Name:
Second Prelim Makeup
ECON 102 – Professor Steven Kyle
April 24, 2008
PART I: Multiple Choice/Fill-In. 10 points (each question is worth ½ point).
1. Suppose the U.S. government increases direct transfers to citizens. Other things equal, this would
result in:
a)
b)
c)
d)
Cost-push inflation
Demand-pull inflation
An increase in net taxes
None of the above
Answer: B
2. According to New Classical macroeconomics:
a) Announced policy changes have no effect on aggregate output
b) Inflation is purely a monetary phenomenon
c) Wages are “sticky” when the demand for labor decreases
d) All of the above
Answer: A
3. Suppose the Federal Reserve accommodates an expansionary fiscal policy when the U.S. economy is
near its productive capacity. Then we would expect:
a)
b)
c)
d)
The price level to increase
The price level to decrease
Aggregate output to decrease
The aggregate supply curve to shift rightward
Answer: A
4. If the aggregate supply curve shifts over time, but the aggregate demand curve does not shift, the
Phillips curve would appear to be:
a)
b)
c)
d)
Downward sloping
Vertical
Upward sloping
Horizontal
Answer: C
5. According to the life-cycle theory of consumption, in one’s retirement years the APC, or Average
Propensity to Consume, is:
a)
b)
c)
d)
Zero
Less than 1
Greater than 1
Equal to the MPC
Answer: C
Name:
Second Prelim Makeup
ECON 102 – Professor Steven Kyle
April 24, 2008
6. Suppose the coupon of a 10-year corporate bond is 8.5%, and you purchase the bond for $500 on
January 1, 2000. Then the total payment you would receive on January 1, 2009 is:
a)
b)
c)
d)
$542.50
$457.50
$85.00
None of the above
Answer: D
7. Suppose deficit targeting legislation has been enacted in the U.S., and U.S. exports decrease
unexpectedly. Then this legislation:
a)
b)
c)
d)
Acts as an automatic stabilizer
Acts as an automatic destabilizer
Shortens the implementation lag of fiscal policy
Shortens the response lag of fiscal policy
Answer: B
8. According to the Monetarist view of macroeconomics:
a)
b)
c)
d)
The velocity of money changes many times during the year
A 10% change in the money supply will lead to a 10% change in nominal GDP
A 10% change in the money supply will lead to a 10% change in real GDP
The money supply should grow at the same rate as the average growth in nominal GDP
Answer: B
9. Which of the following is true regarding the U.S. Social Security (SS) system?
a)
b)
c)
d)
Social Security taxes fall more heavily on upper income brackets
The SS Trust Fund is predicted to run out in the next ten years or less
Individuals who are currently working are taxed to finance current SS recipients
All of the above
Answer: C
10. Suppose there is an increase in transfer payments, and the substitution effect dominates the income
effect. Then we would expect:
a)
b)
c)
d)
Consumption to increase and labor supply to increase
Consumption to decrease and labor supply to decrease
Consumption to decrease and labor supply to increase
Consumption to increase and labor supply to decrease
Answer: D
Name:
Second Prelim Makeup
ECON 102 – Professor Steven Kyle
April 24, 2008
11. Suppose the budget deficit in Germany is 700 billion Euros. If the German DRI is negative and the
government spending multiplier is zero, a 500 billion Euro decrease in government spending
would lead to:
a)
b)
c)
d)
A 500 billion Euro decrease in the German deficit
A 500 billion Euro increase in the German deficit
No change in the German deficit
None of the above
Answer: A
12. The deficit and national debt are:
a)
b)
c)
d)
Stock and flow variables, respectively
Flow and stock variables, respectively
Both stock variables
Both flow variables
Answer: B
13. 1 – (number of employed persons / labor force) defines the:
a)
b)
c)
d)
Employment rate
Labor force productivity rate
Labor force participation rate
None of the above
Answer: D
14. If the U.S. economy is experiencing stagflation and the Federal Reserve has adopted a policy of
inflation targeting, then corrective monetary policy will:
a)
b)
c)
d)
Shift the aggregate demand curve to the right
Shift the aggregate supply curve to the left
Shift the aggregate demand curve to the left
None of the above
Answer: C
15. In long run equilibrium, a positive demand shock will cause:
a)
b)
c)
d)
The price level to increase
Aggregate output to increase
The price level to decrease
Both A and B
Answer: A
Name:
Second Prelim Makeup
ECON 102 – Professor Steven Kyle
April 24, 2008
16. The relationship between output and unemployment is described by:
a)
b)
c)
d)
The Laffer Curve
The Lucas output function
The Phillips Curve
None of the above
Answer: D
17. According to Keynesians, when wages are “sticky,” the supply of labor is ___greater than____ the
demand for labor.
