answer key midterm 2012(1)

8/10/2019 Answer Key Midterm 2012(1)

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ANSWER KEY MIDTERM 2012

Section I

QUESTION 1

1. For each of the following state whether it is a stock or a flow and say why:

(a) depreciation (b) government debt (c) wealth (d) net exports (e) national saving.

ANSWER 1

1. (a) flow (b) stock (c)stock (d) flow (e) flow

FYI box in Chapter 2.

QUESTION 2

2. State whether each of the following is True or False, explaining your choice

concisely.

(a) Nominal GDP = Real GDP/ GDP deflator

(b)Production for inventory contributes to GDP.

(c) LM curve is upward sloping because an increase in r is needed to raise Y.

(d) If neither C nor I responds to changes in r, then monetary policy cannot affect Y in

the ISLM model.

(e) In the Keynesian cross model (Simple Keynesian model) production is increased if

actual expenditure falls short of planned expenditure.

ANSWER 2

2. (a) F. The correct relation to be stated. [Real GDP = Nominal GDP/ GDP deflator]

(b)T. Part of current productive activity.

(c) F. Money demand should be kept unchanged along LM since real money supply is fixed.

An increase in Y raises money demand, which must be neutralized by an increase in r.

(d) T. Change in M causes r to change which affects Y by changing either/both of the two

components of demand, C and I.

(e) T. Y rises if planned expenditure E > Y.


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SectionII

QUESTION 3

3. An economy is described by the following equations:

C = a + b ( Y-T); a and b are constants

I = c + dY; c and d are constant

G = constant

(M/P)s

= constant

(M/P)d

= 1/r

(a) Derive the expression for the equilibrium output.

(b)Derive the government expenditure multiplier for this economy and compare it with

the government expenditure multiplier in the Keynesian cross model.

(c) Derive the equation for the IS curve for this economy and draw a picture of the IS

curve.

(d)Draw a picture the AD curve for this economy.

1+2+3+3= (9)

ANSWER 3

(a) Y = C + I + G = a + bYbT + c + dY + G = (a + c + GbT)/(1-b-d)

(b)From (a) it follows that the government expenditure multiplier (Y/G) = 1/(1 bd) in

this model. In the Keynesian cross model I is treated as wholly given: that corresponds

to the case d = 0 since in that case I = c, a constant. Thus the government multiplier islarger in this case relative to the Keynesian Cross model: 1bd < 1b for d > 0.

(c) Y = (a + c + GbT)/(1bd) is the equation for the IS curve. Since I is independent of r,

changes in r have no effect on the equilibrium Y. Thus the IS curve is a vertical line:

r IS

0 Y

(d)

A change in P, while it changes r in the same proportion, has no effect on Ysince the change in

r does not affect Y as IS is vertical. Hence the AD curve is a vertical line.

P

0 Y


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QUESTION 4

4. In your answer book write the correct answer for each numbered cell following the

example in the first row: 12x0.5= (6)

Effects of Monetary and Fiscal Policies in ISLM

Shift of

IS

Shift of LM Shift of AD Change in r

Increase in

G

Right None Right Up

Increase in

T

2.1 2.2 2.3 2.4

Increase in

M

3.1 3.2 3.3 3.4

Increase in

P

4.1 4.2 4.3 4.4

ANSWER 4

2.1 Left 2.2 None 2.3 Left 2.4 Down

3.1 None 3.2 Right 3.3 Right 3.4 Down

4.1 None 4.2 Left 4.3 None 4.4 Up

________________________________________________________________________


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QUESTION 5

5. The following equations summarize the structure of an economy.

C = 26010r + 0.8 (Y-T)

T = 200 + 0.2YI = 1900-40r

G = 1800

NX = 700 -0.14Y

(M/P)d= 0.25Y -25r

(M/P)s= 2000

(a) Calculate the equilibrium values of Y and r

(b) If a drop in confidence reduces autonomous consumption by 40 and autonomous

investment by 60, find the new equilibrium values of Y and r.

(c) Suppose your answer to part (a) represents Y = Yn, the natural rate of output.

