Intermediate Macroeconomics 311 (Professor Gordon)

Final Examination Fall, 2011

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 won’t get
credit for circled answers in the multiple choice section.
4. Place all of your answers for part B in the space provided.
5. You must show your work for part B questions.
6. Write your essays with a pen. Write clearly! No pencil is allowed and pencil-written essays will be
discarded.
7. Good Luck and Happy Holidays!

PART A (30 points)

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) 2) 3) 4) 5) 6)

7) 8) 9) 10) 11) 12)

13) 14) 15) 16) 17) 18)

19) 20) 21) 22) 23) 24)

25) 26) 27) 28) 29) 30)

Part A. Multiple Choice Questions (30 points)
Make sure to write your answers on the blanks on page 1!

1) Unanticipated inflation will insure that

A) homeowners with outstanding mortgage balances are hurt.
B) homeowners with outstanding mortgage balances are benefited.
C) creditors gain, debtors lose.
D) none of the above
Answer: B

2) Suppose we have an economy in which G = 1100, t = 0.26, Y = 3800, and YN = 3900. At Y the
cyclical deficit is
A) 60.
B) 112.
C) -172.
D) -52.
E) 26.
Answer: E

3) If the Federal Reserve intervenes in the foreign-exchange markets and buys foreign currencies
A) the U.S. money supply rises and foreign currencies depreciate.
B) the U.S. money supply falls and foreign currencies depreciate.
C) the U.S. money supply rises and foreign currencies appreciate.
D) the U.S. money supply falls and foreign currencies appreciate.
Answer: C

4) As used in class, the phrase “demographic dividend” refers to

A) One-child policy in China
B) Baby-boom pattern of U. S. birth rate
C) Increased labor-force participation of older women since 2007
D) A) and B)
E) A) and C)
Answer: B

5) Assuming constant wages implies that

A) an increase in the price of goods raises profits and SAS is vertical.
B) a decrease in the price of goods raises profits and SAS is positively sloped.
C) an increase in the price of goods lowers profits and SAS is vertical.
D) an increase in the price of goods raises profits and SAS is positively sloped.
Answer: D
6) The "long-run Phillips Curve" is the set of points for which
A) expected inflation is zero.
B) expected inflation is equal to actual inflation.
C) actual inflation is zero.
D) actual inflation is equal to expected inflation plus the growth rate of nominal wages.
E) actual inflation is equal to expected inflation minus the growth rate of nominal wages.
Answer: B

7) In the flowchart showing the relationship between policy instruments, policy targets, and economic
welfare in Chapter 14, consumer optimism is considered
A) a policy instrument.
B) an exogenous nonpolicy variable.
C) a structural relation.
D) a target variable.
E) an irrelevant side effect.
Answer: B

8) The acronym BRIC is most closely related to

A) Euro crisis
B) U. S. state government
C) Collapse of housing construction
D) Economic development
E) Education
Answer: D

9) An increase in the rate of growth of nominal GNP

A) will cause a greater increase in real GNP the lower the rate of inflation.
B) will cause a smaller increase in real GNP the lower the rate of inflation.
C) will shift the SP curve upward.
D) will shift the SP curve downward.
Answer: A

10) Given an adverse supply shock, an "accommodating policy" will

A) maintain the inflation rate and the output ratio.
B) lower the inflation rate and the output ratio.
C) raise the inflation rate and the output ratio.
D) maintain the output ratio but allow inflation to increase.
Answer: D
11) The "Fisher Effect" occurs when a one-percentage-point rise in expected inflation ________
interest rate by one percentage point
A) raises the expected real
B) lowers the expected real
C) raises the nominal
D) lowers the nominal
Answer: C

12) The elimination of hourly rate assembly line jobs for unskilled workers by robots is an example of
A) involuntary unemployment.
B) mismatch unemployment.
C) cyclical unemployment.
D) turnover unemployment.
Answer: B

13) Recent studies argue that the most important factor keeping poor countries poor is
A) Insufficient infrastructure
B) Insufficient foreign aid
C) Excessive violence
D) Tropical diseases
Answer: C

14) In the graph of the Solow growth model, at any point to the left of the steady-state intersection we
have national saving per person ________ than steady-state investment per person, causing (K/N) to
________.
A) greater, increase
B) greater, decrease
C) less, increase
D) less, decrease
Answer: A