18. (P – Pe) defines the price __surprise__.
19. Stabilization policy seeks to smooth out fluctuations in __output and employment___ and to keep
__prices__ stable.
20. True/False: If there is structural unemployment, but not cyclical unemployment, and firms are not
holding any excess labor and capital, then the economy as a whole is at full capacity.
Answer: True
PART II. Short Answer. 10 points (each question is worth 2 points).
Answer each question and make a drawing if requested. You must show your work to receive full
credit.
1. List three reasons why the government spending multiplier may not reach its full value when
expansionary fiscal policy is enacted. Briefly describe why each of these factors causes the
multiplier to decrease.
There are several factors that decrease the size of the government spending multiplier: 1) automatic
stabilizers such as taxes increase during expansions, causing the AD curve to shift to the left; 2)
interest rate increases cause decreases in planned investment and consumption, and also shift the AD
curve to the left; 3) the price level increases during expansions, which absorbs some of the impact of
the expansionary policy on aggregate output; 4) firms that hold excess capital and excess labor will
employ these factors when aggregate output increases, which lowers potential increases in investment
and consumption; 5) firms can draw down inventories when demand increases, which slows down
potential increases in aggregate output; and 6) if there are expectations that the expansionary policy
is temporary, rather than permanent, consumption and investment responses will lower in magnitude.
Any three of these answers are acceptable.
Name:
Second Prelim Makeup
ECON 102 – Professor Steven Kyle
April 24, 2008
2. Define and draw the aggregate demand curve. Briefly describe in words how this curve is
derived, and illustrate this derivation using graphs of the money market, the goods market, and
the investment schedule.
The aggregate demand curve shows the negative relationship between aggregate output (Y) and the price
level (P). Graphically:
P
Aggregate
Demand Curve
Y
In deriving the AD curve, we begin with an increase in P. This increases the demand for money, which
shifts the Md curve to the right, and increases the equilibrium interest rate (r). As r increases, planned
investment decreases, which causes planned aggregate expenditures to fall. In equilibrium, this causes
aggregate investment (Y) to decrease. Therefore, an increase in P causes a decrease in Y. Graphically:
Ms
r
r
AE
Md’
Md
M
Money Market
I
Investment
Schedule
Y
Goods Market
Name:
Second Prelim Makeup
ECON 102 – Professor Steven Kyle
April 24, 2008
3. What is meant by potential output? Suppose there exists a short-run equilibrium in which
aggregate output is to the left of potential output. What must be assumed about input prices to
justify a movement back towards the potential output level? In what direction does the aggregate
supply curve shift during such an adjustment?
Potential output is the level of output that can be sustained in the long run without inflation. If there is a
short-run equilibrium such that aggregate output is to the left of potential output, then the AD curve has
shifted to the left. To justify a movement back towards the potential output level, we must assume that
high unemployment and excess capacity cause input prices to fall. This implies a shift in the AS curve to
the right until the level of aggregate output is again at the potential output level.
4. Describe three factors that affect firms’ investment and employment decisions. According to
Keynesians, what phenomenon increases the volatility of firms’ investment decisions?
Three factors that affect firms’ investment and employment decisions are: 1) the wage rate and the rental
rate of capital; 2) firms’ expectations of future output levels; and 3) the amount of excess labor and
excess capital on hand. According to Keynesians, “animal spirits,” which describe investors’ feelings,
increase the volatility of firms’ investment decisions.
5. Describe the pattern of monetary policy responses to changes in the price level and aggregate
output in the U.S. since 1990.
During the 1990-1991 recession, inflation appeared to be under control, and the Federal Reserve
initiated an expansionary monetary policy by decreasing interest rates. The Fed kept interest rates low
from 1992 to 1993, but sustained a contractionary monetary policy from the end of 1993 to 1995 as
aggregate output steadily increased and the unemployment rate decreased. After slow growth in 1995,
the Fed again lowered interest rates, and kept them low until 1998. In 1999, the Fed became concerned
about inflation, raising interest rates until 2000, but initiated a significant expansionary policy until 2004
in response to the recession of 2001.
