ECO 3203: Exam 2 Practice Problems
If Fed A cares only about keeping the price level stable and Fed B cares only about keeping output at its natural level, then in response to an exogenous increase in the price of oil:
Fed A should decrease the quantity of money stable whereas Fed B should increase it
Suppose that the following equations describe a closed economy: Y= C + I + G C= 200 + 0.75(Y-T) I= 200 - 25r G= 100 T= 100 Ms= 500 P= 1 (M/P)d= Y - 100r What are the short-run equilibrium values of r and Y?
Y*=1,100 and r*=6; -17-0.01Y= -5+0.01Y - 22=0.02Y -Y*=1,100 -r=17-0.01(1,100) -17-11 r*=6
In the aggregate demand/aggregate supply model, long-run equilibrium occurs at the combination of output and prices where:
aggregate demand equals short-run and long-run aggregate supply
An increase in wealth in the U.S. will lead to which one of the following in the foreignexchange market?
an increase in the supply of dollars
In the standard IS-LM model, a decrease in the money supply causes an ______ for real moneybalance at an initial interest rate, and thus the interest rate has to ______ to equate thequantity money demanded and the money supply, and this shifts the ______
excess demand; rise; LM curve to the left
In the standard IS-LM model, an increase in the money supply causes an ______ for real money balance at an initial interest rate, and thus the interest rate has to ______ to equate the quantity money demanded and the money supply, and this shifts the ______
excess supply; fall; LM curve to the right
In the standard IS-LM model, when government spending decreases, in short-run equilibrium,the interest rate ______ and output ______
falls; falls
In the standard IS-LM model, when taxation increases, in short-run equilibrium, the interest rate ______ and output ______
falls; falls
In the IS-LM model when MS rises but P remains constant, in short-run equilibrium, in the usualcase, the interest rate ______ and output ______
falls; rises
The law of one price fails as a result of
goods that cannot be traded
Use the AD/AS model with the upward-sloping short-run aggregate supply curve to answer this question. If a short-run equilibrium occurs at a level of output higher than the full-employment level, then in the transition to the long run through the self-correcting process, prices will ______ and output will ______ toward the full-employment level
increase; decrease
Crowding out occurs when an increase in government spending ______ the interest rateand investment ______
increases; decreases
Everything else held constant, an autonomous monetary policy easing ________ aggregate________
increases; demand
Everything else held constant, when financial frictions increase, the real cost of borrowing________ so that planned investment spending ________ at any given inflation rate
increases; falls
In the long run, following a combination of a negative demand shock and a temporarynegative supply shock,
inflation is permanently reduced, while output returns to potential output
A liquidity trap occurs when:
interest rates fall so low that monetary policy is no longer effective
The long-run equilibrium level of aggregate output
is always equal to potential output
When a currency is described as overvalued, this typically implies that
its current market value is higher than the value that is thought to be consistent withpurchasing power parity
In the IS-LM analysis, the increase in equilibrium output resulting from a tax cut is usually______ the increase in income resulting from an equal rise in government spending
less than
The increase in equilibrium output in response to a fiscal expansion in the IS-LM model is:
less than in the Keynesian-cross model unless the LM curve is horizontal
If the short-run aggregate supply curve is horizontal, then changes in aggregate demand affect:
level of output but not prices
With regard to exchange rate determination, the law of one price is a useful theory onlywhen applied to
long-run periods of time
Appreciation of the real exchange rate
makes U.S. exports more expensive to foreigners
The level of unemployment at which the demand for labor equals the supply of labor iscalled the
natural rate level of unemployment
According to the IS-LM model, when the government increases taxes and governmentpurchases by equal amounts:
ncome and the interest rate rise, whereas consumption and investment fall
The aggregate demand curve is the ______ relationship between the quantity of output demanded and the ______
negative; price level
Assume that the economy begins in long-run equilibrium and the SRAS is upwardsloping curve. Then the Fed reduces the money supply. In the short run ______, whereas in the long run prices ______ and output returns to its original level
output and prices both decrease; fall
If the initial short-run equilibrium is below potential output, absent government intervention,in the long run
output increases to potential output and equilibrium inflation decreases
Explain how a currency speculator could use something like the Big Mac Index to make aprofit trading currencies
