ECON2123 Final Practice Question Solution1

1 Multiple Choice
1. If a Hong Kong construction company hire local Chinese worker to built a road in mainland China,
this activity would be
A) fully included in Mainland GNP
B) fully included in Mainland GDP.
C) excluded from Hong Kong GNP.
D) included in Hong Kong GDP but not in Hong Kong GNP.
Answer: B.
2. Suppose consumption C=100+0.5YD and Investment I=100. Every things equal, an increase in the
propensity to consume from 0.5 to 0.75 will definitely lead to
A) a decrease in total saving.
B) the e↵ects on both total saving and consumption are unknown.
C) an increase in consumption.
D) a decrease in consumption.
Answer: C.
Solution: Let’s denote the MPC as c1 . For any given level of autonomous spending, a higher c1 will
imply a higher output. Given that both output and MPC increase, the consumption must be higher.
Given that marginal propensity to save decreases, the e↵ect on saving is unknown.
3. Every other thing equal, an increase in the risk of investment return would cause the IS curve to
A) remain unchanged
B) shift down and to the left
C) shift up and to the right
D) remain unchanged if the risk is small.
Answer: B.
Solution: This is a similar e↵ect as of a decrease in investor confidence.
4. Suppose investment spending is very not sensitive to the interest rate. Given this information, we
know that:
A) the IS curve should be relatively steep
B) the IS curve should be relatively flat
C) the LM curve should be relatively flat
D) the LM curve should be relatively steep
Answer: A.
Solution: method 1: draw two figures with di↵erent sensitivity, and compare. method 2: consider an
extreme case when investment spending is not sensitive to the interest rate at all. Then the IS curve is
1 The question is provided by Prof. Wang. The answers are provided by Astor and Ding. The solutions are provided

by Ding Dong. All errors in solutions are Ding’s.

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a vertical line. Thus, IS curve should be relatively steep when investment spending is very not sensitive
to the interest rate. LM curve will not be a↵ected by the sensitivity.
5. According to IS-LM model, under which circumstance, the increase in money is most e↵ective in
boosting the economy?
A) investment is not sensitive to output change at all.
B) IS curve is vertical
C) IS curve is flat
D) Investment is fixed.
Answer: C.
Solution: The increase in money supply boosts the economy by reducing interest rate to increase
investment. Thus the more sensitive investment is to interest rate (= IS curve is flat), the more
e↵ective is monetary policy.
6. For this question, assume that individuals hold NO currency (i.e., c = 0.0). If the ratio of reserves
to deposits is .25, a purchase of $1000 of bond by the central bank will leads to () increase in money
supply:
A) $4000
B) $3000
C) $5000
D) $1000
Answer: A.
Solution: See lecture note/ tutorial slide on financial market.
7. Based on our understanding of the labor market model presented in Chapter 6, the new labor law
in China which increases the protection of workers to be laid o↵ would leads to :
A) a reduction in the equilibrium real wage
B) an increase in the equilibrium real wage
C) a reduction in the natural rate of unemployment
D) an increase in the natural rate of unemployment
Answer: D.
Solution: The law increases unemployment benefit(z). The equilibrium real wage is determined by price
setting equation, and it will not be a↵ect by change in z. From the labor market equilibrium, when z
increases, natural level of unemployment must increase for equation 1 = (1 + m)F (un , z) to hold.
8. Based on our understanding of the labor market model presented in Chapter 6, an increase in oil
price will make,
A) a reduction in the equilibrium unemployment rate
B) a rise in the real wage
C) a rise in the aggregate price
D) a rise in natural rate of output
Answer: C.
Solution: The e↵ect will be the same as of an increase in mark-up.

