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Intermediate Macroeconomics 311 (Professor Gordon) Final Examination Fall, 2006

YOUR NAME: INSTRUCTIONS: 1. The exam lasts 2 hours. 2. The exam is worth 120 points in total: 30 points for the multiple choice questions, 60

points for the analytical questions, and 30 points for the essays. 3. Write your answers to Part A (the multiple choice section) in the blanks on page 1.

You wont get credit for circled answers in the multiple choice section. 4. Place all of your answers for part B in the space provided 5. Show your work for part B questions 6. Write your essays with a pen. Write clearly! 7. Good Luck and Happy Holiday! PART A Choose the ONE alternative that BEST completes the statement or answers the question. Your answers must be in the space provided below. USE CAPITAL LETTERS. 1. ____ 6. ____ 11. ____ 16. ____ 21. ____ 26. ____ 2. ____ 7. ____ 12. ___ 17. ____ 22. ___ 27. _ _ 3. ____ 8. ____ 13. ____ 18. ____ 23. ____ 28. __ _ 4. ____ 9. ____ 14. _ __ 19. ____ 24. ____ 29. ____ 5. ____ 10. ____ 15. ____ 20. ____ 25. ____ 30. __ _

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1.) Steady state growth will occur according to Robert Solow when A) Y = K. B) y = N. C) kn = y. D) k = n. 2.) If labor's share of national income is to remain constant, then __________. A) labor productivity must grow faster than the real wage B) the combined growth rates of labor productivity and the real wage must equal the growth rate of national income C) the real wage must grow faster than labor productivity D) the real wage must grow at the same rate as labor productivity 3.) The purchasing power parity theory (PPP) of the exchange rate implies that the real exchange rate between two countries A) should be constant. B) should rise when the foreign price level increases relative to the domestic price level. C) should fall when the foreign price level decreases relative to the domestic price level. D) (B) and (C). 4.) In moving from a small to a large open economy model under fixed exchange rates, fiscal policy A) remains totally ineffective. B) loses some of its effectiveness. C) maintains the same degree of effectiveness. D) gains extra effectiveness. 5.) Given the long run implication of Solows growth model with respect to the rate of savings, the low savings rate in the U.S. is not a problem. This statement overlooks that over time it appears that A) total factor productivity and the growth rate of capital per person are positively related. B) total factor productivity and the growth rate of capital per person are inversely related. C) total factor productivity and the difference between the growth rates of capital per capita and population are not related a and k n are not related. D) savings rates and per capita growth rates are inversely related.

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6.) The investment required to maintain steady state growth A) is impossible to achieve since capital for new workers requires continuous increases in s, the per capita savings ratio. B) must equip new workers with capital equal to that employed by existing workers. C) must replace worn out capital. D) B and C. E) is the inverse of the saving rate multiplied by depreciation 7.) The per person production function representing both physical capital per person (K/N) and human capital per person (H/N) is A) Y/N = (K/N)b(H/N)c B) Y/N = (K/N)b + (H/N)c C) Y/N = (K/N)b (H/N)c D) Y/N = (K/N)b/(H/N)c E) Y/N = (K/HN)b*Hb 8.) The Bretton Woods regime refers to a period of ________ exchange rates that was in effect ________ 1971. A) floating; before B) floating; after C) fixed; before D) fixed; after 9.) The theory of economic growth divides the causes of growth into A) elements affecting the output ratio and factors affecting inflation. B) elements affecting the output ratio and factors affecting population growth. C) elements affecting the amount of factor inputs available and the productivity of those inputs. D) None of the above.

