Name: _________________________
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GSI: _________________________
UGBA 101B
Macroeconomic Analysis
Professor Steven Wood
Fall 2012
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 5:00 p.m. on November 1, 2012.
_______________________________________
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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, 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 or need more room to write your answers, use pages 2, 12, 13 and/or 14.
6.
If you finish your exam before 12:25 p.m. you may turn in your exam and quietly exit the room.
7.
If you finish your exam after 12:25 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 (Fall 2012)
1/10
A.
Multiple Choice Questions (30 points). Circle the letter corresponding to the best answer (3 points each).
1.
Suppose that the central bank adopts an inflation target, i.e., it commits to keeping inflation at a fixed rate
and doing whatever is necessary to prevent deviations from that target. If inflation is currently at its target
value and these is a favorable productivity shock, then the central bank should.
a.
b.
c.
d.
2.
According to real business cycle theory, prices are completely flexible. If this theory is correct, then a large
fiscal expansion would:
a.
b.
c.
d.
e.
3.
Both the IS curve and the AD curve become flatter.
Both the IS curve and the AD curve become steeper.
The IS curve becomes flatter and the AD curve becomes steeper.
The IS curve becomes steeper and the AD curve becomes flatter.
Research indicates that aggregate social welfare depends inversely on the levels of both unemployment and
inflation. Suppose that both are equally disliked. If the economy is at its potential output level, then a
central bank maximizing long-run welfare would:
a.
b.
c.
d.
5.
Have no effect on inflation.
Have no effect on economic output.
Have no effect on the real interest rate.
a and b.
a, b, and c.
If the interest rate sensitivity of investment spending increases, then:
a.
b.
c.
d.
4.
Reduce the money supply.
Reduce government purchases.
Increase the money supply.
Increase government purchases.
Do nothing.
Autonomously ease monetary policy.
Autonomously tighten monetary policy.
Increase the sensitivity of changes in the real interest rate to changes in inflation.
Rapid growth of the money supply might seem appropriate to:
a.
b.
c.
d.
e.
f.
Classical economists because it will make prices more flexible.
Classical economists because stabilizing fluctuations contributes to long-run growth.
Keynesian economists because the resulting inflation will have no effect on real output.
Keynesian economists because it can speed the economy’s return to a long-run equilibrium.
All of the above.
None of the above.
Exam #2 (Fall 2012)
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6.
Assuming that the real interest rate does not change, an increase in autonomous _____ leads to an increase
in the equilibrium level of _____:
a.
b.
c.
d.
e.
7.
If the nominal interest rate is above its equilibrium level:
a.
b.
c.
d.
e.
8.
The supply of real money balances will decline.
The quantity of real money balances people are holding is too low.
People are selling financial assets in order to increase their real money balances.
All of the above.
None of the above.
The Friedman-Phelps analysis shows that a negative relationship between inflation and unemployment
holds:
a.
b.
c.
d.
9.
net exports; investment.
investment; consumption.
consumption; investment.
All of the above.
None of the above.
Even when expected inflation changes.
Even when the natural rate of unemployment changes.
Even when both expected inflation and the natural rate of unemployment change
Only when both expected inflation and the natural rate of unemployment are constant.
If a new government adopted some ill-advised regulations that caused the economy to be less efficient:
a.
b.
c.
d.
e.
There would be no permanent change in either output or inflation.
The resulting negative supply shock would lead to an immediate increase in inflation.
In the short-run this would create a negative output gap but eventually the previous general
equilibrium would be restored.
All of the above.
None of the above.
10. When property rights are well defined and inexpensive to enforce:
a.
b.
c.
d.
Little or no collateral is needed to secure a loan.
Banks become less dominant among financial intermediaries.
Poor borrowers are at no disadvantage relative to wealthy borrowers.
Collateral is an efficient solution to asymmetric information problems.
Exam #2 (Fall 2012)
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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.
IS – MP – AD/AS Model. Suppose that the economy is characterized by sticky wages and prices and is
initially, i.e., in Year 0, in general equilibrium.
a.
Based only on this information, use IS – MP – AD/AS model 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.
MP2
r
r
r2 = r0
r2 = r0
MP0
r1
r1
IS1
Y2 Y1
Y0
IS0
Y
π
π2
π1 π0
π
LRAS0
SRAS0(πe = π0)
SRAS1(πe = π0)
SRAS2(πe = π1)
π0
π1
π2
AD2
Y2 Y1 YP = Y0
Exam #2 (Fall 2012)
AD1
AD0
Y
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b.
