MACROECONOMIC THEORY I

ECO2142 B
Fall 2016

prof. Francesca Rondina

MIDTERM 2
November 14th, 2016

VERSION 1 - ANSWERS

Name

Student ID

This exam is closed book/closed notes.

The use of NONPROGRAMMABLE calculators is permitted. Cellular phones and all other elec-
tronic devices must be turned off and put away during the exam.

The exam consists of a total of 33 questions each worth 3 points. Question n.34 asks you to fill in
the version of your exam; this question will give you 1 additional point to reach a total of 100. In
addition, there is one bonus question worth 5 points.

You have 1 hour and 15 minutes to complete the 34 + 1 questions.

Good luck!

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1. Assume that the world works according to the Classical model. If all foreign countries maintain
their policies unchanged, which of the following domestic policies would allow a small open country
to reduce its trade deficit?

(a) A policy that removes tariffs on a number of imported goods.

(b) An increase in taxes T .
(c) An increase in government spending G.
(d) An investment subsidy aimed at encouraging business investment.

2. Consider a small open economy that operates according to the Classical model. If output Y is equal
to $500 and domestic spending (C + I + G) is equal to $550, this country is currently experiencing

(a) a trade surplus of $500.

(b) a trade surplus of $50.
(c) a trade deficit of $50.
(d) balanced trade.

3. The nominal exchange rate between the Canadian dollar and the British pound sterling is 0.6 GBP
/ 1 CAD, and the nominal exchange rate between the British pound sterling at the US dollar is
0.81 GBP / 1 USD. The nominal exchange rate between the Canadian dollar and the US dollar is

(a) 1 CAD / 0.6 USD

(b) 0.8 CAD / 1 USD
(c) 1.41 CAD / 1 USD
(d) 1.35 CAD / 1 USD

4. The nominal exchange rate between the Canadian dollar and the Euro is 0.68 EUR / 1 CAD, the
price level in Europe is pEU R = 100, and the price level in Canada is pCAD = 175. The real exchange
rate between Canada and Europe implies that:

(a) 1.19 European goods can be exchanged for 1 Canadian good.

(b) 0.84 European goods can be exchanged for 1 Canadian good.
(c) 1 European good can be exchanged for 1 Canadian good.
(d) 1.36 European goods can be exchanged for 1 Canadian good.

5. Assume that the world operates according to the Classical model. In a small open economy, the real
interest rate at which National saving equals the quantity of investment demanded domestically is
4%. If the world real interest rate is 3%, which of the following statements is true?

(a) This country is experiencing a trade deficit and a negative net capital outflow.
(b) This country is experiencing a trade surplus and a positive net capital outflow.
(c) This country is experiencing a trade surplus and a negative net capital outflow.
(d) This country is experiencing a balanced trade and zero net capital outflows.

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 6. Assume that the world operates according to the Classical model. A small open economy is currently
experiencing a net capital outflow of $250. If Private saving is equal to $220, Public saving is equal
to $80, and the investment demand function is I = 100 20r, the world real interest rate is

(a) 2.5% (r = 2.5)

(b) 5% (r = 5)
(c) 10% (r = 10)
(d) 15% (r = 15)

7. Consider two small open countries, Country Alfa and Country Beta. You know that the inflation
rate in Country Alfa is higher than the inflation rate in County Beta, while the real exchange rate
between these two countries is constant. Given this information, you would expect the nominal
exchange rate of Country Alfa with respect to Country Beta to

(a) depreciate over time.

(b) appreciate over time.
(c) remain unchanged over time.
(d) appreciate at first, and then remain unchanged.

8. Assume that the M P C is 0.8. In the Keynesian cross diagram, which of the following policies would
allow the government to reduce output by $400?

(a) A contemporaneous increase in taxes by $400 and in government spending by $400.

(b) A contemporaneous decrease in taxes by $100 and in government spending by $100.
(c) A increase in taxes by $100.
(d) An increase in government spending by $100.