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10.) Suppose that U.S. and British inflation rates are equal, and $2 exchanges for 1 British pound. Then if U.S. inflation slows down relative to British inflation, the PPP theory predicts ________ of the dollar, so that the pound will cost ________ than $2. A) an appreciation, more B) a depreciation, less C) a depreciation, more D) an appreciation, less 11.) The New Yorkers complaint about a $5 cup of coffee in Europe implies that: A) the dollar is predicted to appreciate B) the dollar is predicted to depreciate C) the theory of PPP works D) the theory of PPP doesnt work 12.) The Economist criticizes the Asian squirrels because A) heavy buying of dollars inflates money supplies and pushes down on interest rates B) heavy buying of dollars inflates money supplies and raises interest rates C) too much money is being invested in low-yielding American Treasury bonds D) A) and C) E) B) and C) 13.) What is the inflation tax? A) the difference between nominal and real interest rates received on financial assets, due to inflation B) the fact that our tax system is based on nominal incomes and not real incomes, so that the government collects more taxes due to inflation alone C) the government obtaining goods in exchange for newly created high-powered money that does not add to the real value of private assets due to the resulting inflation D) the fact that greater government spending leaves fewer goods available to the private sector, thus lowering their prices. 14.) After a period of sustained unexpected inflation, it is likely that the renegotiation of nominal wages will A) shift the SAS curve upward thereby decreasing output. B) shift the AD curve downward thereby increasing output.

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C) shift the SAS curve upward thereby increasing output. D) shift the SAS curve downward thereby increasing output. 15.) When the Fisher effect holds, a one-percentage-point increase in the long-run money growth rate, because it _________ expected inflation, causes ___________ in the nominal interest rate in the long run. A) equally lowers, a one-percentage-point decrease B) does not change, a one-percentage point decrease C) does not change, no change D) equally raises, no change E) equally raises, a one-percentage-point increase 16.) The shoe-leather cost of a fully anticipated inflation is A) the inconvenience of holding less cash and having to go to the ATM/bank more often. B) the higher prices of imported raw materials due to currency depreciation. C) the extra time spent on shopping in order to beat price increases. D) the effort of changing posted prices on price tags and producing new price lists and catalogs. 17.) The reason so many foreign students work in the summer in Wisconsin Dells is that A) American teenagers are all in summer school B) American teenagers avoid low-end restaurant jobs C) the population of European teenagers is growing faster than of American teenagers D) the unemployment rate of American teenagers is below the natural rate of unemployment 18.) Which of the following periods have not been used to criticize Alan Greenspans chairmanship of the Fed? A) High interest rates in 1988-89 B) Decline of interest rates in 1991-93 C) Increase of interest rates in 1998-99 D) Low interest rates in 2002-04

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19.) Suppose the private sector wishes to hold a constant level of real high-powered money. This means that with an ongoing inflation of p percent, each year the government treasury can obtain goods from the private sector in exchange for __________ p times the existing high powered money, a government revenue source called _____________. A) creating, seignorage B) creating, transfer payments C) collecting, seignorage D) collecting, transfer payments E) collecting, debt 20.) Who among the following is not frictionally unemployed? A) Andrew, a teenager who has just entered the labor market looking for his first part-time job B) Barbara, who is re-entering the labor market after a divorce C) Charles, who was laid off from his factory job but expects to be recalled in a few weeks D) Diana, who has quit her job and is now looking for another 21.) The Economist catching up criticizes the standard convergence scatter plot as shown in the textbooks Chapter 11 because A) the plotted points are not weighted by population B) the plotted points are based on market exchange rates instead of PPP exchange rates C) the plotted points are based on PPP exchange rates rather than on market exchange rates D) the plotted points for GDP per head in the textbook refer to 1960 rather than 1980 as in the Economists graph 22) You, an expert in fiscal and monetary issues, are given the following information about the government budget: T = 100, p = 5%, i = 8%, H/P = 3000 and B/P = 1000. The level of government expenditures that is needed to hold the stock of real high powered money and real bonds fixed is: A) 150 B) 30 C) 90 D) 220 E) 280

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23.) Personal retirement accounts replacing the current social security system have been criticized because of A) the transition problem B) administrative costs of running hundreds of millions of accounts C) owners of these accounts might choose risky investments D) A) and C) E) A) B) and C) 24.) Given that all countries have the same Cobb-Douglas production function, i.e. Y/N = (K/N)b, a ten-fold difference in per capita income requires a difference in capital per capita by a factor of A) 10. B) 10b. C) 101/b. D) b. 25.) A recession normally causes ______ in government net tax revenues, ______ the budget deficit is an example of ______ automatic stabilization. A) an increase, increasing, the working of B) an increase, decreasing, a failure of C) a decrease, decreasing, the working of D) a decrease, increasing, a failure of E) a decrease, increasing, the working of 26.)Suppose the government increases its expenditures by $100 million and finances the resulting deficit by selling bonds. Then the LM curve will A) shift rightward. B) shift leftward. C) become steeper. D) None of these.