the Big Mac Index is meant to be a simplified illustration of the theory of purchasing power parity (PPP). PPP really looks at a basket of goods, not one single good, andwould consider goods that are transportable since it is an extension of the law of one price. Big Macs are really not transportable. Finally, the price of the Big Mac is highly dependent on local costs such as wages, taxes, and rent. That being said, a speculator would look at something like the Big Mac Index to determine which currencies areovervalued and which are undervalued. A speculator could profit by buying undervalued currencies or by making forward transactions in overvalued currencies. A speculator would use a much more sophisticated tool than the Big Mac Index for suchtrading, but the index does give us a general idea of what is possible
the Taylor principle explains why, when inflation increases
the Fed increases real interest rates
If the real money demanded function is (M/P)d= aY-br and the slope coefficient b is extremely large, then:
the LM curve is relatively flat
If money demand is extremely responsive to the interest rate, then:
the fiscal policy is effective
If money demand is extremely sensitive to the interest rate, then the ______ curve is ______
LM; horizontal
In the aggregate demand-aggregate supply model, short-run equilibrium occurs at the combination of output and prices where:
aggregate demand equals short-run aggregate supply
If a bank has $100,000 of checkable deposits, a required reserve ratio of 20 percent, and it holds $40,000 in reserves, then the maximum deposit outflow it can sustain without altering its balance sheet is
$25,000; INSERT EXPLANATION
Use the following system of equations to answer this question. Suppose that the following equations describe a closed economy: C= 60 + 0.8(Y-T) I=150 - 10r G= 250 T= 200 Ms= 100 P= 1 (M/P)d= 40 + 0.1Y - 10r Now reset the problem back to the initial equilibrium point. Suppose that the Fed want to achieve the equilibrium output at 1,400 (desired Y* = 1,400) through money supply policy alone. By how much would the Fed have to increase money supply?
60; -r= 30-0.02(1,400) -r= 2 -Ms=(M/P)d -Ms= 40+0.1(1,400)-10(2) -Ms= 40+140-20 -Ms2=160 -Ms2-Ms1= 160-100= 60
Suppose that favorable weather produces a record crop of wheat and corn in the Midwest. Isthis a supply shock or a demand shock? Use a graph to show the effects on aggregate output andinflation in the short run and in the long run
A record crop of wheat and corn represents a temporary positive supply shock. This shiftsthe short-run aggregate supply curve to the right (down). Output increases and inflationdecreases in the short run; in the long run, output falls back to potential, and inflationincreases, returning to the original level
If the labor force becomes more productive over time, how would the long-run aggregatesupply curve be affected?
As labor productivity grows, the long-run aggregate supply curve shifts to the right. Thisis because the existing labor force, along with a given amount of capital and otherresources, can produce more output, indicating a greater amount of potential output
The principal method used by the Federal Reserve to change the money supply is through open-market operations. State in words what happens to prices and output in the short run and the long run
In the short run output increases, while the price level remains unchanged. In the long run, prices increase and output returns to the full-employment level
The economy of Macroland is initially in long-run equilibrium. A severe drought causes an adverse supply shock a. What happens to prices and output in the short run?
In the short run, prices increase and output decreases
Consider the following statements and judge whether the statements are TRUE or not: I. The monetary policy is more effective when investment demand is relatively inelasticto a change in interest rate. II. Other things equal, an increase in government spending has a larger effect onequilibrium output when the LM curve is relatively flat
Only II is true
Assume that the long-run aggregate supply curve is vertical at Y = 3,000 while the shortrun aggregate supply curve is horizontal at P = 1.0. The aggregate demand curve is Y = 2(M/P) and M = 1,500 a. If the economy is initially in long-run equilibrium, what are the values of P and Y?
P=1.0 and Y=3,000; -Since the economy is in long run equilibrium, Y=Y of long run supply curve and P=P of short run supply curve
Assume that the long-run aggregate supply curve is vertical at Y = 3,000 while the shortrun aggregate supply curve is horizontal at P = 1.0. The aggregate demand curve is Y = 2(M/P) and M = 1,500 b. If M increases to 2,000, what are the new short-run values of P and Y?
P=1.0 and Y=4,000; -In the short-run, price will remain at 1 -The new value of Y will be: Y=2(M/P)--> 2(2,000/1.0)= 4,000
Assume that the long-run aggregate supply curve is vertical at Y = 3,000 while the shortrun aggregate supply curve is horizontal at P = 1.0. The aggregate demand curve is Y = 2(M/P) and M = 1,500 c. Once the economy adjusts to long-run equilibrium at M = 2,000, what are P and Y?
P=1.33 and Y=3,000; -In the long-run, Y will remain at 3,000 -The new value of P will be: Y=2(M/P)--> 3,000=2(2,000/P)--> P=1.33
What is the link between purchasing power parity, inflation, and the exchange rate?