In Year 1, there is a sharp decline in autonomous net exports. Based only on this additional
information, clearly and accurately show in your diagram above the Year 1 effects of the decline
in net exports on (1) 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 diagram above. Discuss what,
if anything, happens in Year 1 to (1) economic output, (2) inflation, and (3) the real interest rate.
Be sure to explain why these effects take place and what causes them.
The decline in autonomous net exports is a decline in planned expenditures at any real
interest rate. This can be represented by a leftward shift of the IS curve from IS0 to IS1.
The decline in autonomous net exports is also a decline in aggregate demand at any inflation
rate. This can be represented by a leftward shift of the AD curve from AD0 to AD1.
At the initial inflation rate of π0, there is now excess supply (or insufficient demand) in the
economy. This excess supply, or negative output gap, causes inflation to decline and induces
businesses to produce less so that economic output declines along the SRAS curve SRAS1(πe
= π0). As inflation slows, the central bank decreases the real interest rate along the MP curve
MP0. As the real interest rate declines, planned expenditures increase along the new IS curve
IS1 and aggregate demand increases along the new AD curve AD1.
A new short-run equilibrium is reached after inflation has declined from π0 to π1, the real
interest rate has declined from r0 to r1, and economic output has declined from Y0 to Y1,
which is below potential output, i.e., Y1 < YP.
Exam #2 (Fall 2012)
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d.
In Year 2, the central bank adopts a real interest rate target at the initial general equilibrium real
interest rate, r0. Based only on this additional information, clearly and accurately show in your
diagram above the Year 2 effects of adopting this real interest rate target on (1) 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 drawn in your diagram above. Be sure to
discuss what happens to (1) economic output, (2) inflation, and (3) the real interest rate. Be sure to
explain why these changes take place and what causes them.
At the end of Year 1, actual inflation is at π1 while expected inflation is at π0. With expected
inflation determined by a one-year adaptive process, expected inflation will decline in Year 2
from π0 to π1. This can be represented by a downward shift of the SRAS curve from
SRAS1(πe = π0) to SRAS2(πe = π1); the SRAS2 curve intersects the LRAS curve at π1. Inflation
is now lower at any given level of economic output.
In order to maintain the real interest rate at r0, the central bank engages in a contractionary
monetary policy, increasing the real interest rate for any inflation rate. This can be
represented by an upward (or leftward) shift of the MP curve from MP0 to MP2.
The increase in the real interest rate from r1 to r2 = r0 reduces planned expenditures along
the new IS curve IS1, which also reduces economic output at every inflation rate. This can be
represented by a leftward shift of the AD curve from AD1 to AD2.
At an inflation rate of π1, there is now excess supply (or insufficient demand) in the economy.
This excess supply, or negative output gap, causes inflation to decline and induces businesses
to produce less so that economic output declines along the SRAS curve SRAS2(πe = π1). As
inflation slows, the central bank decreases the real interest rate along the new MP curve
MP2. As the real interest rate decreases, planned expenditures increase along the new IS
curve IS1 and aggregate demand increases along the new AD curve AD2.
A new short-run equilibrium is reached after inflation has declined from π1 to π2, the real
interest rate has increased from r1 to r2 = r0, and economic output has declined from Y1 to
Y2, which is even further below potential output, i.e., Y2 < Y1 < YP.
Exam #2 (Fall 2012)
6/10
2.
The AD – AS Model (35 points). Suppose an economy, which is characterized by sticky wages and
prices, has an initial, i.e., Year 0, unemployment rate that is substantially above the natural rate of
unemployment.
a.
Based only on this information, use an AD – AS model diagram to clearly and accurately show
the economy’s current (1) economic output and (2) inflation. This diagram should be drawn in
BLACK.
π
LRAS0
SRAS0(πe = π-1)
SRAS1a(πe = π0)
π-1
SRAS1(πe = π0)
SRAS2(πe = π0)
π0
SRAS2a(πe = π0)
π2
π1
AD1
Y1
Exam #2 (Fall 2012)
Y0
Y2
AD0 = AD2
YP
Y
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b. Provide an economic explanation of what you have shown in your diagram above.
Because the unemployment rate is substantially above the natural rate of unemployment,
economic output is substantially below potential output, i.e., Y0 < YP.
The inflation rate is π0, at the intersection of the aggregate demand curve AD0 and the shortrun aggregate supply curve SRAS0(πe = π-1). The short-run aggregate supply curve SRAS0(πe
= π-1) interests the long-run aggregate supply curve LRAS0 at an inflation rate of π-1.
The economy is in short-run equilibrium but not in general equilibrium.
Exam #2 (Fall 2012)
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c.
