University of California, Davis Econ 101- Intermediate Macroeconomic Theory Summer Session 2, 2013 Prof.

Ariel Weinberger

PRACTICE FINAL

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Please complete the following information: Name: Student ID Number:

You will have 110 minutes to complete this exam. This exam consists of two parts. The first part consists of 20 multiple choice questions worth 50 points. The second part consists of 4 short answer questions worth a total of 75 points.

PART 1: Multiple Choice (50 points- 2.5 points each)- Please choose the best answer
1) The IS curve will shift to the right when which of the following occurs? A) an increase in the money supply B) a reduction in the interest rate C) an increase in government spending D) all of the above E) none of the above

2) The LM curve shifts down (or, equivalently, to the right) when which of the following occurs? A) an increase in output B) an increase in taxes C) an increase in consumer confidence D) an open market sale of bonds by the central bank E) none of the above

3) During 2008 in the United States, consumer confidence fell significantly. Which of the following will occur as a result of this reduction in consumer confidence? A) the IS curve will shift leftward. B) the LM curve will shift down. C) the LM curve will shift up. D) the IS curve will shift rightward. E) the IS curve will shift rightward, and the LM curve will shift up.

4) For this question, assume that investment spending depends only on the interest rate and no longer depends on output. Given this information, a reduction in government spending A) will cause a reduction in output and have no effect on the interest rate. B) may cause investment to increase or to decrease. C) will cause investment to decrease. D) will have no effect on output. E) will cause investment to increase.

5) Suppose there is a simultaneous fiscal expansion and monetary expansion. We know with certainty that A) output will increase. B) output will decrease. C) the interest rate will increase. D) the interest rate will decrease. E) both output and the interest rate will increase.

Use the information provided below to answer the following questions. The non-institutional civilian population is 250 million, of which 100 million are employed and 10 million are unemployed. 6) Based on the information above, the labor force participation rate is A) 66%. B) 40%. C) 90.1%. D) 44%. E) 36%.

7) The price setting equation is represented by the following: P = (1+m)W. When there is perfect competition (and assuming no intermediate inputs), we know that m will equal A) W/P. B) P. C) 0. D) W. E) none of the above

8) The natural level of employment (N) will increase when which of the following occurs? A) an increase in the markup of prices over costs B) a reduction in unemployment benefits C) an increase in the actual unemployment rate D) all of the above E) none of the above

9) Suppose that increased international trade makes product markets more competitive in the U.S. Given this information, we would expect to observe which of the following? A) an upward shift in the WS curve B) a downward shift in the WS curve C) an upward shift in the PS curve D) a downward shift in the PS curve E) none of the above

10) When the current price level is equal to the expected price level, we know that A) the goods market and financial markets are in equilibrium. B) the output is equal to the natural level of output. C) the unemployment rate is zero. D) the money market is in equilibrium. E) none of the above

11) In the aggregate demand relation, an increase in the price level causes output to decrease because of its effect on A) the nominal wage. B) government spending. C) the money market and, subsequently, investment. D) firms' markup over labor costs. E) the expected price level.

12) Assume the economy is initially operating at the natural level of output. Which of the following events will NOT change the composition of output (i.e., the percentage of GDP composed of consumption, investment, ... etc.) in the medium run? A) a reduction in the desire to save B) an increase in consumer confidence C) an increase in the money supply D) a cut in taxes E) a reduction in government spending

13) If Y < Yn, we know with certainty that A) P > Pe. B) P < Pe. C) P = Pe. D) u < un.

