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Economics 312 Spring 2011 Practice Problem Set 2 100 points total

Name: ____________________________________

Multiple Choice: 40 points (2 points each) 1. According to the Solow growth model, in an economy with no population growth or technological progress, the formula for steady-state consumption per worker (c*) as a function of output per worker and investment per worker is: A) c* = f(k*) k*. B) c* = f(k*) + k*. C) c* = f(k*) dk*. D) c* = k* f(k)*. 2. If an economy with no population growth or technological change has a steady-state MPK of 0.125, a depreciation rate of 0.1, and a saving rate of 0.225, then the steady-state capital stock: A) is greater than the Golden Rule level. B) is less than the Golden Rule level. C) equals the Golden Rule level. D) could be either above or below the Golden Rule level. 3. Assume two economies are identical in every way except that one has a higher population growth rate. According to the Solow growth model, in the steady state the country with the higher population growth rate will have a ______ level of total output and ______ rate of growth of output per worker as/than the country with the lower population growth rate. A) higher; the same B) higher; a higher C) lower; the same D) lower; a lower 4. One explanation for greater economic development in moderate versus tropical climates is that institutions established by colonial settlers in moderate climates ______, while institutions established by colonists in tropical climates ______. A) were based on English common law; were based on the Napoleonic Code B) were based on the Napoleonic Code; were based on English common law C) protected property rights; were extractive and authoritarian D) were extractive and authoritarian; protected property rights

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5. If the short-run aggregate supply curve is horizontal, then a change in the money supply will change ______ in the short run and change ______ in the long run. A) only prices; only output B) only output; only prices C) both prices and output; only prices D) both prices and output; both prices and output 6. If a central bank accommodates an adverse supply shock, output falls ______ and prices rise ______ than they would if the central bank does nothing. A) less; more B) less; less C) more; less D) more; more 7. If Central Bank A cares only about keeping the price level stable and Central Bank B cares only about keeping output at its natural level, then in response to an exogenous increase in the price of oil: A) both Central Bank A and Central Bank B should increase the quantity of money. B) Central Bank A should increase the quantity of money whereas Central Bank B should keep it stable. C) Central Bank A should keep the quantity of money stable whereas Central Bank B should increase it. D) both Central Bank A and Central Bank B should keep the quantity of money stable. 8. An interpretation of why the IS curve slopes downward and to the right is that as income rises, national saving rises, and this increase drives the interest rate: A) down, thereby decreasing investment. B) down, thereby increasing investment. C) up, thereby decreasing investment. D) up, thereby increasing investment. 9. If the interest rate is above the equilibrium value, the: A) demand for real balances exceeds the supply. B) supply of real balances exceeds the demand. C) market for real balances clears. D) demand for real balances increases. 10. The intersection of the IS and LM curves determines the values of: A) r, Y, and P, given G, T, and M. B) r, Y, and M, given G, T, and P. C) r and Y, given G, T, M, and P.

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D) p and Y, given G, T, and M. 11. In the Keynesian-cross analysis, if the consumption function is given by C = 100 + 0.6(Y T), and planned investment is 100, G is 100, and T is 100, then equilibrium Y is: A) 350. B) 400. C) 600. D) 750. 12. In the IS-LM model, a decrease in government purchases leads to a(n) ______ in planned expenditures, a(n) ______ in total income, a(n) ______ in money demand, and a(n) ______ in the equilibrium interest rate. A) decrease; decrease; decrease; decrease B) increases; increase; increases; increase C) decrease; decrease; increase; increase D) increase; increase; decrease; decrease 13. If MPC = 0.75 (and there are no income taxes but only lump-sum taxes) when T decreases by 100, then the IS curve for any given interest rate shifts to the right by: A) 100. B) 200. C) 300. D) 400. 14. The Pigou effect suggests that falling prices will increase income because real balances influence ______ and will shift the ______ curve. A) money demand; LM B) the money supply; LM C) consumer spending; IS D) government spending; IS 15. An increase in government spending raises income: A) and the interest rate in the short run, but leaves both unchanged in the long run. B) in the short run, but leaves it unchanged in the long run, while lowering investment. C) in the short run, but leaves it unchanged in the long run, while lowering consumption. D) and the interest rate in both the short and long runs. 16. In a small open economy with a floating exchange rate, the exchange rate will depreciate if: A) the money supply is decreased.

