Principles of Macro
Prof. Wyatt Brooks
Fall 2012
Final Exam
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Part I: Definitions (10 of 200 points) a) What is the definition of gross domestic product?
The market value of all final goods and services produced in a country in a particular time period (usually a quarter or a year). (Midterm 1) b) What is the definition of purchasing power parity?
Purchasing power parity is a theory that predicts that all currencies have the same purchasing power in all countries. (Problem Set 2) c) What is the Efficient Markets Hypothesis?
Asset prices reflect only all currently available public information. (Midterm
2)

Part II: Simplified Solow Growth Model (25 of 105 points)
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Consider the simple version of the Solow Growth Model discussed in class summarized by these four equations:
Consumers save a fraction
Capital grows as follows: s of output:
Firms use capital to make output:
There is no government or trade:
I = s Y
K’ = I + (1-δ)K
Y = A K
Y = C + I
0.3
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.
See Problem Set 2 and Midterm 1 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.
f.
Suppose the economy starts with a low level of capital K
0
. Label this on the graph, and show how to find the following period’s capital stock K
1
. d.
Given K
1
show how to find the following year’s capital stock, K
2
. e.
Label the steady state level of capital K* .
Suppose the efficiency level capital K NEW .
A goes up. Label the new steady state level of

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, not labor force
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8 million are not working and are actively looking for work, unemployed
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6 million work full time in the military, not labor force
 34 million are retired, not labor force
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24 million work part time, employed
 8 million more people work part time and are actively looking for full time work, employed

16 million would like to work but are not actively looking, not labor force

12 million are full time students, not labor force

20 million work full time in government jobs, employed
 the remaining 100 million work full time in the private sector. employed
1) What is the unemployment rate? 8/160 = 5%
2) What is the labor force participation rate? 160/250 = 64%
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? 6/150 = 4%
4) What is the labor force participation rate? 150/250 = 60%
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?
Avoids situations like that illustrated in 1 and 3 above. Measures the effect of discouraged workers not being employed, and part time workers not working as much as they may want.
6) What is one disadvantage of this measure compared to unemployment?
Picks up long run trends not related to the business cycle (female labor force participation). Also, unemployment better measures worker welfare.

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. 88% x $1000/1.1 = $800
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. 77% x $1000/1.1 = $700 c) Define the term risk averse . A person is risk averse if they prefer less volatile consumption to more volatile. 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? Should choose X Corporation because their return is less volatile.
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? Better off choosing both because this allows you to diversify the risk of one corporation defaulting.

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 .
See chapters 20 and 21 for graphs: permanent AD shift to the right. Then in the long run, SRAS shifts left and prices are permanently higher. On the Phillips
Curve, the increase in AD is a move along the SRPC, then in the long run, the
SRPC shifts out.
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 up Output up Inflation up Unemployment down
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 .
The AD curve initially shifts out (with the increase in government spending), then Fed policy immediately shifts it back. So point A = point D.
5) What are the costs and benefits of Fed intervention to adjust to permanent changes in government spending? Cost: cut short the initial boom; Benefit: reduce long run inflation.

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 .
This is equivalent to the oil shock example in the book.
Without Fed intervention, the SRAS curve shifts out, then in the long run it shifts back. The Phillips curve temporarily shifts out, then shifts back.
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 up Output down Inflation up Unemployment up
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 .
Fed intervention shifts out the AD curve. This gives permanently higher prices and inflation.
5) What are the costs and benefits of Fed intervention to adjust for fluctuating input prices? Cost: cause long run inflation; Benefit: cut short the recession.

6) What is the sacrifice ratio ? By how much GDP falls when inflation is reduced.
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 .
 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.
Fed policy reduces aggregate demand, which lowers GDP and prices. Also it moves along the SRPC to higher unemployment and lower inflation. In the long run, the SRAS curve shifts right, and the SRPC shifts left so that we end up back at point A .
8) What are rational expectations ? People use all their available information to forecast the future.
9) If people have rational expectations, is the sacrifice ratio low or high? Why?
Low, because people’s price expectations adjust rapidly.
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. The higher is the sacrifice ratio, the more GDP is lost when trying to move from D to A . In the graphs, a high sacrifice ratio is associated with point E being further to the left.

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.
Shift of the demand curve in the foreign exchange market. Then, real interest rates, net exports and NCO stay the same, while the exchange rate goes up.
For graphs, see the Japan example in chapter 19.
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?
Capital controls is an increase in NCO, which both shifts the NCO curve right and the demand curve in the LF market right. This brings the exchange rate back to where it was before the shock in part 1, and also increases real interest rates and net exports.
For graphs, see the capital flight example in Lecture 21.
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? Yes, if capital controls are being used to control the exchange rate, monetary policy is still free to stabilize the economy (see the “Unholy Trinity Theorem”)

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. (opposite) b.
Tax cuts also affect aggregate supply. c.
Increased government spending increases the deficit. (so does tax cuts) 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. (opposite) c.
The economy is open to foreign capital flows. (doesn’t matter) 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. (shift of AD curve) d.
Lower prices reduce interest rates, so the exchange rate depreciates.
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.