Name:

Section Number:

Second Prelim ECON 102 25 April 2006

This exam has 20 multiple choice questions, 4 short answer questions and 2 essay
questions
Part 1: Multiple Choice Questions
One point per question.
Write the answers on the separate sheet provided.
1. An increase in oil prices, such as the oil shocks in the 70s, lead to _______ thereby
causing ________
a) a movement along the AS curve; cost-push inflation
b) a leftward shift in the AS curve; demand-pull inflation
c) a rightward shift in the AS curve; cost-push inflation
d) a leftward shift in the AS curve; cost-push inflation
Answer: d
2. In the 1930s, when Keynes was alive, a expansionary fiscal policy, taking everything
else constant, would have led (in the short-run) to________
a) a relative large increase in Y, a smaller increase in P
b) a relative large increase in P, a smaller increase in Y
c) both Y and P increasing with an percentage
d) only Y increased
Answer: a
3. If the aggregate supply curve is vertical in the long-run, _______ has (have) an effect
on the aggregate output in the long run
a) sometimes monetary and/or fiscal policy (i.e. it depends)
b) monetary policy does but fiscal policy does not
c) monetary policy does not but fiscal policy does
d) neither monetary policy nor fiscal policy
Answer: d
4. Which of the following statements is correct:
a) the money supply does not play a role in sustained inflation
b) the Fed is accommodating when they decrease the money supply after the
government has increased G
c) inflation initiated by an increase in aggregate demand is referred to as demandpull inflation
d) in order to avoid crowding-out after the government has increased G, the Fed
often decreases the money supply in order to lower the interest rates
Answer: c
5. Employment tends to _______ when aggregate output ______
a) rise, falls
b) rise; rises
c) falls; rises

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Second Prelim ECON 102 25 April 2006

d) not change; falls

Answer: b
6. It was an empirical fact that in the 50s and 60s the inflation rate ________ when the
unemployment rate _________. Today the relationship between those to variable can
be described as ________
a) falls; rises; strongly negative correlated
b) rises; rises; strongly negatively correlated
c) falls; rises; unstable
d) rises; rises; unstable
Answer: c
7. The ___________ lag for fiscal policy is generally ______ than it is for monetary
policy.
a) recognition; shorter
b) recognition; longer
c) implementation; shorter
d) implementation; longer
Answer: d
8. During periods of negative demand shocks, deficit target reductions such as those
mandated in the Gramm-Rudman-Hollings Act would tend to:
a) stimulate the economy and increase employment.
b) result in additional recessionary declines in employment and income.
c) stimulate defense spending.
d) have an automatic stabilizing impact upon the economy.
Answer: b
9. In which cases would the deficit of a government be considered problematic by the
majority of the economists?
a) when the deficit was the result of mainly capital spending (eg infrastructure)
b) when the deficit was brought about by a stabilization program during a probably
temporary recession
c) when the deficit adds to an existing budget surplus
d) when the private and public lenders (i.e. IOU holders) loose faith in the capacity
of the government to pay back its debts
Answer: d
10. A bond is
a) a promise to pay back a loan over an unspecified period
b) allows the firm to access funds with mo liabilities
c) the only way a firm can raise funds
d) a document that promises to pay back a loan under specified terms over a
specified period of time
Answer: d

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Second Prelim ECON 102 25 April 2006

11. The market price of bonds can fluctuate depending on

a) how many bonds were sold
b) who bought the bonds
c) the amount of the coupon
d) the interest rate
Answer: d
12. Which statement (s) is (are) TRUE about stocks?
I.
when a firm issues new shares of stock, it adds to its debt
II.
a stockholder is promised a fixed dividend payment
III.
when the price of stocks increase, other things equal, households tend to increase
their consumption
IV.
the larger the expected future dividends, the smaller the current stock price, other
things being equal
V.
when the price of a stock is strictly larger than its discounted value of expected
future dividends, one can say that there is a bubble in the stock market
a I, III, VI, V
b II, III, V
c III, V
d III only
Answer: c
13. Keynes suggested that _______ income households consume a ________ proportion
of their income than ________ income households
a) low; smaller; high
b) low; larger; high
c) high; larger; low
d) low; smaller; middle
Answer: b
14. At any given level of the interest rate, expectations are likely to be ________
optimistic and planned investment is likely to be _______ when _____ is growing
rapidly than when it is growing slowly or falling.
a) less; higher; output
b) more; higher; output
c) less; lower; unplanned investment
d) more; lower; unplanned investment
Answer: c
15. The quantity theory of money allows monetarists to obtain a number of economic
predictions by assuming a constant
a) velocity of money
b) nominal output
c) overall price level
d) stock of money

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Second Prelim ECON 102 25 April 2006