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9. Based on your understanding of the AS/AD model, which of the following is an INCORRECT
statement about the short-run adjustment process for the macro economy?
A) A reduction in employment leads to lower prices
B) An increase in output above the natural level leads to higher nominal wages
C) Output in excess of the natural level leads to higher prices
D) none of the above
Answer: D.
Solution: A reduction in employment is equivalent to a reduction in output, which does not necessarily
lead to price reduction.
10. Based on your understanding of the AS/AD model, an permanently reduction in government
spending will lead to ( ) in the medium run
A) an increase in consumption
B) a decrease in consumption
C) an increase in investment
D) a decrease in investment
Answer: C.
Solution: In the medium run, output remains unchanged, but interest rate will be lower. Thus con-
sumption remains unchanged but investment will be higher.
11. Which of the following will cause the velocity of money to decrease?
A) the introduction of credit cards into the economy
B) a reduction in the interest rate
C) an increase in the interest rate
D) all of the above
E) none of the above
Answer: B.
12. Which of the following will cause a rightward shift in the money demand curve?
A) an increase in the money supply
B) a reduction in the interest rate
C) a reduction in income
D) all of the above
E) none of the above
Answer: E.
Solution: The question is equivalent to asking: given interest rate level, which one will increase money
demand. Money supply change or interest rate change will move along the curve. A reduction in income
will decrease money demand. None is correct.
13. Suppose the economy is operating on the LM curve but not on the IS curve. Given this information,
we know that:
A) the money market and goods market are in equilibrium and the bond market is not in equilibrium.
B) neither the money, bond, nor goods markets are in equilibrium.
C) the money market and bond markets are in equilibrium and the goods market is not in equilibrium.

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D) the money, bond and goods markets are all in equilibrium.
E) the goods market is in equilibrium and the money market is not in equilibrium.
Answer: C.
14. Which of the following represents the medium-run e↵ect of a reduction in the money supply?
A) a decline in output
B) a decrease in the price level
C) an increase in the interest rate
D) all of the above
E) none of the above
Answer: B.
Solution: See lecture note/ tutorial note on AS-AD.
15. Assume the economy is initially operating at the natural level of output. Now suppose a budget is
passed that calls for a tax cut. This fiscal expansion will, in the medium run, have no e↵ect on which
of the following?
A) the price level
B) the interest rate
C) employment
D) all of the above
E) none of the above
Answer: C.
Solution: See lecture note/ tutorial note on AS-AD.
16. Assume the economy is initially operating at the natural level of output. Which of the following
events will NOT change the composition of output (i.e., the percentage of GDP composed of consump-
tion, investment, etc.) in the medium run?
A) an increase in consumer confidence
B) a reduction in government spending
C) an increase in the money supply
D) a cut in taxes
E) a reduction in the desire to save
Answer: C.
Solution: Changes in consumer confidence, government spending will a↵ect both IS and LM curve in
the medium run, leading to no changes in output but changes in interest rate. Changes in money supply
have no e↵ect on either IS or LM in the medium run, thus will not a↵ect consumption, investment or
gov spending.
17. Answer this question using the AS/AD model presented in the textbook. Which of the following
would cause a reduction in the natural level of output in the medium run?
A) an increase in taxes
B) a decrease in government spending
C) a decrease in the money supply
D) both A and C

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E) none of the above
Answer: E.
Solution: See lecture note/ tutorial note on AS-AD.
18. At the current level of output, suppose the actual price level is greater than the price level that
individuals expect (i.e., Pt > Pte ), We know that:
A) the nominal wage will tend to decrease as individuals revise their expectations of the price level.
B) output is currently below the natural level of output.
C) the AS curve will tend to shift down over time.
D) the interest rate will tend to rise as the economy adjusts to this situation.
E) none of the above
Answer: D.
Solution: Individuals will adjust their price expectation up, leading AS curve to shift up. LM curve
will shift to the left thus interest rate will be higher.
19. Assume the economy is initially operating at the natural level of output. Which of the following
events will initially cause a shift of the aggregate supply curve?
A) an increase in consumer confidence
B) an increase in the money supply
C) an increase in government spending
D) all of the above
E) none of the above
Answer: E.
Solution: See lecture note/ tutorial note on AS-AD..
20. Suppose the economy is operating at the steady state and that there is no technological progress.
Which of the following is true given this information?
A) The growth of output per worker is zero.
B) The growth of output per worker is equal to the rate of investment.
C) The growth of output per worker is equal to the rate of depreciation.
D) The growth of output per worker is equal to the rate of saving.
E) none of the above
Answer: A.
Solution: See lecture note/ tutorial note on growth theory.
21. Suppose in an economy without technology progress and population growth, an increase in depre-
ciation rate, will lead to total deprecation k to () ?
A) increase.
B) decrease
C) unchanged.
D) increase if and only the saving rate is above the golden rule level.
E) decrease if and only the saving rate is above the golden rule level.
Answer: B.

