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Econ 100B
Macroeconomic Analysis
Professor Steven Wood
Spring 2012
Exam #1 ANSWERS
Please sign the following oath:
The answers on this exam are entirely my own work. I neither gave nor received any aid while taking this exam. I will not
discuss the questions on this test until after 5:00 p.m. on February 21, 2012.
_______________________________________
Signature
Any exam turned in without a signature will be assigned a grade of zero.
Exam Instructions
1.
When drawing diagrams, clearly and accurately label all axes, lines, curves, and equilibrium points.
2.
Explanations should be written in pencil or black. Legibility is a virtue; practice good penmanship.
3.
Explanations should be succinct and to the point; make use of bullet points and common mnemonics.
4.
If you have a question, go to the aisle and ask one of the GSIs. However, the GSIs have not seen the exam beforehand
and can only provide general guidance. You are totally responsible for your answers regardless of what a GSI has told
you.
5.
If you need to re-draw a diagram and/or need more room to write your answers, use pages 2, 11 and/or 12.
6.
When time is called, STOP writing, immediately CLOSE your exam packet and turn it in to me or the nearest GSI.
You WILL BE PENALIZED if you continue to write past the official end of the exam.
7.
If you finish your exam before 4:55 p.m. you may turn in your exam to one of the GSIs and quietly exit the room. If
you finish your exam after 4:55 p.m., close your exam packet but remain seated until time is called. Once time is
called, you should immediately turn in your exam to me or the nearest GSI.
Do NOT open this test until instructed to do so.
Exam #1 (Spring 2012)
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A. Multiple Choice Questions (30 points). Circle the letter corresponding to the best answer (3 points each).
1.
Which of the following is (are) likely to cause the marginal product of labor to decrease?
a.
b.
c.
d.
e.
2.
Europe has been experiencing an unusually harsh winter with well above average snowfalls and well below
average temperatures. This has significantly disrupted transportation throughout Europe. As a result:
a.
b.
c.
d.
3.
Exogenous shocks to the economy will have a larger effect on unemployment.
Exogenous shocks to the economy will have a smaller effect on unemployment.
Exogenous shocks to the economy will have the same effect on unemployment.
Exogenous shocks to the economy will have an indeterminate effect on unemployment.
When wages and prices are completely flexible:
a.
b.
c.
d.
e.
5.
Both the real wage and the real rental cost of capital would increase.
Both the real wage and the real rental cost of capital would decrease.
The real wage would increase but the real rental cost of capital would decrease.
The real wage would decrease but the real rental cost of capital would increase.
Japan has been deregulating its domestic market for goods and services and opening its domestic market for goods
and services to foreign firms. This has increased the degree of competition between business firms. As a result:
a.
b.
c.
d.
4.
A decrease in the real wage.
An increase in total factor productivity.
A decrease in the amount of labor used in production.
All of the above.
None of the above.
Unemployment is unaffected by changes in economic output.
Inflation is determined by expected inflation and price shocks.
Expansionary monetary and fiscal policies have no affect on the economy.
All of the above.
None of the above.
The standard assumption is that the investment function is given by I = I – δ*r. But suppose that the investment
function is instead given by I = I + ν*Y – δ*r. Then for any given change in autonomous monetary policy:
a. The change in unemployment rate would be larger when compared with the standard assumption.
b. The change in the unemployment rate would be smaller when compared with the standard assumption.
c. The change in the unemployment rate would be indeterminate when compared with the standard
assumption.
d. There would be no difference in how the unemployment rate would change.
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6.
One of the advantages of the commercialization of the Internet was the rise of job matching sites like Monster.com
and CareerBuilder.com. These new websites allowed for faster and better matching between people seeking new
jobs and businesses seeking qualified workers. As a result:
a.
b.
c.
d.
e.
7.
Suppose that the central bank has adopted a zero nominal interest rate policy and the economy has a negative
output gap. Then the economy’s self-adjustment mechanism will result in:
a.
b.
c.
d.
8.
An increase in both investment and net exports.
A decrease in both investment and net exports.
A decrease in investment but an increase in net exports.
An increase in investment but a decrease in net exports.
Suppose that the central bank has an interest rate target that it is committed to maintaining under all circumstances.
As a result, positive aggregate demand shocks will ultimately cause:
a.
b.
c.
d.
9.
The AD curve would shift to the right.
Both the AD and LRAS curves would shift to the right.
The LRAS curve would shift to the right and the SRAS curve would shift up.
The AD curve would shift to the right and the SRAS curve would shift down.
The LRAS curve would shift to the right and the SRAS curve would shift down.
Deflation.
Disinflation.
Higher inflation.
No change in inflation because of the Taylor Principal.
Suppose that the central bank conducts an open market sale of government securities and the money supply
increases. This:
a.
b.
c.
d.
e.
f.
Would shift the MP curve up.
Would shift the AD curve to the left.
Could be due to banks holding fewer excess reserves.
Could only happen if the currency holding ratio declined.
All of the above.
None of the above.
