Department of Economics University of Waterloo Econ 302 (Section 002 & 003) Macroeconomic Theory 2 Fall 2013

All information pertaining to Final examination is provided in this file. Time & Date: Saturday, December 14 from 4.00 pm to 6.30 pm Allocated rooms for the Exam: Section 002PAC 7 & Section 003PAC 8 Office hours during the Final Exam Period: Monday & Wednesday from 4.00 to 5.30 pm Friday from 12.30 to 3.30 pm Office hour held by TA: (Mohamad Ghaziasgar) Tuesday and Thursday from 3.00 pm to 5.00 pm in PAS 1288/1289 Syllabus: Final exam is comprehensive; includes all chapters we studied throughout the semester. The specific chapters are: Chapter 1: Thinking About Macroeconomics Chapter 2: National-Income Accounting: Gross Domestic Product and the Price Level Chapter 3: Introduction to Economic Growth Chapter 4: Working with the Solow Growth Model Chapter 5: Conditional Convergence and Long-Run Economic Growth Chapter 6: Markets, Prices, Supply, and Demand Chapter 7: Consumption, Saving, and Investment Chapter 8: An Equilibrium Business-Cycle Model Chapter 9: Capital Utilization and Unemployment Chapter 10: The Demand for Money and the Price Level Chapter 11: Inflation, Money Growth, and Interest Rates Chapter 12: Government Expenditure Chapter 13: Taxes The History of Modern Macroeconomics The Global Financial Crisis Assigned Problems from the Textbook: Chapter 2: Questions 1-3 Chapter 3: Questions 6, 7 & 8 Chapter 4: Questions 5 & 6 Chapter 5: Questions 1 & 2 Chapter 6: Questions 1-5 Chapter 7: Questions 1-4 Chapter 8: Questions 1 & 4 Chapter 9: Questions 1 & 2 Chapter 10: Questions 7 & 8

Chapter 11: Questions 1, 2, 3 & 7 Chapter 12: Questions 3, 4 & 5 Chapter 13: Questions 5 & 6

Important Concepts:
Chapter 1: Economic models Parameters, exogenous vs. endogenous variable Structural form and reduced form of the model Comparative statics and sensitivity analysis Solution of the model Characteristics of a good economic model Calculation of economic growth Chapter 2: Gross domestic product Different components of GDP (Y=C+I+G+NX) GDP Deflator GDP as an imperfect measure of welfare Difference between real and nominal GDP GDP vs.GNP Different measures of GDP: expenditure approach, income approach and production approach Chain weighted GDP Measure of overall prices in the economy (consumer price index) CPI and problems in measuring the cost of living GDP Deflator vs.CPI Chapters 3-5: The basic Solow-Swan growth model for a closed economy with no government in discrete time The neoclassical production function CRS The positive and diminishing return to inputs The production function in intensive form The supply of goods [y= Af(k) in intensive form] The demand for goods [y= c+i] The consumption function [c= (1-s)y] The law of motion for capital [k=s(y/k)-s -n] The steady state Approaching the steady state The golden rule level of capital (the steady state value of capital that maximizes the consumption per worker) The effects of changes in s, A, L(0), n & Absolute convergence and conditional convergence The Solow-Swan growth model with technological progress The efficiency of labour and the production function The steady state and the Golden rule level of capital Absolute and conditional convergence The effects of changes in s, A, L(0), n & Absolute convergence and conditional convergence

