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Econ 100B
Macroeconomic Analysis
Professor Steven Wood

Fall 2013

Exam #2 ANSWERS

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On my honor, the answers on this exam are entirely my own work. I neither gave nor received any aid while taking
this exam. I will not discuss the questions on this test until after 5:00 p.m. on November 5, 2013.

_______________________________________
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Exam Instructions
1. When drawing diagrams, clearly and accurately label all axes, lines, curves, and equilibrium points.

2. Explanations should be written in pencil or black. Legibility is a virtue; practice good penmanship.

3. Explanations should be succinct and to the point; make use of bullet points and common mnemonics.

4. If you have a question, ask one of the GSIs. The GSIs have not seen the exam beforehand and can only
provide general guidance. You are totally responsible for your answers regardless of what a GSI has said to you.

5. If you need to re-draw a diagram and/or need more room to write your answers, use pages 2, 14, 15 and/or
16.

6. If you finish your exam before 4:55 p.m. you may turn in your exam and quietly exit the room.

7. If you finish your exam after 4:55 p.m., close your exam packet but remain seated until time is called.

8. When time is called, STOP writing, immediately CLOSE your exam packet and TURN IN your exam. You
WILL BE PENALIZED if you continue to write past the official end of the exam.

Do NOT open this test until instructed to do so.

Exam #2 (Fall 2013) 1/12

A. Multiple Choice Questions (30 points). Highlight the best answer (3 points each).

1. According to the flexible price framework:

a. Economic fluctuations determine long-run outcomes.

b. A change in inflation alters the amount of planned investment.
c. A change in the money supply has no effect on real economic output.
d. All of the above.
e. None of the above.

2. In the IS model, assuming that the real interest rate does not change, an increase in _____ leads to an
increase in equilibrium saving by households:

a. Inflation.
b. Autonomous taxes.
c. Government purchases.
d. Autonomous consumption.
e. None of the above.

3. If the actual nominal interest rate is above the equilibrium nominal interest rate, then:

a. The opportunity cost of holding money is low and rising.

b. The opportunity cost of holding money is high and rising.
c. Purchases of bonds and other assets will cause the nominal interest rate to decline.
d. Issuance of bonds and other assets will cause the supply of real money balances to increase.
e. None of the above.

4. In the long-run, a permanent increase in government purchases of military equipment would, according to
the AD-AS model, cause real economic output to _____ and inflation to _____:

a. rise; rise
b. remain constant; fall
c. remain constant; rise
d. rise; remain constant
e. fall; remain constant

5. Suppose that the central bank adopts a new monetary policy regime that is more sensitive to changes in
inflation. If the economy then experiences a negative short-run aggregate supply shock, then this new
regime would cause (compared to the outcome associated with the previous monetary policy regime):

a. Higher inflation.
b. A deeper recession.
c. A shallower recession.
d. A decrease in potential economic output.
e. An increase in the natural rate of unemployment.

Exam #2 (Fall 2013) 2/12

 6. Suppose that the central bank has overestimated potential economic output. If the central bank then keeps
the economy at what it thinks is potential economic output, this mistake will lead to:

a. Deflation.
b. Disinflation.
c. Rising inflation.
d. No change in inflation.

7. Suppose that the net export function for Country A is given by NX = NX + α*YB – x*r where YB is the
economic output in Country B. If both countries start in general equilibrium and then Country B increases
taxes to reduce its budget deficit, this will ultimately cause:

a. The AD curve in Country A to shift to the left.

b. The AD curve in Country A to shift to the right.
c. The AD curve in Country A to shift to the right and the SRAS curve in Country A to shift up.
d. The AD curve in Country A to shift to the left and the SRAS curve in Country A to shift down.
e. None of the above.

8. What is the main difference between a positive demand shock stemming from monetary policy and a
positive demand shock stemming from fiscal policy?

a. The monetary policy shock raises inflation permanently while the fiscal policy shock raises
inflation only temporarily.
b. The monetary policy shock has only a temporary effect on the real interest rate while the fiscal
policy shock has a permanent effect on the real interest rate.
c. In the short-run, the monetary policy shock lowers the real interest rate and increases aggregate
economic output while the fiscal policy shock has the opposite effect on both variables.
d. None of the above.

