Disclaimer: This is a copy of an actual test#3 in the past. This should be used only to become
familiar with the format and possible wording of the tests, not for learning the course
materials. There could be some typos in the test or its solution. Your test could be different in
terms of coverage, focus on the materials, assumptions of questions, or approach of solutions,
as the notes and version of the textbook are changing over time. So, these issues can’t be used
for any future claims about your tests.
Questions 2 and 3 of sample test#2 are relevant to test#3. Questions 2, 3, and 4 of this past test are
more relevant for the final exam.
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1)- Answer the following questions briefly.
a)- Intuitively explain the shape of AD curve is downward sloping.
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b)- Explain the “Neutrality of Money” and “classical “dichotomy” in detail.
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c)- Explain the differences/similarities between depreciation/appreciation and revaluation/devaluation.
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2)- Suppose for an economy, we have following relations:
Phillips curve:
πt = πte + 0.4(Yt – 200) + νt
Monetary policy rule: it = πt + 4 + 0.4(πt – 3) + 0.4(Yt – 200)
IS curve:
Yt = 200 – 2.5(rt – 4) + εt
Fisher equation:
rt = it – πet+1
Adaptive expectations: πet+1 = πt
(Do all the calculation in 4 digits after the decimal point.)
(For variables like inflation or interest rate, value 2 means 2%)
a)- Derive equations for dynamic aggregate demand and supply (DAD and DAS) curves.
b)- Find output, inflation, nominal and real interest rates in the long run equilibrium. You need to show
your work.
c)- Suppose the economy is in its long run equilibrium at time t. But next period (in period t+1) a temporary
adverse supply side shock, ONLY for one period hits the economy, like: νt+1 = 10.
Find the income and inflation rate for periods t+1 and t+ 2. Find the income and inflation rate at the new
long run equilibrium.
d)- Using a well-marked DAD/DAS graph to show the original and new equilibrium points, plus the short
run points, determined in part (c), with related numbers. (Only neat and complete graph receives the full
mark.)
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3)- Suppose the Phillips Curve is given by πt = πte + 0.3 – 6 ut, and people form their expectations according
to this relation: πte = 0.828 πt-1. The economy is currently in its long run equilibrium, with inflation rate,
πt=50%. (Keep the calculation results with 4 digits after decimal point).
a)- What are the natural rate of unemployment and NAIRU.
b)- The authorities have decided to decrease inflation to ALMOST 5%, by keeping the unemployment rate
1% above the natural level, during the policy period. How long should the authorities continue the policy?
(Show the details of your work.)
c)- Calculate the approximate sacrifice ratio in part (b) during the policy period.
d)- Now suppose πte = 0.533 πt-1, now how long does it take to reach the same goal, using the same policy?
(Show the details of your work.)
e)- Calculate the sacrifice ratio in part (e).
f)- Comparing the cost of disinflation under these two scenarios, explain the difference.
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4)- Consider an economy in its long run equilibrium in year 0, where Pe0 = P0=100, r0= 10%, and the
money supply growth rate =20% per year every year. Potential output is 100. Suppose in year 2, the
central bank decides to reduce the money supply growth rate to zero percent, unexpectedly. Also
suppose that the economy reaches its new long run equilibrium again, in year 3.
Using a neat set of IS/LM, and AS/AD curves, show the possible short and long run equilibrium
points for years 0, 1, 2, and 3. No explanation is necessary. Draw the graph with values for Pe, P, r,
and Y, whenever possible.
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5)- Suppose while in a closed economy, while the goods market and money market are in equilibrium,
investors become pessimistic about the future of the economy, so they cut back their investment.
Only neat, complete, and well-marked graphs receive full marks.
a)- Using the IS/LM curves show the initial equilibrium (point O), and the equilibrium after this shock
(Point A). (No explanation is necessary. Be clear about the equilibrium points.)
b)- Explain intuitively and in the right casualty order, how this shock affects all the economic variables,
after this shock.
c)- If the central bank tries to keep the output fixed when the shock hits the economy, what should it do?
Show it with point B, in your graph in part (b).
d)- If the government tries to keep the output fixed when the shock hits the economy, what should it do?
