Principles of Macro
Prof. Wyatt Brooks
Fall 2012
Final Exam
CODE OF HONOR PLEDGE:
I will not give or receive aid on this examination. I understand that if I am
aware of cheating on this exam, I have an obligation to inform Professor Brooks. I
also understand that Professor Brooks will follow the University of Notre Dame
Academic Code of Honor if he detects acts of academic dishonesty.
Signature: _____________________________________
Printed Name: __________________________________
Date: __________________________________________
Part I: Definitions (10 of 200 points)
a) What is the definition of gross domestic product?
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b) What is the definition of purchasing power parity?
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c) What is the Efficient Markets Hypothesis?
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Part II: Simplified Solow Growth Model (25 of 105 points)
Consider the simple version of the Solow Growth Model discussed in class
summarized by these four equations:
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Consumers save a fraction s of output:
I=sY
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Capital grows as follows:
K’ = I + (1-δ)K
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Firms use capital to make output:
Y = A K0.3
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There is no government or trade:
Y=C+I
where Y is GDP, I is investment, C is consumption, s is the savings rate, K is the
capital stock this year, K’ is the capital stock next year, A is productivity and δ is
the rate of depreciation.
a.
Use these four equations to give an equation for K’ that only depends on
K, A, s and δ. ______________________________________
b.
In the following space, draw a graph that illustrates the relationship
between K, the capital stock this year, and K’, the capital stock next year:
45 degree line
c.
Suppose the economy starts with a low level of capital K0. Label this on
the graph, and show how to find the following period’s capital stock K1.
d.
Given K1 show how to find the following year’s capital stock, K2.
e.
Label the steady state level of capital K*.
f.
Suppose the efficiency level A goes up. Label the new steady state level of
capital KNEW.
Part III: Unemployment (20 of 200 points)
Suppose there are 250 million adults in the United States. They are divided into the
following mutually exclusive groups:
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22 million are stay-at-home parents,
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8 million are not working and are actively looking for work,
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6 million work full time in the military,
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34 million are retired,
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24 million work part time,
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8 million more people work part time and are actively looking for full time work,
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16 million would like to work but are not actively looking,
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12 million are full time students,
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20 million work full time in government jobs,
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the remaining 100 million work full time in the private sector.
1) What is the unemployment rate? __________
2) What is the labor force participation rate? __________
Now suppose that, during a recession, 20 million people that previously worked full
time lose their jobs. Of these, 8 million of them retire, and the other 12 million find part
time work while they look for full time jobs. In addition, 2 million of the workers who
were not employed but searching decide to give up searching and retire.
3) What is the unemployment rate? __________
4) What is the labor force participation rate? __________
Nobel Prize winner Edward Prescott advocates a different measure of employment. It is
simply all the hours worked by everyone in the economy divided by the total number
of people aged 15 to 64.
5) What is one advantage that this measure has over the unemployment rate?
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6) What is one disadvantage of this measure compared to unemployment?
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Part IV: Bonds and Portfolio Choice (25 of 200 points)
Suppose the market interest rate is 10%, and you would like to invest in corporate
bonds. X Corporation is issuing bonds, which make one payment of $1000 one year
from today. There is a 12% chance that X Corporation will go bankrupt and pay nothing
on their bonds.
a) Compute the market price of the bond. ___________________
Suppose that Y Corporation is also issuing bonds identical to those that X Corporation
is issuing, but Y Corporation has a 23% chance of default and pays nothing if they
default. Defaults by X and Y are independent events (if we knew that X Corporation
defaulted, the probability that Y defaulted is unchanged, and vice versa).
b) Compute the market price of Y Corporation’s bond. ___________________
c) Define the term risk averse. _________________________________________
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d) Suppose you are risk averse and have $56,000 to invest. You can only invest in
the bonds of either X Corporation or Y Corporation, but not both. Which should
you choose? Why? ________________________________________________
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e) Now suppose that you are risk averse and are allowed to invest in both X
Corporation and Y Corporation. Should you do so? Would you be better off,
worse off, or the same as in part d? Why? ____________________________
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Part V: Fed Intervention and an “Overheating” Economy (20 of 200 points)
1) Suppose the economy is initially at the natural rate of unemployment and
output. Illustrate this graphically using the AD-AS model and the Phillips Curve.
Label all axes and lines, and label the initial equilibrium A.
2) Suppose that changes in long term foreign policy objectives result in a need for a
larger military, which is a permanent increase in government spending. Illustrate
the short run effect of this in the same graphs above using arrows to illustrate the
shifting of curves, and label the new equilibrium B. What happened to each of
the following: Prices ___ Output ___ Inflation ___ Unemployment ___
3) Continuing from above, in the same graphs illustrate what happens in the long
run (again, labeling shifts in curves with arrows) and label the long run
equilibrium C.