The endogenous growth model The AK model The Romer model The model with technological diffusion The Solow-Swan growth model in continuous time without technological progress The Solow-Swan growth model in continuous time with technological progress Chapter 6: The microfoundations for The Equilibrium Business Cycle model The markets in Macroeconomy: -The Goods market -The Labor Market -The Rental Market -The Bond Market The Prices and Quantities in these markets The One Period Budget constraint Profit in equilibrium The Aggregate Budget Constraint Chapter 7: The microfoundations for The equilibrium business cycle model (continued) Present value The two-period budget constraint The intuition behind the two-period budget constraint Multi-period budget constraint Choosing consumption, saving and investment: -Income effect (overall) -Substitution effect -inter-temporal substitution effect Chapter 8: The Basic Equilibrium Business Cycle model The stylized factspersistence, cyclical variability and co-movements The Real Business Cycle modelpositive and negative technology shock to the economy -The changes in quantities and prices in these four markets -The effects on consumption, saving and investment Variation in labor inputs (upward sloping supply curve) -inter-temporal substitution effects and income effects of wage change Chapter 9: Extension of the Real Business Cycle model Variations in capital inputs (variable capital utilization rate) Demand for capital services Supply of capital services The equilibrium outcome in the rental market Variation in labor inputs (employment rate) Unemployment rate, vacancy rate etc.. the model of job matching (job findings, job separations and natural rate of unemployment) the outcome in the labor market with variations in the labor inputs Chapter 10: Money market Definition of money, alternative definitions of monetary aggregates, 2 kinds of money Average money holdings (The economics of cash management, asset income vs. transaction costs) d The demand for money: M = P. L(Y, i) s The exogenous money supply: M How price level is determined in the money market

The countercyclical behavior of Price level Price level targeting and endogenous money (M) (not included) Chapter 11: Empirical evidence Actual and expected inflation Nominal and real interest rate Expected real interest rate Deriving the Fisher equation Indexed bonds Real rate of return on money The time path of money and time path of inflation Revenue from printing money Chapter 12: Government budget constraint Individual budget constraint with government sector Temporary change in government purchases Permanent change in government purchases Chapter 13: Different types of tax Taxes on labor income Taxes on interest income Government purchases financed by taxes Transfer payments Laffer curve Instructions: Read both the textbook and the lecture notes thoroughly to perform well in the exam. Work out the assigned problems at the end of each chapter. Solve the sample questions for the two midterm exams. A brief solution for the assigned questions (chapters 10 to 13) from the textbook is provided in this file. In addition, there is a new sample questionnaire for you to work out. There are 50 multiple choice and true/false questions in this sample test. Read the book and the chapter notes carefully before you try to answer/solve the questions. To perform well in the multiple choice questions, eliminate the wrong answers one by one. You will be left with one or two answers you think are correct. If you dont know the correct answer from these options, guess. You will be surprised that, most of the time the answer you guessed is actually the correct answer. Good Luck with the Final exam preparation! Sample Questions: (Multiple Choices) 1. When the capital utilization rate, , increases then: a. GDP decreases. c. (hours per period)(number of machines) increases. b. machines are in use fewer hours per period. d. all of the above. ANS: C

2. Higher capital utilization rates may raise user costs of capital because higher utilization rates may imply: a. operating at inconvenient times. c. less highway congestion. b. off-peak utility prices. d. all of the above. ANS: A 3. The model predicts the capital utilization rate, , is: a. acyclical. c. countercyclical. b. procyclical. d. exogenous. ANS: B 4. If the labour force is 100 million, there are 95 million people employed, there are 98 million jobs that employers want occupied, then the number of vacancies is: a. 5 million. c. 2 million. b. 3 million. d. none of the above. ANS: B 5. If the labour force is 100 million, there are 95 million people employed, there are 98 million jobs that employers want occupied, then the unemployment rate is: a. 3%. c. 5.3%. b. 5%. d. none of the above. ANS: B 6. One minus the unemployment rate, 1 - u, is: a. the vacancy rate. b. the labour force. ANS: C 7. a.

c. d.

the employment rate. the level of employment.