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Solution: Write steady state k as a function of , for example, k = (s/ )1/(1 ↵) , thus k = (s/ )1/(1 ↵) .
If increases, k will decrease.
22. Suppose there is a reduction in the saving rate. This reduction in the saving rate must cause a
reduction in consumption per capita in the long run when:
A) the saving is used for consumption rather than physical capital.
B) capital per worker already is less than the golden-rule level.
C) the rate of saving exceeds the rate of depreciation.
D) there is no technological progress.
E) there is no population growth.
Answer: B.
Solution: Reduction in the saving rate must cause a reduction in consumption per capita in the long
run when saving rate is lower than golden-rule level. Because capital per worker is increasing with
saving rate in the steady state. In this case capital per worker must be less than the golden-rule level.
23. Suppose two countries are identical in every way with the following exception. Economy A has a
higher rate of depreciation ( ) than economy B. Given this information, we know with certainty that:
A) steady state consumption in A is lower than in B.
B) steady state consumption in A and in B are equal.
C) steady state growth of output per worker is higher in A than in B.
D) steady state consumption in A is higher than in B.
E) none of the above
Answer: A.
Solution: steady state consumption is a decreasing function of . Steady state growth of output per
worker is zero.
24. At the current steady state capital-labor ratio, assume that the steady state level of per capita
consumption, (C/N )⇤ , is less than the golden rule level of steady state per capita consumption. Given
this information, we can be certain that:
A) a reduction in the saving rate will have an ambiguous e↵ect on (C/N)*.
B) an increase in the saving rate will cause an increase in the steady state level of per capita consumption
((C/N )⇤ ).
C) the capital labor ratio will tend to decrease over time.
D) the capital labor ratio will tend to increase over time.
E) a reduction in the capital-labor ratio will cause a reduction in (C/N )⇤ .
Answer: A.
Solution: If saving rate is above golden rule level, a reduction in the saving rate will increase consump-
tion per worker; If saving rate is below golden rule level, a reduction in the saving rate will decrease
consumption per worker.
25. Suppose an economy experience a 4% increase in each of the following variables: N, K,if the
production exhibits constant return to scale and no change in technology. Other things equal, Given
this information, we know with certainty that:
A) Y will increase by less than 4%.

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B) Y will increase by exactly 4%.
C) Y will increase by more than 4%.
D) Y will increase by less than 8% but by more than 4%.
E) none of the above
Answer: B.
Solution: Definition of constant return to scale.
26. Suppose policy makers want to increase Y and and keep NX unchanged, Which of the following
policies would most likely achieve this?
A) a real appreciation
B) an increase in the real exchange rate
C) an increase in government spending and a depreciation in the real exchange rate
D) a reduction in government spending
E) encourage the countrys trading partners to implement policies that will cause a reduction in foreign
income (Y*)
Answer: C.
Solution: An increase in government spending increases Y but decreases NX; a depreciation in the real
exchange rate increases both Y and NX. Combining this two promises an increases in Y and possibly
unchanged NX.
27. For this question, assume that there is a tax cut. In a fixed exchange rate regime, we know with
certainty that:
A) consumption will increase.
B) investment will increase
C) money supply will increase
D) output will increase.
E) all of the above
Answer: E.
Solution: Fixed exchange rate regime implies that interest rate cannot be changed. Tax cut policy will
increase output, and is likely to increase interest rate if money supply doesn’t change. So money supply
must increase to maintain interest rate. As a consequence, output, consumption, investment increase.
28. For this question, assume the Marshal-Lerner condition holds. Which of the following would occur
as a result of an increase in the real exchange rate?
A) an increase in domestic output
B) an improvement of the trade balance
C) a reduction in the quantity of imports
D) all of the above
E) none of the above
Answer: E.
29. In an open economy under flexible exchange rates, a reduction in the money supply will always
cause
A) a reduction in output

