Final Exam
Economics 4020(001)-Fall 2008
Answer any two out of the following three questions (40 points in total, 20 points each):
1. The Economy in the Short Run: the IS-LM Model
Answer the following sub-questions:
(a) Draw a graph describing an economy in the short run. In your graph, show the IS curve,
the LM curve, the equilibrium interest rate and income, and label both axes correctly.
(b) Explain the meaning of the IS curve and the LM curve and discuss why the IS curve and
the LM curve have the slope/shape they typically have.
(c) Now suppose the economy is in recession and the government/central bank attempts to
use expansionary macroeconomic policies to stimulate the economy. Economists are
debating whether fiscal policy or monetary policy is likely to be more effective.
According to Real World Macro, article 3.1, Professor Fazzari studied alternative factors
that could have impact on investment. What are Fazzari’s findings? Suppose Fazzari’s
findings are correct, draw a new graph showing the economy in the short run, with your
IS curve and LM curve having the slope/shape that is consistent with Fazzari’s findings.
(d) Given Fazzari’s findings, is fiscal policy or monetary policy likely to be more effective?
In your second graph, show the effect of the policy which you believe is more effective.
Indicate the new equilibrium interest rate and income. Explain why your preferred policy
is more effective than the alternative policy in pulling the economy out of recession
(discuss the underlying economic processes in your explanation).
Answer Key:
(a) Graph: IS, LM, r*, Y*, two axes (5 points).
(b) IS: goods market equilibrium, higher r, lower I, lower Y (2.5 points); LM: money market
equilibrium, higher Y, higher money demand, higher r (2.5 points).
(c) Fazzari: between interest rate, sales growth, and cash flow, interest rate exerts the
weakest influence on investment (1 point); New Graph: IS, LM (3 points); New Graph:
rest (1 point).
(d) Fiscal policy (1 point); New IS curve (1 point); Fiscal policy is relatively effective with
small crowding-out effect (1.5 points); Monetary policy is less effective as investment is
unresponsive to interest rate (1.5 points).
2. The Open Economy in the Short Run: the Mundell-Fleming Model
Answer the following sub-questions:
(a) Draw a graph describing a small open economy with fixed exchange rate. In your graph,
show the fixed exchange rate, the IS* curve, the equilibrium income, and label both axes
correctly (do not draw LM* curve at this point).
(b) Now suppose in this economy with fixed exchange rate, the central bank sets money
supply at greater than money demand. In your graph, add a LM* curve that reflects this
monetary policy. What will happen next in this economy? Discuss the process through
which the money market returns to equilibrium.
(c) Draw another graph describing a small open economy with floating exchange rate. In
your graph, show the IS* curve, the LM* curve, the equilibrium exchange rate and
income, and label both axes correctly.
(d) Now suppose the government wants to use expansionary fiscal policy to increase the
level of income. In your graph (for floating exchange rate), show the effect of this
expansionary fiscal policy and the new equilibrium exchange rate and income. Explain
why the equilibrium exchange rate and income have changed (or not changed) in the way
you show in your graph (discuss the underlying economic processes in your explanation).
Answer Keys:
(a) Graph: e, IS*, Y*, axes (5 points).
(b) LM* (1 point); pressure for r to fall, capital outflows, central bank buys domestic
currency with foreign currency, money supply falls (4 points).
(c) Graph: IS*, LM*, e*, Y*, axes (5 points).
(d) New IS*, new e*, Y* (2 points); initial increase in Y, higher demand for money, pressure
for interest rate to rise, capital inflows, currency appreciation, net exports fall offsetting
initial increase in Y (3 points).
3. From Keynesianism to Neoliberalism, and What Will Be the Next?
Based on your reading of Professor Pollin’s article (Real World Macro, article 7.2), discuss why
John Maynard Keynes believed that free market capitalism was fundamentally unstable.
In the post-WWII period, social democratic capitalism was implemented in many
countries. However, by the 1970s, both Keynesianism and social democratic capitalism were in
serious crisis. According to Pollin, what factors/problems had contributed to the downfall of
social democratic capitalism?
Since then a new consensus in mainstream macroeconomics has emerged. It argues that
in the “long run” macroeconomic policies are ineffective and the capitalist market itself can
adjust to return to long run equilibrium. Discuss why the current mainstream macroeconomics
(as is elaborated by Mankiw’s textbook, chapter 13) believes that in the long run, without
government intervention, a capitalist market economy will always gravitate towards either full
employment or natural rate of unemployment (no graph is required, just explain the underlying
reasoning).
According to Professor Pollin, the contemporary mainstream macroeconomics belongs to
the neoliberal intellectual doctrine. In light of the current economic crisis, what do you see as
the future intellectual/economic trend? Will neoliberalism reinvent itself and survive the current
crisis (if yes, how)? Will there be a revival of Keynesianism and social democratic capitalism (if
yes, how could they manage not to repeat the 1970s crisis)? Anything else you would like to
suggest?
Answer Keys:
(a) Keynes on free market capitalism: investment is the main driving force of the economy;
investment is risky, financial markets are speculative (6 points).
(b) Downfall of social democratic capitalism: greater bargaining power for workers;
inflationary pressure; limitations on financial markets; business opposition (6 points).
(c) Mankiw: deviations of the economy from the long run equilibrium arise from mismatches
between the actual price level and the expected price level (3 points). In the long run, as
expectations catch up with actual prices, short run aggregate supply (or economic output)
would move towards long run equilibrium (3 points).
(d) General discussions (being reasonable and self consistent) (2 points).