Answer: a
16. The Lucas-supply function assumes that
a) people and firms are generalists in production and specialists in consumption
b) price surprises are irrelevant
c) most companies tend to produce a large scope of products using only few inputs
d) people and firms are specialists in production but generalists in consumption
Answer: d
17. According to the supply-side model, a reduction in the tax rate
a) could reduce the size of any budget deficit
b) would have no effect on output
c) would have no effect on consumption
d) none of the above
Answer: a
18. Keynes, the father of macro-economic policy stressed that:
a) as the economy was operating at full capacity (in his time), expansionary fiscal
policy would only have an inflatory effect
b) the enormous importance of regulating the money supply in the economy at a rate
which equals the rate of real growth
c) the importance of expansionary fiscal and monetary policies during the 1930s
aiming at shifting the AD curve out
d) as firms use rational expectation models to determine their investment level, the
government will in essence not be able to influence the economy
Answer: c
19. Fill in the blanks: As long as the increase in _________prices lag behind the increase
in _________ prices the aggregate supply function does not become entirely vertical.
Answer: input; output
20. Write down the name of the social phenomenon that can be explained by the sticky
wage theory, but not by the classical view of the labor market: ________________
Answer: involuntary unemployment

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Second Prelim ECON 102 25 April 2006

Part 2: Short Answer Questions (Total of 10 points)

Instructions: answer briefly (up to 5 lines) and make a drawing if requested. Write the
answers in your first exam booklet.
1. Derive the aggregate demand curve using a two panel graph illustrating the goods
market, money market and investment and focusing on the consumption linkage
between money market and goods market. (3 points)
Estimated difficulty: 2
Answer: We are looking for a relation between the price level P and the aggregate
outcome Y. When P increases, the demand for money shifts out (Panel 1). The interest
rate rises. This decreases consumption (p. 320, 142, 244). This shifts down the AE curve
(panel 2) and decreases Y. Repeating this exercise an infinite amount of time will yield
the downward sloping aggregate demand curve. This implies that the AD curve
represents an equilibrium in both goods and money market.
Ms
AE

M
Panel 1

Y
Panel 2

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Second Prelim ECON 102 25 April 2006

P
Aggregate
demand

2. Explain briefly the trade-off the Federal Reserve is facing when contemplating a
reaction to a sudden shift of the aggregate supply curve to the left due to a natural
disaster. (2 points)
Estimated difficulty 1
Answer: When the AS curve shifts to the left, Y will decrease (more unemployment)
and P will increase at the same time. If the Fed adopts a contractionary policy, AD
will shift inwards and inflation will decrease, but unemployment will increase, if on
the other hand the Fed decides to adopt an expansionary policy, AD will shift
outward and inflation will increase but unemployment will decrease. The Philips
curve illustrates this trade-off.
3. Distinguish between the short run and the long run aggregate supply curves. In
particular, explain the shape of each curve. (2 points)
Estimated difficulty 1
Answer: The SRAS curve is relatively flat (but positively sloping) at low Ys and
becomes steep at high Ys. The idea is that at low Ys if the AD were to shift outward,
firms still have lost of excess capacity, so they will produce more while P will only
increase a little. At high Ys firms are operating close to full capacity, so if AD would
shift outward, Y would only increase a little while P would increase a lot.
The basic assumption behind the SRAS curve is that output prices increase before
input price increase. In the long run however input prices will also increase, and
therefore the output level of a profit maximizing firm will not change. Hence the
LRAS curve should be vertical at Yo. This Yo corresponds with the potential GDP of a
country.

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Second Prelim ECON 102 25 April 2006

SRAS

LRAS

Y
o

4. Unemployment can not be explained using the classical view, list three theories
which do given an explanation for unemployment and briefly explain them (in
maximum 2 lines you can use a graph - you do not need to criticize the theories)
(3 points)
Solution:
Sticky wages Keynes
When the economy is in a business cycle and the demand for labor decreases, the
equilibrium wages do not decrease due to wage contracts, labor unions etc
wage
D

unemployment

labor

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Second Prelim ECON 102 25 April 2006

Efficiency wage theory

This theory says that employers pay more than the equilibrium wage because they
believe it will increase the productivity and goodwill of their workers.
wage
weff

labor
unemployment

Imperfect information
The firms do not know the exact position of the demand and supply curve in the labor
market and therefore incorrectly implement a wage which is too high.
Minimum wage laws
Illustrate with a graph.
wage

wmin

labor
unemployment

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Second Prelim ECON 102 25 April 2006

Part 3: Essay Questions (Total of 10 points)

