ECO 102 Name: ______Spring 2016 Semester Midterm #3 Student ID#: ______

Part I. (3 points for each correct answer) Select the one best answer for each of the following questions. If you change your mind, make sure it is obvious what your final choice is.

Read questions carefully! A familiar-looking question might have been altered so that the correct answer changes.

1. A central bank establishes minimum required reserve ratios in order to prevent the banks it supervises from becoming:

a. illiquid

b. insolvent

c. unprofitable

d. unreasonable

e. unethical

2. Suppose the central bank wants to decrease the money supply. It can decrease the money supply by decreasing the Monetary Base by _____. It can decrease the money supply by lowering the money multiplier (not the monetary base) by _____ .

a. making open market purchases of government bonds; raising the discount rate

b. raising the required reserve ratio; making open market purchases of bonds.

c. lowering the discount rate; lowering the required reserve ratio.

d. raising the required reserve ratio; lowering the discount rate.

e. none of the above is correct. 3. The point in time when our economy stops getting better (and the unemployment rate stops falling) and starts getting worse (and the unemployment rate starts rising) is known as the business cycle’s:

a. peak b. trough c. expansion d. recession e. climax

4. In the Keynesian economic model, firms seek to ensure that quantity demanded is equal to quantity supplied by adjusting _____. The result is that in the short run, the AS curve is _____ as long as there are unused resources of land, labor, and capital.

a. Prices flat b. Prices vertical c. Quantity produced flat d. Quantity produced vertical e. None of the above.

5. Expansionary fiscal policy would be a decrease in _____, while expansionary monetary policy would be a decrease in _____.

a. Taxes interest rates b. marginal propensity to consume money supply c. government spending money supply d. imports exports e. government spending taxes

6. Suppose that the consumers in a Keynesian economy see their incomes rise by 100. As a result, their savings rise $30. This means that their marginal propensity to consume must be:

a. 0.3 b. $30 c. $70 d. 0.7 e. $100

2 7. A movement along the country’s Aggregate Demand curve could be caused by ____. A shift of the country’s Aggregate Demand curve could be caused by _____.

a. Expansionary monetary policy; expansionary fiscal policy b. Expansionary monetary policy; a change in the price level c. A change in the price level; expansionary monetary policy d. Expansionary fiscal policy; contractionary monetary policy e. None of the above.

8. If you see an Aggregate Supply curve that is vertical at the level of output equal to potential output, you know that this is a _____ model where _____. a. Keynesian firms adjust wages to keep workers employed b. Keynesian firms adjust prices to maximize profits c. Keynesian firms adjust output to meet the quantity demanded d. Classical prices adjust to set quantity supplied equal to quantity demanded in all markets e. Classical firms adjust prices to preserve market share

9. The aggregate demand curve would shift to the left if:

(i) there is a decrease in the quantity of labor available (ii) there is an increase in government expenditure (iii) firms wish to decrease their planned investment spending due to their pessimistic outlook on the economy. a. only (i) is true. b. only (ii) is true. c. only (iii) is true. d. both (i) and (ii) are true. e. both (ii) and (iii) are true.

10. In the Keynesian model, the equilibrium level of output (and income) in the short term is where:

(i) Unplanned investment is equal to zero. (ii) The planned aggregate expenditure line crosses the 45 degree line. (iii) Inflation is equal to zero. (iv) Output is equal to potential GDP. a. only (i) is true. b. only (ii) is true.

3 c. only (iii) is true. d. only (iv) is true. e. none of the options (a.) through (d.) is correct.

