Econ 201 Final Winter 2008 SOLUTIONS

Multiple Choice - 50 Points

1. Suppose a waiter deposits his cash tips into his savings account. As a result of only this transaction: (a) M2 increases. (b) M1 decreases. (c) M2 decreases. (d) M3 increases. 2. Mark Twain said: (a) It is easy to write 30 pages in 2 days (b) It is easy to write 2 pages in 30 days (c) It is easy to write 2 pages in 2 days (d) It is easy to write 30 pages in 30 days (e) (a) and (b) (f) (c) and (d) 3. On 11/04/04, a euro was worth $1.287, and on 03/07/08, a euro was worth $1.535. Using natural logarithms to calculate the total percent change between these two dates (not annualized), which is true? (a) The dollar appreciated by 19.3% (b) The dollar appreciated by 17.6% (c) The dollar depreciated by 17.6% (d) The dollar depreciated by 19.3% 4. Suppose the economy is in equilibrium and the central bank sells bonds. What happens to the equilibrium quantity of money and interest rates in the short term? (a) Quantity will go up, interest rates will go up. (b) Quantity will go up, interest rates will go down. (c) Quantity will go down, interest rates will go up. (d) Quantity will go down, interest rates will go down. 5. The survey that produces the monthly data on the unemployment rate is based on (a) A survey of employers (b) A survey of employees (c) A survey of households (d) A survey of individuals (e) (b) and (d) (f) (a) and (c) 6. Suppose that Crimson Bank has excess reserves of $800 and the reserve ratio is 20%. If Niels deposits $1,000 of cash into his checking account at Crimson Bank, and then Crimson Bank lends $600 to Mary, what is the most that Crimson Bank can lend to Professor Gordon? (a) $200 (b) $800 (c) $1000 (d) $2400

(In this section each question is worth 1 point)

Pg. 2 7. Consider the market for loanable funds. Other things being equal, an increase in taxes on savings and investment income will: (a) shift demand to the right and increase the interest rate. (b) shift demand to the left and decrease the interest rate. (c) shift supply to the right and decrease the interest rate. (d) shift supply to the left and increase the interest rate. 8. American jobs are lost to: (a) China in manufacturing (b) China in information technology services (c) India in manufacturing (d) India in information technology services (e) (b) and (c) (f ) (a) and (d) 9. Which of the following will not cause the AD curve to shift to the left? (a) Higher income tax rate (b) Lower stock of physical capital (c) Open-market purchase (d) Lower government spending (e) (b) and (c) 10. An example of a double coincidence of wants is: (a) a car mechanic who wants a TV nding an owner of an electronics store who wants a car repaired. (b) a car dealer who wants a TV nding an electronics store owner who wants money. (c) an electronics store owner who wants car repairs nding a car mechanic who wants money. (d) all of the above are examples. 11. What is the main reason that the government does not bail out the households who face foreclosure on their mortgages? (a) Fear of higher ination (b) Fear of lower output (c) Moral hazard (d) Bankruptcy of the mortgage banking industry 12. Advocates of free trade claim that (a) Import competitors are winners and consumers are losers (b) Consumers are losers and import competitors are losers (c) Consumers are losers and export producers are winners (d) Consumers are winners and export producers are winners 13. If a bank has deposits of $100,000, loans of $200,000, cash on hand of $10,000, and $15,000 on deposit at the Federal Reserve, then its reserve ratio is: (a) 5% (b) 10% (c) 12.5% (d) 25% 14. If the nominal quantity of money is $4 trillion, real output is $10 trillion, and the price level is 2, then the velocity of money is: (a) 1 (b) 2 (c) 4 (d) 5

Pg. 3 15. To the money supply, the Fed could (a) decrease; lower the discount rate (b) increase; raise the federal funds rate (c) decrease; conduct open-market purchases (d) increase; lower the required reserve ratio .

