answers to macro econ

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Macroeconomics Exam

1.) You are working at an investment firm that has many investments in Lithuania. You have been asked to do a simple simulation showing the potential effects of Lithuania building a high-speed rail network, and what will happen if there is worldwide pressure on interest rates. All amounts are in millions of Litas. (The Lita is the Lithuanian currency. For this example use the exchange rate you compute, not the actual exchange rate). Government spending is projected to rise by 50 percent due to construction of the high-speed rail network

This is the status quo scenario

Total Output is equal to 5,000

Government spending is equal to 1,000

Tax revenue is equal to 1,000

Consumption is equal to 250+0.75*(Y-T);

The level of investment is 1,000-50r;

Net Exports are 500-500,

The world real interest rate is five percent

Assume that there are three political parties in Lithuania and each think that building the high speed rail network will have different effects on the economy. They have hired you as a consultant (moonlighting from your investment firm) to do an analysis showing what happens if their beliefs end up being true.

a. THE LIBERAL PARTY believes that increasing government spending to build the high speed rail network will increase both G and GDP. That is G, will increase to 1,500 and GDP will increase by 500 too. Compare what happens to the economy if the Liberal party is correct. How do private savings, public savings, national savings, Net exports, and the exchange rate change from the status quo? (10 points)Y = 5000

G = 1000

T = 1000

C = 250 + 0.75*(Y-T)

I = 1000 50r

Net Exports = 500 - 500

r = 0.05

New G = 1500 and Y = 5500

Private Saving = Disposable income consumption

Private Saving = (Y T) Consumption

Private Saving = (Y 1000) (250 + (0.75Y 750))

Private Saving = 0.25Y 1250 + 750

Private Saving = 0.25*5500 500

Private Saving = 1375 500

Private Saving = 875Public Saving = Excess of Taxes over Government expenditure

Public Saving = T G

Public Saving = 1000 1500

Public Saving = 500

National Saving = private saving + public saving

National Saving = 750 + ( 500)

National Saving = 250

National Saving = Domestic Investment + Foreign Investment 250 = 750 + Foreign Investment

Foreign Investment = 500

means, Net Export = 500 Net Export = 500 - 500

500 = 500 - 500

= 2b. THE CONSERVATIVE PARTY believes that building a high speed rail network will put people to work (thus increasing G), but that it will ultimately be useless (there will be no overall wealth created), so GDP will be unchanged. The conservatives are also concerned that the government taking on new debt will be a bad sign to Lithuanias creditors, and that borrowing the money for the high-speed rail system will cause the interest rate to rise 20 percent.Under this scenario, how do private savings, public savings, national savings, Net exports, and the exchange rate change from the status quo? (8 points)







Private Saving = 750

Public Saving = Excess of Taxes over Government expenditure

Public Saving = T G

Public Saving = 1000 1000

Public Saving = 0


National Saving = 750 + 0

National Saving = 750

National Saving = Domestic Investment + Foreign Investment

750 = 750 + Foreign Investment

Foreign Investment = 0

means, Net Export = 0

Net Export = 500 - 500

0 = 500 - 500

= 1

c. THE LIBERTARIAN PARTY believes that taking tax money and using it to build a high-speed rail network does nothing more than take money from one group of people (taxpayers) and give it to another group of people (the construction industry) and that there is no productive economic impact. How do private savings, public savings, national savings, Net exports, and the exchange rate change from the status quo? (8 points)







Private Saving = 750

Public Saving = Excess of Taxes over Government expenditure

Public Saving = T G

Public Saving = 1000 2000 (G = 2000)

Public Saving = -1000


National Saving = 750 + (-1000)

National Saving = -250

National Saving = Domestic Investment + Foreign Investment

-250 = 750 + Foreign Investment

Foreign Investment = -1000

means, Net Export = -1000

Net Export = 500 - 500

-1000 = 500 - 500

= 3

d. Please compare situations a, b, and c. Who do you think is correct, and why? (8 points)

