Lahore University of Management Sciences

Mushtaq Ahmad Gurmani, School of Humanities and Social Sciences

Roll # : Total Pages: (including this page)

Name: Quarter: Fall Semester 2014

Course Title: Intermediate Macroeconomics Academic Year: 2014–2015

Course Code: ECON221 Date: 1st November 2014
100 minutes (1 hours and 20
Instructor: Professor Ahmed M. Khalid Time Allowed: minutes)
Exam: Midterm Total Marks: 100

ANSWER KEY

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PART 1: Conceptual (34 Marks)
Question 1: Multiple Choice Questions (24 Marks; 1.5 marks each)

Choose the most suitable answer to the following questions and place it in the provided
space.

1. A decrease in the effective tax rate on capital would shift the IS curve _______
and the LM curve ______.

a. down; is unchanged
b. down; left
c. up; is unchanged
d. up; left

ANSWER: c

2. The IS-LM model predicts that a temporary adverse supply shock

a. reduces output, national saving, and investment, but not the real interest rate.
b. reduces output, national saving, and the real interest rate, but not investment.
c. reduces the real interest rate, investment, and output, but national saving.
d. reduces output, national saving, investment, and the real interest rate.

ANSWER: a

3. An increase in money demand causes the real interest rate to __________ and
output to ___________ in the short run, before prices adjust to restore
equilibrium.

a. rise; rise
b. rise; fall
c. fall; rise
d. fall; fall

ANSWER: b

4. A temporary decrease in government purchases causes the real interest rate to

__________ and the price level to __________ in general equilibrium.

a. rise; rise
b. rise; fall
c. fall; rise
d. fall; fall

ANSWER: d
 5. In the classical model, a temporary decrease in government spending would
cause a decrease in

a. output, the real interest rate, real wages, and the price level.
b. employment, the real interest rate,real wages, and the price level.
c. output, employment, the real interest rate, and the price level.
d. output, employment, real wages, and the price level.

ANSWER: c

6. Classical economists would explain the fact that money is a leading, procyclical
macroeconomic variable by pointing out that

a. money is not neutral, and changes in the nominal money supply affect real
variables.
b. increasing the money supply shifts the LM curve, reducing real interest rates
and causing an economic expansion.
c. increasing the money supply increases aggregate demand, causing higher
levels of employment and output.
d. when money demand rises because of a beneficial productivity shock, the
Central Bank increases the money supply to prevent the price level from
falling.

ANSWER: d
7. According to the efficiency wage model, during a recession firms

a. will not reduce real wages, because unions would go on strike, reducing
profitability.
b. will not reduce real wages, because this would reduce worker effort and
productivity.
c. will reduce real wages to restore profitability to the firm.
d. will reduce both real wages and the level of employment to restore
profitability to the firm.

ANSWER: b

8. In the Keynesian model, an increase in government purchases affects output by

a. increasing labor supply, because workers feel effectively poorer.

b. increasing saving to pay for future taxes, lowering the real interest rate and
shifting the IS curve to the left.
c. increasing the real interest rate due to crowding out, reducing aggregate
demand.
d. increasing aggregate demand as national saving declines.

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ANSWER d

9. Suppose the government decided to ease monetary policy and then increase
taxes. In the short run in the Keynesian model, the effect of these policies would
be to _______ the real interest rate and ______________ the level of output.

a. lower; increase
b. lower; decrease
c. lower; have an ambiguous effect on
d. have an ambiguous effect on; increase

ANSWER: c

10. In the expectations-augmented Phillips curve π = πe - 3(u - .06), when π = .06

and πe = .03, the unemployment rate is

a. .03.
b. .05.
c. .07.
d. .09.

ANSWER: b

11. Suppose most people had anticipated that inflation would increase by 10% in
the coming year because the Central Bank would increase the money supply by
10%. Instead, the Central bank increases the money supply by only 5 %. In the
short run, this would cause actual output to be __________ full-employment
output and prices to increase by _____________ 5 %.

a. above; more than

b. above; less than
c. below; more than
d. below; less than

ANSWER: c

12. Historically, Brazil has suffered higher and more variable rates of inflation than
Venezuela. You would expect the short-run aggregate supply curve of Brazil to
be _______ than that of Venezuela, and the Phillips curve of Brazil to be
________ than that of Venezuela.

a. flatter; flatter
b. flatter; steeper
c. steeper; flatter
d. steeper; steeper

ANSWER: d

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 13. The most important factor determining how quickly expected inflation adjusts
when the government attempts to reduce inflation is

a. the slope of the Phillips curve.

b. the credibility of the government's disintlationary policy.
c. the degree of gradualism in the government's disintlationary policy.
d. the slope of the IS curve.

ANSWER: b

14. αIS = 0 in an IS equation means:

a. saving in insensitive to interest rate.

b. Investment is insensitive to interest rate.
c. Money demand in insensitive to interest rate.
d. IS curve passes through the origin.

