Economics 102
Intermediate Macroeconomics Professor Gelman
Quiz 2
There are 100 possible points on the exam. You have 75 minutes.
Name: __________________________ Date: _____________
Formulas:
National Income Accounts Identity: Y=C+I+G+NX
Multiple Choice section (5 questions, 5 points each = 25 total points)
To get full credit, you need to show your work when applicable. Please circle or write down the correct answer.
1. Short-run fluctuations in output and employment are called: A) sectoral shifts.
B) the classical dichotomy.
C) business cycles.
D) productivity slowdowns.
Answer: C).
Use the following to answer question 2: Exhibit: Risk Premium
2. A small open economy with a floating exchange rate is initially in equilibrium at A with IS1*, LM1*. If the establishment of a new government in the country decreases the risk
premium, then LM1* will shift to _____ and IS1* will shift to _____.
A) B) C) D)
Answer: C).
LM*;IS* 22
LM*;IS* 23
LM*;IS* 32
LM*;IS* 33
3. During the financial crisis of 2008–2009, many financial institutions stopped making loans even to creditworthy customers, which could be represented in the IS–LM model as a(n):
A) expansionary shift in the IS curve.
B) contractionary shift in the IS curve. C) expansionary shift in the LM curve. D) contractionary shift in the LM curve.
Answer B).
4. If a country chooses to have free capital flows and to maintain a fixed exchange rate, then it must:
A) live with exchange-rate volatility.
B) restrict its citizens from participating in world financial markets.
C) give up the use of monetary policy for purposes of domestic stabilization. D) give up the use of fiscal policy for purposes of domestic stabilization.
Answer: C).
5. In the sticky-price model, the relationship between output and the price level depends on:
A) the proportion of firms with flexible prices.
B) the target real wage rate.
C) the target nominal wage rate.
D) the implicit agreements between workers and firms.
Answer: A).
Short answer section (3 questions, 25 points each = 75 total points):
You must show all your work to get full credit.
1. The Queen of England heard you took Econ 102 and wants you to help with a recession in the UK (characterized by a temporary drop in output).
a. Assuming that the UK is a small-open economy with a floating exchange rate, use the Mundell-Fleming model to suggest what monetary or fiscal policy the UK should undertake in order to increase output. Justify your answer with a graph that is properly labeled and shows the state of the economy before and after your policy recommendations. (7 pts)
I recommend we enact monetary policy by shifting the LM curve out to the right.
b. Explain the causal chain of events that starts from the policy you recommend in (a) and ends with an increase in output (For example, “an increase in money demand will lead to withdrawals from bank accounts… [more details] … which then leads to an increase in output”). (3 pts)
The mechanism is that an increase in money supply will lower temporary lower the domestic interest rate. This temporary drop in the domestic interest rate will result in capital outflows as investors seek the higher world return r*. Eventually this will capital outflow will return the domestic r back to r*. In the process, the domestic exchange rate will fall because investors bought more foreign currency in order to invest in the world interest rate. The decrease in the interest rate leads to an increase in net exports which leads to an increase in Y.
c. Thanks to your help, the UK was able to increase their output and recover from the recession in part (a). Shortly after this recovery, the UK decided to fix their currency against the dollar. Years later, the economy falls into a recession again and the Queen calls on you for policy advice in order to increase output. What policy would you now recommend? Justify your answer with a graph that is properly labeled and shows the state of the economy before and after your policy recommendations. (7 pts)
I recommend we enact fiscal policy by shifting the IS curve out to the right.
d. Once again, explain the causal chain of events that results from your policy recommendation in (c). (3 pts)
Since exchange rates are fixed, increasing the LM* curve will just be reversed as the central bank upholds the currency peg.
Let’s assume we increase G to shift the IS curve out. The mechanism is that an initial increase in G will cause the domestic interest rate to rise, which leads to capital inflows and an appreciation of the domestic currency. This will cause NX to fall which will initially offset the increase in G. Since the central bank is committed to keeping the exchange rate fixed, the LM curve will shift out and lower the exchange rate back to its original level. Now Y will increase because there is no fall in NX to offset the increase in G.
e. Are your policy recommendations for part (a) and part (c) different? Explain the intuition behind your answer. (5 pts)
Yes, they are different because we assumed a floating interest rate in part (a) and a fixed interest rate in part (b). We know that with a floating interest rate, fiscal policy is ineffective and with a fixed interest rate, monetary policy is ineffective
2. In recent years the inflation rate has crept up to 10 percent and the Fed wants to bring it down to 6 percent. A recent CMC grad who works in the Macro department has found
that the Philips curve is And Okun’s law is
= − 0.5( − 5)
− −1 =1−3( − ) −1
Assume that the economy begins at its natural rate of unemployment with a stable inflation rate of 10 percent.
a. What is the natural rate of unemployment for this economy? (2 pts)
The natural rate of unemployment is where inflation equals expected inflation.