15) Steady state growth with no technical change will occur according to Robert Solow when
A) the growth rate of output is greater than the growth rate of capital.
B) the growth rate of capital is greater than the growth rate of population.
C) the growth rate of output times the population growth rate equals the growth rate of capital.
D) the growth rate of capital equals the growth rate of the population.
Answer: D
16) The "nonconvergence" problem with the Solow growth model is that
A) a higher return to capital in poor countries should essentially cause all nations to have roughly the
same standard of living, yet they clearly do not.
B) if a disturbance dislodges an economy from the steady-state point, it continues moving further from
that point indefinitely.
C) technological change is assumed to just "drop from the sky."
D) a rise in the rate of national saving does not raise the growth rate of real GDP per person.
Answer: A

17) If K = 3000, n = 0.02, and d = 0.07, then investment of ________ will hold (K/N) constant.
A) 105
B) 150
C) 270
D) 420
Answer: C

18) In the Solow growth model, given fixed values of A, s, n, and d, the economy has an equilibrium
growth rate of real GDP per capita, (Y/N), equal to
A) n.
B) n - d.
C) s - n.
D) (s - d)/n.
E) zero.
Answer: E

19) The formula for the growth rate of multifactor productivity is

A) a = y + bk + (1 - b)h.
B) y = a + bk + bh.
C) a = y - bk - (1 - b)h.
D) y = a - b/k(1 - b)h.
Answer: C

20) The acronym CINN is most closely related to

A) Euro crisis
B) U. S. state government
C) Collapse of housing construction
D) Economic development
E) Education
Answer: B
21) The “Wizard of Oz” as a monetary allegory focuses on which episode of U. S. history
A) Economic development of the American West
B) Late nineteenth-century deflation
C) The Roaring Twenties
D) The Great Depression
Answer: B

22) Fiscal policy in the United States is hampered by its particularly long ________ lag.
A) data
B) recognition
C) legislative
D) transmission
E) effectiveness
Answer: C

23) Exports are recorded in the balance of payments table of the exporting nation as
A) current account credits.
B) current account debits.
C) capital account credits.
D) capital account debits.
Answer: A

24) Observers of the economy often complain that indicators of economic activity are often
contradictory. This is an example of the ________ lag.
A) data
B) recognition
C) legislative
D) effectiveness
Answer: B

25) India’s advantages over China in economic development include

A) One-child policy in China
B) Millions of small entrepreneurs
C) Better infrastructure
D) A) and B)
E) B) and C)
Answer: D

26) The acronym PIGS is most closely related to

A) Euro crisis
B) U. S. state government
C) Collapse of housing construction
D) Economic development
E) Education
Answer: A
27) “The Missing Fifth” phenomenon is most closely related to the following
A) High teenage unemployment
B) Social security disability program
C) High-school drop outs
D) A) and B)
E) B) and C)
Answer: E

28) When workers lose their jobs in a recession or sluggish recovery, the next job they find often pays
substantially less than the job they lost. This problem is most serious for which types of workers:
A) High income
B) Middle income
C) Low income
D) A) and C)
E) B) and C)
Answer: B

29) Which is true about convergence between rich and poor countries
A) Poor countries area not catching up to rich countries
B) Poor people are not catching up to people in rich countries
C) Poor countries are catching up to rich countries
D) Poor people are catching up to people in rich countries
E) A) and B)
F) A) and D)
Answer: F

30) Data indicate that the effectiveness lag of monetary policy has become longer and the multiplier of
real GDP response to a change in interest rates has become smaller during
A) 1961-75.
B) 1976-90.
C) 1991-2007.
D) None of the above.
Answer: C
PART B (60 points)
Please show your work and write down the formulas you use for partial credit.

QUESTION 1 (5 points)

(a) If the QUARTERLY growth rate of GDP has been 4% for the past five years, and the current level
of GDP is 61, what was the level of GDP five years ago? (3 points)

We have s = 20 because there are 20 quarters in five years.

0.04 = 1/s Ln(Y/Y0) = 1/20 Ln(61/Y0)
Y0 = 61/exp(0.80)=27.409

(b) If the rate of monthly inflation is 10%, by what factor would prices have risen over three years? (2
points)

We have s = 36 because there are 36 months in three years.

0.10 = 1/s Ln(Y/Y0) = 1/36 Ln(Y/Y0)
Y/Y0 = exp(3.6) = 36.598

QUESTION 2 (13 points)

Suppose that the production function in Molonia is a Cobb-Douglas production function Y=AKbN1-b.
Assume that b=1/2, population grows at rate 0.05, physical capital depreciates at rate 0.1, the saving
rate is 0.2 and A=12.

