BADM 527, Fall Midterm Exam 2. Multiple Choice: 3 points each. Answer the questions on the separate bubble sheet. NAME

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1 BADM 527, Fall 2013 Name: Midterm Exam 2 November 7, 2013 Multiple Choice: 3 points each. Answer the questions on the separate bubble sheet. NAME 1. According to classical theory, national income (Real GDP) depends on alone, while Keynes proposed that helps determine the level of national income. A) aggregate demand; aggregate supply B) aggregate supply; aggregate demand C) monetary policy; fiscal policy D) fiscal policy; monetary policy 2. The short run refers to a period: A) of several days. B) during which prices are sticky and unemployment may occur. C) during which capital and labor are fully employed. D) during which there are no fluctuations. Use the following to answer question 3: 3. In this graph, initially the economy is at point E, with price P0 and output Y. Aggregate demand is given by curve AD 0, and SRAS and LRAS represent, respectively, short-run and long-run aggregate supply. Now assume that the aggregate demand curve shifts so that it is represented by AD 1. The economy moves first to point and then, in the long run, to point. A) A; D B) D; A C) C; B D) B; C Page 1

2 4. An increase in government spending generally shifts the IS curve: A) downward and to the left. B) upward and to the right. C) upward and to the left. D) downward and to the right. 5. The variable that links the market for goods and services and the market for real money balances in the IS-LM model is the: A) consumption function. B) interest rate. C) price level. D) nominal money supply. 6. The IS curve provides combinations of interest rates and income that satisfy equilibrium in the market for, and the LM curve provides combinations of interest rates and income that satisfy equilibrium in the market for. A) saving and investment; planned spending B) real-money balances; loanable funds C) goods and services; real-money balances D) real-money balances; goods and services 7. A decrease in the real money supply M/P, other things being equal, will shift the LM curve: A) downward and to the left. B) upward and to the left. C) downward and to the right. D) upward and to the right. 8. In the sticky-price model of Aggregate Supply, the relationship between output and the price level (slope of AS) depends on: A) the proportion of firms with flexible prices. B) the target real wage rate. C) the target nominal wage rate. D) the implicit agreements between workers and firms. 9. The debt-deflation theory of the Great Depression suggests that deflation redistributes wealth in such a way as to spending on goods and services. A) unexpected; reduce B) unexpected; increase C) expected; reduce D) expected; increase Page 2

3 10. The total income of everyone in the economy adjusted for the level of prices is called: A) a recession. B) an inflation. C) real GDP. D) a business fluctuation. 11. In the Keynesian Cross model, planned expenditure is determined by: A) planned investment (I) only. B) government spending (G), and taxes (T) only. C) planned investment (I), government spending (G), and taxes (T). D) national income (Y), planned investment (I), government spending (G), and taxes (T). 12. The theory of liquidity preference implies that: A) as the interest rate rises, the demand for real balances will fall. B) as the interest rate rises, the demand for real balances will rise. C) the interest rate will have no effect on the demand for real balances. D) as the interest rate rises, income will rise. 13. The aggregate demand curve is the relationship between the quantity of output demanded and the. A) positive; money supply B) negative; money supply C) positive; price level D) negative; price level 14. An increase in investment demand for any given level of income and interest rates due, for example, to more optimistic animal spirits will, within the IS-LM framework, output and interest rates. A) increase; lower B) increase; raise C) lower; lower D) lower; raise 15. According to the Keynesian-cross analysis, if the marginal propensity to consume is 0.8 and government expenditures G increase by 100, equilibrium income Y will rise by: A) 0. B) 500. C) 80. D) 100. Page 3

4 (Exhibit: IS-LM Monetary Policy) 16. (Exhibit: IS-LM Monetary Policy) Based on the graph, starting from equilibrium at interest rate r 1 and income Y 1, an increase in the money supply would generate the new equilibrium combination of interest rate and income: A) r 2, Y 2 B) r 3, Y 2 C) r 2, Y 3 D) r 3, Y 3 Page 4