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B) an appreciation in the nominal exchange rate, E
C) a decrease in the interest rate
D) all of the above
E) only A and B
Answer: E.
Solution: See lecture notes/tutorial notes on Open Economy IS/LM.
30. In an open economy under fixed exchange rate policy, an increase in government spending will make
A) Output to increase
B) Money supply to increase
C) Investment to increase
D) Only A and B
E) A, B and C.
Answer: E.
Solution: Fixed exchange rate regime implies that interest rate cannot be changed. Expansionary
fiscal policy will increase output, and is likely to increase interest rate if money supply doesn’t change.
So money supply must increase to maintain interest rate. As a consequence, output, consumption,
investment increase.

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2 Short Essay
1. Unemployment Benefits varies a lot across countries and regions. For example, in Sweden, the
unemployed will receive about 70 percent of his or her normal income during the last 12 months for
about one and a half year. While in Hong Kong and Singapore, there is no comparable system available.
The unemployment rate in Sweden is 7.9% 4.0% in Hong Kong and 2.2 in Singapore in the December
of 2010.
a. Use the labor diagram we learn in Chapter 6 to explain why Sweden has a higher unemployment
rate than Hong Kong and Singapore?
b. The reason why the Administration in Hong Kong and Singapore does not support the establishment
of an unemployment assistance system is that in their opinion, what the unemployed need is a job rather
than a cash hand-out.
Provide a Pro (for) and a Con (against ) to such opinion.
Solution: As attached.

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2. Suppose that one economy is initially at the natural level of output.
a. Using the AS/AD, IS/LM diagrams to analyze the e↵ect of a decline in consumer’s confidence on
consumption, output, investment and interest rate in the short run, in the medium run.
b. suppose that the central bank is making decision on monetary policy to maintain the natural level
output. Should the central bank increase money supply or decrease money supply? Briefly explain why.
Solution: As attached.

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3. The growth model. Suppose there is population and technology level is constant. The production
function is
p
Y = KN (1)

a. Does this production feature constant return to scale?

b. Write y=f(k), where y=Y/N, k=K/N.
c. Assume there is no government, and the private saving rate is a constant fraction of the household
disposable income, s=0.3. And depreciation rate, , is 0.1. Solve for the steady-state k, y and c.
d. solve for the golden-rule level of saving rate in the above economy with no government. And recom-
mend a tax policy for the government to achieve the golden-rule of capital, output and consumption.

Solution: As attached.

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4. Suppose an economy with the following information

C = 6 + 0.8(Y T)

G = 15; T = 20

I = 10 + 0.2Y 100i

N X = 10 0.25Y 50(" 1)

where " is the real exchange rate. Suppose the foreign interest rate is 5% and expected exchange rate
E e = 1.05. Price level is equal to 1 in both countries, namely P = P ⇤ = 1.
a) Write down the real exchange rate as a function of normal interest rate i.
b. Derive the IS curve in the open economy.
We have the following information regarding the financial market:

M/P = Y 100i

The total money supply is M=30.

c. Solve for Y,i,C,I,NX, " and E for this economy under flexible exchange rate.
d. Now consider the government wants to achieve Y= 40, NX=0, how should the money supply be? If
the government keeps T=20 to achieve Y= 40, NX=0, how should the government set its government
spending?
e. Now consider the original case with M=30 and g=15; t=20, but the economy is under fixed change
rate with E=1. What is the equilibrium Y, i,C, I, NX and "? What is the money supply to be consistent
with the equilibrium condition under fixed exchange rate policy?
f. In order to achieve trade balance NX=0, G=15, how should the government set its taxes?
Solution: As attached.

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 ECON2123-FINALPRACTICE-SOLUTION
MC:
1-5. BCBAC
6-10 ADCDC
11-15 BECBC
16-20 CEDEA
21-25 BBAAB
26-30 CEEEE

Short Essay:
1a. Use the labor diagram we learn in Chapter 6 to explain why Sweden has a higher
unemployment rate than Hong Kong and Singapore?
Answer: For any given Price Setting Equation, the wage setting equation of Sweden is higher
than that of Hong Kong/Singapore. Thus the equilibrium unemployment is higher in
Sweden.

