Eco 202
Final Exam
Name_______________________________
16 May 2007
Please write answers in ink. You may use a pencil to draw graphs. Allocate your time
efficiently.
1.
a. Suppose that money supply growth continues to be higher in Turkey than it is in the United
States. What does purchasing-power parity imply will happen to the real and to the nominal
exchange rate between the dollar and the euro?
Higher money growth leads to higher prices, so prices will rise more in Turkey than in the United
States. Under purchasing-power parity, this has no affect on the real exchange rate. However, in
order for a dollar to buy as many goods in Turkey as it buys in the United States when prices are
rising faster in Turkey, the nominal exchange rate must be rising so that a dollar buys more Turkish
lira.
b.Explain how the relation between the real exchange rate and net exports explains the
downward slope of the demand for foreign-currency exchange curve.
When the U.S. real exchange rate appreciates, U.S. goods become more expensive relative to
foreign goods. This induces U.S. citizens to buy more goods overseas, which increases U.S. imports.
The appreciation also induces foreign citizens to buy fewer U.S. goods, so U.S. exports fall. The
decline in exports and increase in imports decreases net exports, and so the demand for U.S.
dollars declines. The inverse relation between the exchange rate and the quantity of U.S. dollars
demanded in the foreign-currency exchange market is represented by the downward-sloping
demand curve.
2. Suppose that U.S. citizens start saving more, as younger Americans come to expect much
lower Social Security benefits. What does this imply about the supply of loanable funds and the
equilibrium real interest rate? What happens to the real exchange rate and net exports?
3. Explain the connection between the vertical long-run aggregate supply curve and the vertical long-run
Phillips curve.
Both reflect the classical dichotomy. The vertical long-run aggregate supply curve says that, in the
long run, the economy will be at its natural rate of output, and that this is the same no matter what
the price level. The natural rate of output depends on the natural rate of unemployment. The
vertical Phillips curve says that, in the long run, the economy will be at the natural rate of
unemployment (corresponding with the natural rate of output), and that this is the same no matter
what the inflation rate. Both curves are consistent with the classical dichotomy that says real
variables are not affected by nominal variables.
4. In 2001, President Bush’s tax program consisted in a $100 billion dollar tax rebate to be paid to
taxpayers during the summer months. Use the aggregate demand and supply model to illustrate the
impact of the $100 billion tax rebate on real GDP and the price level. Explain your analysis. Did this
rebate affect aggregate demand, aggregate supply or both? Is it likely that the tax rebate created a strong
stimulus to real GDP?
Because the Bush tax rebate was a temporary tax cut, it likely had no impact on aggregate supply.
Since this was a rebate that went to households, it wouldn’t have induced business to increase
investment spending. One thing we can say with some certainty is that the effect of that tax cut
on consumer spending and aggregate demand was likely smaller than if the cut had been permanent.
We also know that this fiscal stimulus was stronger than the temporary tax cut of 1992, but a tax
rebate one-tenth the size would have been stronger. According to the permanent income
hypothesis (Milton Friedman), a temporary tax cut is likely to be a weak fiscal stimulus.
5. The Federal Open Market Committee (FOMC) met last week to decide the future direction of
monetary policy. Suppose that the FOMC had decided to raise the federal funds interest rate by 25 basis
points (one-quarter of a percentage point). Explain how in practice the FOMC will raise the federal funds
rate. Use the liquidity preference framework (from chapter 21) to illustrate how the FOMC’s action
affects other short-term interest rates in the economy. Use the Phillips Curve model to illustrate the
impact this action should have on the unemployment rate and the inflation rate. Explain your analysis.
The FOMC raises the federal funds interest rate by selling bonds to bond traders, draining
reserves from the banking system. This is illustrated in the liquidity preference framework as a
leftward shift in the money supply schedule. The interest rate rises to r 2. The higher interest
rate depresses aggregate demand, thereby lowering aggregate output and raising unemployment
(because of sticky wages, etc.). The decline in aggregate demand moves the economy to the
southeast along a short-run Phillips curve (a to b above) as the actual inflation rate falls.
Eco 202
Final Exam
Name_______________________________
17 May 2007
Please write answers in ink. You may use a pencil to draw graphs. Allocate your time
efficiently.
1. What is the logic behind the theory of purchasing-power parity? Why is this theory good at
predicting relative exchange rates in the long run, but very poor at predicting relative exchange
rates in the short run? Explain.