In Year 1, a deep global economic recession caused a sharp decline in exports. Weak global
demand also caused the price of imported crude oil to fall by one-third, subtracting 2 percentage
points from inflation. The unemployment rate rose. Incorporating only this new information,
clearly and accurately show in your diagram above the Year 1 effects, if any, from the declines
in exports and imported crude oil prices have on (1) economic output and (2) inflation. These
effects should be drawn in RED.
d. Provide an economic explanation of what you have shown in your diagram above. Discuss what,
if anything, happens in Year 1 to (1) economic output and (2) inflation. Be sure to explain why
these effects take place and what causes them.
Because the economy is not in general equilibrium in Year 0, at the end of Year 0 actual
inflation of π0 is less than expected inflation of π-1, i.e., π0 < π-1. With expected inflation
determined by a one-year adaptive process, expected inflation declines in Year 1 from π-1 to
π0. This can be represented by a downward shift of the SRAS curve from SRAS0(πe = π-1) to
SRAS1a(πe = π0); the SRAS1a curve intersects the LRAS curve at π0. Inflation is now lower at
any given inflation rate.
Weak global demand that caused a decline in imported crude oil prices is a price (or supply)
shock that reduced inflation by 2 percentage points at any given level of economic output.
This can be represented by a downward shift of the SRAS curve from SRAS1a(πe = π0) to
SRAS1(πe = π0).
The sharp decline in exports reduces aggregate demand at any inflation rate. This can be
represented by a leftward shift of the AD curve from AD0 to AD1.
At an inflation rate of π0 there is now excess supply (or insufficient demand) in the economy.
This excess supply, or negative output gap, causes inflation to decline and also induces
businesses to produce less so that economic output declines along the SRAS curve SRAS1(πe
= π0). As inflation declines, the central bank reduces the real interest rate (along the MP
curve) which increases planned expenditures (along the IS curve) and aggregate demand
(along the AD1 curve).
A new short-run equilibrium is reached after inflation has fallen from π0 to π1 and economic
output has declined from Y0 to Y1. Because the unemployment rose, economic output had to
decline (according to Okun’s Law).
Exam #2 (Fall 2012)
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e.
In Year 2, a sharp global economic recovery caused exports to return to their Year 0 level. Strong
global demand caused the price of imported crude oil to increase by one-half, adding 2 percentage
points to inflation. Incorporating only this new information, clearly and accurately show in your
diagram above what Year 2 effects, if any, the increases in exports and oil prices have on (1)
economic output and (2) inflation. These effects should be drawn in BLUE.
f.
Provide an economic explanation of what you have shown in your diagram above. Discuss what,
if anything, happens in Year 2 to (1) economic output and (2) inflation. Be sure to explain why
these effects take place and what causes them.
Because the economy is not in general equilibrium in Year 1, at the end of Year 1 actual
inflation at π1 is less than expected inflation at π0, i.e., π1 < π0. With expected inflation
determined by a one-year adaptive process, expected inflation declines in Year 2 from π0 to
π1. This can be represented by a downward shift of the SRAS curve from SRAS1(πe = π0) to
SRAS2a(πe = π1); the SRAS2a curve intersects the LRAS curve at π1. Inflation is now lower at
any given inflation rate.
Strong global demand that caused the price of imported crude oil to increase by one-half is a
price (or supply) shock that increased inflation by 2 percentage points at any given level of
economic output. This can be represented by an upward shift of the SRAS curve from
SRAS2a(πe = π1) to SRAS2(πe = π1).
[This upward shift of the SRAS curve from SRAS2a(πe = π1) to SRAS2(πe = π1) is the
exact same magnitude as the downward shift of the SRAS curve from SRAS1a(πe =
π0) to SRAS1(πe = π0) that occurred in Year 1.]
A sharp global economic recovery that caused exports to return to their Year 0 level
increased aggregate demand at any inflation rate. This can be represented by a rightward
shift of the AD curve from AD1 to AD2 = AD0.
At the inflation rate of π1 there is now excess demand in the economy. This excess demand,
or positive output gap, causes inflation to increase and induces businesses to produce more
so that economic output increases along the SRAS curve SRAS2(πe = π1). As inflation
increases, the central bank raises the real interest rate (along the MP curve) which reduces
planned expenditures (along the IS curve) and aggregate demand (along the AD2 curve).
A new short-run equilibrium is reached after inflation has risen from π1 to π2 and economic
output has risen from Y1 to Y2.
[Economic output is definitely higher in Year 2, i.e., Y2 > Y0, and inflation is
definitely lower in Year 2, i.e., π2 < π0.]
Exam #2 (Fall 2012)
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