1b. The reason why the Administration in Hong Kong and Singapore does not support the
establishment of an unemployment assistance system is that in their opinion, what the
unemployed need is a job rather than a cash hand-out. Provide a Pro (for) and a Con
(against) to such opinion.

Answer:
Pro: With high unemployment benefit, the equilibrium /natural level of unemployment will
be higher, thus more people will end up with no job.
(additional points:)
If a worker is unemployed for a long period of time, they may lose their skills and it would
be even more difficult for them to find a job. Also, it may reduce the incentive of
unemployed workers to look for jobs in the market.

Con: Unemployed people have no income, thus no spending. Therefore the effective
demand is low in the economy, leading to low output.

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(additional points:)
For some workers, especially for those low skilled workers, it’s very difficult to get job in the
market. It may be a good idea for the government to provide them with unemployment
benefit for a certain period of time, help them to equip with better skills and improve their
competitiveness in the labor market

2. Suppose that one economy is initially at the natural level of output.

a. Using the AS/AD, IS/LM diagrams to analyze the effect of a decline in consumer’s
confidence on consumption, output, investment and interest rate in the short run, in the
medium run.
Answer:
A decrease in autonomous spending shifts the AD curve to the left. The AS curve does not
shift in the short run. There are two underlying forces for the shift of AD curve: the IS curve
shifts to the left due to a lower consumer confidence. This tends to decrease output and
shift the AD curve to the left, resulting a lower price level. Note that there is an opposing
force: the LM shifts to the right because the decrease in price level (increase in real supply
of money). This tends to increase output and shift the AD curve to the right. But the first
effect is always larger because the second effect is a by-product of the first effect (i.e. the
shift in LM curve is caused by the shift in IS curve). Hence, in the short run equilibrium, the
AD curve shifts to the left. Since the expected price level is higher than the current price
level, people adjust expected price level down gradually. In the medium run, the AS curve
shifts to the right until the new equilibrium output is equal to the original one, because
natural rate of output doesn't change. During this process, the price level decreases which
implies that the LM curve is shifting to the right. Note the LM curve shifts exactly to the
location where the new equilibrium output in the IS-LM diagram is equal to the original one.
So in the medium run, the only effect of the decrease in consumer confidence is a lower
interest rate and price, leaving equilibrium output unchanged. This means that in the
medium run, total savings increases, so the paradox is gone.
Thus, in the short run, consumption is lower, output is lower, interest rate is lower, the
effect on investment is unclear.
In the medium run, consumption is lower (due to a decrease in consumer confidence),
output remains unchanged, interest rate is lower, investment is higher (All relative to
original level).

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As a summary:

Y i P C I
Short Run Decreases Decreases Decreases Decreases (Y Ambiguous
and c0
decreases)
Medium Run Increases Decreases Decreases Decrease Increases
back to Yn further further less than when
Short run comparing
when with initial
comparing investment
with initial (Y=Yn and i
consumption decreases)
(Y=Yn, c0
decreases)

b. suppose that the central bank is making decision on monetary policy to maintain the
natural level output. Should the central bank increase money supply or decrease money
supply? Briefly explain why.

Answer:
The central bank should increase money supply. An increase in money supply will in the
short run shift AD curve to the right, and LM curve down, giving an even lower interest rate,
which increase investment to counteract the decrease in consumption.
(Intuition: in a closed economy, the central bank can choose money supply to affect interest
rate. Interest rate affect output through investment: A lower interest rate increases
investment, thus it is optimal for the central bank to increase money supply to stimulate the
output.)

3.

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a. Does this production feature constant return to scale?
Answer: Yes. F(2K,2N)=2Y.

b. Write y=f(k), where y=Y/N, k=K/N.

Answer: y= Y/N= F(K,N)/N=(K/N)^0.5=k^0.5

c. Assume there is no government, and the private saving rate is a constant fraction of the
household disposable income, s=0.3. And depreciation rate, δ, is 0.1. Solve for the steady-
state k, y and c.
Answer: k=(s/δ) ^(1/1-0.5)=3^2=9; y=3; c=(1-s)y=0.7*3=2.1.
(see lecture slides or tutorial 7 for derivation of this result.)

d. solve for the golden-rule level of saving rate in the above economy with no government.
And recommend a tax policy for the government to achieve the golden-rule of capital,
output and consumption.
Answer:
k=(s/0.1)^0.5; y=10*s; c=(1-s)*10*s.
Golden rule saving rate can be solved by differentiating c with respect to s. Golden rule
s=0.5. Golden rule capital per worker is 5^0.5.