9. In the Keynesian cross diagram, you know that after an increase in taxes by $20, output decreased
by $60. From this information, you can deduce that the MPC is equal to:

(a) 0.33
(b) 0.75
(c) 0.6
(d) 3

10. In the Keynesian cross diagram, C = 0.8(Y T ), I = $180, G = $50, T = $100. If firms are
currently experiencing an unplanned decrease in inventory by $10, current output must be equal
to:

(a) $600
(b) $700
(c) $750
(d) $900

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11. Assume that the world operates according to the Classical model. Consider the country of Openland,
which is currently experiencing a trade deficit. Assume that several foreign countries decide to
implement quotas on a number of goods that they import from Openland, while no trade policy
is implemented in Openland and everything else remains unchanged. According to the Classical
model, in Openland:

(a) the equilibrium real exchange rate will decrease and the country will still be experiencing a
trade deficit.
(b) the equilibrium real exchange rate will decrease and the country will now be operating at a
balanced trade.
(c) the equilibrium real exchange rate will increase and the country will still be experiencing a
trade deficit.
(d) the equilibrium real exchange rate will increase and the country will now be operating at a
trade surplus.

12. Assume that the world operates according to the Keynesian model. In Country A the MPC is 0.5
while in Country B the MPC is 0.9. Assume that the fiscal authorities of Country A decide to
increase public spending G by $50. What is the change in public spending that the fiscal authorities
of Country B would need to implement to obtain the same change in Y ?

(a) A decrease in G by $50.

(b) An increase in G by $10.
(c) An increase in G by $50.
(d) An increase in G by $100.

13. In the Keynesian model, the consumption function is C = 0.8(Y T ), planned investment I is
equal to $150, taxes T are $15, and government spending G is $30. If the full employment level of
output is $750, which of the following statements is true?

(a) The short run equilibrium level of output is below the full employment level, and the economy
is in a recession.
(b) The short run equilibrium level of output is equal to the full employment level of output.
(c) The short run equilibrium level of output is above the full employment level, and the economy
is in a recession.
(d) The short run equilibrium level of output is above the full employment level, and the economy
is in an expansion.

14. Consider an economy operating according to the Keynesian model, with consumption function
C = 0.75(Y T ). The Government of this country decides to implement a fiscal policy consisting
of a contemporaneous increase in spending by $50 and increase in taxes by $20. As a consequence
of this policy:

(a) the equilibrium level of output will decrease by $60 and Public Saving will decrease by $50.
(b) the equilibrium level of output will increase by $30 and Public Saving will increase by $20.
(c) the equilibrium level of output will increase by $200 and Public Saving will decrease by $30.
(d) the equilibrium level of output will increase by $140 and Public Saving will decrease by $30.

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15. Consider the relationship between the Keynesian cross diagram and the IS curve. Assume that
Y1 and Y2 are two equilibrium points in the market for goods and services, corresponding to the
two different quantities of planned investment I1 = I (r1 ) and I2 = I (r2 ), with r1 < r2 . Which of
the following statements is true?

(a) The points {r1 , Y1 } and {r2 , Y2 } will be on the same IS curve, with Y2 < Y1 .
(b) The points {r1 , Y1 } and {r2 , Y2 } will be on the same IS curve, with Y2 > Y1 .
(c) The points {r1 , Y1 } and {r2 , Y2 } will be on two different IS curves, and the IS curve passing
through the {r2 , Y2 } point will be to the right of the IS curve passing through the {r1 , Y1 }
point.
(d) The points {r1 , Y1 } and {r2 , Y2 } will be on two different IS curves, and the IS curve passing
through the {r2 , Y2 } point will be to the left of the IS curve passing through the {r1 , Y1 } point.

16. In the IS LM model, which of the following policies would shift the LM curve to the right?

(a) An increase in the money supply.

(b) An increase in taxes.
(c) An increase in the MPC.
(d) A policy of incentives to investment in physical capital, which increases the demand for in-
vestment at each level of the real interest rate.

17. In the IS LM model, which of the following policies would shift the IS curve to the left?

(a) An increase in the money supply.

(b) A decrease in taxes.
(c) An increase in the MPC.
(d) A decrease in government spending.