By comparing the views of liberal, conservative and libertarian party, I think that the conservative view is correct. The calculated numerical values of private saving, public and national saving, net export and exchange rate indicates that the conservative view is correct. e. The Libertarians use a microeconomics explanation about taxation to argue that the economy will be helped most by simply reducing taxes, even if people only save the money that they dont spend on taxes (C is not affected). They say that this phenomenon is assumed away by most macro-economists. What are they referring to? (2 points)

Of course, the economy will be helped most by simply reducing taxes. In practical, most of the people are not voluntarily paying taxes to the government however their spending on goods and services takes place with taste and preferences also. Technically, reduction in taxes will allow increasing the disposable income of the individuals and this will influence to increase their spending amount. A positive change in spending will attract the new investment and push up the employment and fasten the activities of all economic indicators. 2.) Why cant the Federal Reserve directly control the money supply? What changes in behavior on the part of people or banks can make it harder for an increase in the monetary base to increase M2? (8 points)

Monetary policy is a process of controlling circulation of money in order to stabilize or stimulate the economic growth. The central bank of a country will act as a supreme authority for implementing the monetary policy. In general, the Federal Reserve implements two types of monetary policies such as expansionary monetary policy and contratictionary monetary policies. The expansionary monetary policy will be implemented to boost up the economic activities by increasing the money supply during the period of recession or economic slowdown. Meanwhile, the contractionary monetary policy will be used to stabilize the economic activities during the period of inflationary issues through reducing supply of money in the economy. The role of Federal Reserve is lesser than the contribution of people and banks in determining the supply of money in the economy because these two agents are real players in the circulation of money. M0 and M1, for example, are also called narrow money and include coins and notes that are in circulation and other money equivalents that can be converted easily to cash. M2 included M1 and, in addition, short-term time deposits in banks and certain money market funds.

An increase in the supply of money typically lowers interest rates, which in turns generates more investment and puts more money in the hands of consumers, thereby stimulating spending. 3.) The country of Luxembourg is a small, open economy. Suddenly, a change in world fashions makes the exports of Luxembourg very un-popular. Explain what happens to savings, investment, net exports, the interest rate, and the exchange rate. (6 points)

In the macroeconomic analysis, the gross domestic product/GDP often considered the most significant indicator which shows the economics performance of the country. It can be defined as the market value of all final goods and services produced within a country at a given period of time. The value of the GDP can be calculated by using the following formula

GDP = Consumption + Investment + Government Expenditure + Net Export

The above formula indicates that there is a positive relationship between GDP and net export. A sudden fall in exports of Luxembourg will adversely affect the output of the Luxembourg.

A fall in export will influence to less attract the investment and push down the employment opportunities. These changes in the economy will reduce the private and public savings. In addition, the value of net export will fall down because of negative change in total output and export level. Every economic indicator is interrelated to each other so a fall in saving and investment will force to increase the interest rate in order to encourage the savings. A higher interest rate will offer lenders high rate of return relative to other countries and brings the capital from other nations. Thus, increases in capital flow push up the value of domestic currency relative to other countries in the foreign exchange market.4) Assume that the country of Iran is a small, open economy. George W. Bushs inclusion of Iran as a member of the Axis of Evil, however, has complicated trade with Iran. Assume that every good coming out of Iran is subject to a Terrorism Tariff that makes every quantity of exports effectively more expensive to any nation that buys them.As a result, the willingness to pay by the international community for every quantity of exports from Iran is lower.Explain what happens to savings, investment, net exports, the interest rate, and the exchange rate. (6 points)

The Iran case is completely different from Luxembourgs situation where export fell down because of fall in demand for Luxembourgs goods and services in the international market. But in Iran, the country is voluntarily reducing the export amount because of higher cost for export. Thus, a voluntary reduction in export will influence to less attract the investment and push down the employment opportunities. These changes in the economy will reduce the private and public savings. Further, net export will come down and the interest rate will rise in the economy. Higher interest rate attract the foreign investors and encourage the exchange rate value.5.) What are your predictions for the US economy over the next two years? Use the macroeconomic models you have learned to present a reasoned answer. Explain your assumptions clearly.