Show it with point C, in your graph in part (b).
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6)- Suppose while an open economy is in its initial long run equilibrium, the demand for money
decreases because of expansion of internet banking.
a)- Draw a set of IS*/LM* and AS/AD curves to show the initial long run, short run, and new long run
equilibrium points, if the economy has a floating (flexible) exchange regime.
b)- Draw a set of IS*/LM* and AS/AD curves to show the initial long run, short run, and new long run
equilibrium points, if the economy has a fixed (pegged) exchange regime.
c)- Comparing the long run equilibrium outcomes of these two regimes, how the real exchange rate,
nominal exchange rate, net export, price level, interest rate, and money supply are different in these
two exchange regimes.
d)- Which system is working better when facing this shock? Explain.
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2)a)-
πt = πte + 0.4(Yt – 200) + νt
πet+1 = πt
 DAS: πt = πt-1 + 0.4(Yt – 200) + νt
Yt = 200 – 2.5(rt – 4) + εt
rt = it – πet+1
 Yt = 200 – 2.5(it – πt – 4) + εt
πet+1 = πt
Plugging MP Rule: it = πt + 4 + 0.4(πt – 3) + 0.4(Yt – 200) in to this equation:
 Yt = 200 – 2.5 [πt + 4 + 0.4(πt – 3) + 0.4(Yt – 200) – πt – 4] + εt
 DAD:
Yt = 200 – 0.5(πt – 3) + 0.5 εt
b)-
Long run equilibrium levels:
πt = πt-1 and νt = 0 and DAS: πt = πt-1 + 0.4(Yt – 200) + νt  Yt = 200
εt = 0 and DAD: Yt = 200 – 0.5(πt – 3) + 0.5 εt
 πt = 3
Plugging in to MP Rule: it = πt + 4 + 0.4(πt – 3) + 0.4(Yt – 200)  it = 7
Plugging in to fisher relation:
rt = it – πet+1
 rt = 4
c)-
DAS: πt+1 = πt + 0.4(Yt+1 – 200) + νt+1
DAD: Yt+1 = 200 – 0.5(πt+1 – 3) + 0.5 εt+1
 Yt+1 = 200 – 0.5(πt + 0.4(Yt+1 – 200) + νt+1 – 3)
 Yt+1 = 200 – 0.4167 πt – 0.4167νt+1 + 1.25
and πt =3 and νt+1 =10
 Yt+1 = 195.833
πt+1 = 11.3332
 Yt+2 = 200 – 0.4167 πt+1 – 0.4167νt+2 + 1.25 and πt+1 =11.3332 and νt+1 =0
 Yt+2 = 196.5278 πt+2 = 9.9443
At new equilibrium: Yt = 200
πt = 3
d)-
LRAS
π
DASt+1
DASt+2
11.3332
A
DASt
B
9.9443
3
O’
O
DAD
Y = 200
196.5278
195.833
O: initial long run eq’m
O’: new long run eq’m
A: short run eq’m
B: short run eq’m
Y
1)a)Suppose price level, P, increases
 Real money supply shrinks
 People tend to sell bonds
 Price of bonds falls
 Interest rate, r, rises
 Investment, I, falls
 Planned expenditure falls
 Inventories rise
 Output/income, Y, falls
 Aggregate demand curve is downward slopping.
------------------------------------------------------------------------------------------------------------b)- Neutrality of money: Neutrality of money states that in the medium (long) run, changes in the money
supply can not affect real variables, like real output, real investment, real consumption, real investment,
unemployment, while money supply determines the nominal levels, like price level, nominal exchange
rate, nominal output, nominal investment …
- Based on classical dichotomy, in general economy has two major sides, real side and nominal side.
Real side and real side variables are determined by the available levels of resources, capital, labor,
technology, natural resources, while nominal variables are determined by the real variables and money
supply (price level).
------------------------------------------------------------------------------------------------------------c)- Both depreciation and devaluation mean the domestic currency becomes relatively weaker and the
foreign currency become relatively stronger. But depreciation is the result of market movements, but
devaluation is implemented by the policy makers.