18. Assume that the economy is operating at the equilibrium point in the ISLM model. If government
spending decreases while taxes and the money supply remain unchanged, at the new IS LM
equilibrium

(a) consumption and investment will be lower than in the original equilibrium.
(b) consumption will be higher and investment will be lower than in the original equilibrium.
(c) consumption will be lower and investment will be higher than in the original equilibrium.
(d) consumption and investment will be higher than in the original equilibrium.

19. Consider the AD AS model built from the IS LM . The economy is currently operating at the
long-run equilibrium point A, with price level PA . If a major technological improvement increases
the full employment level of output Y while everything else remains unchanged

(a) the economy will eventually move to another long-run equilibrium point B, with PB > PA .
(b) the economy will eventually move to another long-run equilibrium point B, with PB = PA .
(c) the economy will eventually move to another long-run equilibrium point B, with PB < PA .
(d) in the long-run the economy will remain at the equilibrium point A.

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20. Consider the AD AS model built from the IS LM , and assume that the economy is currently
operating at the short run equilibrium point B, with output level YB higher than the full employment
level of output Y . As the economy adjusts from the short run equilibrium point B to the new long
run equilibrium

(a) the price level will be increasing, the LM curve will be shifting to the left, and the real interest
rate will be increasing.
(b) the price level will be decreasing, the LM curve will be shifting to the left and the real interest
rate will remain constant.
(c) the price level will be increasing, the LM curve will be shifting to the right the real interest
rate will be decreasing.
(d) the price level will be increasing, the LM curve will be shifting to the left, and the real interest
rate will be decreasing.

21. Consider the AD AS model built from the IS LM , and assume that the economy is hit by a
negative supply shock that shifts the SRAS up. What policy should the central bank implement if
its main objective is to maintain the level of the real interest rate unchanged?

(a) The central bank should keep its policy unchanged, because an adverse supply shock will not
affect the level of the real interest rate.
(b) The central bank should decrease the Money Supply in order to shift the LM curve to the left.
(c) The central bank should increase the Money Supply in order to shift the LM curve to the
right.
(d) The central bank should increase the Money Supply in order to shift the IS curve to the left.

22. The AD AS model built from the IS LM predicts that, in the long run, an increase of the
money supply will result in:

(a) higher prices and lower output.

(b) higher prices and no change in output.
(c) higher prices and higher output.
(d) no change in prices and higher output.

23. In the AD AS model, assume that the economy is hit by a shock to the SRAS that decreases the
price level in the short run. If there is no change in either fiscal or monetary policy, this shock will

(a) decrease the price level in the long run.

(b) decrease output in the short run.
(c) decrease output in the long run.
(d) have no impact on the price level or output in the long run.

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24. Consider the AD AS model built from the IS LM . If there is no change in either monetary or
fiscal policy, an increase in the MPC (Marginal Propensity to Consume) will

(a) decrease investment both in the short-run and in the long-run.

(b) decrease the price level in the long run.
(c) increase output in the long-run.
(d) cause a shift of the LM to the right in the short-run.

Problem 1 - Use the following information to answer questions 25-29

Assume that the world works according to the Classical model. In a small open economy, output
is produced according to the production function Y = (20)K 0.25 L0.75 , consumption is equal to
C = 40 + 0.8(Y T ) and the investment function is I = 200 10r. In addition, you know that the
world real interest rate is 4% (r = 4), Private saving is $170, and Public saving is $10.

25. If imports M are equal to $30, then exports X are equal to:

(a) $0
(b) $10
(c) $50
(d) $160

26. Assume that the government of this Country decreases spending G, while government policies in
the rest of the world are left unchanged. As a consequence of this policy, this country will now be
experiencing

(a) a smaller trade deficit.

(b) balanced trade.
(c) a smaller trade surplus.
(d) a larger trade surplus.

27. Assume again that the government of this Country decreases spending G, while government policies
in the rest of the world are left unchanged. As a consequence of this policy:

(a) the real exchange rate of this country will increase, and domestic goods will become relatively
more expensive.
(b) the real exchange rate of this country will increase, and domestic goods will become relatively
cheaper.
(c) the real exchange rate of this country will decrease, and domestic goods will become relatively
more expensive.
(d) the real exchange rate of this country will decrease, and domestic goods will become relatively
cheaper.