Planned Aggregate Expend- iture PAE = C+I+G+NX

(1) (3)

(2)

(4) (5) X Z GDP

11. In the graph of a Keynesian economy shown above, the aggregate expenditure multiplier would be shown as the ratio of the distance between points _____ in the numerator (top of the fraction) to the distance between points _____ in the denominator (bottom of the fraction).

a. (1) and (2); (4) and (5) b. (2) and (3); (1) and (6) c. (3) and (6); (4) and (5) d. (4) and (5); (1) and (2) e. (2) and (3); (4) and (5)

12. Suppose a person’s income is $100 per month, the person spends $80. When he gets a new job paying $150 per month, his spending rises to $130 per month. Therefore his marginal propensity to consume must be: a. 0.8 when income was $100/month, and 13/15 when income is $150/month. b. 0.8 c. 1.0

4 d. 2/3 e. 0.6

13. In the Keynesian model, the role of expectations of prices and wages is most important in determining the position of:

a. the aggregate demand curve. b. The short-run aggregate supply curve. c. The long-run aggregate supply curve. d. The planned aggregate expenditure line. e. The money supply curve.

AS2 AS0 AS1 Price Level

Output

14. In the diagram above, a country’s initial AS curve is AS0. If the supply curve shifts

to AS1, this could be caused by _____. If the supply curve shifts to AS2, this could be caused by _____.

(i) An increase in the expected price level (ii) An increase in the amount or the quality of land, labor, and capital available to use in the economy. (iii) Expansionary fiscal policy.

a. (i) (ii) b. (ii) (iii) c. (i) (iii) d. (ii) (i) e. (iii) (i)

15. As long as prices in all markets adjust eventually to set quantity supplied equal to quantity demanded, the result will be that eventually:

a. The unemployment rate will go to zero.

5 b. The aggregate demand curve will be downward-sloping. c. Output will return to potential GDP. d. The inflation rate will go to zero. e. The aggregate supply curve will be flat.

16. Suppose the central bank wants to maintain a fixed exchange rate between its own currency and another (foreign) currency. When the value of its own currency would otherwise rise in the foreign exchange market, the central bank must ____ its own currency. This transaction tends to make the country’s money supply _____. a. buy fall b. buy rise c. sell fall d. sell rise e. none of the above.

17. When a country has a fixed exchange rate of its currency to some other currency, the exchange rate stays fixed by: a. law. b. making sure that imports are equal to exports. c. having the central bank buy (or sell) the difference between quantity demanded and quantity supplied of its currency in the foreign exchange market at the fixed rate. d. having the government borrow money whenever the supply of money is greater than demand. e. picking the correct level of import tariffs.

18. The Keynesian model assumes that prices do not adjust instantly to set quantity demanded equal to quantity supplied in all markets. One of the markets in which prices adjust most slowly is the: a. product market b. bond market c. labor market d. money market e. foreign exchange market

19. When equilibrium output is less than potential GDP, there is a _____ gap, and unemployment is _____ than the natural rate of unemployment. If the central bank wants to bring GDP closer to potential GDP, it would _____. a. recessionary more lower the discount rate

6 b. recessionary less lower taxes c. inflationary more increase government spending d. inflationary less raise the discount rate e. recessionary more raise the required reserve ratio 20. An example of expansionary fiscal policy would be _____. It would result in _____. Expansionary monetary policy would result in _____.

a. An increase in government expenditure; a shift of the AS to the right; a shift in AD to the right. b. An increase in taxes; a shift of the AD to the right; a shift of the AS to the right. c. A decrease in taxes; a shift of AD to the left; a shift of the AS to the right. d. An increase in interest rates; a shift of AS to the right; a shift of AD to the left. e. An increase in government expenditure; a shift of AD to the right; a shift of AD to the right.

Part II: (30 points total) Instructions: Use the space provided (and the back of the page, if necessary) to answer the following:

Suppose country A has a Keynesian economy with potential GDP of 300.

And…

(1) C = 30 + (3/4)·(Y-T) (2) IP = 30 (3) G = 40 (4) T = 40 (5) X-M = -10

1. Plot PAE as a function of Y, with Y on the horizontal axis and PAE on the vertical axis.

2. On your graph above, identify the unplanned investment that would occur if Y = 300. How much unplanned investment would there be?

3. Find Ye.

7 4. Suppose an economic crisis occurring in country B which purchases country A’s exports causes the net exports of country A to shift suddenly to -20. Because they don’t know when country B will recover and begin buying country A’s products again, the amount of investment that firms in country A are willing to do falls to 25. What would be the new level of equilibrium income?

