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ECON 304 - PRACTICE PROBLEM FOR FINAL EXAM - WE WILL DO THIS IN ITS ENTIRETY ON
FRIDAY, DECEMBER 2.
SAMPLE 'BIG PROBLEM' - SIMILAR TO WHAT YOU WILL SEE ON FINAL EXAM:
IS :
MP:
Y = 16 - r
r = r(bar) + λ π
SRAS: π= π -1 + 1 ( Y - Y P) + p
Potential GDP: YP = 17, π
-1
= 1.5%, λ = .5, r(bar) = 0, p =0
a) (10 points) Derive an expression for the IS curve....Y in terms of r
Y = [ 3 + 2.2 -.2 + 3.0 + 1.5 - 1.5] x (1 / 1 - .5) - (.1 + .2 + .2)/(1 - .5) r
Y = 16 - r
b) (5 points) Derive an expression for Aggregate Demand
AD: Y = 16 - [ 0 + .5 π)........AD: Y= 16 - .5π
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c) (5 points) Find the value of GDP
Y= 16 - .5 [1.5 + 1( Y - 17) + 0]
Y(1 + .5) = 16 - .75 + 8.5
Y = 23.75 / (1 + .5)......Y = 15.833
d) What is the GDP gap?
(15.833 - 17) / 17 = - 6.86%
e) Find the values of π and r
π = 1.5% + 1(15.833 - 17) + 0] ......= .333% = π
r = 0 + .5(.333) .......r = .167%
DRAW THREE DIAGRAMS - AN MP CURVE DIAGRAM TOP LEFT, AN 'IS' CURVE DIAGRAM
ON TOP RIGHT, AND A AS/AD DIAGRAM BELOW THE 'IS' CURVE. PLEASE BE SURE TO
COMPLETELY LABEL DIAGRAMS - LABEL THESE INITIAL CONDITIONS AS POINT A ON ALL
THREE DIAGRAMS.
f) If the Fed wanted to eliminate the GDP gap, what would they need to do exactly? Assume inflation
expectations stay at 1.5%. Show this as points B on all three diagrams.
need to get inflation to = 1.5% (SRAS) and r = -1% (IS)
-1 = r bar + .5 (1.5) ..... r bar = -1.75%....so the Fed would need to lower rbar from 0 to -1.75%
g) What is the new expression for the AD curve
AD: Y = 16 - [ -1.75 + .5 π)........AD: Y= 17.75 - .5π
h) Suppose that the Fed did not do anything and were counting on expansionary fiscal policy - suppose the
Government increases spending (infrastructure) by $ 1 Trillion. What is the new expression for the IS curve
now?
Y = [ 3 + 2.2 -.2 + 4.0 + 1.5 - 1.5] x (1 / 1 - .5) - (.1 + .2 + .2)/(1 - .5) r
Y = 18 - r
i) Resolve for the new Y, π and r. Again, assume that inflation expectations are unchanged. Label as points
C on your three diagrams.
Y= 18 - .5 [1.5 + 1( Y - 17) + 0]
Y(1 + .5) = 18 - .75 + 8.5
Y = 25.75 / (1 + .5)......Y = 17.166
π = 1.5% + 1(17.166 - 17) + 0 ......= 1.66% = π
r = 0 + .5(1.66) .......r = .83%
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j) Let's go back to the original conditions at points A. Assume that the Fed does not change policy and that
there is no change in fiscal policy either. According to the self correcting mechanism, how will the
economy return to full employment - explain how this self correcting would work and explain, don't show,
how each diagram would be effected. Are you confident that this self correcting mechanism would work,
why or why not?
Draw points A and B and C in S = I closed economy diagram (ignore net exports) - be sure to label relevant
shift variables.
Now draw points A, B , and C in an MPK / uc diagram
Recall Homer (the borrower) and Dagwood (the saver) - which do each consumer prefer? A move from A
to B or a move from B to C? Explain.
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