16. Japans lost decade and todays U.S. mortgage meltdown have one thing in common, which is: (a) Falling housing prices. (b) Aggressive use of stimulative monetary and scal policy. (c) Insolvent banks. (d) Use of cash for most transactions. 17. An increase in the price level (a) increases the nominal demand for money. (b) decreases the nominal demand for money. (c) does not aect the nominal demand for money. (d) shifts the nominal demand for money to the left. 18. The money demand curve is because a lower interest rate (a) upward-sloping; increases the opportunity cost of holding money. (b) downward-sloping; increases the opportunity cost of holding money. (c) upward-sloping; decreases the opportunity cost of holding money. (d) downward-sloping; decreases the opportunity cost of holding money 19. If the economy is suering from a recessionary gap, the Fed should conduct monetary policy by the money supply. (a) expansionary; decreasing (b) expansionary; increasing (c) contractionary; decreasing (d) contractionary; increasing 20. In the readings for Chapter 19, there is a debate in Business Week about the desirability of letting the dollar depreciate. Which of the following is not an argument in favor of letting the dollar depreciate? (a) It will make U.S. exports more competitive. (b) It will make U.S. imports more expensive. (c) It will defuse protectionist pressure. (d) It will attract more investment for the U.S. stock market. 21. Deation depresses aggregate demand because of (a) The wealth eect (b) The expectations eect (c) The income eect (d) The consumption eect .

Pg. 4 22. Suppose the AD, LRAS, and SRAS curves in the economy are
Aggregate Price Level LRAS SRAS

AD Real GDP

If real GDP in the economy is at Y and the central bank wants to change real GDP in the short-run to be equal to potential GDP it should: (a) Buy bonds on the open market. (b) Sell bonds on the open market. (c) Do nothing. (d) Tell the government to print more money. 23. Economists argue that money is neutral: (a) in both the short and long run. (b) in the short run only. (c) in the long run but does have an impact on the price level. (d) in the long run but has no impact on the price level. 24. When an economy moves from autarky to free international trade, in the export sector (a) consumer and producer surplus both rise and the economy as a whole gains. (b) consumer surplus rises, producer surplus falls, and the economy as a whole gains. (c) consumer surplus falls, producer surplus rises, and the economy as a whole gains. (d) the decrease in either consumer surplus or producer surplus is suciently large to cause net losses for the economy. 25. Initially, the nominal exchange rate is 0.7 euros per $, and the price index for both the U.S. and the euro area are each 100. Over the following 10 years, the annual U.S. ination rate is 3.5% per year, and that of the euro area is 2.5% per year. What must the nominal exchange rate be after 10 years to maintain the initial real exchange rate? (a) 0.5 euros per $ (b) 0.62 euros per $ (c) 0.7 euros per $ (d) 0.77 euros per $ 26. The three main monetary policy tools are: (a) interest rates, taxes, government purchases, and transfers. (b) currency, near-moneys, and reserve ratio. (c) deposit insurance, discount rate, and money multiplier. (d) reserve requirements, the discount rate, and open-market purchases.

Pg. 5 For the next three problems, consider the following chart showing supply and demand for calculators.
Price of calculators $300 Domestic supply

A $150 $120 PW = $100 $50 35 50 60 F Domestic demand Quantity of calculators B C G

K H

L I J

27. The world price, PW , equals $100. When the economy moves from autarky to free trade, consumer surplus rises by area and producer surplus falls by . (a) B + K + L; B (b) B + C + K + L; B + C + K + L (c) B + C+ H + I + K + L; B + C + H + I (d) B + C + G + H + I + J + K + L; B+C 28. The world price, PW , equals $100. The government imposes a quota restricting imports to 25 calculators. If the import licenses are granted to foreigners, the net loss due to the import quota is equal to areas: (a) K + L (b) G + J (c) G + H + I + J (d) G + H + I + J + K + L 29. The world price, PW , equals $100. The government imposes an import tari of $20 per calculator. Compared with the free trade situation, the tari leads to a deadweight loss equal to areas: (a) K + L (b) G + J (c) G + H + I + J (d) There is no deadweight loss, since the tari revenue the government receives osets any losses. 30. The CPI in September, 2007, was 208.3, and it was 211.2 in December, 2007. The annualized growth rate between September and December was: (a) 1.38% (b) 2.44% (c) 3.84% (d) 5.53%

