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Your Name: _____________________________________________________
Check Your TA’s Name:
____________ Erica Liang ____________ChoongOh Kang
_____________ Zoe Das
_____________Pavel Vacek
Econ 102 - Wissink - S04
KEY TO PRELIM #2
J. WISSINK - April 13, 2004
INSTRUCTIONS
There are three sections in this exam.
ANSWER ALL QUESTIONS. TOTAL POINTS = 100
Part I: 12 multiple-choice questions (3 points each)
Part II: 3 short essay questions (14 points each)
Part III: 1 problem (22 points)
Read all questions carefully.
Write legibly and remember to label all graphs and axes in diagrams.
Total time = 90 minutes.
GOOD LUCK!
P.S.: There is a blank work sheet at the end of this exam for your use.
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Part I. Multiple choice. Do the following 12 multiple choice questions: Read each question
carefully and CIRCLE the best answer. THERE IS ONLY ONE ANSWER TO EACH
QUESTION. It often helps to jot down a quick graph or do some work next to the question before
searching for the answer.
1) For a simple frugal economy with no government and no international trade, which of the following
statements is false?
a) Aggregate desired expenditure equals consumption plus planned investment.
b) Aggregate output/income equals aggregate desired expenditure at every level of income.
c) Aggregate output/income equals consumption plus saving.
d) Saving is a leakage out of the spending stream.
e) If planned investment is exactly equal to saving, then aggregate desired expenditure is exactly equal
to aggregate output/income.
2)
a)
b)
c)
d)
e)
If the consumption function for the economy is: C = 100 + .8Y, then the saving function, S, is:
S = 80 + .2Y
S = -80 + .2Y
S = -100 - .2Y
S = -100 + .2Y
S = 100 + .2Y
3) An increase in the marginal propensity to consume (the MPC) will tend to cause
a) the AEd line to become flatter and a given change in autonomous investment to have a smaller effect
on output.
b) the AEd line to become flatter and a given change in autonomous investment to have a greater effect
on output.
c) the AEd line to become steeper and a given change in autonomous investment to have a smaller
effect on output.
d) the AEd line to become steeper and a given change in autonomous investment to have a greater
effect on output.
e) the AEd line to shift up parallel to itself.
4) Assume a simple frugal economy where the aggregate consumption function (in billions) is:
C = 400 + .5Y and planned investment, I, is $125 billion. If aggregate income, Y, is $1000 billion,
a) unplanned changes in inventories will be zero.
b) there will be an unplanned rise in inventory.
c) aggregate output will tend to decrease.
d) aggregate output will tend to increase.
e) the economy is in equilibrium, so there is no tendency for aggregate output to change.
5) Consider a simple frugal economy where only consumption depends on Y. Suppose equilibrium
output, Y*, needs to rise by $1000. Also assume that the marginal propensity to save (MPS) equals
.20. Given this information, how much would autonomous planned investment have to increase to
cause equilibrium Y* to rise by $1000?
a) $100
b) $150
c) $200
d) $250
e) $800
6)
a)
b)
c)
d)
e)
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Assume an economy is completely represented by the following equations: C = 100 + .5Yd, I = 150,
G = 500, T = 500. In this economy, the government spending multiplier is __________ and the tax
multiplier is ________________.
10, -2
2, 1
Note: You’ll get 1.5 if
6, -5
you picked (b)
4, -3
2, -1
7) Suppose the required reserve ratio on demand deposits is 20%. Suppose that people in the particular
economy of Ivyland tend to borrow money from the commercial banking system and then only
spend half of what they borrow – keeping the other half of what they borrow in cash under their
beds. As compared to an economy where everyone spends all of what they borrow and it all gets
deposited back into the commercial banking system, the behavior of people in Ivyland will tend to
a) increase the value of the money multiplier.
b) make monetary policy less effective.
c) make monetary policy more effective.
d) make fiscal policy less effective.
e) make fiscal policy more effective.
8) What is the initial round of events (in order) that results from an open market purchase of securities
from the public?
a) Aggregate output decreases, demand for money decreases, the interest rate decreases, planned
investment increases, and aggregate output increases.
b) Money supply decreases, the interest rate increases, planned investment decreases, aggregate output
decreases, and money demand decreases.
c) Money demand decreases, the interest rate increases, planned investment decreases, aggregate output
decreases, and money demand decreases.
d) Money supply increases, the interest rate decreases, planned investment increases, aggregate
desired expenditures increase, and equilibrium output increases.
e) Money supply increases, the interest rate increases, planned investment decreases, aggregate output
decreases, and the money demand remains unchanged.
