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)Cost-push inflation
b)Demand-pull inflation
c)An increase in net taxes
d)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
nearits productive capacity. Then we would expect:
a)The price level to increase
b)The price level to decrease
c)Aggregate output to decrease
d)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)Downward sloping
b)Vertical
c)Upward sloping
d)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)Zero
b)Less than 1
c)Greater than 1
d)Equal to the MPC
Answer: C
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)$542.50
b)$457.50
c)$85.00
d)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)Acts as an automatic stabilizer
b)Acts as an automatic destabilizer
c)Shortens the implementation lag of fiscal policy
d)Shortens the response lag of fiscal policy
Answer: B
8. According to the Monetarist view of macroeconomics:
a)The velocity of moneychanges many times during the year
b)A 10% change in the money supply will lead to a 10% change in nominal GDP
c)A 10% change in the money supply will lead to a 10% change in real GDP
d)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)Social Security taxes fall more heavily on upper income brackets
b)The SS Trust Fund is predicted to run out in the next ten years or less
c)Individuals who are currently working are taxed to finance current SS recipients
d)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)Consumption to increase and labor supply to increase
b)Consumption to decrease and labor supply to decrease
c)Consumption to decrease and labor supply to increase
d)Consumption to increase and labor supply to decrease
Answer: D
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)A 500 billion Euro decrease in the German deficit
b)A 500 billion Euro increase in the German deficit
c)No change in the German deficit
d)None of the above
Answer: A
12. The deficit and national debt are:
a)Stock and flow variables, respectively
b)Flow and stock variables, respectively
c)Both stock variables
d)Both flow variables
Answer: B
13. 1 – (number of employed persons / labor force) defines the:
a)Employment rate
b)Labor force productivity rate
c)Labor force participation rate
d)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)Shift the aggregate demand curve to the right
b)Shift the aggregate supply curve to the left
c)Shift the aggregate demand curve to the left
d)None of the above
Answer: C
15. In long run equilibrium, a positive demand shock will cause:
a)The price level to increase
b)Aggregate output to increase
c)The price level to decrease
d)Both A and B
Answer: A
16. The relationship between output and unemployment is described by:
a)The Laffer Curve
b)The Lucas output function
c)The Phillips Curve
d)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 threereasons why the government spending multiplier may not reach its full value when
expansionary fiscal policy is enacted. Brieflydescribe 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 taxesincrease during expansions, causing the AD curve to shift to the left; 2) interest rateincreases 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.
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:
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:
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 onBloomberg.comon 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.”
1.1Describe 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
1.2How would you expect wholesalefirms 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.
1.3If 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 inthe 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 changesdescribed 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:
2.3 Supposethe U.S. economy is in long-run equilibrium, and the short-run aggregate supply curve
shiftsin 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) .