Pg. 6 31. In the absence of international capital ows, the equilibrium interest rate in the U.S. market for loanable funds is 3%, while in Germany it is 7%. International borrowing and lending between the United States and Germany may result in a common interest rate of and . (a) 4%; capital inows to the United States matching the capital outows from Germany (b) 3%; massive capital inows from Germany into the United States (c) 5%; capital outows from the United States matching the capital inows into Germany (d) 7%; massive capital inows from the United States into Germany 32. All else being equal, which of the following could cause exchange rates to change from 1e=$1.50 to 1e=$1.25? (a) interest rates are higher in Europe. (b) interest rates are higher in the United States. (c) interest rates in the United States and Europe are equal. (d) ination is higher in Europe. 33. A Nobel-Prize winner suggested the following combination: (a) Developed countries should lower taris and less-developed countries should raise taris (b) Developed countries should raise taris and less-developed countries should reduce taris (c) Developed countries should lower taris and less-developed countries should reduce taris (d) Developed countries should raise taris and less-developed countries should raise taris 34. Which of the following is true of the 2006 international balance of payments of the U.S.? (a) Current account surplus; private nancial inows > ocial nancial inows (b) Current account surplus; ocial nancial inows > private nancial inows (c) Current account decit; private nancial inows > ocial nancial inows (d) Current account decit; ocial nancial inows > private nancial inows 35. Suppose exchange rates between the U.S. and Europe changed from 1e=$1.50 to 1e=$1.25. This would cause Americans to purchase goods and services from Europe. (a) the same amount of (b) fewer (c) more (d) none of the above 36. Expansionary monetary policy in the United States causes U.S. interest rates to and the dollar to . (a) increase; appreciate (b) increase; depreciate (c) decrease; appreciate (d) decrease; depreciate 37. The U.S. rates lower on indices of well-being than on real per capita GDP because (a) The U.S. ranks lower on life expectancy (b) The U.S. ranks lower on health care expenditures as a share of GDP (c) The U.S. ranks lower in science and math test scores (d) The U.S. ranks lower on energy spending as a share of GDP

Pg. 7 38. A reason for the low U.S. household saving rate is (a) Americans do not care about saving for their children (b) Americans respond to rising imports by spending now (c) Americans respond to capital gains on housing (d) High American investment crowds out saving 39. Suppose the reserve requirement is 20%, and you deposit a $1,000 check received as a gift for acing this exam in your checking account. The bank does NOT want to hold excess reserves. By how much does the monetary base change? (a) $0 (b) $800 (c) $1000 (d) $4000 (e) $5000 40. The order of magnitude increase in prices between 1929 and 2007 was by a factor of (a) 2 (b) 5 (c) 10 (d) 20 (e) 40 41. A myth about the Great Depression is that (a) The New Deal ended the Great Depression (b) The New Deal raised the price level (c) The New Deal raised the wage level (d) The New Deal raised interest rates 42. Consider the following table which shows the maximum amounts of machinery and petroleum that the United States and Mexico can produce if they only produce one good. Both nations face constant costs of production. Countries United States Mexico Machinery (units) 80 60 Petroleum (units) 40 180 , and Mexico has a com-

The United States has a comparative advantage in . parative advantage in (a) both goods; neither good (b) neither good; both goods (c) machinery; petroleum (d) petroleum; machinery

43. The table shows the maximum amounts of autos and clothing that the United States and Canada can produce if they only produce one good. Both nations face constant costs of production. Countries United States Canada Autos (units) 80 60 Clothing (units) 40 30

Given the opportunity costs of production: (a) there is no basis for trade. (b) Canada should specialize in clothing. (c) the United States should specialize in autos. (d) the United States should specialize in both goods, and Canada should not produce either good.

Pg. 8 44. Suppose actual output is below potential output. In the long run: (a) nominal wages will decrease, and the short-run supply curve will shift to the right. (b) nominal wages will increase, and the short-run supply curve will shift to the left. (c) the aggregate demand curve will shift to the right. (d) the long-run aggregate supply curve will shift to the right. 45. Suppose M P C = 0.6 and t = 0.25. Holding all else constant, if capital inows goes up by 100, how much does equilibrium Y change? (a) Y goes up by about 182 (b) Y goes down by about 182 (c) Y goes up by about 333 (d) Y goes down by about 333 46. The circle to the left of George Washingtons picture on the $1 bill represents: (a) The Presidential Seal (b) The importance of the number 13 in the design of the bill (c) The regional Federal reserve bank that issued the bill (d) The roman numeral for 1776 at the base of the pyramid 47. In the twentieth century, the years with the largest inationary gap were: (a) 1932-35 (b) 1942-45 (c) 1952-55 (d) 1962-65 48. Suppose that annual ination is 2% and the annual growth rate of real GDP is 3%. What is the annual growth rate of nominal GDP? (a) 1% (b) 2% (c) 3% (d) 4% (e) 5% (f) 6% 49. The course packet delivers a condemnation of Alan Greenspans reign at the Federal Reserve between 1987 and 2006. Which of these comes closest to the condemnation? (a) Keeping interest rates too low in 1987-91 (b) Keeping interest rates too low in 1992-96 (c) Keeping interest rates too low in 1997-2001 (d) Keeping interest rates too low in 2001-2005 50. An aggregate production function typically exhibits respect to capital per worker. (a) Increasing (b) Decreasing (c) Constant (d) Zero returns to scale with

