PRINCIPLES OF ECONOMICS II MIDTERM EXAM II

June 8, 2005
INSTRUCTIONS: 1. THINK BEFORE YOU WRITE. 2. DO NOT WORRY TOO MUCH ABOUT YOUR ENGLISH. THIS IS AN ECONOMICS EXAM. FEEL FREE TO USE ARROWS, UP/DOWN, GRAPHS, & EQUATIONS.

Professor Kyung-Hwan Kim

Part I. State whether each statement is true (T) or false (F), and briefly explain your answer. (2-3 lines will do.)

1. Holding national saving constant, an increase in net capital outflow increases a country s accumulation of domestic capital. F: S = I + NCO; Since S is constant, an increase in NCO implies a decrease in I. 2. Expansionary monetary policy stimulates the demand for net exports. T: As money supply increase, interest rate falls and NCO increases. Since NX=NCO, NX must increase as well. 3. Suppose that the velocity and output are constant and that the quantity theory and the Fisher effect both hold. Then the inflation and nominal interest rates will all rise by 5 % while real interest rate will remain the same when the money supply growth rate increases from 5 % to 10 %. T: Quantity theory implies that inflation rate by 5 % and the Fisher effect implies that the nominal rate will rise by 5% with no change in real interest rate. 4. When the government is required to balance the budget, the existence of automatic stabilizers (e.g. income tax) will make a recession more serious.

T: Tax revenue will decrease during a recession. If the government is required to balance the budget, it should cut its spending. This will aggravate the recession. 5. Expansionary fiscal policy will have a larger impact on aggregate demand if investment is less sensitive to the interest rate. T: Crowding-out effect will be smaller if investment is less sensitive to the interest rate. 6. If the unemployment rate falls, we can be certain that more workers have jobs. F: It could mean a decrease in labor force.

Part II. Answer each question. Use graphs or equation if necessary.

1. Suppose that reserve requirements for checking deposits are 10 %, and that banks hold no excess reserves and households deposit all the loan proceeds at banks. (1) Some one takes $100 she had kept under her pillow and deposits it in a bank. By how much will money supply increase? Show your calculation. M = Cash + Deposit: Cash decreases by $100 while deposit increases by $1,000 (=100/0.1), implying that money supply increases by $900. (2) Suppose now that banks hold 10 % excess reserves and that households deposit only 50% of loan proceeds in banks. By how much will money supply increase? Show your calculation.

Now the increase in total deposit is D= 100 + 40 + 16 + = 100/(1-0.4) = 1000/6 40=((0.5)x((0.8)x100) The change in cash is

C = -100 + 40 + 16 + = -100 + 40(1/1-0.4) = -100 + 400/6 = 200/6 Thus change in money supply is 1.000/6 + 200/6 = 200

2. Suppose that the economy is in long-run equilibrium. Answer the following questions using a short-run and long-run Phillips curve diagram. (1) Suppose that business pessimism reduces aggregate demand. Show the impact of this shock on your diagram. Can expansionary monetary policy return the economy to its original inflation rate and unemployment rate?

Figure 1 shows the economy in long-run equilibrium at point a, which is on both the long-run and short-run Phillips curves.

A wave of business pessimism reduces aggregate demand, moving the economy

to

point b in the figure. The unemployment rate rises and the inflation rate declines. If the Fed undertakes expansionary monetary policy, it can increase aggregate demand, offsetting the pessimism and returning the economy to point a, with the initial inflation rate and unemployment rate.

Figure 1

(2) Now suppose that the economy is back in long-run equilibrium, and the price of imported oil rises. Show the impact of this shock on your diagram. Can expansionary monetary policy return the economy to its original inflation rate and unemployment rate?
Figure 2 shows the effects on the economy if the price of imported oil rises. The higher price of imported oil shifts the short-run Phillips curve up from SRPC1 to SRPC2. The economy moves from point a to point c, with a higher inflation rate and higher unemployment rate. Now if the Fed engages in expansionary monetary policy, it can return the economy to its original unemployment rate at point d, but the inflation rate will be higher. If the Fed engages in contractionary monetary policy, it can return the economy to its original inflation rate at point e, but the unemployment rate will be higher.

Figure 2

(3) Explain why the situation in (2) differs from (1).

This situation in part (2) differs from that in part (1) because in part (1) the economy stayed on the same short-run Phillips curve, but in part (2) the economy moved to a higher short-run Phillips curve, which gives policymakers a less favorable tradeoff between inflation and unemployment.

3. Suppose that the central bank believed that the natural rate of unemployment was 3% while the actual rate is 3.5 %. If the central bank based its policy decisions on its belief, what would happen to the unemployment rate and inflation rate over time? Illustrate your answer using a short-run and long-run Phillips curve diagram.