Please also address what could happen if the Fed proceeds with a third round of quantitative easing. Please answer the scenarios that could occur, then state which scenario you think is most likely to occur, and state your reasons. (20 points)

The 2008 financial crisis is considered by many economists to the worst economic situation since the great depression of the 1930s. The financial crisis resulted in the thread of total collapse of housing market, financial institutions and downturn in stock market around the world. The economists believe that the primary cause for the 2008 financial crisis is housing market bubble in mid 2000s. All the economic indicators which used to measure the health of the economy went down further the global economy was also in trouble. In order to stimulate the economic activities, the federal government and Federal Reserve immediately implemented expansionary fiscal and monetary policy.

The primary aim of expansionary policy is to encourage and fasten the economic activity through stimulate the growth of the gross domestic product. In order to achieve this objective the Federal Reserve and Federal government initiated various actions like reducing discount rate, cash reserve ratio, purchase of government bonds and securities, reducing the tax rate and expanding the government spending. These changes in the macroeconomic policy returned good result and the latest statistical figures of important economic indicators point out that the economy is getting back to recovery stage from the trough.

Since 2008, the actions of the Federal Reserve have put the U.S. on a path to economic failure. To stem the economic slide of the U.S. housing collapse that first surfaced in 2005, the Federal Reserve unveiled three different quantitative easing (QE) efforts. Since 2008, the Federal Reserve has printed off trillions of dollars, and it continues to add to that number at a staggering rate each month.

The extra dollars pumped into the economy were supposed to spur economic growth. It had the reverse effect, shrinking the buying power of each dollar, the driving force of inflation. As the U.S. dollar continues to decline in value against other world currencies, goods imported into the U.S. become more expensive. And some of the economic indicators statistical figure is still not satisfactory level, they are unemployment level which is still around 8%, higher budget deficit and increasing fear of inflation rate. Under this situation, if the Fed proceeds with a third round of quantitative easing it will worsen the economic activity in the future. The reason for this is because of inflation pressure in the economy. The current rate of inflation in the country is somewhere around 3%, if the Fed proceeds with a third round of quantitative easing it will increase money supply and boost up the inflation in the country. Higher inflation reduces the value of domestic currency as against foreign currencies and force to less attract the foreign investment. These interrelated reactions in the economic activity may stop the growth of the gross domestic product when the Federal Reserve proceeds with a third round of quantitative easing.6) What is the difference between the Federal Funds Rate and the Discount Rate? Please give the difference by providing an explanation of each rate and their purposes? (9 pointsTechnically, the federal funds rate is the interest rate that banks usually charge on other banks while lending money to them. But federal discount rate is the interest rate which is charged by the Federal Reserve on the commercial banks while lending money to them. Federal fund rate

Sometimes, the financial institutions want to lend more amount of money than it has so it borrows money from other financial institutions that has excess reserves in order to meet the loan/withdrawal demand. When one financial institution borrows money from other bank, the rate that is charged is said to be federal funds rate. The higher the federal funds rate, the more expensive it is to borrow money. Since it is only applicable to very creditworthy institutions for extremely short-term (overnight) loans, the federal funds rate can be viewed as the base rate that determines the level of all other interest rates in the U.S. economy.

Federal discount rate

Sometimes the sudden demand for withdrawal or high demand for loans may cause to decrease the required reserve amount. Under this situation the bank will try to borrow money other financial institutions, finally it tries to borrow money from lender of last resort that is central bank or Federal Reserve. This discount rate is higher than the Federal Funds Rate so its used as a last resort for banks needing some cash to boost their reserves.7.) Assume that the GDP deflator was 100 in 2008, 97.5 in 2009, and 96.8 in 2010. How much would a salary offer of $80,000 in 2010 have been worth in 2008? (3 points)

2009

96.8 97.5 / 97.5 * 80,000 = 574

The worth of the salary in 2009 would be equal to $79,426 (80,000 574)

2009

97.5 100 / 100 * 76426 = 1985.65

The worth of the salary in 2008 would be equal to $77,440.35 (79,426 1985.65)

8) If the CPI value for 1960 was 0.5 and 2.5 in 2010, and a GMC four-door sedan cost $2,500 and $20,000 in 2010, what conclusions can you draw? (hint: Be careful what you say!)