Suppose private saving rate is 0.3

Let government tax be proportional to income, say T=t*Y, where t is the tax rate.
Total Saving = private saving + public saving = s(Y-T)+T=s(1-t)+tY = [s(1-t)+t]Y
The golden level of saving rate equals to 0.5. We can set optimal tax rate t=2/7.
(The steady state k=[10(0.3+0.7t)]^0.5; y=10(0.3+0.7t); c=(1-s)(1-t)*10*(0.3+0.7t). )

4.
a. Write down the real exchange rate as a function of normal interest rate i.
Answer: e=EP/P*=E=(1+i) ! " /(1+i*)=1+i

b. Derive the IS curve in the open economy.

Answer:
IS relation:
Y=C+I+G+NX= 6 + 0.8(Y − 20)+ 10+0.2Y −100i+15+ 10−0.25Y −50(e−1).
Given that e=1+i,
Y=6 + 0.8(Y − 20)+ 10+0.2Y −100i+15+ 10−0.25Y −50i, or
(1-0.8-0.2+0.25)Y=6-16+10+15+10-150i.
Y=4(25-150i)=100-600i

Given M/P = Y − 100i. The total money supply is M=30.

c. Solve for Y,i, C, I, NX, e and E for this economy under flexible exchange rate.
Answer: LM: 30=Y-100i, or Y=30+100i.
Recall IS: Y=100-600i.
Combining LM and IS relation will solve out Y=40, i=10%=0.1.
e=E=1+i=1.1.
C=6 + 0.8(Y − 20)=22;

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I=10+0.2Y −100i=10+8-10=8;
G=15;
NX=10−0.25Y −50i =10-10-5=-5

d. Now consider the government wants to achieve Y= 40, NX=0, how should the money
supply be? If the government keeps T=20 to achieve Y= 40, NX=0, how should the
government set its government spending?
Answer:
When central bank chooses money supply (denoted as M),
LM: Y=M+100i.
NX=10−0.25Y −50i.
IS: Y=100-600i.
To have Y=40, NX=0, i=0.
M must equal to 40.

When government chooses government spending (denoted as G):

LM: Y=M+100i.
NX=10−0.25Y −50i
IS: Y=40+4G-150i.
To have Y=40 and NX=0,
i=0, M=40, and G=0

e. Now consider the original case with M=30 and g=15; t=20, but the economy is under fixed
change rate with E=1. What is the equilibrium Y, i,C, I, NX and e. ? What is the money supply
to be consistent with the equilibrium condition under fixed exchange rate policy?
Answer: Under fixed exchange rate, i=i*=5%. e=E=E^e=1.
IS:
Y=6 + 0.8(Y − 20)+ 10+0.2Y −100i+15+ 10−0.25Y −50(e−1)
Y=6+0.8Y-16+10+0.2Y-5+15+10-0.25Y
Y=4(6-16+10-5+15+10)=80.
LM:
M=Y-100i=80-100*0.05=75.
C=6 + 0.8(80− 20)=54
I=10+0.2Y −100i=10+16-5=21;
NX=10−0.25Y −50(e−1)=10-20=-10.

f. In order to achieve trade balance NX=0, G=15, how should the government set its taxes?
Answer:
IS:
Y=6 + 0.8(Y−T)+ 10+0.2Y −100i+15+ 10−0.25Y −50(e−1)
Y=6+0.8Y-0.8T+10+0.2Y-5+15+10-0.25Y
To have trade balance that 10−0.25Y=0, Y=40.
Thus 40=6+0.8*40-0.8T+10+0.2*40-5+15+10-0.25*40
40=4(6-0.8T+10-5+15+10)
6-0.8T+10-5+15+10=10
26=0.8*T
T=26/0.8=32.5