Unemployment can exist in a market clearing model, if: the labour market is in equilibrium. c. we allow for differences among workers and jobs. b. we allow capital utilization of less than 100%. d. all of the above. ANS: C 8. a. A decrease in workers effective real incomes while unemployed, , will: lower the job finding rate and raise the c. raise the job finding rate and lower the expected duration of unemployment. expected duration of unemployment. b. lower the job finding rate and the expected d. raise the job finding rate and the expected duration of unemployment. duration of unemployment. ANS: C 9. If the job separation rate is 0.02 and the job finding rate is 0.3, the natural rate of unemployment is: a. 6.25%. c. 6.67%. b. 15%. d. none of the above. ANS: A

10. The job-finding rate is: a. the number of hires per month divided by the c. number unemployed. b. the number of hires per month divided by the d. number employed. ANS: A 11. The natural rate of unemployment is: a. positively related to that job separations rate. c. b. zero. d. ANS: A 12. A monetary aggregate is: a. high powered money. b. commodity money. ANS: C

the number of hires per month divided by the unemployment rate. the number of hires per month divided by the employment rate.

fixed. positively related to the job finding rate.

c. d.

money defined more broadly than currency. total currency in circulation plus depository institutions deposits at the Bank of Canada.

13. Canadian M1B money includes: a. currency held by the public. b. chequable deposits at chartered banks. ANS: D

c. d.

travelers checks. (a) and (b) of the above.

14. When households reduce their average money balances, they a. purchase more goods. c. incur more opportunity costs. b. they earn less interest. d. incur more transaction costs. ANS: D 15. If a persons income doubles we expect their cash holding to: a. double. c. less than double. b. more than double. d. decline. ANS: C 16. Among the sources of transactions costs associated with reducing average money balances are: a. brokerage fees. c. foregone interest payments. b. opportunity costs. d. all of the above. ANS: A 17. When the supply of money increases, then a. the price level rises. b. the price level falls. ANS: A

c. d.

money demand increases. money demand decreases.

Figure 10.1
P
M -sup p ly M -Demand

18. In Figure 10.1, if money demand decreases then: a. the equilibrium price level rises. c. b. the equilibrium prices level falls. d. ANS: A

the money supply rises. the money supply falls.

19. In Figure 10.1, if the money supply decreases then: a. the equilibrium price level rises. c. money demand increases. b. the equilibrium price level falls. d. money demand decreases. ANS: B 20. If policy makers target a specific price level, then: a. the money supply becomes exogenous in the c. model. b. the money supply becomes predetermined in d. the model. ANS: C

the money supply becomes endogenous in the model. the money supply becomes neutral in the model.

21. In Canadian data from 1961 to 2007, the price level is: a. procyclical as we would expect if the c. countercyclical as we would expect if the monetary authority does not vary the money monetary authority does not vary the money with the business cycle. supply with the business cycle. b. procyclical as we would expect if the d. countercyclical as we would expect if the monetary authority varies the money supply monetary authority varies the money supply with the business cycle. with the business cycle. ANS: C 22. Real money demand is: a. L(Y, i). b. equal to the money supply. ANS: A

c. d.

P L(Y, i). all of the above.

23. If the expected inflation rate is 3% and the unexpected inflation rate is -2%, then the actual inflation rate is: a. 2%. c. -2%. b. 1%. d. 1.67%. ANS: B

24. The real interest rate is a. the nominal interest rate plus the expected inflation rate. b. the nominal interest rate divided by the expected inflation rate. ANS: C 25. The nominal rate of interest on money is: a. positive. b. the real rate of return on money plus the inflation rate. ANS: B

c. d.

the nominal interest rate less the expected inflation rate. the expected inflation rate divided by the nominal rate of interest.

c. d.

minus the inflation rate. all of the above.

26. If the interest rate is 6% and the inflation rate is 2%, then the nominal rate of return on money is: a. 2%. c. 8%. b. 4% d. zero. ANS: D 27. If the inflation rate is 3% and the nominal interest rate is 5% and the money growth rate increases to 2%, then we would expect the nominal interest rate to be: a. 4%. c. 5%. b. 7%. d. 2%. ANS: A 28. If the interest rate is 6% and the inflation rate is 2%, then the real rate of return on money is: a. 2%. c. -2%. b. 4%. d. zero. ANS: C 29. An increase in the money growth rate in the market clearing model causes: a. an increase in the nominal interest rate. c. an increase in the price level. b. a decrease in money demand. d. all of the above. ANS: D 30. When the rate of growth rate of money is constant: a. the inflation rate is growing. c. real money balances are constant over time. b. the nominal interest rate is declining. d. all of the above. ANS: C 31. The government budget constraint is: a. government purchases less transfer payments c. government purchases plus taxes equal equal revenue from money growth less taxes. transfer payment plus revenue from money creation. b. government purchases plus transfer payments d. government purchases times transfer equal taxes plus revenue from money growth. payment equals taxes times revenue from money creation. ANS: B