9. Which of the following is an example of moral hazard?

a. The shiniest packaging often contains disappointment.

b. The foulest-tasting medicine is often the most effective.
c. The customers at a low-price restaurant are unlikely to leave generous tips.
d. Have secured a large loan, a business manager is more likely to have a lavish office party than to
buy new equipment.

10. Suppose that the central bank increases the monetary base and reduces the required reserve ratio. However,
the money supply declines. This could be due to:

a. Consumers shifting deposits from their saving accounts to their checking accounts.
b. Consumers increasing their deposit balances by reducing their currency holdings.
c. Banks selling government securities to the central bank but not making any additional loans.
d. Banks selling government securities to the central bank and using the proceeds to make additional
loans.
e. None of the above.

Exam #2 (Fall 2013) 3/12

 B. Analytical Questions (70 points). Answer BOTH of the following questions based on the standard models of analysis
developed in class. The information in the various parts of the questions is sequential and cumulative.

1. The IS—MP—AD/AS Model (35 points). This question has two scenarios which are independent of each other.

a. Scenario #1. Suppose that the economy, which is characterized by sticky wages and prices, is initially
(i.e., in Year 0) in general equilibrium. Based only on this information use IS (on the left), MP (on the
right), and AD/AS (at the bottom) diagrams to clearly and accurately show the economy’s initial (1)
economic output, (2) inflation, and (3) real interest rate. These diagrams should be drawn in BLACK.

r r
P
Y
MP0

MP1
r0 r0
r1a r1a

r1 r1
IS1 IS0

Y1a Y1=YP Y π1a π1=π0 π

π
LRAS

SRAS0(πe = π0)

π1 = π0
π1a

AD0 = AD1
AD1a

Y1a Y1 = YP Y

Exam #2 (Fall 2013) 4/12

 b. In Year 1, the government increased taxes. Incorporating only this additional information, clearly and
accurately show in your diagrams above what effects this would have on the economy’s (1) economic
output, (2) inflation, and (3) real interest rate. These effects should be drawn in RED.

c. Provide an economic explanation of what you have shown in your diagrams above. Discuss what, if
anything, happens to the economy’s (1) economic output, (2) inflation, and (3) real interest rate. Be sure
to explain why these changes take place.

An increase in taxes would reduce disposable income, causing a decline in consumption

expenditures. The decline in consumption expenditures would occur for any given real interest rate.
This can be represented by a leftward shift of the IS curve from IS0 to IS1.

The decline in consumption expenditures would also decrease economic output for any given
inflation. This can be represented by a leftward shift of the AD curve from AD0 to AD1.

The decline in aggregate demand (and economic output) creates a negative output gap, causing
inflation to decline. Lower inflation causes the central bank to reduce the real interest rate
according to the Taylor Principle, a movement along the monetary policy curve, MP0.

As a result of this increase in taxes, economic output has declined from Y0 to Y1a, inflation has
declined from π0 to π1a and the real interest rate has declined from r0 to r1a.

Exam #2 (Fall 2013) 5/12

 d. Subsequent to the increase in taxes but also in Year 1, the central bank decides to maintain inflation at its
initial (i.e., Year 0) rate. Incorporating only this additional information, clearly and accurately show in
your diagrams above what effects, if any, this would have on the economy’s (1) economic output, (2)
inflation, and (3) real interest rate. These effects should also be drawn in BLUE.

e. Provide an economic explanation of what you have shown in your diagrams above. Discuss what, if
anything, happens to the economy’s (1) economic output, (2) inflation, and (3) real interest rate. Be sure
to explain why these changes take place.

If the central bank then decides to maintain inflation at its initial (i.e., Year 0) level, it will engage in
a discretionary monetary policy easing. This reduces the real interest rate for any given inflation.
This can be represented by a downward (or rightward) shift of the MP curve from MP0 to MP1.