9) When money demand depends on the interest rate, aggregate output/income and the price level, an
increase in the price level will cause
a) an increase in money demand.
b) a decrease in money demand.
c) a movement along the money demand curve.
d) an increase in the money supply.
e) no change in the money demand.
10) At the current level of aggregate output/income and at the current interest rate, suppose there is
excess demand for money. Given this information, we know that there will be pressure for
a) bond prices to decrease and the interest rate to increase.
b) bond prices to decrease and the interest rate to decrease.
c) bond prices to increase and the interest rate to increase.
d) bond prices to increase and the interest rate to decrease.
e) money supply to fall.
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11) As investment becomes less responsive to (i.e., less sensitive to) changes in the interest rate, we
know that
a) a given increase in the money supply will cause a smaller final change in Y.
b) a given increase in the money supply will cause the same final change in Y.
c) a given increase in the money supply will cause a larger final change in Y.
d) the effectiveness of monetary policy in changing output is increased.
e) fiscal policy becomes totally ineffective.
12) A negative cost shock, like increasing oil prices, will result in the aggregate supply curve
a) shifting right.
b) shifting left.
Note: We will also accept (c) for
c) remaining unchanged.
full points
d) having movements along the curve.
e) shifting downward.
Part II. 3 Short Essay/Problems. Read each problem carefully and answer all questions.
1) There is no need whatsoever for either monetary or fiscal policy, since, as businesses react to
unplanned accumulations or depletions of inventories, national income tends toward - and eventually
reaches - its equilibrium level, Y*. We should have a constitutional amendment banning monetary
and fiscal policy. Do you agree or disagree with this set of statements? Defend your position.
Disagree — No one ever said that Y* is the best Y* there could be.
If there is a desire to expand the economy (create more jobs, promote growth, etc.) or contract
the economy (reduce jobs, prevent inflation, etc.), a policy must be implemented to change Y*.
Otherwise, the economy will remain at the current equilibrium.
Furthermore, the government might want to change the composition of output/income and
policy, both fiscal and/or monetary might help them do that.
NOTE: answer does not have to contain ALL these points, as long as one of them is raised in
an accurate way. Don’t look for them saying everything that I put in the answer.
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2) President Bush has asked for your advice regarding the efficacy of monetary and fiscal policy. He
specifically asks you, his trusted economic advisor, what difference it makes (regarding policy
choice) whether the demand for money is highly interest sensitive, or whether it has a very low
interest rate sensitivity. He has also heard from his friends that he should wish for a money demand
function that does not depend on income, but he is confused. Explain things to the President and
give him some useful advice using graphs and/or verbal explanations and arrows.
Ms old
A steep/INsensitive Md function is good
news for monetary policy and bad news for
fiscal policy makers. And vice versa.
Ms new
r
r old
r flat
r steep
Consider an increase in Ms (shown at left).
With steep Md there will be a larger
decrease in the interest rate for any given
increase in money supply. And the larger
the drop in the interest rate, the more of an
increase you will see in investment, and
therefore the larger the increase in Y*. This
is good news for monetary policy.
Md flat
Md steep
M
Consider a fiscal policy expansion that leads to
an increase in Y that leads Md to shift to the
right, increasing r, which, in turn, will decrease
Investment and dampen the effect of the fiscal
expansion. With a steep Md function there is a
large increase in r (not good news for fiscal
guys) but with the flat Md function there is a
much smaller increase in r (better news).
r
Ms
r steep
r flat
r old
Md flat new
Md flat old
Md steep new
Md steep old
M
Finally, both monetary and fiscal people should hope for a Md function that does not vary very
much with Y, since this will minimize the feedback effect of policy via the money demand function.
Recall with expansionary policies…
Monetary: Ms up, leads to r down, leads to I up, leads to AEd up, leads to Y up, which then feeds
back into the money market with…Md up, which leads to r up, which leads to I down, which leads
to Y down
Fiscal: G up, leads to AEd up, leads to Y up, which then feeds back into the money market
with…Md up, which leads to r up, which leads to I down, which leads to Y down
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3) Assume there is an economy with a brand new single monopoly bank and that the central bank has
set the required reserve ratio at 20%. Assume also that this monopoly bank has nothing on its books
at the moment (i.e., no loans, reserves or demand deposits). An individual, Ville, comes to the bank
and deposits $40,000 of currency into the bank.
a) As a result of this deposit, calculate the amount of actual reserves, required reserves and excess
reserves in the monopoly bank.