Purchasing power parity implies that when prices change in one country but not in another, the exchange rate should change as well. Specifically, if prices double in one country and not in another, the currency of the country experiencing the inflation will see its currency depreciate to the point where a unit of its currency will purchase half as many units of foreign currency as it did before
One policy response to the U.S. economic slowdown of 2001 were tax cuts. This policyresponse can be represented in the IS-LM model by shifting the ______ curve to the______
S; right
The economy of Macroland is initially in long-run equilibrium. A severe drought causes an adverse supply shock c. If the Central Bank of Macroland wants to prevent the short-run changes in price and output, what policy action could it take? How would the results of this policy action differ from the prices and output that would result in the long run with no policy action?
The central bank could increase the money supply to return output to full employment, but this would result in a long-run equilibrium at a higher price level than the initial long-run equilibrium
If Americans develop a greater appreciation for Mexican-made goods, we should observewhich one of the following change(s) in the U.S. dollar-peso market?
The demand curve for pesos shifts right
If the Japanese yen appreciates against the U.S. dollar,
U.S. goods should be less expensive relative to Japanese goods in both countries
What do you expect to happen to the economy depicted in Graph A (Y1 is before the LRAS) in the long run?Describe the self-correcting process that would happen in the long run as a result of the changing resource prices. When the economy returns to long-run equilibrium, will the price level rise or fall relative to its current level (P 1 )?
Weak AD for goods andservices will lead to weak demand for resources (such as labor). This will cause the resource prices and wages to fall. Lower wages and resource prices will decrease the cost of production and suppliers will increase the supply. The SRAS will shift to the right and restore the economy at the full-employment level of output again. However, price will fall (below P1)
The economy of Macroland is initially in long-run equilibrium. A severe drought causes an adverse supply shock b. What would happen to prices and output in the long run if there is no policy accommodation?
With no policy accommodation, both output and prices would return to their initial long-run equilibrium levels
Suppose that the following equations describe a closed economy: Y= C + I + G C= 200 + 0.75(Y-T) I= 200 - 25r G= 100 T= 100 Ms= 500 P= 1 (M/P)d= Y - 100r Reset the problem back to its initial stage as described in part a-c, now suppose that the Fed tries to stimulate the economy by raising MS by 700 (MS2 =1,200). What are the new equilibrium values of r and Y?
Y*=1,450 and r*=10; -Ms/P= (M/P)d -1,200/1= Y-100r -r=-12+0.01Y -17-0.01Y= -12+0.01Y -29=0.02Y -Y*=1,450 -r=-12+0.01(1,450) --12+14.5 -r*=2.5
Suppose that the following equations describe a closed economy: Y= C + I + G C= 200 + 0.75(Y-T) I= 200 - 25r G= 100 T= 100 Ms= 500 P= 1 (M/P)d= Y - 100r From the information given above, suppose that the government tries to stimulate the economy by raising G by 200 (G2 =300). What are the new short-run equilibrium values of r and Y?
Y*=1,500 and r*=10; -New IS= C + I + G -Y= 200+0.75(Y-100) + 200-25r + 300 Y= 200+0.75Y-75+200-25r+300 -625+0.75Y-25r -0.25Y=625-25r -25r=-0.25Y+625 -r=-0.01Y+25 -New IS=LM --0.01Y+25= -5+0.01Y -30=0.02Y -Y*=1,500 -r=-0.01(1,500)+25 --15+25 -r*=10
Use the diagrams (A, B, and C) above to answer the following questions. Which diagram(s)represent the following conditions? iii. The current level of output is above the potential level of output
Y1 is after the LRAS
Use the diagrams (A, B, and C) above to answer the following questions. Which diagram(s)represent the following conditions? vi. The economy is in a boom
Y1 is after the LRAS
Use the diagrams (A, B, and C) above to answer the following questions. Which diagram(s)represent the following conditions? i. The economy is in a short-run equilibrium
Y1 is before or after the LRAS
Use the diagrams (A, B, and C) above to answer the following questions. Which diagram(s)represent the following conditions? iv. The current level of output is below the potential level of output
Y1 is before the LRAS
Use the diagrams (A, B, and C) above to answer the following questions. Which diagram(s)represent the following conditions? vii. The economy is in a recession
Y1 is before the LRAS
Use the diagrams (A, B, and C) above to answer the following questions. Which diagram(s)represent the following conditions? ii. The economy is in a long-run equilibrium
Y1 is on the LRAS
Use the diagrams (A, B, and C) above to answer the following questions. Which diagram(s)represent the following conditions? v. The current level of output is equal to the full-employment level of GDP
Y1 is on the LRAS
