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Econ 100B
Macroeconomic Analysis
Professor Steven Wood
Spring 2013
Exam #2 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 3:30 p.m. on April 9, 2013.
_______________________________________
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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, ask one of the GSIs. 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 said to you.
5.
If you need to re-draw a diagram and/or need more room to write your answers, use pages 2, 11, 12, 13
and/or 14.
6.
If you finish your exam before 3:25 p.m. you may turn in your exam and quietly exit the room.
7.
If you finish your exam after 3:25 p.m., close your exam packet but remain seated until time is called.
8.
When time is called, STOP writing, immediately CLOSE your exam packet and TURN IN your exam. You
WILL BE PENALIZED if you continue to write past the official end of the exam.
Do NOT open this test until instructed to do so.
Exam #2 (Spring 2013)
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A. Multiple Choice Questions (30 points). Highlight the best answer (3 points each).
1.
It has been argued that higher inflation causes business firms to become permanently less efficient because
they now have more pricing power. If this were true and economic output was initially at its potential level,
then compared to the standard model, a fiscal expansion would cause:
a.
b.
c.
d.
2.
According to real business cycle theory, wages and prices are completely flexible in the short-run. If this
theory is correct, then the large fiscal contraction from the recent budget sequestration would:
a.
b.
c.
d.
3.
Deflation.
Disinflation.
Hyperinflation.
Higher inflation.
If a country is running a net export surplus, the most effective way of eliminating that net export surplus
would be to _____ government purchases and _____ the domestic money supply.
a.
b.
c.
d.
5.
Not shift the AD curve.
Have no effect on inflation.
Have no effect on economic output.
Increase economic output in the short-run but not in the long-run.
Suppose that the central bank has underestimated the economy’s potential output level. If the central bank
then pursues a policy to keep the economy at what it thinks the economy’s potential output level is, then
this will initially result in:
a.
b.
c.
d.
4.
Lower inflation than in the standard model.
Higher inflation than in the standard model.
Inflation would be the same as in the stardard model.
What happens to inflation is indeterminate; it could be either higher or lower than in the standard
model.
Increase; increase.
Increase; decrease.
Decrease; increase.
Decrease; decrease.
Suppose that the government initially has a balanced budget but then undertakes a large, permanent fiscal
expansion. In which case would inflation accelerate the most?
a.
b.
c.
d.
When the deficit is caused by lowering taxes.
When the deficit is financed by borrowing from the public.
When the deficit is financed by increasing the money supply.
When the deficit is caused by increasing government purchases.
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6.
Along the SRAS curve with expected inflation of 4%, the economy will be below potential output when:
a.
b.
c.
d.
7.
The flatter the SRAS curve, the _____ the initial effect on inflation and the _____ the initial effect on
unemployment for any given change in monetary or fiscal policy.
a.
b.
c.
d.
8.
larger; larger
larger; smaller
smaller; larger
smaller; smaller
Suppose that the unemployment rate is initially at the natural rate of unemployment. The fiscal authorities
then increase taxes while the monetary authorities react immediately with an autonomous policy to
completely offset the effects on economic activity of the change in fiscal policy. This short-run effect of
these two policy actions is to:
a.
b.
c.
d.
9.
Inflation falls below 4%.
Inflation rises above 4%.
Expected inflation falls below 4%.
Expected inflation rises above 4%.
Increase inflation.
Decrease inflation.
Increase the real interest rate.
Decrease the real interest rate.
Problems of moral hazard in the financial sector could be reduced by requiring loan applicants to:
a.
b.
c.
d.
Provide collateral against the loans.
Sign promissory notes to repay the loans.
Submit detailed financial information before the loans are approved.
All of the above.
10. The collapse of one bank might easily lead to the failure of several others because:
a.
b.
c.
d.
Deposit insurance makes all banks equally risky.
No bank can survive when its competitors cease to operate.
Depositors cannot trust each other to keep their money in the bank.
Government regulators will step in to punish any bank suspected of poor management.
Exam #2 (Spring 2013)
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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 questions is sequential and cumulative.
1.
The IS – MP – AD/AS Model. Suppose that the economy, which is characterized by sticky wages and
prices, is initially in general equilibrium.
a.
Based only on this information, use IS – MP – AD/AS diagrams to clearly and accurately show
the economy’s initial (1) economic output, (2) inflation, and (3) real interest rate. These diagrams
should be drawn in BLACK.