Dp = $40,000
Actual Reserves = $40,000
Required Reserves = (Dp)(rrr) = (40,000)(.20) = $8000
Excess Reserves = Actual Reserves – Required Reserves = $32,000
b) The bank proceeds to make loans up to its legal limit and all loans made stay in the bank as
demand deposits. After the bank has issued the maximum amount of loans it legally can make,
what is the bank’s total amount of loans and total amount of demand deposits?
Since the rrr=.20, the bank can turn the $32,000 of excess reserves into $160,000 of loans/deposits.
Total amount of loans will be $160,000
Total amount of demand deposits will be $160,000 + $40,000 = $200,000
Note now the bank has $40,000 in actual reserves and $200,000 in demand deposits.
Required reserves = (200,000)(.20) = $40,000.
Excess reserves are now 0.
c) What is the size of the money multiplier in this economy?
The money multiplier is: (1/rrr) = 5
d) If the central bank wants to increase the money supply by $500, should it buy or sell securities?
To increase the money supply the Fed should BUY securities.
e) How many dollars’ worth should it buy or sell?
(Change in Ms) = (money multiplier) (change in reserves), so $500 = (5) (change in reserves) so
the Fed should BUY $100 in securities from the public.
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Part III. Problem. Read the problem carefully and answer all questions. Show as much work as
possible given time limitations. Partial credit will be given when appropriate, so if you have
trouble with numerical solutions draw the pictures anyway, they are certainly worth something,
especially if they are drawn correctly.
Suppose that the following set of equations describes ALL the relevant information about the island
nation, Itsanice.
Consumption function: C = 1000 + .6Yd (where Yd = disposable income)
Planned Investment function: I = 700
Government expenditures function: G = 800
Tax function: T = 500
Export function: EX = .2Y
Import function: IM = 100
The full employment level of national income: YFull Employment = 14,500.
The money market can be safely ignored for now.
Inflation is assumed to be non-existent.
a. Determine the equilibrium level of national income, Y*.
AEd = C + I + G + EX – IM
AEd = 1000 + .6[Y-500] + 700 + 800 + .2Y – 100
AEd = 2100 + .6Y + .2Y
AEd = 2100 + .8Y
Now set Y* = AEd and solve for Y*
Get:
Y* = 2100 + .8Y*
Y*(1-.8) = 2100  Y*=10,500
b. Calculate the multiplier for government spending – show some work for how you arrived at this
particular value.
KG = 1/[1-mpc-mpex] = 1/[1-.6-.2] = 1/.2 = 5
SO… KG = 5
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c. How could the government use fiscal policy to achieve full employment national income? Be
specific with respect to the values and directions of the policy you suggest. (Only one suggestion is
required.)
NOTE: You need to change Y* by 4000 to get full employment.
Option 1: Increase G only.
Note KG=5. So Y* = KGG  4000 = 5G so that G = 800.
So you would increase G by $800.
Option 2: Decrease Taxes only.
Note KT = -mpc/[1-mpc-mpex] = -.6/.2 = -3. So Y* = KTT  4000 = -3T so that T = -1333.33.
(Note that this would leave you with a negative tax bill, which is ok by me. You would be
receiving a subsidy from the government. Recall T started at 500 and you LOWERED taxes by
1333.33 so now your tax bill is –833.33.)
Option 3: Increase G and T together so that G = T. Note KG=5 and KT = -3 so that KBB = 2.
So Y* = KBB[G=T]  4000 = 2[G=T] so that G = 2000 and T = 2000.
So you would increase G and T by $2000 at the same time.
Suppose now we recognize that there is a money market and that 1) investment depends on interest in
the typical way and 2) money demand depends on interest and aggregate output/income in the usual
way. Inflation can still be safely ignored.
d. How will this wrinkle affect the efficacy of the fiscal policy plan you suggested to achieve
YFull Employment? How will your fiscal policy plan have to be altered, i.e., what would you change and
in what way/direction? Use graphs and/or arrows. No numerical calculations are required.
It will reduce the efficacy of the fiscal plan you suggested, no matter which one. So you would
have to increase G by more or reduce taxes by more or if you choose the balanced budget plan,
you would have to increase G and increase T together by more. So your fiscal policy is WEAKER
and you have to give the economy a bigger shot to get the results you desire. This is because as
you, let’s say, increase G, it leads to AEd going up, which leads to Y going up, which then feeds
back into the money market with…Md up, which leads to r up, which leads to I down, which leads
to Y down. You’d like to stop this feedback effect.
e. How could “The Fed” help the government’s fiscal policy makers out? Explain.
The Fed could help out by EXPANDING the money supply so that the interest rate does not
increase when money demand shifts out due to the effects of the expansionary fiscal policy. This
money supply expansion would prevent the crowding out of investment, which in the end would
serve to increase the efficacy of your fiscal policy.