Use the diagrams (A, B, and C) above to answer the following questions. Which diagram(s)represent the following conditions? viii. The economy is at full employment
Y1 is on the LRAS
Suppose that the economy starts from an equilibrium output level Y1 and interest rate r1, and then IS curve shifts to the right as a result of an increase in government spending (∆G). The new equilibrium output level is at ______, the distance between Y1and Y3 is equal to ______, and the crowding-out effect is equal to the distance between _______
Y2; ∆G(1/1-MPC); Y2 and Y3
Suppose the economy is producing at the natural rate of output. A decrease in consumer andbusiness confidence will cause ________ in aggregate output in the short run and ________ ininflation in the short run, everything else held constant
a decrease; a decrease
The theory of purchasing power parity says that
a dollar should buy the same goods no matter where in the world you go
According to the IS-LM model, if Congress cuts taxes but the Fed wants to hold incomeconstant, then the Fed must ______ the money supply
decrease
In the IS-LM model, a decrease in government purchases leads to a(n) ______ in planned expenditures, a(n) ______ in total income, a(n) ______ in money demand, and a(n) ______ in the equilibrium interest rate
decrease; decrease; decrease; decrease
Everything else held constant, a decrease in government spending ________ aggregate________
decreases; demand
Everything else held constant, an increase in net taxes ________ aggregate _______
decreases; demand
An expected appreciation of the dollar, everything else held constant, should cause the
demand for dollars to increase
Considering the theory of purchasing power parity, if inflation in Mexico is 5% whileprices in the United States are stable, we should expect, over the period of a year, the
dollar to appreciate 5% relative to the peso
When an aggregate demand curve is drawn with real GDP (Y) along the horizontal axis and the price level (P) along the vertical axis, if the money supply is decreased, then the aggregate demand curve will shift:
downward and to the left
A decrease in the price level, holding nominal money supply constant, will shift the LM curve:
downward and to the right
The dilemma facing the Federal Reserve in the event that an unfavorable supply shock moves the economy away from the natural rate of output is that monetary policy can either return output to the natural rate, but with a ______ price level, or allow the price level to return to its original level, but with a ______ level of output in the short run
higher; lower
The same laptop computer cost $2,000 in the United States, 220,000 Japanese yen,£1,300 British pounds, and €1900 in Germany. If the law of one price holds, what are the yen/$;£/$ and €/$ exchange rates?
if the law of one price holds, the yen/$ exchange rate is 110 yen/$ (220,000/2,000); the £/$ exchange rate is 0.65£/$ (1,300/2,000); and the €/$ exchange rate is 0.95€/$ (1,900/2,000)
Explain the effects of a negative demand shock in both the short-run and long-run
in the short run, a negative demand shock causes the aggregate demand curve to shift tothe left decreasing output below the potential level and lowering inflation. In the long runoutput returns to potential level and inflation declines further
According to the IS-LM model, when the government increases taxes and governmentpurchases by equal amounts:
income and the interest rate rise, whereas consumption and investment fall
Select the change described below that could result in the shift illustrated in the following graph: -demand and supply curve -demand curve shifts to the right
increase in riskiness of U.S. investment (relative to foreign investment)
In the IS-LM model, a decrease in the interest rate would be the result of a(n):
increase in the money supply
Aggregate output is ________ related to autonomous consumer expenditure, and is________ related to planned investment spending
positively; positively
A Keynesian short-run aggregate supply curve shows fixed ______, and a Classical long-run aggregate supply curve shows fixed ______
prices; output
A short-run aggregate supply curve shows fixed ______, and a long-run aggregatesupply curve shows fixed ______
prices; output
Use the following system of equations to answer this question. Suppose that the following equations describe a closed economy: C= 60 + 0.8(Y-T) I=150 - 10r G= 250 T= 200 Ms= 100 P= 1 (M/P)d= 40 + 0.1Y - 10r From the information given above, what are the equilibrium r* and Y*?
r* = 6 and Y* = 1,200; -IS=LM -30 - 0.02Y= 0.01Y - 6 -36= 0.03Y - Y*= 1,200 -30 - 0.02(1,200) - r*= 6
Use the following system of equations to answer this question. Suppose that the following equations describe a closed economy: C= 60 + 0.8(Y-T) I=150 - 10r G= 250 T= 200 Ms= 100 P= 1 (M/P)d= 40 + 0.1Y - 10r From the information given above, suppose that the government increases its spending (G) from 250 to 310. What are the new short-run equilibrium values of r and Y?