The lower real interest rate increases borrowing and spending and also increases economic output
in a movement along the IS curve IS1. The decline in the real interest rate must be large enough to
fully offset the decline in economic output from the reduction in consumption expenditures due to
the increase in taxes. Thus, economic output has increased for any given inflation. This can be
represented by a rightward shift of the AD curve from AD1a to AD1, which is the same as AD0, i.e.,
AD1 = AD0.

As a result of this monetary policy easing, economic output has increased from Y1a to Y1 = YP,
inflation has increased from π1a to π1 = π0, but the real interest rate has declined from r1a to r1.

Exam #2 (Fall 2013) 6/12

 f. Scenario #2. Suppose that the economy, which is characterized by sticky wages and prices, is initially
(i.e., in Year 0) in general equilibrium. Based only on this information use IS (on the left), MP (on the
right), and AD/AS (at the bottom) diagrams to clearly and accurately show the economy’s initial (1)
economic output, (2) inflation, and (3) real interest rate. These diagrams should be drawn in BLACK.

r IS0 r MP0
P
Y

r0 r0

MP1
r1a r1a

r1 r1

YP Y1a Y1 Y π1a π1 = π0 π

π
LRAS

SRAS0(πe = π0)

SRAS1(πe = π0)
π1 = π0

π1a AD1

AD0

YP Y1a Y1 Y

Exam #2 (Fall 2013) 7/12

 g. In Year 1, the discovery of new crude oil deposits in Brazil causes the world price of oil to drop
significantly. Incorporating only this additional information clearly and accurately show in your
diagrams above what effects, if any, this would have on the economy’s (1) economic output, (2) inflation,
and (3) real interest rate. These effects should be drawn in RED.

h. Provide an economic explanation of what you have shown in your diagrams above. Discuss what, if
anything, happens to the economy’s (1) economic output, (2) inflation, and (3) real interest rate. Be sure
to explain why these changes take place.

The decline in the world price of oil would be a positive short-run supply shock, reducing the cost
of production and distribution for any given output level. This can be represented by a downward
shift of the SRAS curve from SRAS0(πe = π0) to SRAS1(πe = π0). Inflation is lower at any given
output level.

Because inflation has declined, the central bank reduces the real interest rate according to the
Taylor Principle, a movement along the monetary policy curve MP0. The lower real interest rate
increases borrowing and spending and also increases economic output in a movement along the IS
curve IS0. Lower inflation and a lower real interest rate also increase economic output, a
movement along the AD curve AD0.

As a result of the decline in the world oil price, economic output has increased from Y0 to Y1a,
inflation has declined from π0 to π1a, and the real interest rate has declined from r0 to r1a.

Exam #2 (Fall 2013) 8/12

 i. Subsequent to the decline in oil prices but also in Year 1, the central bank decides to maintain inflation at
its initial (i.e., Year 0) rate. Incorporating only this additional information, clearly and accurately show
in your diagrams above what effects, if any, this would have on the economy’s (1) economic output, (2)
inflation, and (3) real interest rate. These effects should also be drawn in BLUE.

j. Provide an economic explanation of what you have shown in your diagrams in both part e and part f
above. Discuss what, if anything, happens to the economy’s (1) economic output, (2) inflation, and (3)
real interest rate. Be sure to explain why these changes take place.

If the central bank then decides to maintain inflation at its initial (i.e., Year 0) level, it will engage in
a discretionary monetary policy easing. This reduces the real interest rate for any given inflation.
This can be represented by a downward (or rightward) shift of the MP curve from MP0 to MP1.

A lower real interest rate will increase borrowing and spending and thus to an increase in economic
output along the IS curve IS1. The increase in economic output occurs for any given inflation. This
can be represented by a rightward shift of the AD curve from AD0 to AD1.

The resulting positive output gap increases inflation along the SRAS curve SRAS1(πe = π0). In order
to maintain inflation at its initial (i.e., Year 0) level, the increase in economic output and the output
gap must be large enough to increase inflation from π1a to π1 which is identical to π0, i.e., π1 = π0.

As a result of this monetary policy easing, economic output has increased from Y1a to Y1, inflation
has increased from π1a to π1 = π0, but the real interest rate has declined from r1a to r1.