5 Use the following to answer questions 17-18: (Exhibit: Keynesian Cross) 17. (Exhibit: Keynesian Cross) In this graph, the equilibrium levels of income and expenditure are: A) Y 1 and PE 1. B) Y 2 and PE 2. C) Y 3 and PE 3. D) Y 3 and PE (Exhibit: Keynesian Cross) In this graph, if firms are producing at level Y 1, then inventories will inducing firms to production. A) rise; increase B) rise; decrease C) fall; increase D) fall; decrease 19. Business cycles are: A) regular and predictable. B) irregular but predictable. C) regular but unpredictable. D) irregular and unpredictable. 20. The assumption of constant velocity in the quantity equation (MV=PY) is the equivalent of the assumption of a constant: A) demand for investment. B) level of government expenditures. C) price level in the short run. D) demand for real money balances M/P per unit of output. Page 5

6 Short Answer (40 points): Please answer in the space provided. Currently, most observers believe that the US economy is operating at a level of output Y well below full employment GDP, Y. a) (5 points) Do you agree that current US Real GDP is currently below full employment GDP Y? [YES]. Explain briefly, including a definition of full employment GDP and citing any statistics or theory that you can think of to support your position. Full employment GDP is the level of Real GDP consistent with the natural rate of unemployment, u n, which most economists believe currently stands at 5.5% to 6%. The actual rate of unemployment currently stands at 7.3%, which is much higher, and is consistent with a level of Y substantially below full employment GDP. Full employment GDP may also be defined as the highest sustainable level of real GDP, or the long-run equilibrium level of real GDP, or the level of GDP at which the economy s resources are fully used, consistent with structural and frictional constraints. b) (10 points) Assuming that most observers are correct, and Real GDP Y is currently less than Y, draw a diagram that illustrates the current condition of the economy, including an upwardsloping AS curve, a LRAS curve, and AD. Label all curves, axes, and short-run equilibrium P* and Y*, as well as full-employment GDP, Y. The chart must show the intersection of AS and AD to the left of the LRAS curve, point A below, as the short-run equilibrium. Short-Run Equilibrium at Y* < Y, point A Page 6

7 c) (5 points) Many experts believe that the economy will soon recover on its own. On your diagram above, show the natural movement of the economy to full employment, as explained in chapter 12. In order for the economy to return to full employment naturally what set of economic variables must become unstuck? PRICES Adjustment to Long-Run Equilibrium: Prices fall, EP falls, and AS shifts to the right until P = EP = P 0. Page 7

8 d) (20 points) Suppose that Congress or the Federal Reserve decides to implement a policy designed to affect AD so as to bring the economy back to full employment. Name a policy that might be appropriate: Expansionary Monetary ( M) or Fiscal ( G or T) Policy Now, in the space below, use diagrams to show how your chosen policy works, according to the IS-LM model. Include (if and as required) diagrams or equations for Investment I(r), the Keynesian Cross, the Liquidity Preference model, as well as the IS and LM curves and the AS and AD curves. Be sure to show all curve shifts, label axes and curves, and label equilibrium interest rates (r) and GDP (Y). Expansionary Monetary Policy: Drives interest rates down at current GDP, moves LM to the right. M M/P (rightward shift of money supply curve) LM AD 1) Liquidity Preference Model 2) IS-LM Model 3) AS-AD ModelTHe For expansionary Fiscal Policy, you should have drawn diagrams of the Keynesian Cross ( PE), the IS- LM model ( IS), and an AS-AD diagram that looks just like the one on the left. Page 8

9 Extra Credit (10 points maximum): We noted in class that the ex ante nominal interest rate, i = r + E is the actual opportunity cost of holding money, yet we ve been writing the money demand function as L(r, Y), as if the demand for money depended only on the real interest rate r. One way to acknowledge the importance of expected inflation E is to rewrite the money demand function as L(r, Y, E ). If we did this, X1) When E decreases, the money [DEMAND] curve shifts to the [RIGHT] X2) If E decreases, the [LM ] curve shifts to the [LEFT]. X3) Show, using diagrams, the effect of a change in inflation expectations from zero expected inflation to expected deflation on real interest rates r and output Y. E L(r, Y, ) r LM r, Y AD. Page 9

10 Answer Key 1. B 2. B 3. C 4. B 5. B 6. C 7. B 8. A 9. A 10. C 11. D 12. A 13. D 14. B 15. B 16. D 17. B 18. C 19. D 20. D Page 10