14) In the short run, an increase in the price of oil will cause A) an increase in the interest rate. B) an increase in output C) a reduction in the price level D) all of the above E) none of the above

15) Since approximately 1970, the most stable Phillips-type relationship for the United States has been between which of the following? A) the unemployment rate and the rate of inflation B) the change in the unemployment rate and the change in the rate of inflation C) the inverse of the unemployment rate and the rate of inflation D) the rate of inflation and the change in the unemployment rate E) the unemployment rate and the change in the rate of inflation

16) An increase in the price of oil will likely cause which of the following? A) increase the natural rate of unemployment B) increase the markup in the Phillips curve equation C) increase the sum "m+ z" in the Phillips curve equation D) all of the above E) none of the above

17) Assume that expected inflation is based on the following: et = t-1. If = 0, we know that A) the Phillips curve illustrates the relationship between the level of inflation rate and the level of the unemployment rate. B) a reduction in the unemployment rate will have no effect on inflation. C) low rates of unemployment will cause steadily increasing rates of inflation. D) high rates of unemployment will cause steadily declining rates of inflation.

18) Which of the following does NOT represent a "labor market rigidity" to which critics refer when discussing unemployment in Europe? A) a high degree of employment protection B) relatively high minimum wages C) generous unemployment insurance D) restrictive monetary and fiscal policies E) none of the above

19) TED spread is A) the difference between the riskless rate and return on stocks. B) the difference between the riskless rate and the yield on corporate bonds. C) the difference between the riskless rate and the rate at which banks are willing to lend to each other. D) none of the above

20) Suppose a liquidity trap situation exists. Which of the following is most likely to occur if taxes are cut? A) an increase in output and a reduction in the interest rate B) no change in output and no change in the interest rate C) an increase in output and little change in the interest rate D) an increase in output and an increase in the interest rate E) none of the above

PART 2: Short Answer Questions (4 questions- 75 points)

1. IS-LM in the Short Run

Suppose the Federal Reserve were to raise the money supply by some amount. Use the IS-LM model to analyze the short run implications of this policy. Assumptions (for this short run only model): i) Prices are completely fixed in the short run ii) Investment is just a usual function of income and interest rate iii) Consumption is a function of a disposable income alone with a constant marginal propensity to consume iv) Money demand response to income and interest rate in the same way we used in lecture (a) Graphically illustrate the short-run effect of this policy in an IS-LM graph. Be sure to label the axes, the curves, and use arrows showing the direction the curves shift. Also mark the initial equilibrium as point A, and the short run equilibrium as point A. Explain briefly the reason for any curve shift. (b) What will happen to the following variables in the short run equilibrium? Briefly explain reason for each variable in no more than in a few sentences. (i) Interest rate (ii) Consumption (iii) Investment

(c) Suppose that investment now responds to the interest rate to a greater degree than you assumed above (the investment function has a larger coefficient on the interest rate, or b2 is larger given the investment equation from lecture and the homework). How would it affect the slope of the IS and LM curve? Briefly provide intuitive reason for your argument. (d) Finally, compare how the 3 variables in part (b) are different in the new short run equilibrium with the larger coefficient on the interest rate in the investment function.

2. Recession: IS-LM and AD-AS Models

Suppose the US experiences a recession where consumption is falling and interest rates are falling as well as GDP. Given just this information and the usual assumption of the IS-LM model and AD-AS model (where prices are not fixed in the short run but also not completely flexible until the medium run), what might cause such a recession? For each of the economic shocks listed below, indicate if it could be a potential cause of the countrys recession or not. Make sure you explain your logic. A fall in autonomous consumption (fall in consumer confidence) An adverse supply shock An exogenous rise in money demand (flight to liquidity) A fall in taxes A fall in consumer and investor confidence, but with quick policy responses: a combined expansionary fiscal and monetary policy.

3. Fiscal Policy in the Medium Run

Suppose the economy begins with output equal to its natural level. Then, there is a permanent reduction in government expenditure a. Using the AD-AS and IS-LM diagrams, graphically show the effects of a permanent reduction in government expenditure on the position of the AD, AS, IS, and LM curves in the medium run. Make sure you label axes, initial equilibrium point, short run equilibrium and medium run equilibrium point in your diagram

b. What happens to output, the interest rate, and the price level in the medium run? What happens to consumption and investment in the medium run? Explain your logic.

4. Lucas Critique
Explain what is meant by the Lucas critique and discuss how it can be used to explain the effects of a monetary policy action that attempts to reduce unemployment below the natural rate of unemployment.