Second Prelim ECON 102 – 11 April 2006
Name:
Section Number:
This exam has 20 multiple choice questions, 4 short answer questions and 2 essay
questions
Multiple Choice Questions
One point per question.
Write the answers on the separate sheet provided.
1. The aggregate demand curve _____ a market demand curve _____ it _____ the sum
of all market demand curves in the economy.
a) is not; and; is not
b) is; and; is
c) is; but; is not
d) is not; but; is
Answer: a
2. An increase in money supply will cause
a) a rightward shift in the AD curve
b) a leftward shift in the AS curve
c) a rightward shift in the AS curve
d) a leftward shift in the AS curve
Answer: a
3. When an economy produces at its ____ level of output, the aggregate supply curve
becomes ______
a) maximum; horizontal
b) maximum; vertical
c) minimum; vertical
d) minimum; relatively flat and negatively sloped
Answer: b
4. If there were no time lag between the input and output price changes the _____
aggregate supply curve would be almost entirely ______
a) long-run, horizontal
b) long-run, negatively sloped
c) short-run, vertical
d) short-run, horizontal
Answer: c
5. Which of the following factors will shift the aggregate supply curve to the left?
a) supply of better educated labor
b) late monsoon rains in an agricultural nation like India
c) investment in infrastructure
d) good weather
Answer: b
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Second Prelim ECON 102 – 11 April 2006
6. One possible explanation for involuntary unemployment is
a) the wage rate does not adjust immediately to changes in the labor demand
b) the labor market is perfectly competitive
c) the firms, knowing the supply and demand curve for labor, implement the
equilibrium wage, which happens to be so low that many people prefer to stay at
home
d) maximum wages which are implemented
Answer: a
7. If inflationary expectations _____, the results will be a(n) _______ in the rate of
inflation even though the unemployment rate _____ have changed
a) increase; decrease; may not
b) increase; decrease; may
c) decrease; increase; may not
d) decrease; decrease; may not
Answer: d
8. Whether government debt is considered a good/bad thing by economists does not
depend on
a) the relative size of the debt
b) the absolute size of the debt
c) the proportion spent on consumption spending versus capital spending
d) whether the bonds issued were bought by foreigners vs. domestic residents
Answer: b
9. Which of the following components of government spending can be categorized as a
consumption expenditure (CE) and which can be categorized as an investment
expenditure (IE) respectively?
a) CE: spending on unemployment payments; IE: salaries of the soldiers in the Iraq
war
b) CE: paying gardeners to maintain the White House grounds; IE: construction of a
library
c) CE: construction of new conference halls; IE: research and development
expenditure
d) CE: senators’ fringe benefits; IE: purchase of consumables for defense
Answer: b
Read the following scenario and answer the following 3 questions:
In April data collected about the first quarter of 2010 indicates that the economy is in a
recession. The Fed’s economists reach a consensus in July as to what the best course of
action required to restore full employment would be. The corrective policy is
implemented at the end of July. The economy only registers the full impact of the policy
in December.
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Second Prelim ECON 102 – 11 April 2006
10. The time period between April and July is defined as ______ and the time period
between July and December is defined as ______.
a) response lag; implementation lag
b) recognition lag; response lag
c) implementation lag; response lag
d) recognition lag; implementation lag
Answer: c
11. Which of the following policies could the Fed’s economists recommend?
I.
FOMC (Federal Open Market Committee) should buy back securities
II.
The Fed should decrease the supply of the US Dollar
III.
The discount rate should be increased
IV.
The treasury should increase taxes
a) I, II and IV
b) I, II and III
c) I and IV
d) I only.
Answer: d
12. Assume that the economists in the Fed are geniuses and that they implement
monetary policy that is just enough to offset the recessionary gap of April and move
the economy to full employment, though the full effect isn’t felt until December.
Assume also that in September there is an unexpected rise in oil prices which raises
input prices. In this event, policy implemented by the Fed will result in an equilibrium
which is:
a) at full employment
b) below full employment
c) above full employment
d) in line with the NAIRU
Answer: b
13. Which one is NOT TRUE about bonds?
a) if bond prices decrease, bond yields would increase
b) when interest rates rise, bond holders will suffer a loss (in value of securities they
own)
c) bondholders do not have right to share in firm’s profit
d) a bond is a fixed income security as it offers a fixed annual percentage return no
matter which year it is purchased
Answer: d
14. According to the life-cycle theory of consumption, people
a) consume less than they earn in the beginning of their life cycle
b) consume less than they earn in their retirement years
c) consume more than they earn between their early working years and retirement
d) tend to save the most during their working years
Answer: d
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Second Prelim ECON 102 – 11 April 2006
15. Knowing about substitution and income effects one can predict that
a) an increase in the wage rate will increase the labor supply
b) an increase in the wage rate will decrease the labor supply
c) winning the lottery will decrease my labor supply
d) winning the lottery will have an ambiguous effect on my labor supply
Answer: c
16. The accelerator effect refers to the effects of
a) interest rate on investment
b) changes in economy activity (i.e. output) on investment
c) the money supply on inflation
d) wages on inflation (i.e. cost-push inflation)
Answer: b
17. An _______ in inventories has _______ effect on future production
a) unexpected decrease; a negative
b) unexpected decrease; a positive
c) expected increase; a positive
d) expected decrease; no
Answer: b
18. The Laffer Curve……
a) shows the positive relationship between tax rates and tax revenues
b) shows the negative relationship between tax rates and tax revenues
c) is used by supply-side economists to argue that it is possible to generate higher
tax revenues by decreasing tax rates
d) illustrates how a decrease in taxes, which are reflected in an increase of the
disposable income of the workers, increases the incentives to work, thereby
always increasing the tax revenues collected
Answer: c
19. Fill in the blank: NAIRU is the acronym for ______________
Answer: Non-Accelerating Inflation Rate of Unemployment
20. The velocity of money is defined as_________
PY
Answer: V 
M
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Second Prelim ECON 102 – 11 April 2006
Name:
Section Number:
Part 2: Short Answer Questions (Total of 10 points)
Instructions: answer briefly (up to 5 lines) and make a drawing if requested. Write the
answers in your first exam booklet.
1. Derive the aggregate demand curve using the three panel graph illustrating the
goods market, money market and investment and focusing on the investment
linkage between money market and goods market. (3 points)
Estimated difficulty 1
Answer: see figure below. When the price level increases, the demand for money will
increase (panel 1), this will increase the interest rate, which in its turn will decrease the
planned investment (panel 2). This will decrease the aggregate expenditure in panel 3
and decrease Y, the aggregate output. (2 points) Repeating this exercise an infinite
amount of time will yield the downward sloping aggregate demand curve. This implies
that the AD curve represents an equilibrium in both goods and money market. (1 point)
AE
r
r
Interest rate
rateraterater
Ms
M
Panel 1
I
Panel 2
Y
Panel 3
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Second Prelim ECON 102 – 11 April 2006
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P
Aggregate
demand
Y
2. Explain how the Federal Reserve can sustain inflation by “accommodating” an
expansionary fiscal policy. (3 points)
Estimated difficulty 2
Answer: Suppose that the government increases G thereby shifting AD0 to AD1. This is
demand-pull inflation (the price level goes up). (1 point) Because the prices go up, the
demand for money will increase, leading to a higher interest rate, which will decrease
planned investment. (1 point) Suppose that the government does not like this increasing
interest rate and uses monetary policy to counteract this. The Fed increases the money
supply, thereby further increasing the AD to AD2. This in its turn will again increase the
price level. We can go on and on like this. (1 point) Most economists therefore believe
that sustained inflation can only exist when the Fed accommodates the fiscal policy.
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Second Prelim ECON 102 – 11 April 2006
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P
AS0
AD2
AD1
AD0
Y
Note that the AS graph does not have the right shape (this was difficult to do on the PC)
3. Explain the deficiencies of the efficient wage theory in explaining unemployment
(2 points)
Estimated difficulty: 2
Answer: efficient wage theory says that the firm could increase the productivity of its
worker by raising the wage above w* . Raisons for the firm could be improved morale, a
higher productivity…. But this does not explain the cyclical behavior of unemployment as
the wages should always be > w* (1 point). Nor does the argument has a lot of credibility
in countries such as America where people are in general already quite well-fed…(1
point)
4. Explain (briefly) the pro-budget deficit and the contra-deficit arguments discussed
in lecture. (2 points)
Answer: whether the deficit is considered harmful of not depends on may factors, i.e. how
large the deficit is w.r.t the size of the economy, who owns the debt?, whether the money
was spend on consumption versus investment (create an asset on the other side of the
govt. balance). Some pro-deficit arguments are: an economy needs public goods, and
stabilization policies.(1 point) Some contra-deficit arguments are: stabilization does not
always work (refer to the “fool in the shower”, and the problems associated with debt
owned by politically important countries and too much money spend on consumption
spending versus capital investment). (1 point)
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Second Prelim ECON 102 – 11 April 2006
Name:
Section Number:
Part 3: Essay Questions (Total of 12 points)
Instructions: answer all these questions in your second booklet.