Consumer price index is a measure that examines the weighted average of prices of a basket of consumer goods and services. The value of consumer price index is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.The numerical value of CPI indicates that a positive change in value of CPI influence to increase the true value of money. So an increase in value of CPI from 0.5 in 1960 to 2.5 in 2010 caused to raise the GMC four-door sedan cost from $2500 in 1960 to $20000 in 2010.

Please answer the next five questions as True, False, or Uncertain. Uncertain indicates that the statement may or many not be true (not that the respondent is uncertain). Feel free to provide a justification for your answer in the space provided, if you think that will be helpful.

9.) An increase in interest rates will cause a decrease in Aggregate Demand, and a slowdown in the economy. (2 points)

True

An increase in interest rates will create adverse effect on investment because investment will be costly. If investment fell down then other interrelated economic factors like employment opportunities and household income will also come down. Moreover, falling employment opportunities and income will pull down the aggregate demand through reduction in the consumption expenditure. Overall, decreasing demand wont encourage the economic activity instead it will slow down the economy.

10.) A decrease in interest rates will cause an increase in Aggregate Demand, and an expansion in the economy. (2 points)

True

A decrease in interest rates will create positive effect on investment because investment will be cheaper. If investment increases then other interrelated economic factors like employment opportunities and household income will also increase. Thus, positive change in employment opportunities will allow the individual to spend more and this attract the new investment and fasten the economic activities in the country.

11.) If the economy is not expanding, and the world interest rate is exogenous, an increase in the money supply will only cause an increase in current prices. (2 points)

Uncertain

If the economy is not expanding and the world interest rate is exogenous then an increase in money supply may or may not cause to increase the current prices because there will be movement of money from the domestic to international.

12.) The Consumer Price Index has difficulty accounting for changes in technology such as the developments in computers, while the chain-weighted GDP deflator does not. (2 points)

FalseConsumer price index is a measure that examines the weighted average of prices of a basket of consumer goods and services. The value of consumer price index is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Both CPI and GDP deflator have difficulty in accounting for changes in technology.

13.) In the US, over the last 50 years, the Consumption component of gross domestic product has been more volatile than the Investment component (2 points)

False

The components of GDP include consumption expenditure, investment expenditure, government expenditure and net export. The percentage of consumption expenditure is larger than any other components proportionate value. Last 50 years, the consumption is smoothly increasing and there is no volatility. However, the investment is highly volatile in past 50 years.

14) All else held equal, higher budget deficits should be associated with higher trade deficits.

TrueUsually economists believe that a large budget deficit will increase the value of the dollar. The logic is that higher budget deficits are believed to cause higher interest rates, which makes holding bonds and other dollar denominated assets more attractive. This is how a budget deficit can cause a trade deficit.-BONUS-

4.) What would a family who made $200,000 in 1995 make today? Use the 2012 index value for today. (4 points)

2012 value = $200, 000 * (CPI 2012 / CPI 1995)

2012 value = $200, 000 * (229.594 / 152.4)

2012 value = $301, 304.5

When should the Fed have increased the money supply according to this table? (4 points) Provide a detailed answer of how could they have increased the money supply. (12 points)

The table illustrates that the Federal Reserve has increased the money supply during the 2009 where the consumer price index is lesser than the previous years consumer price index. The lesser consumer price index will create adverse effect on supply and investment because of lower profit. The lower CPI value will reduce the supply of goods and services and further less attract the investment. In order to keep the economic factors in stable the federal reserve would have to increase the money supply if the value of consumer price index is lower than the previous year. If gasoline had gone up at only the rate of inflation, how much would it have cost per gallon in 1994? Assume the price of gasoline today is $4.00 per gallon. (4 points)

1994 value = $4 * (CPI 1994 / CPI 2012)

1994 value = $4 * (148.2 / 229.594)

1994 value = $2.58

Thus, gasoline price in 1994 should be $2.58YearCPI

1993144.5

1994148.2

1995152.4

1996156.9

1997160.5

1998163

1999166.6

2000172.2

2001177.1

2002179.9

2003184

2004188.9

2005195.3

2006201.6

2007207.342

2008215.303

2009214.537

2010218.056

2011224.939

2012229.594

answers to macro econ

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