In this case it is 5.
b. How much does inflation fall if the unemployment rate goes up by 1 percent point? (2 pts)
The -0.5 in front of ( − ) indicates that inflation falls by 1⁄2 percent when the
unemployment rate goes up by 1 percentage point.
c. Assuming that individuals have adaptive expectations where = , what
must the Fed do in order to bring the inflation rate down to 6 percent? Draw a graph that shows the transition from an inflation rate of 10 percent to an inflation rate of 6 percent. (6 pts)
We know from the previous part that raising the unemployment rate by 1 percentage point lowers inflation by 1⁄2 percent. Therefore in order to lower inflation 4 percent from 10 to 6, we must raise unemployment by 8 percentage points. We can do this all at once or we can spread it out over time.
d. How many percentage points of output are lost during the transition? What is the economy’s sacrifice ratio? (3 pts)
According to Okun’s law, 3 percent of output are lost for each percentage point increase in unemployment. Therefore, 24 percent of output will be lost. The
sacrifice ratio is = .
−
e. Now imagine individuals have rational expectations. What must the Fed do in order to bring the inflation rate down to 6 percent? Draw a graph that shows the transition from an inflation rate of 10 percent to an inflation rate of 6 percent.
(6 pts)
If individuals have rational expectations, the Fed just needs to convince people that it’s committed to reducing inflation. If the Fed is credible, expected inflation will drop to 6 percent without any change in unemployment.
f. How many percentage points of output are lost during the transition? What is the economy’s sacrifice ratio? (3 pts)
Since there is no unemployment, there is no output lost during the transition. The sacrifice ratio is 0 because we didn’t have to give up any output.
g. Do you get a different answer in part (d) and part (f)? Explain why or why not.
(3 pts)
Yes, the answers are different in part (d) and part (f). In part (d) the adaptive expectations assumptions meant that we have to move along the Philips curve and gradually lower inflation before we can change expectations. On the other hand, in part (f), rational expectations meant that we can lower the expected level of inflation instantaneously without having to move along the Philips curve. This meant that we shifted the curve immediately to the desired level of inflation.
3. An economy is initially described by the following equations
= 200 + 0.75( − ) = 600−10
Planned expenditures is = 1000 + 0.75 − 10
‘ ‘ = −160
= 500
= 400 = 4,000 =2
a. Assuming that = 20, plot the two lines that determine the Keynesian cross equilibrium. Label all axes, curves, and state what the equilibrium condition is. Calculate the equilibrium. (4 pts)
The equilibrium condition is that actual expenditures equals planned expenditures or = = 800 + 0.75
= 800 + 0.75 0.25 = 800
= 3200
b. Suppose the government wants to improve the highway infrastructure and increases spending by 200. Show graphically how this alters the curves you graphed in part (a). What is the new equilibrium? What is the government purchases multiplier? (4 pts)
In the Keynesian cross model, the government expenditures multiplier is = = = .
− − . .
Therefore, the change in total expenditures is = × = × =
. So total expenditures will rise 800 to 4000.
You can also just re-do part (a) using = .
c. Now let’s relax the assumption that = 20 by allowing it to move freely and reset back to its original value of 500. Derive and graph the IS curve and the LM curve on a separate plot. Calculate the equilibrium. (4 pts)
: = ( − )+ ( )+ =200+0.75( −400)+ 600−10 +500 = 1000 + 0.75 − 10
d.
Once again, the government increases spending by 200. Show graphically how this alters the curves you graphed in part (c). What is the new equilibrium? What is the government purchases multiplier? (4 pts)
0.25 = 1000 − 10 = −
: = ( , )
2000 = − 160 = +
4000 − 40 = 2000 + 160
So equilibrium output is 3600 and the equilibrium interest is 10.
The equilibrium is where IS=LM
2000 = 200 =
=
: = 4800 − 40 : = 2000 + 160 2800 = 200
= 14
= 4240
Δ = 640
Δ = 640 = 3.2 Δ 200
e.
The new equilibrium output is 4240 and the new equilibrium interest rate is 14. The government purchases multiplier is 3.2.
Are your answers for the government purchases multiplier different in part (b) and (d). Explain the intuition behind this result. (2 pts)
Part (b) uses the Keynesian cross framework where r is fixed while part (d) uses the IS-LM framework where r is flexible. Therefore, an increase in government purchases will raise the interest rate because it will increase the demand for cash. This increase in the interest rate will somewhat offset the increase in Y due to the increase in G.
f. Derive the Aggregate Demand curve by assuming P is no longer fixed and G is once again back to its original value. (2 pts)
The idea is that the AD curve represents all of the equilibrium values of Y and P for a given r. Mathematically, we can solve this by solving for r and equating the two terms. The resulting equation gives us the relationship between Y and P regardless of what r is.
: = −
: = −
= −
Multiply the IS equation by 4 to make it the same left hand side
Now set them equal
− = −
= +
= +