Econ 601 Wray Winter 2011
REVIEW QUESTIONS FOR MIDTERM
Use these questions to study for the midterm.
You can bring 1 page of notes (8 ½” by 11”, you can write on both sides).
1. Keynes’s General Theory.
a) Explain why the equilibrium level of employment need not be at full employment.
b) Explain why falling wages wouldn't necessarily move the economy toward full employment.
c) Does government spending necessarily "crowd-out" private spending? Explain.
d) Explain the "paradox of thrift".
e) Using the Chapter 17 exposition, explain the results of a rise of liquidity preference.
f) Using the Chapter 17 exposition, explain the results of a rise of expected profitability.
g) What are the determinants of the system? What are the determinates? That is, what are the dependent variables and
what are the independent variables?
h) Explain Keynes's critique of the “two postulates” about the labor market adopted by “classical” economists.
i) Contrast Keynes's "marginal efficiency of capital" with the Neoclassical "marginal productivity of capital".
j) According to Keynes, what are the “two outstanding faults” of capitalism? What can be done to mitigate them?
k) Why does Keynes call his a “general theory” and the neoclassical a “special case”? Explain.
l) Which units of measurement did Keynes adopt? Why?
m) According to Keynes, there are two types of expectations. Compare and contrast them, and explain why expectations
matter in his theory.
n) According to Keynes, why does capital receive a return? How does this differ from classical and Austrian views?
o) What are the essential properties of money? Why are they important?
2. Neoclassical Model (sometimes called the Classical Model). Use pictures and words to show determination of
equilibrium values for income, expenditure, consumption, saving, interest rates, wages, price level, and employment in
the Neoclassical Model. Then answer each of the following questions concerning this model.
a) Explain why the equilibrium level of employment must be at full employment.
b) Explain why falling wages would necessarily move the economy toward full employment.
c) Show the results of an increase of government spending. Does government spending "crowd-out" private spending?
Explain.
d) Show and explain the results of an increase of "thriftiness".
e) Explain the results of a rise of the money supply.
f) Show and explain the results of a rise of productivity.
3. Monetarism Mark I (Friedman-type) Model. Use the equation of exchange to present the Monetarist model. Explain
the assumptions normally made. Then answer the following questions about this model.
a) Assume the Fed increases the money supply. What are the expected results on: spending, real GNP, employment,
nominal and real interest rates, inflation, and velocity?
b) What is the appropriate monetary policy?
c) Is involuntary unemployment possible in the model?
d) What are the likely results of an increase of government spending, assuming the money supply is held constant?
e) Can the Fed control the money supply? Explain.
f) How does the expectations-augmented Phillips Curve modify the inflation-unemployment trade-off?
g) Briefly summarize the critiques of Friedman-type monetarism provided by Laidler and Galbraith.
4. Textbook Keynesian ISLM Model. Derive the IS-LM model and use it to answer the following questions.
a) Does the equilibrium level of income have to be at full employment in the simple ISLM model? Explain.
b) Explain the "Keynes" effect and the "Pigou" effect. Explain how this modifies your answer to part a.
c) What if investment is not a function of the interest rate—what implications does this have for policy?
d) Use the ISLM model to show the results of an increase of government spending. Is there any crowding out? Explain.
e) Assume money demand is not a function of the interest rate. How would this affect the decisions of policy makers
who are trying to stabilize the economy?
f) Explain what a "liquidity trap" is. If the economy were in one, what type of policy would be appropriate?
g) If consumption is made a function of wealth, does fiscal policy become more powerful?
h) Show and explain the likely results of an increase of the money supply. Show and explain the likely results of a
decrease of the price level.
i) Does the ISLM analysis reach the same conclusion as Keynes with respect to achievement of full employment?
Explain.
j) Hicks later claimed ISLM analysis is “confused”. Explain.
k) According to Foley, we need to be very careful when we claim that a stock equilibrium gives the same result as a flow
equilibrium. Explain. How does this relate to Hicks’s arguments about treatment of time in the ISLM analysis?
l) Cooley and LeRoy argue that a money demand function cannot be identified unless money demand and supply are
independent. Are they likely to be independent? Who cares whether you can identify money demand functions? That is,
what difference does it make?
m) Using ISLM analysis, when is it better to choose a money target? An interest rate target? Explain. Refer to Poole as
well as Sargent and Wallace—that is, to adaptive and rational expectations models.
5. Discuss the New Classical approach, and contrast it with the Friedman-type Monetarist approach. How did Lucas
provide for temporary non-neutrality of money, even as all markets clear? What role do rational expectations play in the
New Classical approach? What role does instantaneous market clearing play? What is the “Lucas Critique”, and why
was it important in providing criticism of the “income-expenditure” models in use in the 1960s? Explain the notion of
“dynamic time inconsistency” and its implication for policy formation. (While you are not required to use math to
explain the model, you are encouraged to do so.)
6. Discuss the Real Business Cycle theory (RBC) approach, and contrast it with both the Friedman and the Lucas
“monetarist” approaches. What drives the fluctuations, according to RBC? What role does money play in RBC? What
policy implications does RBC have? How did RBC combine both “cycle” and “trend”? Does the concept “involuntary
unemployment” make any sense from the perspective of RBC? (While you are not required to use math to explain the
model, you are encouraged to do so.)
7. Explain the New Keynesian (NK) approach. What is it able to explain that the NC and RBC approaches cannot
explain? What is credit rationing, and what role does in play in NK economics? What are the primary explanations given
for a) rigid prices, and b) rigid wages? What role do “long term labor contracts” play in explaining employment
fluctuations? Do both demand-side shocks and supply-side shocks play a role in generating NK cycles? Explain. Gordon
claims that “Keynesian” economics is all about sticky wages and prices that prevent markets from clearing. Is this claim
consistent with Keynes’s own approach? Explain. Explain Gordon’s input-output approach; what deficiency is he
attempting to resolve?
8. Some (Clower, Leijonhuvud) have interpreted Keynes’s approach as disequilibrium economics. Explain how
“coordination failures” might arise in an economy in which “goods buy money and money buys goods, but goods don’t
buy goods”. According to this approach, are sticky wages and prices necessary to obtain involuntary unemployment?
Explain.
9. Explain how neoclassical growth theory (Solow) evolved from extensions to Keynes that were designed to allow
investment to affect capacity. What is the Domar problem, and how is it related to economic growth? What is Harrod’s
knife edge and how is it related to economic growth? How did Solow solve the knife edge problem? (While you are not
required to use math to explain the model, you are encouraged to do so.)
10. Evaluate the evolution of the Phillips Curve idea, from “textbook Keynesians” to monetarists (mark I and II) and
finally to the most recent orthodox approaches, New Keynesians and Real Business Cycle theorists. Refer to the work by
DeVroey on the possibility of involuntary unemployment—have modern theorists, such as the New Keynesians,
managed to provide a true “Keynesian” explanation for its existence?