Economics 201 Intermediate Macroeconomic Theory Spring 2006 Exam 3 Name ________________________________ Score _________ (12 Points) 1. Consider an economy described by the following equations AD = C + I + G C = 170 + 0.6(Y – T) I = 100 – 4r G = 350 T = 200 (M/P)d = 0.75Y – 6r Ms = 1,470 Price level = 2 a. Derive the IS curve. b. Derive the LM curve. c. Find equilibrium income, the interest rate, consumption, investment, and the government surplus/deficit. d. Suppose government spending increases by 36 to 386. By how much does income change? e. Show your results graphically including the effect of the change in government spending. 2. (8 Points) The following questions focus on the IS-LM model, for each scenario show graphically the effect and describe the impact on interest rates and output. The government uses expansionary fiscal policy: The Fed uses contractionary monetary policy: The Fed increases the money supply and the government increases taxes: The government decreases government spending. What should the Fed do to maintain output at the original level? (10 Points) 3. Suppose the economy were initially in long-run and short-run equilibrium. a. Illustrate this position by drawing an IS-LM graph and, directly below it, the aggregate supply and aggregate demand graph. b. Recently there was a dramatic run up in the price of oil. On the graphs above show what happens in both the short-run and long-run to the IS curve, LM curve, short-run aggregate supply curve, long-run aggregate supply curve, aggregate demand curve, and the equilibrium levels of the interest rate, prices, and income. Explain the changes and the adjustment from the short-run to the long-run. [Make sure your steps are very clear.] 4. (8 Points) The slopes of the IS and LM curves are very important in determining the effectiveness of fiscal and monetary policy. a. Describe verbally and show graphically the conditions when fiscal policy is ineffective. b. Describe verbally and show graphically the conditions when monetary policy is ineffective. 5. (10 Points) The following questions focus on the traditional and Ricardian views of the tax plan proposed by the White House as described below. WASHINGTON (AP) -- Senate moderates' worries about growing budget deficits and weakened state economies are complicating Republican plans to pass a $350 billion tax cut in the narrowly divided chamber. The House bill would reduce taxes by $550 billion through the next decade, but some provisions end within three years to keep the cost of the package down. Lawmakers assume the popular tax cuts, such as a $1,000 child care credit and breaks for married couples, will be extended after they expire. a. If the goal of the plan is to stimulate the economy what would those who support the concept of Ricardian equivalence have to say about the stimulus plan? b. What are the key assumptions behind Ricardian equivalence? c. What would those who support the traditional view of a debt financed tax cut say will happen to output, interest rates, consumption and investment following the debt financed tax cut? d. Based on the traditional view of debt financing why do we sometimes call the government deficit and the trade deficit “Twin deficits”? [Think hard and explain carefully.] 6. (10 Points) The following questions focus on the debate between rules and discretionary policy. a. One possible rule is a balanced budget rule, that is G = T always. What are the advantages and disadvantages of a balanced budget rule? b. What is meant by the time inconsistency of economic policy? Why might a policymaker be tempted to renege on an announcement they made earlier? [i.e. Why is commitment so important.] c. Briefly describe the Lucas critique. d. Based on the Lucas critique and our assumptions of agents as forward-looking with rational expectations explain why we might say “only surprise money matters.” [A graph may be helpful] (12 Points) 1. The investment function and the IS curve slope A. upward because higher interest rates induce more investment. B. upward because higher interest rates induce less investment. C. downward because higher interest rates induce more investment. D. downward because higher interest rates induce less investment. 2. The slope of the IS curve depends on A. the sensitivity of investment to the interest rate. B. the level of government expenditures. C. the sensitivity of the demand for real money balances to the interest rate. D. none of the above. 3. If money demand became more sensitive to the level of income, the LM curve would A. become steeper. B. become flatter. C. shift inward. D. shift outward. 4. Suppose that the government raises taxes. According to the IS-LM model, what does the Fed have to do to keep income constant and what is the subsequent effect on interest rates? A. The Fed needs to increase the money supply; interest rates remain unchanged. B. The Fed needs to increase the money supply; interest rates go down. C. The Fed needs to decrease the money supply; interest rates remain unchanged. D. The Fed needs to decrease the money supply; interest rates go up. 5. Suppose that income is temporarily above the natural rate level. In the IS-LM model, long-run equilibrium is achieved when the price level A. falls and the LM curve shifts outward. B. rises and the LM curve shifts inward. C. falls and the IS curve shifts inward. D. rises and the IS curve shifts outward. 6. When the nominal wage is stuck, a higher price level will cause the real wage to A. fall. B. stay the same. C. rise. D. rise and then fall. 7. All three models of aggregate supply presented in Chapter 13 share the feature that, if the price level is above the expected price level, then A. nominal wages will fall. B. nominal wages will rise. C. output will be below its natural rate. D. output will be above its natural rate. 8. The Phillips curve represents the trade-off between A. inflation and expected inflation. B. output and unemployment. C. inflation and unemployment. D. output and interest rates. 9. If expected inflation rises, the Phillips curve A. shifts upward. B. shifts downward. C. becomes steeper. D. becomes flatter. 10. Consumers are thought to be forward-looking. This implies that current consumption depends on A. current as well as future income. B. future income alone. C. future inflation. D. future consumption. 11. Under Ricardian equivalence, a tax cut today will raise consumption if A. taxes are raised in the future. B. government spending is reduced. C. government spending is increased. D. consumers are forward-looking. 12. All of the following are valid arguments against maintaining a large government debt EXCEPT A. debt leads to less flexible labor markets. B. debt leads to loss of political clout. C. debt encourages capital flight. D. debt is generationally unjust.