LRAS
r
r
MP0
IS0
r1
r1
r2 = r0
r2 = r0
MP2
IS1
Y 0 = YP
Y1
Y2
Y
π0
π1
π2
π
LRAS
SRAS2(πe = π1)
π
SRAS1(πe = π0)
π2
SRAS0(πe = π0)
π1
π0
AD2
AD1
AD0
Y0 = YP
Exam #2 (Spring 2013)
Y1
Y2
Y
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b. In Year 1, there was a sharp increase in crude oil prices to which the government reacted by
reducing taxes. Incorporating only this new information, clearly and accurately show in your
diagrams above the Year 1 effects, if any, these events would have on the economy’s (1) economic
output, (2) inflation, and (3) real interest rate assuming that the unemployment rate declined.
These effects should be drawn in RED.
c.
Provide an economic explanation of what you have shown in your diagrams above. Discuss
what, if anything, happens in Year 1 to the economy’s (1) economic output, (2) inflation, and (3)
real interest rate. Be sure to explain why these effects take place.
In Year 1, two separate events occur.
First, the sharp increase in crude oil prices is a temporary short-term supply shock,
increasing inflation for any given level of economic output. This can be represented
by an upward shift of the short-run aggregate supply curve from SRAS0(πe = π0) to
SRAS1(πe = π0).
Second, the government reacted to the increase in crude oil prices by reducing taxes.
This would increase planned expenditures and economic output at any given real
interest rate. This can be represented by a rightward shift of the IS curve from IS0
to IS1. This would also increase economic output for any given inflation. This can be
represented by a rightward shift of the aggregate demand curve from AD0 to AD1.
Because the unemployment rate declined, according to Okun’s Law economic output had to
increase relative to potential output. Consequently, the combination of these two Year 1
events generated a new, short-term equilibrium with economic output rising from Y0 to Y1,
with inflation increasing from π0 to π1, and with the real interest rate rising from r0 to r1 as
the central bank tightened monetary policy endogenously along the monetary policy curve
MP0.
When the Year 1 effects were complete, economic output had increased such that Y1 > Y0,
inflation had increased such that to π1 > π0 , and the real interest rate had increased such that
r1 > r0.
[The higher real interest rate has partially reduced the increase in economic output
(relative to what it would have been had the real interest rate not increased) along
the IS curve IS1. As a result, economic output did not increase as much as it would
have had the real interest rate not increased.]
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d. In Year 2, the central bank adopted a real interest rate target at the initial general equilibrium real
interest rate. Assume that the central bank knows exactly what inflation is or will be in Year 2.
Incorporating only this new information, clearly and accurately show in your diagrams above the
Year 2 effects, if any, this event would have on the economy’s (1) economic output, (2) inflation,
and (3) 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, if anything, happens in Year 2 to the economy’s (1) economic output, (2) inflation, and (3)
real interest rate. Be sure to explain why these effects take place.
In Year 2, two separate events occur.
First, in Year 1 actual inflation exceeded expected inflation, i.e., π1 > πe1 = π0. With
inflationary expectations determined by a one-period (year) adaptive process,
expected inflation increased in Year 2 to π1, i.e. πe2 = π1. This can be represented by
an upward shift of the short-run aggregate supply curve from SRAS1(πe = π0) to
SRAS2(πe = π1).
Second, the central bank adopted a real interest rate target at the initial general
equilibrium real interest rate r0, i.e., rT = r0, with the full knowledge of what
inflation will be in Year 2. In order to target the real interest rate at r0, the central
bank had to engage in an autonomous easing of monetary policy. This can be
represented by a downward shift of the monetary policy curve from MP0 to MP2.
With the shift in the monetary policy curve, the real interest rate is lower for any
given inflation. The lower real interest rate increased planned expenditures and
economic output along the IS curve IS1. This would also increase economic output
for any given inflation. This can be represented by a rightward shift of the
aggregate demand curve from AD1 to AD2.
[In order to compensate for the rise in inflation that the autonomous easing
of monetary policy caused, the central bank must initially reduce the real
interest rate below its eventual Year 2 equilibrium level and then allow the
real interest rate to increase endogenously with higher inflation.]
Because the central bank’s policy resulted in a lower real interest rate, economic output had
to increase from Y1 to Y2. Consequently, the combination of these two Year 2 events
generated a new short-run equilibrium with economic output rising from Y1 to Y2, with
inflation increasing from π1 to π2, and with the real interest rate declining from r1 to r2.
When the Year 2 effects were complete, economic output had increased such that Y2 > Y1 >
Y0 = YP, inflation had increased such that π2 > π1 > π0, and the real interest rate had declined
such that r2 < r1 but also r2 = r0.