32. If there is no revenue from money growth, then the governments budget constraint without borrowing is: a. Gt + Vt = Tt. c. Gt = Vt - Tt b. Gt = Vt + Tt. d. all of the above. ANS: A 33. Among the governments sources of funds are; a. transfer payments. c. b. government purchases. d. ANS: C

real revenue from printing money. all of the above.

34. According to the market clearing model a permanent increase in government purchases leads to: a. an increase in capital utilization. c. an increase in the demand for capital services. b. a decrease in the supply of capita services. d. no change in the real rate of interest. ANS: D 35. A flat-rate tax structure is one: a. whose marginal rate increases as income increases. b. that has graduated rates. ANS: C
w,

c. d.

whose average rate equals the marginal rate. whose marginal rate decreases as income increases.

36. If the marginal tax rate on labour income, could have: a. raised some other tax. b. used all the increased revenue due to the higher marginal tax rate for real transfers. ANS: B

changes but government purchases dont, then the government c. d. reduced some income tax deductions. all of the above.

37. One less the marginal tax on wages, (1 - w) is: a. the fraction of wage income paid in taxes. c. b. the fraction of wage income the worker gets to keep. ANS: B d.

the fraction of income the government receives. the average marginal tax rate.

38. If the real marginal tax rate, w, increases in the market clearing model then: a. the supply of labour increases. c. real output, Y, rises. b. the demand for capital decreases. d. all of the above. ANS: B

39. In the long run an increase in the marginal tax rate on asset income, r, in the market clearing model: a. increases the stock of capital and real GDP. c. decreases the stock of capital and real GDP. b. increases the stock of capital and decreases d. decreases the stock of capital and increases real GDP. real GDP. ANS: C 40. If the marginal tax on labour income, a. rise. b. fall. ANS: D
w,

rises then the tax receipts of the government: c. stay the same. d. may rise, fall or stay the same.

41. The governments uses of funds include: a. borrowing. b. printing money. ANS: C

c. d.

paying interest on the past government debt. all of the above.

42. A decrease in the marginal tax rate on asset income, r, in the short run in the market clearing model: a. raises the stock of capital c. reduces the market clearing rental price of capital. b. does not change real GDP. d. all of the above. ANS: B 43. If money and the price level are constant, then the governments real budget debt is: g g g a. (B t - B t-1)/P. c. (Bt + B t)/P. g b. B t/P. d. none of the above. ANS: B 44. Government transfer payments as a percentage of GDP have been: a. generally rising. c. cyclical. b. generally falling. d. constant. ANS: A 45. In the market clearing model a permanent increase in government purchases does not increase the real wage because: a. labour supply and labour demand increase c. labour demand is downward sloping. about the same amount. b. labour supply is fixed. d. neither labour demand nor labour supply shift due to the permanent increase in government purchases. ANS: D 46. If the interest rate increases, then the real demand for money also increases. ANS: F 47. The neutrality of money means that one time changes in the money supply do not affect real variables. ANS: T

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48. In the market clearing model an increase in the money growth rate leads to a decrease in the nominal interest rate. ANS: F 49. A permanent increase in government purchases causes an increase in the real rate of interest. ANS: F 50. A permanent increase in government purchases increases GDP. 2. The term (1 - w) is the faction of labour income the worker gets to keep. ANS: T