10. In 2008, the Federal Reserve increased the assets on its balance sheet by more than 150%. However, the money
supply increased by only 4.5%. This must have been due to:
a.
b.
c.
d.
Banks increasing their excess reserves, causing the money multiplier to increase.
Banks increasing their excess reserves, causing the money multiplier to decrease.
Banks decreasing their excess reserves, causing the money multiplier to increase.
Banks decreasing their excess reserves, causing the money multiplier to decrease.
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B. Analytical Questions (70 points). Answer BOTH of the following questions based on the standard models of analysis developed in class. The information in the various parts of the question is sequential and cumulative.
1.
The Production Function and Labor Market Model (35 points). In 2007, the U.S. economy was in general equilibrium. Assume that the labor supply
is a positive function of the real wage and that the capital stock is fixed.
a.
Based only on this information, use a Production Function diagram (on the left) and a Labor Market diagram (on the right) to clearly and
accurately show the economy’s initial levels of (1) actual economic output, (2) potential economic output, (3) employment, and (4) the real
wage rate. These diagrams should be drawn in BLACK.
w
Y
Y = A0*F(K0,
LS2
LS0
YP0 =Y0
Y = A1*F(K0,
Y P2 = Y 2
Y1
w1 = w0
w2
LD0
LD1
L1 L2 L0
Exam #1 (Spring 2012)
L
L1
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L2
L0
L
b. In 2008, Lehman Brothers, an investment bank, collapsed. This disrupted the financial system in such a
way that firms throughout the economy had difficulty raising the (financial) capital to continue funding
their business operations at their previous levels. In addition, the labor market was in disequilibrium so
that there was no change in the real wage. Incorporating only this new information, clearly and
accurately show in your diagrams above what effects this would have on (1) actual economic output, (2)
employment, and (3) the real wage. These effects should be drawn in RED.
c.
Provide an economic explanation of what you have shown in your diagrams above. Discuss what
happens to (1) actual economic output, (2) employment, and (3) the real wage. Be sure to explain why
these effects take place.
When firms had more difficulty raising the (financial) capital to continue funding their business
operations at their previous levels, economic output declined for any given levels of labor and
capital. This implies that total factor productivity had declined. This is represented by a downward
rotation of the production function from Y = A0*F(K0, L) to Y = A1*F(K0, L).
The downward rotation of the production function causes the marginal product of labor to decline
at every level of employment. This reduces the demand for labor and is represented by a leftward
shift of the demand for labor curve from DL0 to DL1.
At the initial equilibrium wage rate, w0, the quantity of labor supplied is greater than the quantity
of labor demanded so that the labor market is in disequilibrium. Because there was no change in
the real wage, i.e., w1 = w0, employment falls from L0 to L1 where the marginal product of labor is
equal to the real wage. With employment now at L1, economic output declines from Y0 to Y1 along
the new, lower production function Y = A1*F(K0, L).
Actual economic output has declined from Y0 to Y1; employment has fallen from L0 to L1; but the
real wage has not changed so that w1 = w0.
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d. In 2009, there was a permanent decline in the labor force participation rate and a decline in the real wage
that returned the labor market to equilibrium. Incorporating only this new information, clearly and
accurately show in your diagrams above what effects this would have on (1) actual economic output, (2)
potential economic output, (3) employment, and (4) the real wage. These effects should be drawn in
BLUE.
e.
Provide an economic explanation of what you have shown in your diagrams above. Discuss what
happens to (1) actual economic output, (2) potential economic output, (3) employment, and (4) the real
wage. Be sure to explain why these effects take place.
A permanent decline in the labor force participation rate reduces the labor force for any real wage.
This is represented by a leftward shift of the supply of labor curve from LS0 to LS2.
At the 2008 real wage of w1, the quantity of labor supplied is greater than the quantity of labor
demanded. Consequently, when the labor market returns to equilibrium, the real wage has
declined from w0 = w1 to w2 and equilibrium employment has increased from L1 to L2.
With equilibrium employment now at L2, economic output increase from Y1 to Y2 along the new,
lower production function, Y = A1*F(K0, L). Because the labor market is in equilibrium, this level
of economic output is also the economy’s new potential output level, i.e., Y2 = YP2.
Actual economic output has increased from Y1 to Y2 but has declined from Y0; potential economic
output has declined from YP0 to YP2; employment has increased from L1 to L2 but has declined
from L0; and the real wage has declined from w1 = w0 to w2.
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2.
The IS, MP, and AD-AS Model (35 points). In 2008, the U.S. economy, characterized by sticky wages and
prices, had an actual unemployment rate that was above the natural rate of unemployment and moderate inflation.
a.
IS1a
r
IS1
Based only on this information, use an IS diagram (on the left), a MP diagram (on the right), and an ADAS diagram (on the bottom) to clearly and accurately show the economy’s initial levels of (1) economic
output, (2) inflation, and (3) the real interest rate. These diagrams should be drawn in BLACK.