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27.) In Taylor rule equation, high value of parameter a indicates that: A) Fed cares more about avoiding recessions and high unemployment than about avoiding inflation. B) Fed cares more about avoiding inflation than about avoiding recessions and high unemployment. C) Fed cares more about avoiding recessions than about avoiding high unemployment. D) Fed cares more about avoiding high unemployment than about avoiding recessions. 28.) Monetary policy has one clear advantage over fiscal policy by virtue of its very short A) data lag. B) data and recognition lags. C) legislative and transmissions lags. D) effectiveness lag. 29.) Governments promote long-run inflation when they heavily depend on ___________ to finance their expenditures. A) issuing bonds B) taxation C) raising the national debt D) money creation E) selling off assets 30.) Evidence based on the Taylor Rule suggests that after 1981 the Fed A) Pursued an inflation target B) Pursued an output gap target C) Put equal weight on inflation and the output gap D) Shifted its weights in the late 1980s from inflation to the output gap

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PART B (60 points) QUESTION 1 (15 points) Let the following equations describe a small open economy with a flexible exchange rate system. C = CA + 0.85(Y-T) CA = 200-8r T = 200+0.2Y (M/P)D = 0.25Y-25r MS/P = 2250 IP = 1700-32r G = 1800 NX = 870-0.08Y-200e (A) Initially let foreign and domestic interest rates be equal (r = rf ) and let the foreign exchange rate (e) equal 2. Find the IS and LM equations. Compute the equilibrium domestic and foreign interest rates (r and rf). Compute equilibrium real output (4 points) k = 1/(0.15*(1-0.2)+0.2+0.08)=2.5 AP = 200-8*r -0.85*200 +1700-32*r +1800+470= 4000-40*r IS: Y=k*AP or Y = 2.5 (4000-40*r) ; Y = 10,000 100*r LM: MS/P=(M/P)D or 2,250 = 0.25*Y-25*r ; Y = 9,000 + 100*r Y = 9,500 and r= rf = 5 (B) We now let the small economys domestic interest rate diverge temporarily from the foreign interest rate. Suppose the monetary authority decreases the money supply, MS/P, by 50 to 2200.

1) Derive the equation for the new LM curve. (1 point) New LM curve: MS/P=(M/P)D ; 2,200 = 0.25*Y-25*r ; Y=8,800+100*r

2) Compute the new (temporary) equilibrium domestic interest rate (r) and output (Y) (2 points)

Combine the new LM curve with the IS curve to get: Y=9,400 and r=6

3) Given the decrease in the real money supply, compute the level of output that equalizes domestic and foreign interest rate. (2 points)

Use the new LM curve and domestic interest rate r= rf = 5 to get: Y = 8,800 + 100*5 = 9,300

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4) Find the exchange rate that equalizes domestic and foreign interest rates. (6 points) Use the IS curve and the change in output level to determine the change in the exchange rate. Given that interest rate does not change, we can write: Y=k*Ap=k*(-200)* e; Solving for e, e=Y/(-200*k)=(9,300-9,500)/(-200*2.5)=0.4. The new exchange rate: e=e+e=2+0.4=2.4 QUESTION 2 (20 points) This question deals with the Solow model of economic growth, the basis for most modern theories of economic growth. Consider an economy characterized by the following production function !! "= 1NAKY , where

1=A and 3

1=! . Assume that the growth rate of capital 5.1=k , the growth rate of labor

5.1=n , the saving rate 4.0=s , and the depreciation rate of capital 1.0=d .

