Intermediate Macro s1

ECO 302b Intermediate Macro Spring 2009 Midterm 3

Part I: Answer completely in the spaces provided, or use the back of the page. (40 points total)

1. An economy is described by the following equations:

Desired Consumption Cd = 26 + 0.5(Y – T) - 100r Desired Investment Id = 20 - 100r Government Purchases G = 20 Taxes T = 20 Real Money Demand L = 0.5Y - 200r Real Money Supply M/P = 264/P Full-employment output YFE = 100

Assume that expected inflation is zero so that money demand depends directly on the real interest rate. a. Write the equation that describes the IS curve.

b. Write the equation that describes the LM curve.

c. Calculate the real interest rate, price level, consumption, and investment if all markets are in equilibrium at the full-employment level of output.

d. Suppose that consumers feel more secure about their future wealth, and the consumption function shifts to become:

Desired Consumption Cd = 46 + 0.5(Y – T) - 100r

Assuming that the price level is fixed in the short run, what will be the new short-run equilibrium output and real interest rate? e. Under the new consumption function in part d, what will be the long run level of output and the new price level?

2. The discovery of a new technology raises the expected future marginal product of capital (MPK). a. Use the classical IS-LM-FE model to determine the effect of the change in MPK on current output, the real interest rate, employment, real wages, consumption, investment, and the price level. Assume that expected future real wages and future incomes are unaffected by the new technology. Assume that current productivity is unaffected.

b. Fine the effects of the increase in expected future MPK on current output and prices using the AD – AS diagram based on the misperceptions theory. What accounts for the difference in your answer here compared to part a? Part II: Select the best answer for each of the following questions and mark it clearly on the page. (3 points each)

1. Above is the degree of effort (or productivity) a typical employee might offer according to the wage paid. If the prospect of unemployment becomes less frightening to the employee (because unemployment compensation is made more generous), then the effort curve will shift to the ______and the wage the firm will want to pay will _____. a. right fall b. left fall c. left rise d. right rise e. none of the above.

2. If a firm’s current price for its product is pretty close to the “perfect” (profit- maximizing) price, profits should be pretty close to the maximum level of profit. It might not be worth the bother or cost of adjusting the price to the perfect level. This is the idea behind the ______theory. a. implicit contract b. insider-outsider c. menu cost d. reverse causation e. misperceptions

3. If existing employees regard a newcomer who is paid less than them as a threat to their jobs, the existing employees will withhold cooperation and undermine the work of the new employee. This makes the employer reluctant to hire new employees at lower wages. This is the idea behind the _____ theory. a. implicit contract b. insider-outsider c. reverse causation d. misperceptions e. menu cost 4. If money demand increases suddenly, then the ______; which will cause the _____. a. IS curve to shift to the left AS curve to shift to the right b. IS curve to shift to the right AS curve to shift to the left c. LM curve to shift to the left AD curve to shift to the left d. LM curve to shift to the right AD curve to shift to the right e. none of the above.

5. Keynesians believe that the ____ market can remain in disequilibrium, so business cycle movements can be caused by shifts in _____. a. labor AS b. product AD c. labor AD d. product AS e. asset AD

6. The Phillips Curve relationship between inflation and unemployment appears to be stable when governments do not attempt to manage the economy – but unstable when governments do try to manage the economy. This outcome is best explained by: a. Implicit Contract Theory b. Real Business Cycle Theory c. Lucas Misperceptions Theory d. Keynesian Business Cycle Theory e. Reverse Causation Theory

7. According to Keynesians, firms keep some workers on the payroll during recessions even if the firm doesn’t need them at that moment – to avoid losing hard- to-replace workers. When demand increases, the firm can increase output without adding many new workers. This will make _____ appear to be pro-cyclical, even though there has been no change in the production function. a. real wages b. average labor productivity c. labor force participation d. inventory investment e. money supply growth

8. The Phillips Curve relationship between inflation and unemployment is what would result if the SRAS were _____ and the AD curve was _____. a. upward-sloping and stable unstable b. upward-sloping and unstable stable c. vertical and unstable stable d. vertical and stable unstable e. horizontal and stable unstable 9. A government wants to lower inflation by lowering the growth rate of the money supply. If it believes inflation expectations will adjust quickly to a dramatic change in policy, it will prefer the ____ approach to lowering inflation. a. gradual b. Lucas c. Phillips d. Bernanke e. cold turkey

10. The _____ theory explains why there might still be involuntary unemployment even when the labor market is in “equilibrium” (no tendency for wages to either rise or fall). a. implicit contract b. efficiency wage c. menu cost d. quantity e. reverse causation

11. When an economy experiences a prolonged period of high unemployment, some members of the population become less employable because of the lack of job history or experience. Thus the natural rate of unemployment depends on the history of actual unemployment rates. This is the idea behind _____ . a. hysteresis b. psoriasis c. halitosis d. implicit contracts. e. political business cycle.

12. According to the Lucas misperceptions model, a shift to the right of the AD curve will cause a business cycle expansion if the shift is _____. a. caused by a shift of the IS curve. b. caused by a shift of the LM curve. c. caused by a shift of the FE line. d. unexpected. e. perfectly anticipated.

13. The Solow residual is: a. the difference between national savings and desired investment. b. the difference between the quantity supplied and quantity demanded of non- monetary assets. c. the portion of the change in output that cannot be explained by changes in measured capital or labor inputs. d. the portion of the adult population that is not counted as part of the labor force. e. the difference between actual inflation and expected inflation. 14. The “reverse causation” argument is useful to ____ economists because it helps explain why ______. a. Keynesian average labor productivity is counter-cyclical b. classical money supply growth is leading and pro-cyclical c. classical stock prices are leading variables d. Keynesian real wages are pro-cyclical e. Keynesian unemployment is a lagging variable

15. In 1914, Henry Ford tried to reduce worker turnover and absenteeism in his factory by offering workers $5 per day to work (double the normal wage for factory workers at the time.) The result was: a. even more turnover and absenteeism. b. union protests. c. his cars became too expensive to sell profitably. d. absenteeism and turnover fell, and labor productivity went up. e. the union demanded $6 per day.

16. Examples of “aggregate demand shocks” include:

(i) change in desired investment arising from changes in expected future marginal product of capital (ii) changes in government expenditures or taxes (iii) changes to consumer confidence that affect the position of the desired national savings curve. a. only (i) is true. b. only (ii) is true. c. only (iii) is true. d. only (i) and (ii) are true. e. (i), (ii), and (iii) are all true.

17. Both classical and Keynesian economists agree that the long-run Phillips Curve is: a. unstable. b. dependant on expected inflation c. downward-sloping d. vertical over the natural rate of unemployment e. upward-sloping 18. People who believe that the natural rate of unemployment can be reduced suggest that ____ might work to lower the natural rate.

(i) government support for job training and worker relocation (ii) increased labor market flexibility (iii) more generous unemployment compensation a. only (i) is true. b. only (ii) is true. c. only (iii) is true. d. both (ii) and (iii) are true. e. both (i) and (ii) are true.

19. A government that wants to implement a policy to lower inflation will be more successful if the government ____ credibility and tries to make sure the new policy is _____. a. does not have anticipated. b. does not have unanticipated c. has anticipated d. has unanticipated e. none of the above.

20. The “sacrifice ratio” is the ratio of: a. the percentage of output lost in order to reduce the inflation rate by 1%. b. the percentage of investment lost when real interest rates rise by 1%. c. the percentage of GDP lost when tax rates rise by 1%. d. the percentage of investment lost when the government budget deficit rises by 1%. e. the percentage of real wage decrease when the labor force increases by 1%.