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Answer Key for assigned problems from textbook: Chapter 10: (Question 7 & 8) 7. Endogenous money implies that changes in the demand for money will cause predictable changes in the supply of money. In that case, the supply of money is determined by factors within the model. If the monetary authorities choose to respond to changes in the money demand with similar changes in the supply of money, then factors which lead to increased demand for money will also lead to increased supply of money. For example, if real GDP, Y, were to increase, then the demand for money would increase. Money supply would also increase. There would be a positive correlation between money supply and real GDP, but the change in money supply would be an effect, not the cause of the increase in GDP. 8. The answers to all of these questions are true. a. True. One reason is that more production in an agricultural society is for home use, not to be sold on the market. The division of labour and structure of production is not as complex, resulting in fewer transactions for a given level of production. Fewer transactions mean less demand for money. b. True. Liquidity provides more options for those attempting to escape persecution which is more likely in dictatorships. The underground economy is likely to be larger. It is more likely that the economy will be a planned economy, in which case shortages are likely to develop. People will need money just in case goods become available. c. True. It is true, if the elderly are more dependent on income from their assets, which are liquidated during their retirement. They will have a higher ratio of monetary transactions to income. d. True. Higher literacy rate implies a more educated individual who is likely to keep more wealth in interest bearing assets because they know how to manage them. Chapter 11: (Question 1, 2, 3 & 7) 1. a. False. A constant rate of inflation will be incorporated into a constant nominal rate. b. True. A growing rate of inflation will cause corresponding changes in i. 2. The real interest rate is the nominal interest rate minus the inflation rate. Positive rates of inflation change the purchasing power of money over time, reducing the real value of interest. Higher nominal rates are needed to compensate lenders for this loss in purchasing power. 3. The actual rate can only be determined after the fact, when actual inflation rates can be measured. Before the fact, inflation rates can only be predicted. 7. a. The price level increases proportionately, but nominal interest rates do not change.

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b. The increase in the money growth rate causes a similar increase in inflation and nominal interest rates. The price level jumps during the transition to a higher level. c. Prices increase because of the reduction in money demand, nominal interest rates rise. Chapter 12: (Questions 3-5) 3. a. If public and private security guards are perfect substitutes in production, there should be no impact on GDP. However, because national income accounts treat government purchases of labour as a final good, the measured GDP will increase. This is a case of double counting. 4. a. If the government gives its capital to a private business and then purchases the final goods from that business, GDP would increase. For example if government built a marina for coast guard patrol boats, the services would not be counted as GDP. If the government gave the dock to a private owner and paid the private owner rental fees, the GDP would increase. b. Under government ownership the implicit flow of services would be valued at the estimated depreciation rate of the dock. If they gave it to a private owner and rented it, then the GDP would increase by that amount. In this case, since the market value of the service is likely to be greater than the estimated depreciation rate, government ownership is still likely to understate the true GDP, though the bias will be reduced. 5. a. Based on the assumptions of the model used in this chapter, we will treat the government purchase as a reduction in future income (= 0). If the capital and labour supply is fixed, there will be no change in GDP. Because of consumption smoothing, people will reduce current consumption, and investment will increase. b. This could occur during election years when the leading candidate is proposing a significant expansion of government programs. Chapter 13: (Question 5 &6) 5. a. The tax on consumption will raise the effective price; it will now take (1+c) to purchase consumer goods. The household budget constraint can be written as: (1+c)C + (1/P)B + K = (w/P)L + r(B/P +K) + V-T
s

b. The tax on consumption reduces the effective opportunity cost of leisure in terms of current (and future) consumer goods. The labour supply would decrease by the substitution effect. c. The reduction in the labour supply found in part (b) would reduce the marginal product of capital services, just as in the earlier case. Capacity utilization rates and real interest rates would fall. d. This change introduces inter-temporal substitution effects. Current consumption is less expensive than future consumption, so current consumption increases and real savings decreases. A tax on

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asset income would have a similar effect on real savings, because it would reduce the opportunity cost of current consumption. 6. a. The increase in nominal wage and interest rates would have pushed individuals into brackets with higher marginal tax rates. b. The indexing should maintain the real income tax brackets at their original levels; only changes in real income will cause a change in marginal tax rates. Some corrections on the textbook:

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