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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 0.9Y - - 50 (0.1)Y 2500 (0.055) Y 200 (0.035) Y Y 2755 0.9Y 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 3 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 3001500i ; 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 0.75Y - 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 4 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 0.75Y - 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!!!) 5 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. 6 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 110i ; 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 0.5Y - 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%) 7 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. 9