Final Exam

Economics ForManagers
1. The macroeconomic effects of the indexation of wages (2 points)

Suppose that the Phillips curve is given by

pt - pte = 0.1 - 2ut

wherepte = pt-1

Suppose that inflation in year t - 1 is zero. In year t, the central bank decides to keep the unemployment rate at 4%
forever.

a. Compute the rate of inflation for years t, t + 1, t + 2, and t + 3. Now suppose that half the workers have indexed
labor contracts.

b. What is the new equation for the Phillips curve?

2. The natural rate of unemployment (2 points)

Suppose that the markup of the prices of products over wagecost, z, is 10%, and that the wage-setting equation
is

W = P*(1 - 4m + z)

where m is the unemployment rate and z is the unemploymentbenefit/minimum wage.

a. What is the real wage, as determined by the price-setting equation?

b. Solve for the natural rate of unemployment

c. What happens to the natural rate of unemployment if z falls from 15% to 10%? Explain your answer.

3. Consider the following numerical example of the IS-LM model: (2 points)

C = 500 + 0.6YD

I = 450 + 0.3Y - 800i

T = 200

G = 300
i= .05

(M/P)s= 1600

(M/P)d= 3Y - 2000i

a. Find the equation for aggregate demand (Y).

b. Derive the IS relation.

c. Derive the LM relation if the central bank sets an interest rate of 2%.

d. Solve for the equilibrium values of output, interest rate, C and I.

4. Modern bank runs. Suppose that a European bank has customer deposits of €500 million and capital of
€100 million and total assets of €600 million, divided as loans equal to €400 million and other assets
equal to €200 million. (2 points)
a. Prepare the balance sheet of the bank.

b. Suppose that some recent problems with the bank prompt customers to withdraw €100 million of their
deposits. How can the bank preserve the same level of capital and assets on its balance sheet?

c. Prepare the new balance sheet of the bank.

d. If that the central bank does not insure customers’ deposits, do you think that there will be a deposit run?
How would the outcome change if the bank announces that it had recently approached a highly reputable
and financially solid private insurance firm that has legally agreed to ensure customers’ deposits?

e. Now suppose that it becomes known that the bank is facing serious solvency problems that do not allow
it to borrow from depositors or financial institutions. What are the two options available to the bank to
avoid bankruptcy?

5. Suppose the interest rate in Belgium is 4%, and the expected inflation is 0.5%. The Swiss interest rate is
also 4% and the expected Swiss inflation is 0.8%. (2 points)
a. What are the exact real interest rates in Belgium and Switzerland?
b. What are the approximate real interest rates in Belgium and Switzerland?
c. How do you explain the difference in real rates between Belgium and Switzerland
 6. Discuss the following statements. (2 points)
An increase in a bank’s leverage ratio tends to increase both the expected profit of the bank and the risk of the
bank going bankrupt.

The Phillips curve implies that when an economy is operating below full capacity, a significant increase in
aggregate demand is likely to cause a reduction in unemployment and an increase in inflation.

7. Discuss the following statements. (2 points)

The formation of expected inflation. We have the following model of expected inflation

pte = (1 – O)*p + Op t-1

a. Describe the process of the formation of expected inflation when O = 0.

b. Describe the process of the formation of expected inflation when O = 1.

c. How do you form your own expectation of inflation? More like a, or more like b?

8. Discuss the following statements. (2 points)

If people assume that inflation will be the same as last year’s inflation, the Phillips curve relation will be a
relation between the change in the inflation rate and the unemployment rate.

As long as expected inflation remains roughly constant, the movements in the real interest rate are roughly
equal to the movements in the nominal interest rate.

9. Bargaining power and wage determination (2 points)

Even in the absence of collective bargaining, workers do have some bargaining power that allows them to
receive wages higher than their reservation wage. Each worker’s bargaining power depends both on the nature
of the job and on the economy-wide labormarket conditions. Let’s consider each factor in turn.

For any given job, how do labor market conditions affect a worker’s bargaining power? Which labor-market
variable would you look at to assess labor-market conditions?

Compare the job of a delivery person and a computer network administrator. In which of these jobs does a
worker have more bargaining power? Why?

10. Discuss the following statements. (2 points)

The fiscal stimulus program adopted by the United States in response to the financial crisis helped offset the
decline in aggregate demand and reduce the size of the recession.
The fiscal stimulus program adopted by the United States included a large increase in the deficit measured as a
percent of GDP.

11. Discuss the following statements. (2 points)

If people assume that inflation will be the same as last year’s inflation, the Phillips curve relation will be a
relation between the change in the inflation rate and the unemployment rate.

The original Phillips curve is the negative relation between unemployment and inflation that was first observed
in the United Kingdom.

12. Discuss the following statements. (2 points)

For some periods of history, inflation has been very persistent between adjacent years. In other periods of
history, this year’s inflation has been a poor predictor of next year’s inflation.

In the late 1960s, the economists Milton Friedman and Edmund Phelps said that policy makers could achieve as
low a rate of unemployment as they wanted.

13. label each of the following statements true, false, or uncertain. Explain briefly. Without Explanations, I
will grade zero! (1 point)

When a bank has high leverage and low liquidity, it may have to sell assets at fire sale prices.

14. label each of the following statements true, false, or uncertain. Explain briefly. Without Explanations, I
will grade zero!

Banks and other financial intermediaries have assets that are less liquid than their liabilities.

Multiples

15. When inflation is not persistent (1 point)

1. expected inflation does not depend on past inflation. Thus, the relation becomes a relation between
inflation and unemployment.
2. expected deflation does not depend on past inflation. Thus, the relation becomes a relation between
inflation and unemployment.
3. expected inflation does not depend on past inflation. Thus, the relation becomes a relation between
deflation and unemployment.
4. expected price level does not depend on future inflation. Thus, the relation becomes a relation between
inflation and employment.

16. The price set by firms depends on the wage and on the markup of prices over wages.(1 point)
1. A higher markup implies a higher price given the wage, and thus a lower real wage.
2. A higher markup implies a lower price given the wage, and thus a higher real wage.
3. A lower markup implies a higher price given the wage, and thus a lower real wage.
4. A lower markup implies a lower price given the wage, and thus a higher real wage.

17. The IS-LM model must be extended to take into account: (1 point)
1. the difference between the nominal and the real output rate, and the difference between the policy
program chosen by the government and the interest rate at which firms and people can borrow.
2. the difference between the default and the nominal interest rate, and the difference between the policy
rate chosen by the central bank and the interest rate at which banks and people can borrow.
3. the difference between the nominal and the real interest rate, and the difference between the policy rate
chosen by the central bank and the interest rate at which firms and people can borrow.
4. the difference between the nominal and the real interest rate, and the difference between the policy rate
chosen by the government and the interest rate at which firms and people can invest.

18. fiscal contraction and monetary expansion can, for example, achieve: (1 point)
1. a decrease in the budget deficit while avoiding an increase in output.
2. a decrease in the budget deficit while avoiding a decrease in output.
3. an increase in the budget deficit while avoiding a decrease in output.
4. a decrease in the budget proficit while avoiding a decrease in output.