IS0
r
MP0
r0
r0
r2
r1
r2
r1
Y2 Y1
Y P0
Y0
MP1
Y
π1 π2 π0
π
π
SRAS2(πe = π1)
SRAS0(πe = π-1)
SRAS1(πe = π0)
π-1
π0
π2
π1
SRAS2a(πe = π1)
AD0
AD1
Y2
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Y1
Y0
Y P0
Y
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b. In 2009, sharp declines in home prices and the stock market significantly reduced household wealth. In
response, the government enacted a substantial economic stimulus package while the Federal Reserve
significantly reduced its policy interest rate. Nevertheless, the unemployment rate increased.
Incorporating only this new information, clearly and accurately show in your diagrams above what
effects this would have on (1) actual economic output, (2) inflation, and (3) the real interest rate. These
effects should be drawn in RED.
c.
Provide an economic explanation of what you have shown in your diagrams above. Discuss what
happens to (1) actual economic output, (2) inflation, and (3) the real interest rate. Be sure to explain why
these effects take place.
In 2008, the actual unemployment rate was above the natural rate of unemployment. According to
Okun’s Law, this implies that economic output was below potential economic output, i.e. Y0 < YP.
Because of this negative output gap, actual inflation in 2008 was below expected inflation for 2008,
i.e., π0 < πe = π-1.
As a result of inflationary expectations in 2008 not being met, expected inflation for 2009 declined
from π-1 to π0. This is represented by a downward shift of the SRAS curve from SRAS0(πe = π-1) to
SRAS1(πe = π0).
In addition, there were three (3) aggregate demand shocks to the economy in 2009.
First, sharp declines in home prices and the stock market that significantly reduce
household wealth cause autonomous consumption to decline. At any given real interest
rate, the level of economic output has declined. This is represented by a leftward shift of
the IS curve from IS0 to IS1a. This will also cause the AD curve to shift to the left.
Second, the substantial economic stimulus package that the government enacted is either
an increase in autonomous government spending and/or a decrease in autonomous tax
revenues. At any given real interest rate, the level of economic output has increased. This
can be represented by a rightward shift of the IS curve from IS1a to IS1. This will also cause
the AD curve to shift to the right.
Third, when the Federal Reserve significantly reduced its policy interest rate it engaged in
an autonomous monetary policy easing. This is represented by a downward shift of the MP
curve from MP0 to MP1. This will also cause the AD curve to shift to the right.
Because the unemployment rate rose, economic output MUST have declined according to Okun’s
Law. Thus, the net effect of the shifts in the IS curve and the AD curve is to the left.
A new short-run equilibrium is established where economic output has declined from Y0 to Y1.
Because of the decline in expected inflation and the negative output gap, inflation has declined from
π0 to π1. Finally, the real interest rate has declined from r0 to r1 as a result of both the Federal
Reserve’s autonomous monetary policy easing and the decline in inflation.
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d. In 2010, there was a sharp, sudden increase in oil prices and unemployment rose further. Incorporating
only this new information, clearly and accurately show in your diagrams above what effects this would
have on (1) actual economic output, (2) inflation, and (3) the real interest rate. These effects should be
drawn in BLUE.
e.
Provide an economic explanation of what you have shown in your diagrams above. Discuss what
happens to (1) actual economic output, (2) inflation, and (3) the real interest rate. Be sure to explain why
these effects take place.
In 2009, economic output was below potential economic output, i.e. Y1 < YP. Because of this
negative output gap, actual inflation in 2009 was below expected inflation for 2009, i.e., π1 < πe = π0.
As a result of inflationary expectations in 2009 not being met, expected inflation for 2010 declined
from π0 to π1. This is represented by a downward shift of the SRAS curve from SRAS1(πe = π0) to
SRAS2a(πe = π1).
However, there was also a sharp, sudden increase in oil prices which produced a temporary
negative short-run price shock. This is represented by an upward shift of the SRAS curve from
SRAS2a(πe = π1) to SRAS2(πe = π1).
Because the unemployment rate rose further, economic output had to decline further according to
Okun’s Law. This implies that the upward shift of the SRAS curve due to the oil price shock was
sufficient to move the SRAS curve above its SRAS1 level (although we wouldn’t know precisely how
much without additional information).
This temporary negative short-run price shock increases inflation from π1 to π2. This causes the
Federal Reserve to endogenously increase the real interest rate from r1 to r2 along the new, lower
MP curve MP1 according to the Taylor Principal. A higher real interest rate would endogenously
reduce borrowing and spending activity along the IS curve IS1, further reducing economic output
from Y1 to Y2.
A new short-run equilibrium is established where economic output has declined from Y1 to Y2.
Because the temporary negative price shock had a greater effect on inflation that did the decline in
expected inflation and the negative output gap, inflation rose from π1 to π2 (which may or may not
be greater than π0 depending on the magnitude of the shift in the SRAS curve). Finally, the real
interest rate has increased from r1 to r2 (which may or may not be greater than r0 depending on the
magnitude of the shift in the SRAS curve) as a result of the Federal Reserve endogenously
increasing the real interest rate in response to higher inflation.
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