1) Find the share of capital in output and the share of labor in output. Assume that each factor is paid its marginal product. (5 points)

Standard stuff, you should find that sK = 1/3 and sN = 2/3.

2) Find the steady-state capital-labor ratio (N

K) and the steady-state per person output (

N

Y)

(5 points)

Steady state equation for capital-labor ratio is : N

Kdn

N

Ys )( += , or

N

Kdn

N

KsA )()( +=! .

Substituting parameters: N

K

N

K)1.05.1()(4.0 3

1

+= , which gives: 125.0=N

K and 5.0=

N

Y

3) Assume now that there is an increase in saving rate from 4.0=s to 5.0=s . Find the new steady-state capital-labor ratio and the new steady-state per person output. Compare with your answer in part 2 and provide economic intuition. (5 points)

Steady state equation for capital-labor rate is: N

Kdn

N

KsA )()( +=! , or

N

K

N

K)1.05.1()(5.0 3

1

+= , which gives: 17469.0=N

K and 55901.0=

N

Y.An increase in

saving rate makes both steady-state capital-labor ratio and per person output go up. 4) Assume now that there is an increase in the depreciation rate of capital from 1.0=d to

2.0=d (but the saving rate did not change, so 4.0=s ). Find the new steady-state

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capital-labor ratio and the steady-state per person output. Compare with your answer in part 2 and provide economic intuition.(5 points)

Steady state equation for capital-labor rate is: N

Kdn

N

KsA )()( +=! , or

N

K

N

K)2.05.1()(4.0 3

1

+= , which gives: 1141344.0=N

K and 48507.0=

N

Y. A higher

depreciation rate makes both steady- state capital-labor ratio and per person output go down. QUESTION 3 (15 points) Consider an economy characterized by the following: A 1% increase in the log-output ratio raises inflation by 2%; The expected rate of inflation equals the previous periods actual inflation a) Write down the equationssubstituting in the parameters, where relevantof the Short-run Phillips curve (SP) and the DG curve. (3 points) (SP) zYgpp e ++= or zYpp ++= ! 21

(DG) pxYY !+= ! 1 b) Assume that the economy is in a long-run equilibrium at t = 0 and that

0x = p0= pe0= 4, z0=0

and0Y = 0. In periods 1 and 2 there are supply shocks, z1 = 1 and z2 = -1.

1) Assuming an accommodating policy, and using the equations derived above fill in the following table. (6 points) (Hint. Recall: an accommodating policy gives Y =0 for all t )

Period tx zt pt

tY p

et

0 4 0 4 0 4 1 5 1 5 0 4 2 4 -1 4 0 5

Relevant equations:

zpp += !1

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px = The two shocks cancel out, and at t=2 we are back in the long-run equilibrium. 2) Assuming an extinguishing policy, and using the equations derived above fill in the following table. (6 points) (Hint. Recall: an extinguishing policy gives pt=4 for all t)

Period

tx zt pt

tY p

et

0 4 0 4 0 4 1 3.5 1 4 -0.5 4 2 5 -1 4 0.5 4

Relevant equations:

zY2

1 !=

41+!= !YYx

QUESTION 4 (10 points) Assume that country A has a capital stock of 200=

AK , and country B has a capital stock of

100=B

K . Also assume that the percentage annual growth rate of capital in country A is %15=

Ak , and the percentage annual growth rate of capital in country B is %25=

Bk . How

long it will take for country B to catch up with country A ? (Hint: Recall that the annual growth

rate of any variable X at some time t (and starting at time 0 ) is t

XXx

t)/ln(100 0= ).

Denote by t = the length of time it takes for country B to catch up. Then:

t

KKk

AtA

A

)/ln(100 0,,= and

t

KKk

BtB

B

)/ln(100 0,,= . Since we know that

tBtAKK

,,= , we

can solve for t to get:

AB

BA

kk

KKt

!=

)/ln(100 0,0, , or 93.6=t years.