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28. Consider now the original situation, in which Private saving is $170 and Public saving is $10.
Assume that most countries in the rest of the world implement expansionary fiscal policies, while
the government of this Country leaves its fiscal policy unchanged. As a consequence of the world
policies, this Country will now be experiencing

(a) a smaller trade deficit.

(b) a smaller trade surplus.
(c) a larger trade surplus.
(d) a trade deficit, balanced trade, or a trade surplus, depending on the sizes of the world fiscal
policies.

29. Consider again the original situation, in which Private saving is $170 and Public saving is $10.
Assume that this country decides to forbid international capital mobility and trade. In other
words, this country decides to become a closed economy. As a consequence of this decision

(a) the real interest rate in this country will decrease, and the quantity of investment demanded
will decrease.
(b) the real interest rate in this country will decrease, and the quantity of investment demanded
will increase.
(c) the real interest rate in this country will increase, and the quantity of investment demanded
will increase.
(d) the real interest rate in this country will increase, and the quantity of investment demanded
will decrease.

Problem 2 - Use the following information to answer questions 30-33

This morning, the price of a pair of Nike Lunarglide shoes was CAD 200 on Nike.com/ca (Canadian
website), USD 142.5 on Nike.com/us (U.S. website), and EUR 125 on Nike.com/fr (French website).
At the same time, the nominal exchange rates between these currencies were: 0.75 USD / 1 CAD
and 0.70 EUR / 1 CAD.

30. Convert the price of a pair of Nike Lunarglide shoes in Canada, the U.S. and France into the
same currency using the given nominal exchange rates. In which country is this pair of shoes the
cheapest?

(a) In France
(b) In the U.S.
(c) In Canada.
(d) In both the U.S. and Canada.

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31. Consider the information for Canada and the U.S. Given the price of a pair of Nike Lunarglide
shoes in the U.S. and the nominal exchange rate between the CAD and the USD, what price of the
pair of Nike Lunarglide shoes in Canada would make the Purchasing Power Parity (PPP) theory
hold?

(a) CAD 190

(b) CAD 125
(c) CAD 200
(d) CAD 142.5

32. Now consider the information for the U.S. and France. Given the price of a pair of Nike Lunarglide
shoes in the U.S. and in France, what nominal exchange rate between the USD and the EUR would
make the PPP theory hold?

(a) 0.70 USD / 1 EUR

(b) 1.5 USD / 1 EUR
(c) 1.14 USD / 1 EUR
(d) 1.25 USD / 1 EUR

33. Finally, consider the information for Canada and France. Assume that the nominal exchange rate
changes from 0.70 EUR / 1 CAD to 0.65 EUR / 1 CAD while the price of the pair of Nike Lunarglide
shoes in these two countries remains the same. Which of the following statements is true?

(a) The Canadian pair of Nike Lunarglide shoes will become relatively more expensive, and Net
Exports of these shoes to France will decrease.
(b) The Canadian pair of Nike Lunarglide shoes will become relatively more expensive, and Net
Exports of these shoes to France will increase.
(c) The Canadian pair of Nike Lunarglide shoes will become relatively cheaper, and Net Exports
of these shoes to France will increase.
(d) The real exchange rate of the Canadian pair of Nike Lunarglide shoes will not be affected
by the change in the nominal exchange rate, and Net Exports of these shoes to France will not
change.

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34. Write the version of your exam (you can find it in the front page).

(a) Version 1
(b) Version 2
(c) Version 3
(d) Version 4

35. BONUS QUESTION. Consider the AD AS model built from the IS LM . Which of the
following would increase consumption but decrease investment in the long-run?

(a) An increase in government spending.

(b) A decrease in taxes.
(c) An investment tax credit aimed at encouraging business investment, which shifts the invest-
ment demand function to the right.
(d) An increase in the money supply.
(e) A shock to the SRAS that decreases prices in the short run.

1. b 8. c 15. a 22. b 29. b

2. c 9. b 16. a 23. d 30. a
3. d 10. b 17. d 24. a 31. a
4. a 11. a 18. c 25. c 32. c
5. a 12. b 19. c 26. d 33. c
6. a 13. d 20. a 27. d 34. a
7. a 14. d 21. c 28. c 35. b

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