Pg. 9

Short Answer - 70 points

PLEASE NOTE: In order to receive full credit, in calculating growth rates you must use the logarithmic or exponential formulas from the classroom handout. 1. (14 pts.) Consider the economy of the country Microvilleshire. Its short-run aggregate supply and aggregate demand equations are described as follows: SRAS: CPI = 20 + 6Y AD: CPI = 60 4Y (a) Suppose Microvilleshire is in long-run equilibrium. (2 pts.) What is output in the long-run? SOLUTION: We are told Microvilleshire is in long-run equilibrium, so we can just nd the short-run equilibrium, and we know thats the same as the long-run one. 20 + 6Y = 60 4Y Y = 4 (2 pts.) What is CPI in the long-run? SOLUTION: CPI = 20 + 6 4 = 44 (3 pts.) Draw a graph of aggregate supply and aggregate demand that illustrates AD, SRAS, and LRAS. SOLUTION: The graph should have CPI on the y -axis and Y on the x-axis, and it should include SRAS, which has intercept 20 and slope 6, AD, which has intercept 60 and slope -4, as well as LRAS, which is vertical. All three lines should cross at Y = 4 and CPI = 44. (b) Now suppose that Microvilleshires main trade partner, Macrovilleshire, changes their trade policy in a way that decreases their demand for Microvilleshire products. This shifts AD such that for every level of output, the CPI is decreased by 30. (1 pt.) Does this result in a inationary gap, a recessionary gap, or no output gap of any sort? SOLUTION: AD falls Y falls recessionary gap. (2 pts.) If you think there is an inationary or recessionary gap, what is the magnitude? If you think there is no output gap, explain why. SOLUTION: The new AD curve is CPI = 30 4Y . Setting SRAS=AD, we get 30 4Y = 20 + 6Y Y = 1. So, the recessionary gap is 4 1 = 3. (1 pt.) Change your graph above in (a) to include the new AD and the inationary or recessionary gap you found. SOLUTION: There should be a forth line added to the graph: the new AD curve, which has intercept 30 and slope -4. It should cross the old SRAS line at Y = 1 and CPI = 26. (c) (3 pts.) What is the new long-run equilibrium output and long-run equilibrium CPI? SOLUTION: Long-run output is still Y = 4. The new long-run prices will be CPI = 30 4 4 = 14.

Pg. 10 2. (14 pts.) Consider a closed economy with three types of goods: consumption goods, investment goods, and government-purchased goods. In 2000, data on these goods is given by: 2000 Consumption goods: Investment goods: Government goods: Average Price $100 $700 $500 Quantity 1400 900 700

After 2000, the Federal Reserve decreases the money supply, and the government engages in expansionary scal policy. This leads to the following data for 2001: 2001 Consumption goods: Investment goods: Government goods: Average Price $90 $650 $600 Quantity 1300 750 850

(a) (2 pts.) What is nominal GDP in 2000 and 2001? SOLUTION: GDP in 2000 = 100 1400 + 700 900 + 500 700 = 1120000 GDP in 2001 = 90 1300 + 650 750 + 600 850 = 1114500 (b) (1 pt.) Using base year 2000, what is real GDP in 2001? SOLUTION: Real GDP in 2001 using 2000 as base year = 100 1300 + 700 750 + 500 850 = 1080000 (1 pt.) Using base year 2001, what is real GDP in 2000? SOLUTION: Real GDP in 2000 using 2001 as base year = 90 1400 + 650 900 + 600 700 = 1131000