- Both appreciation and revaluation mean the domestic currency becomes relatively stronger and the
foreign currency become relatively weaker. But depreciation is the result of market movements, but
devaluation is implemented by the policy makers.
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4)-
1 point
3)a)πt = πte + 0.3 – 6 ut , πt = πte  Natural rate of unemployment: un = 5%
NAIRU = Natural rate of unemployment  NAIRU= un = 5%
b)We can rewrite the Phillips curve like this: πt – 0.828 πt-1 = –6 (ut –5%), and (ut – 5%) = 1%
The authorities need to hold on the policy for 4 years, from t to t+4, because:
πt+1 = 0.828 πt – 6(ut+1 – 5%)  πt+1 = 0.828 * 50% – 6*1%  πt+1 = 35.4%
πt+2 = 0.828 πt+1 – 6(ut+2 – 5%)  πt+2 = 0.828 * 29.15% – 6*1%  πt+2 = 23.31%
πt+3 = 0.828 πt+2 – 6(ut+3 – 5%)  πt+3 = 0.828 * 23.31% – 6*1%  πt+3 = 13.3%
πt+4 = 0.828 πt+3 – 6(ut+4 – 5%)  πt+4 = 0.828 * 213.31% – 6*1%  πt+4 = 5%
c)Sacrifice ratio = total lost employment/total reduction on inflation rate = (4*1%) / (50% –5%) =0.0889
d)The authorities need to hold on the policy for 2 years, from t to t+2, because:
πt+1 = 0.533 πt – 6(ut+1 – 5%)  πt+1 = 0.533 * 50% – 6*1%  πt+1 = 20.7%
πt+2 = 0.533 πt+1 – 6(ut+2 – 5%)  πt+2 = 0.533 * 20.7% – 6*1%  πt+2 = 5%
e)Sacrifice ratio = total lost employment/total reduction on inflation rate= (2*1%)/(50% –5%) = 0.0444
f)If we compare expectations under these two scenarios, πte = 0.828 πt-1 vs. πte = 0.533 πt-1, under the first
scenario, the inflationary expectations persist longer, so inflation falls slower, leading to a higher cost of
disinflation.
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5)-
LM
a)- See the graph
b)Investors’ pessimism
 Investment, I, falls.
 Planned expenditure falls.
 Inventory levels rises.
 Output/income, Y, falls.
 Demand for real money falls.
 People tend to buy bonds.
 Price of bonds rises.
 Interest rate, r, falls.
 Investment, I, rises.
Also:
- Consumption falls
- Unemployment rises
̅C
r
r1
r2
O
LM1
IS
A
B
Y1
IS1
Y
Point O: Initial equilibrium.
Point A: New equilibrium.
c)- Explanation and equilibrium at point B,
The central bank must impose expansionary monetary policy to keep output fixed (Point B).
d)- Explanation and equilibrium at point C
The government must impose expansionary fiscal policy to keep output fixed (Point C)
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Y
6)a)Point O: Initial long run equilibrium
Point A: Short run equilibrium
Point B: New long run equilibrium
LRAS
P
P1
P
B
SRAS1
O
A SRAS
AD1
AD
ε
ε
Y
LM*
O
Y
Y1
LM*1
B
A
ε1
IS*
Y
Y1
Y
b)All three points, the initial long run,
short run, and new long run
equilibrium points are the same.
LRAS
P
c)- Real exchange rate is the same in both systems.
- Nominal exchange rate is lower in the flexible
exchange system.
- Net export is the same in both systems.
- Price level is higher in the flexible exchange
system.
P
- Interest rate is the same in both systems.
B O
A
AD
- Money supply is lower in the fixed system.
d)- In this case the fixed exchange
regime works better.
ε
SRAS
Y
Y
LM*
- Because, facing this shock, the fixed
exchange regime keeps the economy at the
full employment (so no short run), while
under a flexible regime, the economy is
B
O A
overheated (boom) in the short run, and the
IS*
price level rises in the long run. Also, it is
time-consuming and painful to go back to
the new long run equilibrium.
Y
Y