In trying to restore Y to Yn, policy makers also wish to make investment (I) as high as

possible. Consider the six options given below:

(i) Government (reduces/raises) G

(ii) Government ( reduces/raises) T

(iii) The central bank (reduces/raises) M

ANSWER 5

5. C = 26010r + 0.8(YT)

T = 200 + 0.2Y

I = 190040r

G = 1800

NX = 7000.14Y

(M/P)d = 0.25Y25r

(M/P)s= 2000

(a)

IS: Y = C + I + G + NX

Y = 260 -10r +0.8Y0.8(200 + 0.2Y) + 190040r + 1800 + 7000.14Y

Y0.8Y + 0.16Y + 0.14Y = 4500 50r


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0.5Y = 450050r

0.5Y + 50r = 4500 ..(i)

LM: Demand for real balances = supply of real balances

0.25Y25r = 2000 ..(ii)

Or Y = (2000 + 25r)/0.25

Or Y = 8000 + 100r

Substituting Y in (i)

4000 + 50r +50r = 4500

Or r = 5

And Y = 8000 + 100.5 = 8500

(b)

If autonomous spending falls by 60 plus 40 = 100 then (i) becomes 0.5Y =440050r

Y = 8000 +100r from the LM equation

So 4000 + 50r + 50r = 4400

Or 100r = 400

Or r = 4

And Y = 8400

New values are Y =8400 and r = 4

(c)

Moving Y to Yn and increasing investment means that r has to be reduced. This can be done by

the central bank by reducing r through an increase in money supply. LM shifts to the right hand

side or LM comes down.

r

Y

LM

IS


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QUESTION 6 (1)

6(1) Consider the AD-AS model.

(a) Draw a long run equilibrium diagram with AD, SRAS, LRAS curves. Mark the

equilibrium as 1.(b)An adverse supply shock reduces Ynand also opens up short run unemployment.

Show this new equilibrium in the same diagram and mark it as 2.

(c) Show the long run equilibrium if the government does not intervene in the same

diagram and mark it as 3.

(d)Suppose the government decides to intervene and stimulates aggregate demand to

restore equilibrium at the new lower Ynafter the shock. Mark this new equilibrium

as 4 in the same diagram.

(e)Comment on the two alternative outcomes. (Not more than 2 sentences).

ANSWER 6 (1)

6(1) (a) (b) (c) (d)

(e)

Between outcomes 3 and 4 the demand management intervention has led to full employment

at 4 albeit at a higher price level, while no intervention has allowed market forces to move the

LRAS

SRAS

AD

P

YYn

2

3

4

New AD

pushes

economy

to 4New

LRAS

New

SRAS

New SRAS

When economysettles back without

intervention at 3New Yn after

supply shock


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economy to the full employment point 3 with a lower price level. However, in practical contexts,

the time required for the two alternative outcomes to be attained may be quite different with

intervention likely to be a faster path to full employment (natural rate of output).

QUESTION AND ANSWER 6(2)

6(2). (a) Suppose that the nominal wage rate W is fixed. Then an increase in P increases

Y if (i) the demand for labour (DL) depends on _____; and (ii) employment is determined

by _____. Fill in the blanks with an appropriate word, an expression using standard

notation, or a phrase involving some economic concept.

Ans (a) (i) W/P, the real wage rate (ii) DL

(b)Write an equation relating W to the target real wage in the Sticky Wage Model.

Ans (b) W = Pex, where Pe = expected price level, and = the target real wage

(c) Why is the long run aggregate supply curve (LRAS) vertical? Explain in one sentence.

Ans (c) In the long-run, the amounts used of K and L are determined by factor market

equilibrium and since these demands and supplies depend on (R/P) and (W/P) and not

on P, Y = F(K, L) is not affected by changes in P

(d)Apart from market clearing what other condition is fulfilled in long run equilibrium?

Ans (d) Fulfilment of expectations; in particular P = Pe

2x3+3= (9)

QUESTION AND ANSWER 7

7. Consider the modified ISLM model. In addition to disposable income (Y-T),

consumption (C) also depends on (M/P).

(a) What happens to C if P increases, given (Y-T) and M?

(b) How would the IS curve shift in this case? Draw a diagram to depict your answer.

2+3= (5)

Ans (a) C would be positively associated with (M/P). Hence an increase in P, with (Y

T) and M fixed, should reduce C.


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(b) If C goes down with (YT) fixed then the IS curve should be shifted to the left: for

the same rand hence Ithere is now a fall in demand (C + I + G). Equivalently the

fall in C will raise S and so Y has to fall to bring it back into equality with I, which has

not changed for the same r.

answer key midterm 2012(1)

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