Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers Part A – Multiple Choice Questions A1. In a system with fractional-reserve banking: A) all banks must hold reserves equal to a fraction of their loans. B) no banks can make loans. C) the banking system completely controls the size of the money supply. D) all banks must hold reserves equal to a fraction of their deposits. A2. Reducing risk by holding many imperfectly correlated assets is called: A) diversification. B) moral hazard. C) risk aversion. D) leveraging. A3. Use the following to answer this question: In a small open economy represented in the graph above, if the world interest rate is r1, then the economy has: A) a trade deficit. B) balanced trade. C) a trade surplus. D) negative capital outflows. A4. In a small, open economy if net exports are negative, then: A) domestic spending is greater than output. B) saving is greater than investment. C) net capital outflows are positive. D) imports are less than exports. Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers A5. In a small open economy, if the government adopts a policy that lowers imports, then that policy: A) raises the real exchange rate and increases net exports. B) raises the real exchange rate and does not change net exports. C) raises the real exchange rate and decreases net exports. D) lowers the real exchange rate. A6. Use the following to answer this question: In the graph above, assume that the economy is at point E. With no further shocks or policy moves, the economy in the long run will be at point: A) A. B) B. C) C. D) D. A7. Assume that an economy starts from long-run equilibrium. If the central bank increases the money supply, then ______ increase(s) in the short run and ______ increase(s) in the long run. A) prices; output B) output; prices C) output; output D) prices; prices Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers A8. Use the following to answer this question: In the graph above, if firms are producing at level Y3, then inventories will ______, inducing firms to ______ production. A) rise; increase B) rise; decrease C) fall; increase D) fall; decrease A9. According to the Keynesian-cross analysis, if MPC stands for marginal propensity to consume, then an increase in taxes of T will: A) decrease equilibrium income by T. B) decrease equilibrium income by T/(1 – MPC). C) decrease equilibrium income by (T)(MPC)/(1 – MPC). D) not affect equilibrium income at all. A10. The vertical long-run aggregate supply curve satisfies the classical dichotomy because the natural rate of output does not depend on: A) the labor supply. B) the supply of capital. C) the money supply. D) technology. Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers A11. Use the following to answer this question: Based on the graph above, if the interest rate is r3, then people will ______ bonds and the interest rate will ______. A) sell; rise B) sell; fall C) buy; rise D) buy; fall A12. If the government wants to raise investment but keep output constant, it should: A) adopt a loose monetary policy but keep fiscal policy unchanged. B) adopt a loose monetary policy and a loose fiscal policy. C) adopt a loose monetary policy and a tight fiscal policy. D) keep monetary policy unchanged but adopt a tight fiscal policy. A13. In a small open economy with a floating exchange rate, if the government imposes an import quota, then in the new short-run equilibrium the IS* curve shifts to the right, raising the exchange rate: A) but not raising net exports or income. B) and net exports but not income. C) and income but not net exports. D) net exports and income. Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers A14. Use the following to answer this question: Based on the graph above, starting from equilibrium at interest rate r1 and income Y1, an increase in government spending would generate the new equilibrium combination of interest rate and income: A) r2, Y2 B) r3, Y2 C) r2, Y3 D) r3, Y3 A15. According to the Lucas critique, when economists evaluate alternative policies they must take into consideration: A) how the policies will affect expectations and behavior. B) whether the policy will offset the impact of automatic stabilizers. C) the stage of the political business cycle in which the policy is to be implemented. D) the length of the inside lags associated with the policies. A16. Under a fixed-exchange-rate system, the central bank of a small open economy must: A) have a reserve of its own currency, which it must have accumulated in past transactions. B) have a reserve of foreign currency, which it can print. C) allow the money supply to adjust to whatever level will ensure that the equilibrium exchange rate equals the announced exchange rate. D) follow a rule specifying a constant growth rate for the money supply. Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers A17. Use the following to answer this question: A small open economy with a floating exchange rate is initially at equilibrium A with IS*1, LM*1, equilibrium exchange rate e2, and equilibrium output Y1. If there is an increase in government spending to IS*2, the new equilibrium will be at ____, holding everything else constant. A) A B) B C) C D) D A18. In a short-run model of a large open economy with a floating exchange rate, net capital outflow ______ as the domestic interest rate increases and is just equal to ______. A) decreases; the increase in net exports. B) decreases; the decrease in net exports. C) increases; the increase in net exports. D) increases; the decrease in net exports. A19. Expansionary fiscal policy in a large open economy ______ the real interest rate and ______ the real exchange rate. A) does not change; increases B) increases; increases C) increases; decreases D) decreases; increases Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers A20. If a country chooses to restrict international capital flows and to maintain a fixed exchange rate, then it must: A) live with exchange-rate volatility. B) control its citizens' access to world financial markets. C) give up the use of monetary policy for purposes of domestic stabilization. D) give up the use of fiscal policy for purposes of domestic stabilization. Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers PART B B1 (13 marks) In this economy, we have the following information regarding the consumption function (C), the investment function (I), government spending (G), government taxation (T), the money demand function (Md/P), the money supply function (Ms/P) and the price level (P): C = 600 + 0.6(Y – T) I = 1200 – 60r Ms/P = Md/P = 0.5Y – 125r Y = C + I + G Ms = 1,600 G = 1,100 P = 1 T = 1,000 where the interst rate, r, is epressed as a percentage. a) Write the equation for the IS schedule. (2 marks) b) Write the equation for the LM schedule. (2 marks) c) Find the equilibrium interest rate (r), and the equilibrium level of income, Y. (4 marks) d) The government decides to increase national saving by reducing government expenditure and balancing the budget. i.e. so that G = T = 1000. Explain the impact of this policy, first in the short run using an IS-LM diagram, then in the short run and long run with the aid of an AD-AS diagram. (5 marks) a) Write the equation for the IS schedule. (2 marks) Y = C + I + G Y = 600 + 0.6(Y – T) + (1200 – 60r) + G Y = 600 + 0.6(Y – 1000) + (1200 – 60r) + 1100 Y = 2300 + 0.6Y 60r 0.4 Y = 2300 60r Y = 5750 150r Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers b) Write the equation for the LM schedule. (2 marks) 1600 0.5 125 1 3200 250 S d M M P P Y r Y r c) Find the equilibrium interest rate (r), and the equilibrium level of income, Y. (4 marks) In equilibrium the LM curve intersects the IS curve. Therefore 3200 + 250r = 5750 150r 400 r = 2550 r = 6.375% Y = 5750 150r Y = 5750 150 6.375 Y = 4793.75 d) Assume that the economy described above is at long run equilibrium. The government now decides to increase national saving by reducing government expenditure and balancing the budget. i.e. so that G = T = 1000. Without calculating new equilibrium values, explain the impact of this policy, first in the short run using an IS-LM diagram, then in the short run and long run with the aid of an AD-AS diagram. (5 marks) Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers IS-LM diagram In the short run, the decrease in G means that the IS curve shifts to the left. National saving increases and there is an increase in the supply of funds to the loanable funds market. The interest rate falls from r1 to r2. Output falls from Y to Y2. Unemployment increases. AD-AS diagram The AD curve shifts to the left. In the short run prices are fixed at P1. The new short-run equilibrium is at the intersection of SRAS1 and AD2 with output at Y2. Long run, AD-AS diagram In the long run prices are flexible Prices fall as Y2 < Y . The cost of inputs, e.g. labour, falls. The SRAS curve moves down and output increases, moving along AD2. In the long run the economy moves back to long run equilibrium at Y with unemployment at the natural level and the price level lower at P2. Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers B2 (12 marks) a) The principal method used by a central bank to change the money supply is through open-market operations. Use the AD-AS model to illustrate graphically the impact in the short run and the long run of a central bank decision to increase open-market purchases, i.e. to increase the money supply. Be sure to label: the axes; the curves; the initial equilibrium values; the direction the curves shift; and the final equilibrium values. State in words what happens to aggregate supply, aggregate demand, prices and output in the short run and the long run. (6 marks) In the short run, prices are fixed. An increase in open-market purchases increases M. The supply of real money balances (M/P) increases, which leads to an increase in aggregate demand. The AD curve shifts from AD1 to AD2. In the short run output increases along the SRAS curve from the natural rate Y1 (A) to Y2 (B). At Y2 output is above the natural rate. Employees are working longer hours and capital is being utilized at above the normal rate. In the long run, costs increase and prices increase from P1 to P2. As prices increase, real money balances decrease and there is movement up along the AD curve from B to C. At C, Y has returned to the natural level of output and the economy is back at long run equilibrium. Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers b) Use the AD-AS model to explain the impact of a financial crisis on output and prices in an economy in the short run. Be sure to label: the axes; the curves; the initial equilibrium values; the direction the curves shift; and the final equilibrium values. Explain the factors that cause changes from the initial equilibrium to the new short-run equilibrium. What are the long run outcomes for the economy? Explain what actions the government can take to offset the impact of the financial crisis in the short run. (6 marks) The credit crunch brought about by the financial crisis decreases consumption expenditures and investment spending including housing investment. The decrease in the value of houses decreases household wealth, which has a further dampening effect on consumption spending. The AD curve shifts to the left. In the short run, there is a decrease in output to Y2. In the long run output returns to Y and there is a decrease in the price level to P2. The government can stimulate demand in the short run either through fiscal policy (increasing G or decreasing T) or monetary through expansionary monetary policy or a combination of these. The result will be a rightward shift of the demand curve from AD2. Other things being equal the economy will return to the natural level of output faster than the case without demand stimulus. However the new price level will be higher than P2. Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers B3 (13 marks) Consider a small open economy with a floating exchange rate described by the following equations: Y = 640 + 5G – 4T + 5NX – 250r (IS* curve) Y = 240r – 125 + 2(M/P) (LM* curve) NX = 300 – 175 where is the exchange rate where e is the exchange rate r* = 2.5 per cent (international interest rate) (international interest rate) The price level (P) is fixed at 1.0, M = 150, G = 300 and T =350. a. Determine the equilibrium level of Y in the small open economy. (3 marks) b. What is the equilibrium value of NX? (3 marks) c. If this value of NX is to be achieved, what must be the equilibrium exchange rate, ? (2 marks) d. If I = 75, what is the level of national saving? (1 mark) a) Determine the equilibrium level of Y in the small open economy. (3 marks) The equilibrium level of Y is determined by the vertical LM schedule. LM* schedule Y = 240r – 125 + 2(M/P) Y = 240(2.5) – 125 + 2(150/1.0) Y = 775 b) What is the equilibrium value of NX? (3 marks) IS* schedule Y = 640 + 5G – 4T + 5NX – 250r Y = 640 + 5(300) – 4(350) + 5NX – 250(2.5) Y = 115 + 5NX At equilibrium Y = 115 + 5NX 775 = 115 + 5NX 660 = 5 NX NX = 132 Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers c) What is the equilibrium exchange rate, ? (2 marks) NX = 300 – 175 132 = 300 – 175 = 0.96 d) If I = 75, what is the level of national saving? (1 mark) S – I = NX S – 75 = 132 S = 207 (ii) In the Mundell-Flemming model with floating exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when taxes are raised. Illustrate your answer graphically and explain in words. (4 marks) In the Mundell–Fleming model, an increase in taxes shifts the IS* curve to the left. With a floating exchange rate the LM* curve is unaffected. The exchange rate falls while aggregate income remains unchanged. The fall in the exchange rate causes the trade balance to increase. Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers B4 (12 marks) (a) A large open economy faces an increase in investment demand due to major improvements in computer information technology and communications. What is the predicted impact of this increased investment demand on the country’s interest rate, its exchange rate, and net exports, holding other factors constant? Illustrate your answer graphically and explain in words. (6 marks) The increase in domestic investment demand will shift the I+CF curve to the right and the domestic interest rate will increase. The higher domestic interest rate will reduce net capital outflows because investing in the home country is more attractive. The supply of dollars to the FX market will decrease. The reduced supply of dollars in the foreign exchange market will increase the exchange rate. The higher real exchange rate makes the country’s exports less competitive and imports more attractive, reducing its net exports. Semester One Final Examinations, 2018 ECON7021 The Macroeconomy Model Answers (b) Explain how a steep decline in the value of the stock market and housing prices would affect the level of domestic output, the interest rate, and the exchange rate in a large open economy with a floating exchange rate. Illustrate your answer graphically and explain in words. (6 marks) The decline in the stock market and housing price reduces the wealth of consumers and hence consumption spending decreases and shift the IS curve to the left. Output (Y) and the domestic interest rate are lower. The lower interest rate makes domestic investment opportunities less attractive and increases net capital outflows. The supply of dollars to the FX market will increase. The exchange rate falls and net exports increase. Thus, output, the interest rate, and the exchange rate all decline as a result of the stock market and housing price declines.
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