(a) Write the general form of the production function (no numbers) in Molonia in terms of output per
capita (Hint: You need write down the production function for Y/N, not for Y). (3 points)

Y/N = A(K/N)b

(b) Solve for the steady state values of the capital-labor ratio (K/N), per-capita GDP (Y/N), per capita
consumption and per capita investment. (6 points)

K/N = (sA/(n+d))1/(1-b) =
= (0.2*12/(0.05+0.1))2 = 256
Y/N = 12*2561/2 = 192
C/N = (1-s)Y/N = 0.8*192 = 153.6
I/N = sY/N = 0.2*192 = 38.4

(c) Write down the marginal product of capital and evaluate it at the steady state. (4 points)

MPK = bA(K/N)b-1
= 1/2*12*256-1/2 = 0.375
or MPK = b(Y/N)/(K/N) = 1/2*192/256 = 0.375
QUESTION 3 (20 points)

Suppose the economy is at its long run equilibrium which is described by the following
conditions:
 a one unit change in the log of the output ratio leads to a 7 unit change in the actual inflation
rate
 inflation expectations are given by the equation,
pe = 1/2p−1+1/2pe-1
 We start off at the long run equilibrium so the variables take on the following values at the
beginning of our ”experiment”
pe = p−1 = = 1, Ŷ−1 = 0
x̂

Recall that x̂
= x - yN, Ŷ= ln
(YY )
N and that we can replace the excess of actual GDP growth over
natural real GDP growth (y - yN) with (Ŷ-Ŷ-1).

(a) Write down the SP equation, both its general form and its specific form with these particular
parameter assumptions inserted. (2 points)

p = pe+gŶ+z = 1/2p−1+1/2pe-1 + 7Ŷ+z

(b) Write down the general (i.e. for now do not plug in any number or any piece of information from
the description of the economy) DG equation. Make sure you end up with an equation with Ŷ on the
left-hand side . (2 points)

Ŷ= x̂
+ Ŷ-1 - p

Accommodating Policy
(c) Suppose that in period zero there is no supply shock (z0 = 0) and the economy is at its long run
equilibrium. Fill in the first line of the table below. (1 point)
x̂
Assume that the central bank follows an accommodating policy: they choose to make sure that
Ŷ=0.

(d) Now consider what happens if, in period 1, z1 = -2 and this shock is temporary. That is, z1 = -2, z2 =
0. Fill the remaining two lines of the table (report two decimals). (6 points)

t x̂
t pet-1 pt-1 Ŷt-1 p et pt Ŷt zt

0 1 1 1 0 1 1 0 0

1 -1 1 1 0 1 -1 0 -2

2 0 1 -1 0 0 0 0 0
Neutral Policy
Suppose that in period zero there is no supply shock (z0 = 0) and the economy is at its long run
equilibrium. Fill in the first line of the table below.
x̂
Assume that the central bank follows a neutral policy: stays constant.
x̂
(e) Substitute the DG equation into the numerical SP equation and solve for p as a function of , p-1,
pe-1 and Ŷ-1. (3 points)

p = 1/8(1/2p−1+1/2pe-1 + 7 x̂
+7Ŷ-1+z)

f) Now consider what happens if, in period 1, z1 = -2 and this shock is temporary. That is, z1 = -2, z2 =
0. Fill the remaining two lines of the table (report two decimals). (6 points)

t x̂
t pet-1 pt-1 Ŷt-1 p et pt Ŷt zt

0 1 1 1 0 1 1 0 0

1 1 1 1 0 1 0.75 0.25 -2

2 1 1 0.75 0.25 0.875 1.2031 0.0469 0

QUESTION 4 (10 points)

Greece is a small open economy, which takes the interest rate as given from the international capital
markets. In June 2000, Greece fixed its exchange rate to the Euro, in order to enter the monetary union.
That is, the monetary union can be seen as a regime of exchanged fixed rate between Greece and the
rest of the Euro zone.
For this problem, assume that Greece is as a small open economy with a fixed exchange rate, and that
we can use our knowledge on the small open economy IS-LM model.

The financial crisis created a negative shock to consumers’ confidence. The Greek government wants to
avoid the recession that this shock implies.
As an expert in the small open economy IS-LM model, what policy action would you recommend to
avoid the recession? That is, which policy variable would have the most effect on Y and how should it
be changed? (3 points).

Fiscal policy is the only effective policy. An increase in government spending will shift the IS right
back to the initial Y.