ANSWER: d

15. If αIS = 0.7, αLM = 0, βIS = 0.005, βLM = 0.005, cr = 500, ir = 500, M=600, and P =
15, then Rs100 million increase in government spending (G) will lead to:

a. more than Rs100 million increase in Y

b. less then Rs100 million increase in Y
c. exactly Rs100 million increase in Y
d. none of the above.

ANSWER: c

16. A beneficial supply shock would cause

a. a movement up the short-run Phillips curve.
b. a movement down the short-run Phillips curve.
c. the short-run Phillips curve to shift upward and to the right.
d. the short-run Phillips curve to shift downward and to the left.

Answer: d

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PART 2: Analytical (26 Marks)
Question 3 (8 Marks)
Suppose that under a new law all businesses must pay a tax equal to 6% of sales
revenue. Assume that this tax is not passed on to consumers. Instead, consumers pay
the same prices after the tax is imposed as they did before. What is the effect of this tax
on labour demand? If the labour supply curve is unchanged, what will be the effect of
this tax on employment and the real wage? [Clearly explain the mechanism of moving
from one equilibrium to a new equilibrium.]

Answer:

a) Labour demand shift backward

b) Unemployment goes down and real wage rate goes down.

Question 4 (8 Marks)
Assume a Keynesians economy. Suppose that the central bank in this economy has a
policy of increasing the money supply when it observes that the economy is in
recession. However, suppose that about six months are needed for an increase in
money supply to affect aggregate demand, which is about the same amount of time
needed for firms to review and reset their prices. What effects will the central bank’s
policy have on output and price stability?

Answer:

Output moves to Y2 (above Yf) and economy moves from one disequilibrium to
another disequilibrium.

Question 5 (10 Marks)

Consider an economy with two labor markets, neither of which is unionized. Now
suppose a union is established in one market.
a) Show the effect of the union on the market in which it is formed. In what sense
is the quantity of labor employed in this market an inefficient quantity?
b) Show the effect of the union on the non-unionized market. What happens to the
equilibrium wage in this market?

Answer:

a) Real wage rate increases and employment goes down. It is inefficient.

b) Real wage rate goes down and employment increases.

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PART 3: Numerical Applications (40 Marks)
Question 6 (30 Marks)
Consider the following Keynesian closed economy:

Consumption C = 388 + 0.4(Y-T) – 600r

Investment I = 352 – 400r
Government purchases G = 280
Taxes T = 300
Full-employment output Y* = 1400
Nominal money supply M = 12,600
Real money demand L = 1750 + 0.75Y – 8750 (r + πe)
Expected inflation πe = 0.02

Where r: real interest rate

a) What is the equation for IS curve (3 Marks)

Answer:
Y  1500  (1666  2/3)r. Equivalently, r  0.9  0.0006Y.

b) Suppose that the price level is fixed at P = 7 in the short-run. What is the
equation for LM curve int eh short-run, while the price level remains fixed? (4
Marks)

Answer:
r  0.0257143  0.0000857143Y or r  9/350  (3/35000)Y.

c) What are the short-run equilibrium values of output, the real interest rate,
consumption, and investment? (6 Marks)

Answer:
Y  1350.
Consumption  C  754.
Investment  I  316.
Note that C  I  G  754  316  280  1350  Y.

d) What are the long-run equilibrium values of output, the interest rate,
consumption, and investment? (3 Marks)

Answer:
Y  1400.
Consumption  C  792.
Investment  I  328.
Note that C  I  G  792  328  280  1400  Y.

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 e) Now show this equilibrium using IS-LM-FE and AD-AS diagrams. Suppose the
government wants to expand the economy by using expansionary monetary policy.
Specifically, the government increases nominal money supply to 16,000. Graphically
show the effect of this policy on equilibrium values states above. Cleary suggest which
variables will increase, which variables and which variables will not change in the
short-run? In the long-run? [MUST specify your assumptions.] (14 Marks)

Answer:
Short-run:
Y increases, r goes down, C increases, I increases, P increases.
Long-run:
Y unchanged, r unchanged, C unchanged, I unchanged, P increases.

Question 7 (10 Marks)

Consider an economy in long-run equilibrium with an inflation rate (π) of 0.08 per year
and a natural unemployment rate of 0.05. Suppose Okun's law holds and a one
percentage point increase in the unemployment rate reduces real output by 2% of full-
employment output. The expectations-augmented Phillips curve is given by
π = πe - 2.5 (u - 0.05).
Consider a two-year disinflation. In the first year, π = 0.06 and πe = 0.08. In the second
year, π = 0.04 and πe = 0.05. Now answer the following questions.

(a) In the first year, what is the value of the unemployment rate?
(b) In the first year, by what percentage does output fall short of full-employment
output?
(c) In the second year, what is the value of the unemployment rate?
(d) In the second year, by what percentage does output fall short of full-
employment output?
(e) What is the sacrifice ratio for this disinflation?

Answer:
(a) u = .058.
(b) 1.6%.
(c) u = .054.
(d) 0.8%.
(e) sacrifice ratio = 0.6.
END OF MID-TERM EXAM

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