Exam #2 (Fall 2013) 9/12

2. The Aggregate Demand – Aggregate Supply Model (35 points). Suppose that the economy is initially (i.e., in Year
0) in general equilibrium. (HINT: The slope of the AD curve does not change in this problem.)

a. Based only on this information, use an AD – AS model diagram to clearly and accurately show the
economy’s initial (1) economic output and (2) inflation. This diagram should be drawn in BLACK.

π
LRAS0

SRAS0(πe = π0)
= SRAS1(πe = π0)

SRAS2(πe = π1)

π0

π1
π2

AD0
AD2

AD1

Y1 Y2 Y0 = YP Y

Exam #2 (Fall 2013) 10/12

 b. In Year 1, transfer payments to low-income individuals, a relatively large group with a high marginal
propensity to consume, were reduced by $100 billion. Incorporating only this new information, clearly
and accurately show in your diagram above what effects, if any, this would have on the economy’s (1)
economic output and (2) inflation. These effects should be drawn in RED.

c. Provide an economic explanation of what you have shown in your diagram above. Discuss what, if
anything, happens to the economy’s (1) economic output, (2) inflation, and (3) unemployment rate. Be
sure to explain why these effects take place and what causes them.

Reducing transfer payments to low-income individuals by $100 billion would reduce their
disposable income and consumption expenditures. This decrease in consumption expenditures can
be represented by a leftward shift of the AD curve from AD0 to AD1.

Because they are a relatively large group and have a high marginal propensity to consume, the
reduction in consumption expenditures would be relatively large.

The decline in aggregate demand (and economic output) creates a negative output gap, causing
inflation to decline. Lower inflation causes the central bank to reduce the real interest rate
according to the Taylor Principle, a movement along the MP curve.

As a result of these reduced transfer payments to low-income individuals, (1) economic output has
declined from Y0 = YP to Y1, (2) inflation declined from π0 to π1, and (3) the unemployment rate has
increased according to Okun’s law.

Exam #2 (Fall 2013) 11/12

 d. In Year 2, taxes on high-income individuals, a relatively small group with a low marginal propensity to
consume, were reduced by $100 billion. Incorporating only this new information, clearly and accurately
show in your diagram above what effects, if any, this would have on the economy’s equilibrium (1)
economic output and (2) inflation. These effects should be drawn in BLUE.

e. Provide an economic explanation of what you have shown in your diagram above. Discuss what, if
anything, happens to the economy’s (1) economic output, (2) inflation, and (3) unemployment rate. Be
sure to explain why these effects take place and what causes them.

Two events happen in Year 2.

First, in Year 1, actual inflation was at π1 while expected inflation was at π0. Because
expected inflation is determined through a one-period (i.e., one-year) adaptive process,
expected inflation in Year 2 declines from π0 to π1. This can be represented by a downward
(or rightward) shift of the SRAS curve from SRAS1(πe = π0) to SRAS2(πe = π1).

Inflation is lower at any given output level. Lower inflation leads to a lower real interest
rate according to the Taylor Principle; a lower real interest rate leads to more borrowing
and spending and a high level of economic output.

Second, reducing taxes on high-income individuals by $100 billion would increase their
disposable income and consumption expenditures. This increase in consumption
expenditures can be represented by a rightward shift of the AD curve from AD0 to AD1

Because they are a relatively small group with a low marginal propensity to consume, the
increase in consumption expenditures would be relatively small. Although the aggregate
demand curve shifted to the right it was still to the left of this initial (i.e., Year 0) aggregate
demand curve, i.e., AD2 < AD0.

As a result of reduced taxes on high-income individuals, in Year 2, (1) economic output increases
from Y1 to Y2, (2) inflation declines from π1 to π2, and (3) the unemployment rate declined
according to Okun’s law.

[Depending on the relative magnitude of the shifts of the AD curve and the SRAS curve, it
is possible that in Year 2 economic output could be above potential, i.e, Y2 > YP and that
inflation could increase, i.e., π2 > π1.]

Exam #2 (Fall 2013) 12/12