If the Fed acts on its belief that the natural rate of unemployment is 6 percent, when the natural rate is in fact 5.5 percent, the result will be a spiraling down of the inflation rate, as shown in the figure below. run that Starting from a point on the long-

Phillips curve, with an unemployment rate of 5.5 percent, the Fed will think the economy is overheating, since the unemployment rate is below what it So the central bank will contract the money supply,

thinks is the natural rate. moving will

the economy along the short-run Phillips curve SRPC1. The inflation rate

decline and the unemployment rate will rise to 6 percent. As the inflation

rate declines, people's expectations of inflation will eventually decline, and the short-run Phillips curve will shift to the left to SRPC2. and the inflation rate will spiral downwards. This process will continue,

Part III. Answer the following multiple-choice questions. You do not need to explain your answers.

1. Which of the following statements is true? a. In the long run, output is determined by the amount of capital, labor, and technology; the interest rate adjusts to balance the supply and demand for money; and the price level adjusts to balance the supply and demand for loanable funds. *b. In the long run, output is determined by the amount of capital, labor, and technology; the interest rate adjusts to balance the supply and demand for loanable funds; and the price level adjusts to balance the supply and demand for money. c. In the long run, output is determined by the amount of capital, labor, and technology; the interest rate adjusts to balance the supply and demand for loanable funds; and the price level is stuck. d. In the long run, output responds to the aggregate demand for goods and services; the interest rate adjusts to balance the supply and demand for loanable funds; and the price level adjusts to balance the supply and demand for money. 2. In the long run, fiscal policy primarily affects a. aggregate demand. In the short run, it affects primarily aggregate supply. b. aggregate supply. In the short run, it affects primarily saving, investment, and growth *c. saving, investment, and growth. In the short run, it affects primarily aggregate demand. d. saving, investment, and growth. In the short run, it affects primarily aggregate supply. 3. Which of the following illustrates how the investment accelerator works? a. An increase in government expenditures increases the interest rate so that the Sleepwell Hotel chain decides to build fewer new hotels. *b. An increase in government expenditures increases aggregate spending so that the Sleepwell Hotel chain finds it profitable to build more new hotels. c. An increase in government expenditures increases the interest rate so that the demand for stocks and bonds issued by the Sleepwell Hotel chain rises.

d. An increase in government expenditures decreases the interest rate so that the Sleepwell Hotel chain decides to build more new hotels 4. The economy is in long-run equilibrium. Pessimism on the part of investors then shifts the aggregate demand curve $50 billion to the left. The government wants to increase spending in order to avoid a recession. If the crowding-out effect is always half as strong as the multiplier effect, and if the MPC equals 0.9, by how much does government purchases have to rise? *a. $10 billion b. $50 billion c. $90 billion d. $100 billion 5. If the minimum wage decreased, than at any given rate of inflation a. both output and employment would be higher. b. neither output nor employment would be higher. *c. output would be higher and unemployment would be lower. d. unemployment would be higher and output would be lower 6. In recent years, inflation expectations have fallen. This has shifted the short-run Phillips curve *a. left, meaning that at any given inflation rate unemployment will be lower in the short run than before. b. right, meaning that at any given inflation rate unemployment will be lower in the short run than before. c. right, meaning that at any given inflation rate unemployment will be higher in the short run than before. d. left, meaning that at any given inflation rate unemployment will be higher in the short run than before. 7. If a central bank reduced inflation by 3 percentage points and that made output fall by 3 percentage points for 3 years and the unemployment rate rises from 3 percent to 9 percent for three years, the sacrifice ratio is a. 1. b. 2. *c. 3. d. None of the above is correct

8.

Ultimately, the short-run reduction in unemployment associated with an increase in inflation is due to a. the shape of the long-run aggregate supply curve. *b. unanticipated inflation, not inflation per se. c. rational expectations. d. anticipated changes in the price level.

9.

A law that requires the money supply to grow by a fixed percentage each year would eliminate a. the time inconsistency problem, but not political business cycles. b. the political business cycle, but not the time inconsistency problem. *c. both the time inconsistency problem and political business cycles. d. neither the time inconsistency problem nor political business cycles.

10. The five debates over macroeconomic policy exist mostly because a. economists disagree over basic issues such as the importance of saving for economic growth. *b. there are tradeoffs and people disagree about the best way to deal with them. c. politicians offer misleading information. d. people fail to clearly see the benefits or the costs of most changes. 11. According to the classical dichotomy, when the money supply doubles, which of the following also double? *a. the price level and nominal wages b. the price level, but not the nominal wage c. the nominal wage, but not the price level d. neither the nominal wage nor the price level

12.

Which of the following causes of unemployment is not associated with a wage rate above the equilibrium level? a. unions b. efficiency wages *c. job search d. minimum-wage laws

GOOD LUCK!