(c) (6 pts.) Using the GDP deator as your price index, what is the chain-weighted ination rate between 2000 and 2001? 1120000 SOLUTION: Using 2000 as base year, GDP deator in 2000 = 1120000 100 = 100 1114500 Using 2000 as base year, GDP deator in 2001 = 1080000 100 = 103.194 Using 2000 as .194 = 3.1445%. Using 2001 as base year, GDP deator base year, ination = ln 103 100 1120000 in 2000 = 1131000 100 = 99.0274. Using 2001 as base year, GDP deator in 2001 1114500 = 1114500 100 = 100. Using 2001 as base year, ination = ln 99100 .0274 = 0.9774%. So, 0.031445+0.009774 chain-weighted ination = = 2.0609%. 2 (d) (1 pt.) Write the equation that relates the velocity of money (call it V ) to the money supply and nominal GDP. Y SOLUTION: M V = P Y V = PM = nominal GDP money supply (3 pts.) Suppose that in 2000, the money supply was $224,000. Assume that the velocity of money is the same in 2000 and 2001. Use the values of nominal GDP you found in part (a) for 2000 and 2001 to calculate the money supply in 2001. SOLUTION: V = nominal GDP = 1120000 224000 = 5. Since V is the same in 2001, we money supply 1114500 = 222900. have M 5 = nominal GDP M = 5

Pg. 11 3. (17 pts.) Consider an economy in equilibrium with the following initial structure: Equilibrium GDP = Y = 10, 000 MPC = 3 4 1 Income tax rate = t = 9 Reserve ratio = rr = 0.10 The desired currency to deposit ratio is 15%, so c = 0.15 Interest rate = i = 0.04 (= 4%) Money demand is characterized by M D = 550 1000i (in millions of dollars, where i is written as a decimal. For example, if i = 0.07, then M D = 550 1000 0.07 = 480). Assume consumption takes the standard form C = A + M P C (Y T ), and taxes take the form T = Ta + t Y . A, Ta , t, G, X , Im, and M P C do not change when the interest rate changes. However, investment does change based on the interest rate. Specically, I = 1000 5000i. (Again, i is written as a decimal. For example, if i = 0.07, then I = 1000 5000 0.07 = 650.) (a) Given that the economy is in equilibrium: (2 pts.) What is the money supply? (Hint: consider the market for money and the equilibrium condition that relates M D to M S ) SOLUTION: M S = M D = 550 1000 0.04 = 510 (2 pts.) What is the monetary base? S 550 SOLUTION: B = M 1+c = 1.15 = 110.87
c+rr 0.25

(b) (2 pts.) Now suppose that the central bank sells 5 million dollars worth of bonds on the open market. What is the change in money supply? c 1.15 SOLUTION: M S = c1+ +rr B = 0.25 (5) = 23 (c) (2 pts.) What is the new interest rate? SOLUTION: M S = M D 510 487 = 550 1000 i i = 0.063 (d) (4 pts.) What is the new equilibrium Y that results from the open market operation described in parts (b) and (c)? (Hint: rst, nd how I changes.) SOLUTION: I = (1000 5000 0.04) (1000 5000 0.063) = 115 I 115 Y = 1M P C (1t) = 10.75 8 = 345 Y = 9655
9

(e) (5 pts.) Going back to the initial equilibrium (i.e., before the open market operations in (b) happened), suppose that net exports decreases by 100 and G increases by 20. The central bank wants to keep output unchanged (i.e., wants to keep Y = 10, 000). How many million dollars of bonds should they buy or sell? SOLUTION: We want the change in I to oset the change in N X and G. If the Fed does nothing, we will have AAE = 20 100 = 80. So, we want I = 80 to oset the changes. This means we want a new level of investment of I = (1000 5000 0.04) + 80 = 880. If I = 880, we need an interest rate of 880 = 1000 5000 i i = 0.024. In order to have i = 0.024, we need M S = 550 1000 0.024 = 526. Thus, we need a change in M S of M S = 526 510 = 16. This means we needs a change in B of 16 MS B = 1+c = 1.15 = 3.47826. Thus, the Fed needs to buy 3.47826 million dollars worth
c+rr 0.25

of bonds.

