0.10)Y  2800 
Y
2800
 28000
(0.1)
Multiplier is   10 and equilibrium income is Y*  28000 .
2
Izmir University of Economics
Department of Economics
I. Hakan Yetkiner
http://www.hakanyetkiner.com
3. (15 Points) Turkish government has been experiencing fiscal deficit for years.
Suggest a policy mix in the IS-LM setup to achieve a decrease in fiscal deficit while
keeping interest rate i constant. Discuss in detail possible macroeconomic implications
of this policy mix on aggregate expenditure and its components? Do not forget to
support your answer by a figure.
The rise in T or the fall in G shifts IS left. (Y,i) decrease. An accompanying decrease in
M shifts LM down (left). Output decreases and interest rate stays constant. Aggregate
expenditure falls. Consumption and investment is expected to fall.
i
i
MS0/P0
LM0
MD0
IS0
IS1
Real Balances
Y
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Izmir University of Economics
Department of Economics
I. Hakan Yetkiner
http://www.hakanyetkiner.com
4. (20 Points) Consider the following IS-LM model:
C  400  0.75YD ; T  400  0.1 Y ; I  3001500i ; G  600 ; P  0.5
M d  3  Y  12000  i (real money demand); M s  3000 (nominal money supply). If
you solve this model, you find that IS equation is i 
i
1000 0.325

Y
1500 1500
and
3
6000
is LM equation. And equilibrium values are Y*  2500 and
Y
12000
12000
i*  0.125 (=12.5%).
(a) Suppose now that government spending decreased by 100 (from 600 to 500).
What is the government spending multiplier?
(b) Suppose that the Central Bank targets a fixed interest rate. How should CB adjust
the money supply (nominal) to keep the interest rate fixed in response to a
decrease in government spending by 100 in (a)? Calculate.
One may find IS equation from income-expenditure equality.
Y  400  0.75Y - 400 - 0.1Y 300 - 1500i  500 
Y  900  0.675Y -1500i 
0.325Y  900 - 1500i 
i
900 0.325

Y
1500 1500
This is IS equation
LM equation can be derived from the money market.
6000  3  Y 12000i 
12000i  3  Y  6000 
i
3
6000
This is LM equation
Y
12000
12000
Equilibrium income and interest rate can be found via LM and IS equations.
900 0.325
3
6000

Y
Y

1500 1500
12000
12000
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Izmir University of Economics
Department of Economics
I. Hakan Yetkiner
http://www.hakanyetkiner.com
900 6000
3
0.325


Y
Y
1500 12000 12000
1500
13200  5.6  Y 
Y*  2357.1
i*  0.089 (=8.9%)
Hence government spending multiplier is Y*  (2357.1  2500) /(100)  1.429
(b) Fixed interest rate:
From IS equation, given the interest rate.
Y  400  0.75Y - 400 - 0.1Y 300 - 1500i  500 
Y  900  0.675Y -1500i 
0.325Y  900 - 1500(0.125) 
Y *  2192.3
Using this info in LM equation for an unknown money supply:
M
 3  Y  12000i 
0.5
M
 3  (2192.3)  12000(0.125) 
0.5
M *  2538.4 (Nominal MS!!!)
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Izmir University of Economics
Department of Economics
I. Hakan Yetkiner
http://www.hakanyetkiner.com
5. (15 Points) Turkish economy is an oil-dependent one. Suppose that recently TPAO
(Turkish National Oil Co.) discovered rich oil resources in the Black Sea. The price of
oil is expected to decrease at least by half in a year. Explore the macroeconomic effects
of this discovery on Turkish economy, using the AD-AS setup. Do not forget to discuss
and show the effects of this change on the position of AD, AS, IS, and LM curves and
on output, the interest rate, and the price level in the short run and medium run. Assume
that the economy was at the natural level of output before the discovery.
LRAS Right, MRAS right, MS Right, LM right, MD Right; Potential Y increase, i
decreases, P decreases.
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Izmir University of Economics
Department of Economics
I. Hakan Yetkiner
http://www.hakanyetkiner.com
6. (15 Points) Consider the following AD-AS model:
C  1 0.5YD ; T  2 ; I  110i ; G  2 ; P  (1/ 5)  Y (medium run AS) and Y *  5
M d  300  1000  i (real money demand); M s  300 (nominal money supply)
(a) Derive the AD equation (5 Points).
(b) Find the medium run and long run equilibrium Y, P and i values. (5 Points)
(c) Illustrate medium and long run values in respective graphs. (5 Points)
(a) One may first find IS equation from income-expenditure equality.
Y  1  0.5Y - 2 1 - 10  i  2 
Y  3  0.5Y -10  i 
i
3 0.5

Y This is IS equation
10 10
LM equation (depends on P)
300
 300  1000  i 
P
1000  i  300 
i  0.3 
300

P
0.3
P
Hence, AD is:
3 0.5
0.3

Y  0.3 

10 10
P
P Y  6
(b) Medium run equilibrium values are.
P  (1 / 5)  Y  Y 2  30  Y*  5.47
P*  1.09
i *  0.0265 (=2.65%)
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Izmir University of Economics
Department of Economics
I. Hakan Yetkiner
http://www.hakanyetkiner.com
Long run equilibrium values are.
Y*  5  i 
i  0.3 
3 0.5

5  i*  0.05
10 10
0.3
 P*  1.2
P
8
Izmir University of Economics
Department of Economics
I. Hakan Yetkiner
http://www.hakanyetkiner.com
7. (10 Points) Suppose that the firm’s markup over costs is 5%, and the wage-setting
equation is W  P(1 - u  z) , where u is the unemployment rate and z is the catch-all
variable that stands for all other variables that may affect the wage setting equation.
(a) What is the real wage as determined by the price-setting equation?
(b) What is the natural rate of unemployment if z  0.02 ?
(c) Suppose that z increases to z  0.03 . How does the real wage and natural rate of
unemployment change? Support your answer by a figure.
a. W/P=1/(1+μ)=1/1.05=.95
b. From the wage setting relation, un=1-W/P+0.02=7%
c. W/P=does not change; un=1-.95+0.03=8%. The natural rate of unemployment
rises. The increase in the catchall variable is essentially a fall in labor supply
(actually a shift of the labor supply curve). Intuitively, less competition in the
labor market leads to lower desired supply of output by workers and therefore to
a fall in labor supply. The fall in labor supply increases unemployment but does
not change the real wage.
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