4) Redraw the graphs from parts 1 and 2 here, and illustrate what happens if
instead the Fed intervenes to bring output back to its original level. Illustrate the
equilibrium after Fed intervention D.
5) What are the costs and benefits of Fed intervention to adjust to permanent
changes in government spending? _____________________________________
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Part VI: Input Price Changes and the Sacrifice Ratio (45 of 200 points)
1) Suppose the economy is initially at the natural rate of unemployment and
output. Illustrate this graphically using the AD-AS model and the Phillips Curve.
Label all axes and lines, and label the initial equilibrium A.
2) Suppose the economy experiences a temporary increase in international steel
prices. Illustrate the short run effect of this in the same graphs above using arrows
to illustrate the shifting of curves, and label the new equilibrium B. What
happened to: Prices ___ Output ___ Inflation ___ Unemployment ___
3) Continuing from above, in the same graphs illustrate what happens in the long
run (again, labeling shifts in curves with arrows) and label the long run
equilibrium C.
4) Redraw the graphs from parts 1 and 2 here, and illustrate what happens if
instead the Fed intervenes to bring output back to its original level. Illustrate the
equilibrium after Fed intervention D.
5) What are the costs and benefits of Fed intervention to adjust for fluctuating input
prices? _____________________________________________________________
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6) What is the sacrifice ratio? ________________________________________________
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7) Suppose that the Fed engages in the policy described by your answer to part 4,
then decides that they would like to move from point D back to point A. Show
how the Fed can get back to point A in the long run in the space below.
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Suppose the economy starts at point D.
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Next, find the short run equilibrium following the change in Fed policy,
and label that point E.
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Then show how the economy adjusts in the long run to reach point A.
Indicate shifting curves using arrows.
8) What are rational expectations? ____________________________________________
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9) If people have rational expectations, is the sacrifice ratio low or high? Why?
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10) How does the sacrifice ratio affect the position of point E in the figure above?
That is, compare where point E would be if the sacrifice ratio was high to where
it would be if the sacrifice ratio was low. __________________________________
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Part VII: Capital Controls (25 of 200 points)
1) Using the appropriate graphs, in the space below illustrate the effect of an
increase in foreign demand for domestic products on domestic real interest rates,
net exports, net capital outflows and exchange rates.
2) Suppose that the government is trying to keep the exchange rate constant over
time. Therefore, in response to the increase in foreign demand from part 1, they
place restrictions on the flow of capital into the country in order to return the
exchange rate to its original level. Illustrate this in the space below. How are real
interest rates and net exports affected?
3) If the government is pursuing the policy described in part 2, is it still possible to
use monetary policy to stabilize the economy? Why or why not? ______________
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Part VIII: Multiple Choice (30 of 200 points)
Circle the one correct answer for each question.
1) According to the Austrian theory of the business cycle:
a. Fed policy has no effect on the economy.
b. The effect of Fed policy on the economy is unknowable.
c. The Fed has a role in stabilizing the economy over the business cycle.
d. Fed policy makes business cycles worse.
2) One advantage of tax cuts over government spending increases is that:
a. Tax cuts affect aggregate demand more directly than spending.
b. Tax cuts also affect aggregate supply.
c. Increased government spending increases the deficit.
d. All of the above.
3) The short run aggregate supply curve is vertical if:
a. Money is neutral.
b. Menu costs are so high no one can ever pay them.
c. The economy is open to foreign capital flows.
d. All of the above.
4) Being part of the Eurozone is a problem for Greece and Spain because:
a. They use the same currency as their major trading partners.
b. They use the same currency as their major foreign creditors.
c. Monetary policy cannot specifically target their economies.
d. All of the above.
5) Which of the following does not illustrate why the aggregate demand curve is
downward sloping:
a. Lower prices make people consume more.
b. Lower prices encourage savings, driving up investment.
c. Lower prices encourage government expenditure.
d. Lower prices reduce interest rates, so the exchange rate appreciates.
6) Nominal interest rates have a zero lower bound because:
a. To get a negative interest rate, the Fed would cause hyperinflation.
b. No one would ever buy a bond with a negative nominal interest rate.
c. Negative nominal interest rates reduce confidence in the Fed.
d. Fiscal policy is less powerful if nominal interest rates are negative.
EXTRA PAGE
Use this area to do any work that won’t fit in other parts. If you want to receive partial credit,
clearly label which parts correspond to which questions, and note it on the original question.