5. After the events in question 4, what would the new level of government expenditure need to be to bring equilibrium GDP up to 300?

6. At the beginning of this problem, both G and T were equal to 40, so the government’s budget was balanced. In question 5, you calculated a new level of G, but did not change T. What are the risks of following this course of action?

Extra Credit:

The questions below are from the “economic literacy” test sponsored by the Minneapolis Federal Reserve Bank (https://www.minneapolisfed.org/publications/the- region/economic-literacy-survey).

Economists believe that any adult who knows how to chew gum should be able to answer these questions correctly. In the survey, the typical American adult was able to answer 5.7 questions out of 13 correct. Therefore the typical American is dumber than a bag of hammers. (This may explain why many American adults think Donald Trump is a viable candidate for president.)

You receive extra credit points only to the degree you are smarter than the typical American adult. You will get one-half extra point for the number of correct answers you get above 5.7.

8 1. Which of the following occurs when one country trades wheat to another country in exchange for oil? a. Both countries gain. b. Both countries lose. c. The country that trades wheat gains, the country that trades oil loses. d. The country that trades oil gains, the country that trades wheat loses.

2. What is the most important task of all economics? a. To balance imports and exports. b. To balance the government's budget. c. To make the best use of scarce resources. d. To save money to reduce the national debt.

3. When a country's people and its other resources are fully employed, which of the following must be true before more of any one item can be produced? a. Private enterprise has to produce it rather than the government. b. There has to be less production of other products. c. There has to be a general decrease in prices.

4. When industries or countries specialize in producing goods and services, this results in ... ? a. Increased price inflation. b. Less output per hour worked. c. Greater economic interdependence. d. More equal distribution of income.

5. What is the most essential characteristic of a market economy? a. Effective labor unions. b. Good government regulation. c. Responsible action by business leaders. d. Active competition in the marketplace.

9 6. In a market economy, individuals pursue their own self-interest. Does this serve the public interest because of the ...? a. Operation of competitive markets. b. Social responsibility of business leaders. c. Careful planning and coordination of market activity. d. Individuals understand what is in the public interest.

7. What would happen to employment if the government mandated a minimum wage above what employers currently pay? a. Employment would go up. b. Employment would go down. c. Employment would stay the same.

8. Why do professional sports players generally earn more than farmers and steelworkers? a. Team owners are monopolists. b. Sports players are really entertainers rather than producers. c. There are fewer professional sports players than farmers or steelworkers. d. Good sports players are more scarce, given the demand for their services.

9. Which of the following approaches to pollution control makes the best use of a country's economic resources? a. Abolishing the use of toxic chemicals. b. Using resources to reduce all pollution damage. c. Controlling pollution as long as the extra benefits are greater than the extra costs. d. Prohibiting economic activities that cause pollution or harm the environment.

10. Which of the following limits an economy's potential output? a. The quantity and quality of labor, capital, and natural resources. b. Business demand for final goods and services. c. Government regulations and spending. d. The amount of money in circulation.

10 11. If your annual income rises by five percent while prices of the things you buy rise by ten percent ...

a. You are better off. b. You are worse off. c. You are unaffected.

12. What must the government do to reduce high inflation?

a. Increase both spending and the money supply. b. Decrease both spending and the money supply. c. Decrease spending and increase the money supply. d. Increase spending and decrease the money supply.

13. Why are private businesses not likely to operate a lighthouse?

a. Ship owners buy insurance policies to protect themselves from losses so they won't pay for lighthouses. b. The light from the lighthouse can be used even by ships that do not pay a fee for the service. c. It would cost private business more to operate a lighthouse than it costs the government. d. The cost of operating a lighthouse is too high.

The above test, and the rationale for the correct answers, are based on the "Test of Economic Literacy," Second Edition, Examiner's Manual, by John C. Soper and William Walstad, Joint Council on Economic Education, 1987.

11 Double-bonus extra credit:

The shape below can be divided into two identical shapes with one cut. Show how.

12