[Although the central bank has achieved its interest rate target there is an even
larger positive output gap and inflation is even higher than had they not followed
this policy. And because of the large positive output gap, the central bank will have
to repeat its Year 2 monetary policy action in subsequent years.]
Exam #2 (Spring 2013)
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2.
The AD/AS Model (35 points). In 2010, the Spanish economy, which is characterized by sticky wages and
prices, was in a deep recession.
a.
Based only on this information, use an AD/AS model diagram to clearly and accurately show the
Spanish economy’s 2010 (1) economic output and (2) inflation. This diagram should be drawn in
BLACK.
LRAS
π
SRAS0(πe = π-1)
SRAS1(πe = π0)
π0
SRAS2(πe = π1)
π1
π2
AD0
AD2
Y2
Exam #2 (Spring 2013)
Y1
Y0
AD1
YP
Y
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b. In 2011, the severity of the recession had an adverse impact on the profitability of Spanish banks,
causing them to significantly increase their lending standards and collateral requirements. Also in
2011, the unemployment rate increased. Incorporating only this new information, clearly and
accurately show in your diagram above the 2011 effects, if any, these events would have on
Spain’s (1) economic activity and (2) inflation. These effects should be drawn in RED.
c.
Provide an economic explanation of what you have shown in your diagram above. Discuss what,
if anything, happens in 2011 to Spain’s (1) economic output and (2) inflation. Be sure to explain
why these effects take place.
In 2011, two separate events occur.
First, because the Spanish economy was already in recession, economic output was
below potential output, i.e., Y0 < YP and 2010 actual inflation was below 2010
expected inflation, i.e., π0 < πe0 = π-1. Because inflation expectations are formed by a
one-period (year) adaptive process, in 2011 expected inflation fell from π-1 to π0.
This can be represented by a downward shift of the short-run aggregate supply
curve from SRAS0(πe = π-1) to SRAS1(πe = π0).
Second, in 2011 Spanish banks significantly increased their lending standards and
collateral requirements. This would lead to less borrowing and lending activity at
any given (central bank determined) real interest rate. Less borrowing and lending
activity would reduce planned expenditures and economic output for any given real
interest rate. This can be represented by a leftward shift of the IS curve. This would
also reduce economic output for any given inflation. This can be represented by a
leftward shift of the aggregate demand curve from AD0 to AD1.
Because the unemployment rate rose further, according to Okun’s Law economic output had
to decline relative to potential output. Consequently, the combination of these two 2011
events generated a new, short-term equilibrium with economic output declining from Y0 to
Y1 and with inflation declining from π0 to π1.
When the 2011 effects were complete, economic output had declined such that Y1 < Y0 < YP
and inflation had declined such that π1 < π0.
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d. In 2012, the Spanish government sought outside assistance to bail-out the Spanish banks. In order
to receive this outside assistance, the Spanish government was required to adopt significant fiscal
austerity measures. Also in 2012, the unemployment rate increased further. Incorporating only this
new information, clearly and accurately show in your diagram above what 2012 effects, if any,
these events would have on Spain’s (1) economic output and (2) inflation. These effects should be
drawn in BLUE.
e.
Provide an economic explanation of what you have shown in your diagram above. Discuss what,
if anything, happens in 2012 to Spain’s (1) economic output and (2) inflation. Be sure to explain
why these effects take place.
In 2012, two separate evens occur.
First, actual inflation in 2011 was less than expected inflation in 2011, i.e, π1 < πe1 =
π0. Because inflation expectations are formed by a one-period (year) adaptive
process, in 2012 expected inflation will fall from π0 to π1. This can be represented by
a downward shift of the short-run aggregate supply curve from SRAS1(πe = π0) to
SRAS2(πe = π1).
Second, the Spanish government adopted contractionary fiscal policies, i.e., reduced
government purchases and/or increased taxes. This would reduce planned
expenditures and economic output for any given real interest rate. This can be
represented by a leftward shift of the IS curve. This would also reduce economic
output for any given inflation. This can be represented by a leftward shift of the
aggregate demand curve from AD1 to AD2.
Because the unemployment rate rose further, according to Okun’s Law economic output had
to decline relative to potential output. Consequently, the combination of these two 2012
events generated a new, short-term equilibrium with economic output declining from Y1 to
Y2 and with inflation declining from π1 to π2.
When the 2012 effects were complete, economic output had declined such that Y2 < Y1 < Y0 <
YP and inflation had declined such that π2 < π1 < π0.
Exam #2 (Spring 2013)
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