PART III. Newspaper Analysis. 10 points (each question is worth 5 points).
Answer each question and make a drawing if requested. You must show your work to receive full
credit.
1. Read the following excerpt from an article that appeared on Bloomberg.com on April 9, 2008:
U.S. Wholesale Inventories
“Inventories at U.S. wholesalers rose more than forecast in February, reflecting the biggest
slump in sales in more than a year. The 1.1 percent gain followed a revised 1.3 percent increase
in January that was larger than previously reported, the Commerce Department said today in
Washington. Sales dropped 0.8 percent, the most since January 2007. Distributors had enough
goods on hand to last 1.12 months at the current sales pace, the most in five months.”
Name:
Second Prelim Makeup
ECON 102 – Professor Steven Kyle
April 24, 2008
1.1 Describe the equation that relates end of period inventories to beginning of period inventories, sales
and production. (1 point)
Inventories (end of period) = inventories (beginning of period) + production – sales
1.2 How would you expect wholesale firms to respond to the unexpected change in inventories described
in the article? (1 point)
Since inventories have increased unexpectedly, we would expect wholesale firms to decrease output in
future production periods.
1.3 If firms respond as indicated in the previous question, what would be the effect on aggregate income
and consumption? (1 point)
When firms decrease output, aggregate income and consumption will decrease.
1.4 Describe, using the concepts of marginal benefits and marginal costs, how a firm determines its
desired/optimal level of inventories. (2 points)
Firms face trade-offs when holding inventories. If inventories are too low relative to demand, firms lose
sales and potential revenue. If inventories are too high relative to demand, firms must pay storage costs
and forgo the interest revenue that could have been earned on the funds used to produce the goods in
inventory. Therefore, firms determine their desired/optimal level of inventories by setting the marginal
cost (in terms of lost sales) of a small decrease in inventories to the marginal benefits (in terms of
decreased storage costs and increased interest revenue) of such a decrease.
2. Read the following excerpt from an article which appeared in the Economist on April 17, 2008:
More Bounty
“[L]ast year, Petrobras, Brazil's partly state-owned oil firm, announced the world's biggest oil
discovery since 2000: the Tupi field, which it hopes will produce between 5 billion and 8 billion
barrels. Now the head of Brazil's National Petroleum Agency (ANP) says another nearby
discovery might hold as much as 33 billion barrels, which would make it the third-largest field
ever found. That alone would be enough to raise Brazil to eighth position in the global oil
rankings—if these estimates are correct.”
2.1 Define a cost shock. (1 point)
A cost (or supply) shock is a change in costs that shifts the aggregate supply curve.
2.2 Other things equal, how would the U.S. aggregate supply curve shift in the short run in response to
the changes described in the article? What would be the effects on the price level and on aggregate
output? Draw a graph illustrating these effects. (2 points)
Since oil is a common input in many U.S. firms, an increase in the supply of oil in Brazil would be
expected to decrease the world price of oil, and therefore decrease costs for these firms. This downward
move in costs would shift the AS curve rightward. When the AS curve shifts rightward, the price level
decreases and aggregate output increases. Graphically:
Name:
Second Prelim Makeup
ECON 102 – Professor Steven Kyle
April 24, 2008
AS0
AS1
P
P0
P1
AD
Y0 Y1
Y
2.3 Suppose the U.S. economy is in long-run equilibrium, and the short-run aggregate supply curve
shifts in a way implied by the article, such that aggregate output is no longer at the potential
output level. All else equal, if the Federal Reserve tried to hasten the return to the potential output
level, would it initiate contractionary or expansionary monetary policy? If it did so successfully,
would the price level increase or decrease from its level in the original long-run equilibrium?
(2 points)
Referring to the graph below, if the economy is in long-run equilibrium, then aggregate output equals the
potential output level, Y0. The cost shock implied by the article would shift the AS curve rightward (from
AS0 to AS1), such that aggregate output (Y1) is greater than potential output. The price level would also
decrease from P0 to P1. If the Federal Reserve wanted to return the economy to the potential output level,
it would shift the AD curve leftward (from AD0 to AD1) by initiating a contractionary monetary policy. In
the new long-run equilibrium, the price level will decrease from its level in the original long-run
equilibrium (from P0 to P2) .
P
AS0
AS1
P0
P1
P2
AD0
AD1
Y0 Y1
Y