r* = 8; Y* = 1,400; -New IS= 60 + 0.8(Y-200) + 150-10r + 310 -60+0.8Y-160+150-10r+310 -360+0.8Y-10r -0.2Y=360-10r -10r=360-0.2Y -r=36-0.02Y -New IS=LM -36-0.02Y= 0.01Y-6 -42=0.03Y -Y*= 1,400 -r=36-0.02(1,400) -r*= 8
Use the following system of equations to answer this question. Suppose that the following equations describe a closed economy: C= 60 + 0.8(Y-T) I=150 - 10r G= 250 T= 200 Ms= 100 P= 1 (M/P)d= 40 + 0.1Y - 10r From the information given above, what is the equation for LM curve?
r= 0.01Y - 6; -Ms/P= (M/P)d -100/1= 40 + 0.1Y - 10r -10r=-60 + 0.1Y -r= 0.01Y - 6
Use the following system of equations to answer this question. Suppose that the following equations describe a closed economy: C= 60 + 0.8(Y-T) I=150 - 10r G= 250 T= 200 Ms= 100 P= 1 (M/P)d= 40 + 0.1Y - 10r From the information given above, what is the equation for IS curve?
r= 30 - 0.02Y; -IS: Y= C+I+G -60+0.8(Y-200) + 150-10r + 250 -60+0.8Y-160+150-10r+250 -0.8Y+300-10r -0.2Y= 300-10r -10r=300-0.2Y -r= 30 - 0.02Y
Suppose that the following equations describe a closed economy: Y= C + I + G C= 200 + 0.75(Y-T) I= 200 - 25r G= 100 T= 100 Ms= 500 P= 1 (M/P)d= Y - 100r What is the equation for LM curve?
r=-5+0.01Y; -Ms/P= (M/P)d -500/1= Y-100r -r=-5+0.01Y
Suppose that the following equations describe a closed economy: Y= C + I + G C= 200 + 0.75(Y-T) I= 200 - 25r G= 100 T= 100 Ms= 500 P= 1 (M/P)d= Y - 100r From the information given above, what is the equation for IS curve?
r=17-0.01Y; -Y= C + I + G -200+0.75(Y-100) + 200-25r + 100 -200+0.75Y-75+200-25r+100 -425+0.75Y-25r -0.25Y=425-25r -25r=425-0.25Y -r=17-0.01Y
In the IS-LM model when M S remains constant but P rises, in short-run equilibrium, inthe usual case, the interest rate ______ and output ______
rises; falls
If workers demand and receive higher real wages (a successful wage push), the cost ofproduction ________ and the short-run aggregate supply curve shifts _______
rises; leftward
In the standard IS-LM model, when taxation decreases, in short-run equilibrium, the interestrate ______ and output ______
rises; rises
In theory, the law of one price makes a lot of sense. So why do we see it fail so often?
the law of one price fails often because in many cases countries will place tariffs onimports. Also, many products do not trade or ship easily, for example concrete. As aresult, they can have significantly different prices across markets and countries. Also,there can be technical differences in products; many home appliances would have to bere-wired to be used in other countries. Finally, many services simply do not transportwell, for example haircuts and restaurant meals
The vertical long-run aggregate supply curve satisfies the classical dichotomy because the natural rate of output does NOT depend on:
the money supply
The long-run aggregate supply curve is a vertical line passing through
the natural rate of output
The real and nominal exchange rates differ in the sense that
the nominal exchange rate does not reflect differences in purchasing power between currencies
The nominal exchange rate is
the price of one country's currency stated in units of another country's currency
If investment does not depend on the interest rate, then the IS curve is ________________ and _____________ policy has no effect on output
vertical; monetary
Consider the following graph, which illustrates supply and demand for the dollar-poundmarket, where the horizontal axis is labeled quantity of British pounds. Show on the graph andthen explain what happens when there is an increase in Americans' wealth. Does the Britishpound appreciate or depreciate? Explain
when Americans' wealth increases, ceteris paribus, the demand for British poundsincreases, meaning the demand curve will shift to the right. When this is added to thegraph above, it is evident that it takes more dollars to buy a pound so that the pound hasappreciated relative to the dollar
If government policymakers intervene in foreign exchange markets to cause the domesticcurrency to appreciate, this
would be harmful to exporters
If the LM curve is vertical and government spending rises by G, in the IS-LM analysis, then equilibrium income rises by:
zero