Fiscal deficit in Greece is unsustainable. The European countries are demanding Greece to cut its
government spending. This means that fiscal policy is not available to respond to the negative
confidence shock.
Suppose that the European Central Bank (ECB) decides to help Greece. They do it by reducing the
foreign interest rate faced by Greece. What effect does this have on income? Using the small open
economy IS-LM model, explain how the economy adjusts to the new equilibrium (3 points).

A reduction in the foreign interest rate works as if the domestic interest rate was above the
foreign one. Financial capital would like to come to Greece, generating pressures to appreciate
the domestic currency. To keep the exchange rate fixed, the LM curve must shift right. This
increases income and reduces the domestic interest rate, keeping the exchange rate constant.

The Greek Prime Minister explains to his people that he cannot use fiscal policy to avoid the recession.
The Minister of Finance reminds him about the existence of monetary policy. Using the small open
economy IS-LM model, you know that one of the exchange rate regimes you studied can avoid a
recession using monetary policy.
Which exchange rate system delivers the effectiveness of the monetary policy on output? (1 point).

Monetary policy is effective on a flexible exchange rate regime.

Assume that Greece adopts the exchange rate regime that makes monetary policy effective. How
should the money supply be changed to avoid the recession caused by the confidence shock? Using the
small open economy IS-LM model, explain how the economy adjusts to the new equilibrium. Does the
exchange rate appreciates, depreciates or stays constant? (3 points).

If Greece adopts a flexible exchange rate regime, the money supply can be increased, shifting the
LM right. This will increase income, and since the exchange rate is flexible, it will cause
depreciation.
QUESTION 5 (12 points)

Suppose that the real government spending equals 500, real net taxes equals 440, real high-powered
money equals 3600, and the total amount of outstanding real government bonds is equal to 2400. The
nominal interest rate equals 5%, and the economy is in a long-run steady state with fixed H/P and B/P.

(a) What is the inflation rate that keeps the real value of bonds and high-powered money fixed? (2
points)

G-T = p(H/P + B/P) – iB/P

p = (G-T+i*B/P)/(H/P+B/P) = 0.03

(b) What is the amount of seignorage (inflation tax)? (2 points)

pH/P = 0.03*3600 = 108

(c) What is the amount of real interest that the government pays out on its bonds? (2 points)

(i-p)B/P = (0.05-0.03)*2400 =48

(d) Suppose that all of a sudden the government is required to run a balanced budget (G=T). Assume
that the nominal interest rate did not react at all to this policy change. What is the inflation rate that
keeps the real value of bonds and high-powered money fixed? (3 points)

G-T=0, so p = (i*B/P)/( H/P + B/P )

p = 0.05*2400/( 3600+2400) = 0.02

(e) If the inflation rate you found in d) persisted, after enough time had passed for the Fisher equation
to hold (and without anything else changing), will the government be able to run a basic deficit without
changing the real level of high-powered money and bonds? (3 points)

The new nominal interest rate is i=0.02+0.02 = 0.04.

Then p(H/P + B/P) – iB/P = 0.02*(3600+2400) – 0.04*2400 = 24
Part C. Essay Questions (30 points)
Write your answers clearly with a pen in the blue book. Be sure that you PRINT your name on
the front of your blue book. You must write your answers with a pen, not a pencil.

1. (15 minutes, 15 points). The graphs, tables, and analysis in the textbook end in December,
2010. Write an essay about what has happened in the U. S. economy since one year ago. Your
essay should cover the following issues.

a) The unemployment rate in November, 2010, was 9.8 percent. The unemployment rate for
November, 2011, announced last Friday December 2, was 8.6 percent. Using that
information and anything else you have learned in the course (or heard about from outside
media), characterize the U. S. economy in terms of its basic performance during 2011–
output growth, inflation, output gap, interest rates, fiscal deficit.

b) What initiatives has monetary policy taken since a year ago and what has been their effect,
if any ?

c) What is the nature of the fiscal situation of the U. S. in 2011 ? What proposals have been
offered to deal with it and why has agreement not been reached ?

2. (15 minutes, 15 points). During 2011 the news has been dominated by the Euro crisis and the
summer debate about the U. S. debt ceiling. You have learned a lot about the euro in class
lectures, in the discussion of the « Trilemma » in Chapter 7, in the analytical questions of
Chapter 7 about the IS-LM model with fixed vs. Flexible exchange rates, and in the two-page
box on the Euro in Chapter 14.

a) What are the underlying causes of the Euro crisis ? What are differences and similarities
with the U. S. fiscal situation ?

b) What factor(s) make the Euro crisis more difficult to solve than the U. S. fiscal situation ?
What factor(s) make the Euro crisis easier to solve ?