Pg. 12 4. (25 pts.) Suppose an economy has the following data: Year 2004 2005 2006 Y YD C 700 800 I 200 220 250 G 150 200 200 X 200 300 300 Im 150 170 T 100 150 NS

The consumption function and the tax function are the same in every year. Additionally, imports are a function of disposable income. In particular, the import function is Im = a + b YD where a and b are some numbers. This function also stays the same every year. (a) (2 pts.) What is Y (GDP or output) and YD (disposable income) in 2004 and 2005? SOLUTION: Y = C + I + G + X Im. In 2004, Y = 700 + 200 + 150 + 200 150 = 1100. In 2005, Y = 800 + 220 + 200 + 300 170 = 1350. YD = Y T . In 2004, YD = 1100 100 = 1000. In 2005, YD = 1350 150 = 1200. (b) (2 pts.) What are national savings in 2004 and 2005? SOLUTION: N S = P S + GS = Y T C + T G = Y C G. In 2004, N S = 1100 700 150 = 250. In 2005, N S = 1350 800 200 = 350. (c) (Hint: for the three sections in part (c), use the data for 2004 and 2005.) (3 pts.) What is the consumption function? (Hint: your answer should be of the form C = A + M P C YD .) SOLUTION: The two equations to solve are: 700 = A + M P C 1000 and 800 = A + M P C 1200. These give M P C = 0.5 and A = 200. Thus, the consumption function is C = 200 + 0.5 YD . (3 pts.) What is the tax function? (Hint: your answer should be of the form T = Ta + t Y .) SOLUTION: The two equations to solve are: 100 = Ta + t 1100 and 150 = Ta + t 1350. These give t = 0.20 and Ta = 120. Thus, the tax function is T = 120 + 0.20 Y . (3 pts.) What is the import function? (Hint: as above, your answer should be of the form Im = a + b YD .) SOLUTION: The two equations to solve are: 150 = a+b1000 and 170 = a+b1200. These give b = 0.10 and a = 50. Thus, the import function is Im = 50 + 0.10 YD . (d) (Hint: you should be using the three functions you found in part (c), along with the data from the table for 2006, to help solve for Y .) SOLUTION: Y = C + I + G + X Im Y = A + M P C (Y (Ta + t Y )) + I + P C Ta +I +G+X a+bTa G + X (a + b (Y (Ta + t Y ))) Y = AM 1M P C (1t)+b(1t) (2 pts.) What is the multiplier for 2006? 1 SOLUTION: From above, the multiplier is 1M P C (11 t)+b(1t) = 10.5(10.2)+0.10(10.2) = 1.4706 (2 pts.) What is AAE for 2006? SOLUTION: From above, AAE= A M P C Ta + I + G + X a + b Ta = 200 0.5(120) + 250 + 200 + 300 50 + 0.10(120) = 948

Pg. 13 (1 pt.) What is equilibrium GDP for 2006? SOLUTION: Y = 948 1.4706 = 1394.12 (e) (2 pts.) What is the trade balance in equilibrium in 2006? SOLUTION: Trade balance= X Im = 300(50+0.10(1394.12 (120 + 0.2 1394.12))) = 126.47 (f) (3 pts.) Now suppose that the government changes the tax policy by decreasing Ta by 80. By how much does equilibrium GDP change? (Hint: use the formula you found for Y in part (d).) 0.5(80)+0.1(80) M P C Ta +bTa AAE SOLUTION: Y = 1M P C (1t)+b(1t) = 1M P C (1t)+b(1t) = 10.5(10.2)+0.10(10.2) = 47.0588 (g) Return to part (d) (i.e., ignore the change in part (f)). Suppose between 2006 and 2007, M P C changes to 0.70, and t changes to 0 (no income tax). (1 pt.) What is the new multiplier in 2007? SOLUTION: Multiplier = 1M P C (11 t)+b(1t) =
1 10.7(10)+0.10(10)

= 2.5

(1 pt.) Assume AAE is the same in 2007 as it was in 2006 (from part (d)). What is equilibrium GDP in 2007? SOLUTION: Y = 948 2.5 = 2370 NOTE: AAE does change. Its new value is AAE = A M P C Ta + I + G + X a + b Ta = 200 0.7(120)+250+200+300 50+0.1(120) = 972 Y = 972 2.5 = 2430