The logic behind purchasing-power parity is the law of one price, which asserts that a good must
sell for the same price in all locations. If the price for a good is higher in one market than in
another, then someone can make a profit by purchasing the good where it is relatively cheap, and
selling the good where it is relatively expensive. This process of arbitrage leads to an equalization
of prices for the good in all locations. If purchasing power parity holds, the amount of dollars it
takes to buy a good in the U.S. should buy enough foreign currency to buy the same good in a
foreign country.
PPP states that exchange rates should adjust to reflect changes in the price levels between two
countries. PPP may fail to fully explain exchange rates because goods are not identical, and price
levels include traded and nontraded goods and services. Long-run exchange rates are determined
by domestic price levels relative to foreign price levels, holding other factors (trade barriers,
import and export demand, and productivity) constant.
2. Suppose the U.S. government institutes a "Buy American" campaign, in order to encourage
spending on domestic goods. What effect will this have on the U.S. trade balance? Will the
policy have any affect on Americans’ standard of living? Explain.
Such a campaign will increase the demand for domestically produced goods and hence decrease the
demand for imports. This raises net exports, which increases the demand for dollars in the market
for foreign currency. The real exchange rate of the U.S. dollar will appreciate, and the net effect
will be no change in the trade balance. The level of net exports ultimately depends upon domestic
saving and investment, neither of which is affected by the campaign.
Trade policies reduce both imports and exports. While they leave the trade balance unchanged,
they reduce trade overall and so reduce the gains from trade. This lowers the standard of living.
U.S. industries that produce goods that compete with imports may gain, but overall there is a loss in
net social gains to society.
3. Suppose that a decrease in the demand for goods and services pushes the economy into
recession. What happens to the price level? If the government does nothing, what ensures that
the economy still eventually gets back to the natural rate of output?
A decrease in aggregate demand causes the price level to fall. If the government takes no action to
counter this, then the actual price level will be below the price level that people expected.
Individuals will eventually correct their expectations of the price level. As they do so, prices and
wages will adjust accordingly, shifting the aggregate supply curve to the right (down). For example
if wages are sticky, in light of the lower price level, firms and workers will eventually make bargains
for lower nominal wages. The reduction in wages lowers costs of production, so firms are willing to
produce more at any given price level. Consequently, the short-run aggregate supply curve shifts
right. The rightward shift in aggregate supply eventually causes output to rise back to the natural
rate.
4. What did Friedman and Phelps predict would happen if policymakers tried to move the
economy upward along the Phillips curve? Did the behavior of the economy in the late 1960s
and the 1970s prove them wrong?
Friedman and Phelps predicted that, over time, people would come to expect the higher inflation, so
the short-run Phillips curve would shift right (up). When this happened, unemployment would go
back to its natural rate, but inflation would be higher (this is the natural-rate hypothesis). The
behavior of the economy in the late 1960s and the 1970’s was consistent with their theory.
Inflation rose but unemployment did not remain low, as was suggested by a permanent trade-off
between unemployment and inflation.
5. Use the aggregate demand and supply model to illustrate what is likely to happen if both the
federal government and the Federal Reserve policy makers believe that the natural rate of unemployment is 4% when it is actually 6%. If policymakers persist in the belief that 6%
unemployment is too high, what type of inflation does this policy mistake create? Explain your
analysis.
Policymakers can set a target for unemployment that is too low because it is below the natural rate
of unemployment. The consequence of an unemployment target that is too low is depicted below.
Because the policymakers target on a
level of unemployment below the
natural rate level, the targeted level
of real output, marked as Ymd, is
above the natural rate level of output,
Y,. If the economy is initially in longrun equilibrium, Point 1, the policy
authorities will feel that there is too
much unemployment because output is
less than the target level. In order to
hit their output target, the policymakers will conduct an expansionary
policy that will shift the aggregate
demand curve out to AD2 and the
economy will move to Point A. Because
unemployment is now below the natural
rate level, wages and prices will begin
to rise, shifting the short-run
aggregate supply curve up to AS2 and
sending the economy to Point 2.
The price level has now risen from PI to P2, but the process will not stop there. The economy is still
operating at an output level below the target, and so the policymakers will shift the aggregate
demand curve out again, this time to AD3. The economy will eventually head to Point 3, and
policymakers will again shift the aggregate demand curve outward, sending the economy to Point 4
and beyond.