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B) import quotas are imposed. C) government spending is increased. D) taxes are increased. 17. According to the Mundell-Fleming model, import restrictions in an economy with flexible exchange rates cause net exports to ______ and in an economy with fixed exchange rates import restrictions cause net exports to ______. A) increase; increase B) increase; remain unchanged C) remain unchanged; remain unchanged D) remain unchanged; increase 18. In the Mundell-Fleming model, if the economy is operating below the natural level of output in the short run, then in the long run the price level will fall, the real exchange rate will ______, and net exports will ______ to restore the economy to its natural rate. A) appreciate; increase B) appreciate; decrease C) depreciate; increase D) depreciate; decrease 19. According to the sticky-price model, other things being equal, the greater the proportion, s, of firms that follow the sticky-price rule, the ______ the ______ in output in response to an unexpected price increase. A) greater; increase B) smaller; increase C) greater; decrease D) smaller; decrease 20. After examining international data, the economist Robert Lucas found that aggregate demand has the biggest effect on output in countries where aggregate demand: A) and prices are most stable. B) and prices are most variable. C) is most stable but prices are most variable. D) is most variable but prices are most stable.

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Mathematical Analysis: 20 points Write your final answers on the blanks provided. Show your work in the white space. With the exception of question 23(c), each final answer should be a number rather than a formula. 21. (8 points) Assume that an economys production function is y = k3/4, where y is output per effective worker and k is capital per effective worker. The saving rate is 12 percent, the depreciation rate is 3.5 percent, the rate of population growth is 3 percent, and the rate of technological progress is 1.5 percent. a. What is the steady-state level of capital per effective worker? __________ b. What is the steady-state level of output per effective worker? __________ c. What is the steady-state level of consumption per effective worker? __________ d. What is the steady-state growth rate of capital per worker (Y/L)? __________

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22. (6 points) Assume the following model for a small open economy with a floating exchange rate, with the world real interest rate (r*) equaling 2.5 percent: IS* curve: Y = 400 + 3G 2T + 3NX 200r LM curve: Y = 200r 200 + 2(M/P) NX curve: NX = 200 100e P = 1.0 G = 100 T = 100 M = 100 What are the short-run equilibrium values of Y, NX, and e? Y = __________ NX = __________ e = __________

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23. (6 points) Assume that an economy has the Phillips curve =

0.8(u 0.06).

a. How many percentage point years of cyclical unemployment are needed to reduce inflation by 3 percentage points? __________ b. Based on the version of Okun's Law used in class (provided below) and your answer to part (a), what is the sacrifice ratio for this economy? __________ Okun's Law: % change in real GDP = 3.5% [2 * change in unemployment rate] c. If the Phillips curve was instead = 1 0.9(u 0.06), would the sacrifice ratio be higher, lower, or the same as your answer in part (b)? (Note that it is not necessary recalculate parts (a) and (b) to answer this.) __________

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Graphical Analysis: 40 points 24. a. (4 points) Suppose a government is able to permanently reduce its budget deficit. Use the Solow growth model of Chapter 8 to graphically illustrate the impact of a permanent government deficit reduction on the steady-state capital-labor ratio and the steady-state level of output per worker. Be sure to label the axes, the curves, the initial steady-state levels of capital and output, the ending steady-state levels of capital and output, and the direction that any curve(s) shifts. b. (2 points) Comparing the initial steady-state values to the ending steady-state values, indicate whether each of the following variables increases, decreases, or stays the same: capital per effective worker (k = K/(LE)): __________ growth rate of total output (Y): __________

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25. a.

(4 points) As an economy moves into a recession, income falls. Illustrate graphically the short-run impact of a decrease in income on the equilibrium interest rate using the theory of liquidity preference and the market for real money balances. Label the initial equilibrium point as A and the ending equilibrium point as B. Be sure to label the axes, the curves, the initial equilibrium values, the ending equilibrium values, and the direction that any curve(s) shifts.

b.

(2 points) State whether each of the following variables increases, decreases, or stays the same: real interest rate __________ real money balances __________

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26. a.

(4 points) How can the Fed keep the economy from falling into a recession if the budget deficit is reduced? Use the IS-LM model to illustrate graphically the short-run impact of both the fiscal policy reducing the deficit and the monetary policy, which prevents output from falling. Label the initial equilibrium point as A and the ending equilibrium point as B. Be sure to label the axes, the curves, the initial equilibrium values, the ending equilibrium values, and the direction that any curve(s) shifts.

b.