1. Read the following article from BBC News 5 July 2002.
Stock markets bounce back
US and European share prices closed sharply higher on Friday, partially recouping hefty
losses earlier this week. In New York, the benchmark Dow Jones index closed 3.58%
higher at 9,379.5, while the Nasdaq index of technology stocks settled up nearly 5% at
1,448.38. Wall Street closed at lunchtime, with many traders taking a prolonged weekend
break after Thursday's independence Day holiday. The jump in prices marked the Dow's
biggest one-day rally since. September 24, lifting shares from the five-year low they
touched earlier this week. The price surge reflected strong buying activity as investors
snapped up shares deemed cheap after a sustained decline over the last two weeks.
Tech stocks soar
Panic buying by traders who had borrowed stocks and sold them in the expectation that
prices would fall again - so-called short-covering - also helped support the market. Major
technology firms, whose stocks came under particularly heavy selling pressure earlier in
the week, led the recovery. The rally came despite weaker than expected US
unemployment figures and renewed fears over terrorist attacks following a shooting
incident on Thursday in Los Angeles. The recovery was helped by a strong performance
in European shares on Thursday, while the US markets were closed.
But traders on both sides of the Atlantic downplayed hopes that the higher prices mark
the beginning of a turnaround, describing the recovery as a "relief rally."
1.1. Explain how the prices of stocks are determined. (1 point)
Answer: the price of stock equal the discounted value of expected future dividends. This
discount factor depends on the interest rate (if the interest rate goes up, the price goes
down) and the risk factor (if risk goes up, price goes down) Dividends refer to the
percentage of annual profits that the firms pays to its stockholders. .
1.2. What is the price/earnings ratio of a stock? (1 point)
Answer:
Pt
P

Earning t Per share earning
With per share earning = company’s after tax profits dividends divided by the number of
outstanding shares
P(t) as defined before, always at a certain period t measures
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Second Prelim ECON 102 – 11 April 2006
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1.3. Give some examples of how the boom in the stock market of 1995-2000 has
positively impacted the economy. (2 points)
Answer: Firms invest more as they have more money to invest available and households
increase consumption (as their wealth increases).
2. Read the following article from BBC News 12 March 2002
Death of a controversial economist
James Tobin, the Nobel-prize winning economist who first proposed a tax on currency
speculators, has died at the age of 84. Mr Tobin was one of the last of Keynesian
economists and a former economic advisor to President John F Kennedy who advocated
tax cuts in the United States to boost economic growth.
Mr Tobin's most lasting achievement was to help bring the Keynesian revolution to the
United States, where he advocated a degree of government intervention to stabilize
markets. He served as an influential member of the Council of Economic Advisors to
President Kennedy, and advocated a modest tax cut to boost economic growth. He was
not in favor of the recent tax cuts by the Bush administration, however, and also found
the monetarist approach of Margaret Thatcher not to his liking.
2.1. Explain briefly the philosophy of Keynes related to the role of government
intervention in the economy. Why was his view popular in the 30s? (2 points)
Answer: Keynes was in favor of active govt. intervention to regulate to smooth out the
business cycle problems with unemployment and inflation. (1 point) During the period
when Keynes lives in the 30s the US economy was operating at the almost horizontal part
of the AS curve, which implies that an expansionary monetary and fiscal policy indeed
would lead to an increase in Y (and a decrease in unemployment) rather than inflation. (1
point)
2.2. Explain the main differences between a monetarist view and the Keynesian view
(make sure to discuss the following topics: do expectations adjust?, difference long-run
short run?, is there full employment?, what are the policy conclusion related to both
monetary and fiscal policy?, what are the main critiques of each model?)
Expectations adjust? 0.5 pt
LS/SR different? 0.5 pt
Full employment? 0.5 pt
Policy conclusion 1 pt
(monetary/ fiscal policy)
Keynes
Very slow
Short run very important
Far away
Govt. must intervene with
fiscal and monetary policy
Demand management
important
monetarist
Quite fast
Almost the same
Always close
Skeptical about ability govt.
to manage economy
because of time lags
Money supply should grow
at same rate as the real
economy to avoid inflation
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Critiques 1.5 pt
Second Prelim ECON 102 – 11 April 2006
V not constant; what is M?;
other elements impact the
economy next to money
(from quantity theory of
money)
Worked well in 30s (see
previous question).
Recognize time lags.
2.3. Give your own opinion about the different macro-theories which we have seen in
class: which one do you favor (if you do) and why? 2 points
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