Instructions: answer all these questions in your second booklet.
1. Read the following article from Yahoonews published Monday April 3, 2006
DATA VIEW: Indonesia March Inflation Eases; Policy On Hold
JAKARTA (Dow Jones)--Indonesia's consumer price index rose 15.74% on-year last
month amid declining food prices during the seasonal harvest, the official Central
Statistics Agency said Monday. On month, the inflation rate was 0.03%. In February, onyear inflation was 17.92% while the on-month reading was 0.58%. Core inflation - which
excludes prices that are controlled by the government, such as energy and food - was
9.64% on year. March inflation was below the average forecast of 16.18% by five
regional analysts polled by Dow Jones Newswires. They expected on-month inflation at
0.31%.
March's on-month inflation was the lowest such increase in two years, Central Statistics
Agency Chairman Choiril Maksum told reporters at a press briefing. The March inflation
result "was caused by the decreasing price of rice, as the harvest season has begun,"
Maksum said. "If we can maintain the (same) level of inflation as in March, on-year
inflation by the end of the year should be good." Maksum didn't provide any specific
forecasts for on-year inflation. He urged the government to ensure that food supply and
distribution systems are functioning well to reduce potential new sources of inflation. The
March CPI data appeared to reflect official projections that the stubbornly persistent
inflationary trend will ease toward the single-digit level on year by the end of 2006. Bank
Indonesia has forecast on-year inflation of around 8.0% by end-December.
The government decided last month to shelve a politically unpopular plan to also raise
electricity tariffs this year, in order to avoid a renewed surge in inflationary pressure.
The March CPI data will likely fuel expectations that Bank Indonesia will soon start
planning cuts in the one-month benchmark rate if easing inflationary pressure rolls into
April.
But Bank Indonesia Senior Deputy Governor Miranda Gultom said last month that the
bank's tightening posture remains intact due to concerns about potential inflation-spiking
"external influences," including a possible increase in the price of crude oil on the global
market.

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1.1. Show the impact of consumer expectations on the Indonesian Phillips Curve. (2
points)
Answer: As this essay confused many people, we have decided to allow the following two
answers:
Consumers expect inflation to be lower (from paragraph 1 and 2) and hence the SRPC
shifts down (to the left).

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Inflati

Consumers expect inflation to be higher (from paragraph 4 and 5) and hence the SRPC
shifts up (to the right).

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Second Prelim ECON 102 25 April 2006

1.2. Using an AD-AS diagram illustrate what would happen in Indonesia if the
government raises electricity tariffs. (2 points)
Answer: Government deficit will fall, consumer spending and investment spending will
fall and hence AD will shift down (P and Y will decrease)
OR/AND as production costs increase, AS will shift to the left. P will increase and Y will
decrease
You need to illustrate at least one of the two previous movements in a graph.

S
S

2. Read the following articles from St. Louis Business Journal - February 22, 2006 and
BBC NEWS - 7 February 2006
Possible budget surplus could restore Medicaid cuts
Missouri Budget Project Chief Economist Tom Kruckemeyer said in a statement that the
state is on track to end the year with about $245 million more in revenue than originally
anticipated.
"This unexpected windfall should be used to restore health care to the 90,000 low-income
Missourians who were cut from the Medicaid health insurance program in 2005,"
Kruckemeyer said. He added that the state's net general revenue growth rate of 5.7
percent for the first seven months of fiscal year 2006 is relatively healthy and keeps the
state on course for a revenue surplus at year-end June 30.
The Missouri Budget Project is a statewide, nonprofit, nonpartisan organization that
informs the public about the state's budgetary and tax policy options and their impact on
low-income Missourians.
Bush seeks defense spending rise

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President George W Bush has proposed a $2,770bn annual budget, with more money to
fight terrorism, but less for many social areas. Mr. Bush is seeking a 6.9% hike in US
military spending to $439.3bn, and a 3.3% rise in homeland security funds.
To keep plans to cut the fiscal deficit on track, big cuts have been proposed in healthcare
spending. While Democrats attacked the proposed cuts, Mr. Bush's Republican allies said
they were a sign of fiscal prudence. Democratic Senate Minority Leader Harry Reid said
Mr Bush's budget was "filled with pages of giveaways to special interests and cuts to
those who can least afford it". But Republican Senate Budget Committee Chairman Judd
Gregg said action was needed to cut the budget deficit. "We have to face up to the fiscal
reality that this baby boom generation is going to retire soon and we need to do
something about it," she said.
Mr. Bush wants to cut spending on Medicare - the healthcare program for elderly and
disabled people - by $35.9bn over the next five years. Savings are also sought in
vocational education, justice and transportation. The reductions are needed as Mr. Bush
aims to halve the US budget deficit by 2009.
Try to shed some light on the debates in the previous articles:
2.1. Give one pro and one contra argument of allocating the foreseen budget surplus in
Missouri State to Medicaid this month versus debt reduction (2 points)
Answer: Pro arguments: building human capital (may be not so much of an argument if it
mainly concerns old people), immediate impact on welfare citizens, Contra arguments
(for debt reduction): interest rate of debts accumulate and will need to be paid back at a
certain point,.
2.2. Give one pro and one contra argument of allocating budget revenues to military
expenses (2 points)
Answer: Pro: defense of the country might be a necessity in times of war, Contra: it is a
consumption spending and does not create and asset in the governments balance
2.3. Give a few conditions under which economists decide that a government debt has
become alarmingly high and unsustainable? (2 points)
When creditors become worried and do not believe the government can pay back any
more
When the debt as a percentage of GDP becomes very high

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