(2 points) State whether each of the following variables increases, decreases, or stays the same: real interest rate __________ money supply __________

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27. a.

(4 points) Economic expansion throughout the rest of the world raises the world interest rate. Use the Mundell-Fleming model to illustrate graphically the short-run impact of an increase in the world interest rate on the exchange rate and level of output in a small open economy with a floating-exchange-rate system. (Hint: you must consider two shifts.) Label the initial equilibrium point as A and the ending equilibrium point as B. Be sure to label the axes, the curves, the initial equilibrium values, the ending equilibrium values, and the direction that any curve(s) shifts.

b.

(2 points) State whether each of the following variables increases, decreases, or stays the same: exchange rate __________ output __________

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28. a.

(12 points) Assume that an economy is initially operating at the natural rate of output when a reduction in government spending produces a budget surplus. Illustrate graphically the short-run and long-run effects on price and output using the model of aggregate demand and aggregate supply (using the upward-sloping short-run aggregate supply curve) and the short-run and long-run effects on inflation and unemployment using a Phillips curve diagram. In each graph, label the initial equilibrium point as A, the short-run equilibrium point as B, and the long-run equilibrium point as C. Be sure to label the axes, the curves, the initial equilibrium values, the ending equilibrium values, and the direction that any curve(s) shifts.

b.

(4 points) State whether each of the following variables increases, decreases, or stays the same: From initial equilibrium to new LR equilibrium: price level __________ From initial equilibrium to new LR equilibrium: output __________ From SR equilibrium to new LR equilibrium: inflation __________ From SR equilibrium to new LR equilibrium: unemployment __________

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Answer Key
1. 2. 3. 4. 5. A B C C B 6. 7. 8. 9. 10. A C B B C 11. 12. 13. 14. 15. C A C C B 16. 17. 18. 19. 20. D D C A A

21. a. In steady state: k*/f(k*) = s/(+n+g) k*/(k*)3/4 = (k*)1/4 = 0.12/(0.035 + 0.03 + 0.015) = 0.12/0.8 = 1.5 k* = (1.5)4 = 5.0625 b. y* = f(k*) = (k*)3/4 = (5.0625)3/4 = 3.375 c. c* = (1 s)y* = (0.88)(3.375) = 2.97 d. In steady state, growth rate in Y/L = g = 0.015 22. From LM curve: Y = (200)(2.5) 200 + (2)(100/1) = 500 200 + 200 Y = 500 From IS* curve: 500 = 400 + (3)(100) (2)(100) + 3NX (200)(2.5) = 400 + 300 200 + 3NX 500 3NX = 500 NX = 166.67 From NX curve: 166.67 = 200 100e 100e = 33.33 e = 1/3 or 0.33 23. a. = 1 0.8(u 0.06). 1 = 0.03 = 0.8(u 0.06) (u 0.06) = (0.03)/( 0.8) = 0.0375 cyclical unemployment needed = (u un) = 0.0375 or 3.75 percentage point years b. From Okuns Law: 3.75 percentage point years of cyclical unemployment => 7.5 percentage points of real GDP lost sacrifice ratio = (7.5% points of real GDP)/(3% points of inflation) = 2.5 c. Lower. The Phillips curve would be steeper, so any given reduction in inflation would be associated with a smaller change in unemployment.

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24. a.

b.

steady-state level of k* increases steady-state growth rate in Y = (n+g) and neither n nor g changes, so stays the same

25. a.

b.

real interest rate decreases real money balances stays the same

26. a.

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b.

real interest rate decreases money supply increases

27. a.

IS* curve: r* increases => quantity of investment decreases => IS* shifts left LM* curve: r* increases => economy moves up and right along the LM curve (not the LM* curve) => LM* curve shifts right

b.

exchange rate decreases output increases

28. a.

AD-AS graph:

I could not find a suitable pre-made Phillips curve graph, so here is a description: Point A should be at u1 = un and 1 = 1e. Point B should be down and to the right along the same Phillips curve such that u2 > u1 and 2 < 1. From the short-run to the long-run, people revise their expectations of inflation downward, shifting the Phillips curve downward such that Point C should be at u3 = u1 = un and 3 = 1.

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b.

Initial to new LR: price decreases Initial to new LR: output stays the same SR to new LR: stays the same SR to new LR: unemployment decreases

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