EXAM (ANSWERS)

Name of subject: Macroeconomics for EOR

Subject code: 35B101

Date of examination: 7 January 2013

Length of examination: 180 minutes (3 hours)

Lecturers: i.m.vdnbijgaart@uvt.nl h.a.a.verbon@uvt.nl (phone 2878)

Telephone number of departmental secretariat: 2416

This is a closed book exam. You are allowed to use only a simple calculator (no graphical or computerized calculator). You can use a dictionary for translating English terms into your own language.

This examination consists of 20 multiple-choice questions, and 2 open questions. Please read the instructions on the next page carefully. Note that a statement is only correct if all of its elements are correct. In other words, if an answer is not fully correct it should be regarded as incorrect.

Each multiple-choice question gives you the same points.

Where questions refer to specific chapters, they refer to chapters of the textbook that is compulsory for this course.

Explanations with regard to filling in the TU Exam form The “UvT tentamenformulier” is the scanform, used for multiple choice exams at TU. It is divided into a number of blocks. Exam- and Student information This block has to be filled out by the student: - Date - Name of the student - Name of the subject/course

Administration Number “Administratienr (ANR)” This block has to be filled out by the student: First, write down the 6-digit ANR in numbers, then provide your ANR by colouring the circles in the corresponding columns underneath. The ANR can be found on your TU-card. NB: Please do not use the 7-digit number! (in the format U1234567) Version Number “Versie” If there are more versions of the exam (e.g. A, B etc.) please fill out the correct version number. If there is only one version, you may leave this blank. Questions Mark your answers carefully: Colour the boxes completely, use black or blue! Only one answer can be given to each question. Please remember to answer all questions! Correction To avoid making mistakes, it is advisable to write down your answers on a scrap of paper before entering them on your exam form. If necessary, you can correct a given answer. Please make sure that your final answer can be distinguished beyond all doubt. The preferred way to correct is to cross out the wrong answer and colour the correct box. Hand in The student is allowed to hand in only one final TU Exam form per multiple choice exam. If you filled in a trial form first, please make sure that you copy all the answers on the final form you wish to hand in. Cross out the trial form, this will be destroyed. Don’t forget to hand in the trial form as well. When leaving the examination room, please return both your answer forms and this set of questions.

Good luck!

Exercise 1.

Consider an economy that consumes and produces meat, bread and hamburgers. A bakery bakes 200 loafs of bread and sells half of its produce directly to consumers for €1,00 a loaf and the other half is sold to a hamburger seller for €0,50 a loaf. A cattle farmer produces 100 kilograms of meat, 50 kilograms of which is sold directly to consumers for €20,00 a kilogram and the remainder is sold to the hamburger seller for €15,00 a kilogram. From one loaf of bread and one half kilogram of meat the hamburger seller produces 10 hamburgers. A hamburger is sold for €2,00 a piece. Typically, the hamburger seller fails to sell one out of 10 produced hamburgers. Unsold hamburgers have to be thrown away.

For this economy GDP equals :

a. €1900.-, b. €2900.-,c. €3700.-, d. €3900.-.

Answer

Bread: 100 sold to final consumers: 100 * €1,- = €100,-Meat: 50 kg sold to final consumers: 50 * €20,- = €1000,-Hamburgers: 100 loafs of bread and 50 kg produces are boughtfor: 100* €0,50 + 50* €15,-= €50,-+ €750,-= €800,- and produces 1000 hamburgers 900 hamburgers are sold to final consumers: 900 * €2,- = €1800,-Total value added: = € 2900.-

Wrong calculations:

Bread: 100 sold to final consumers: 100 * €1,- = €100,-Meat: 50 kg sold to final consumers: 50 * €20,- = €1000,-Hamburgers: 100 loafs of bread and 50 kg produces are boughtfor: 100* €0,50 + 50* €15,-= €50,-+ €750,- = €800,- and produces 1000 hamburgers. 900 hamburgers are sold to final consumers: 900 * €2,- = €1800,-Profit for the Hamburger seller: €1800,- – €800,- = €800,-Total value added: = €1900.-

Bread: 100 sold to final consumers: 100 * €1,- = €100,-Meat: 50 kg sold to final consumers: 50 * €20,- = €1000,-Hamburgers: 100 loafs of bread and 50 kg produces are boughtfor: 100* €0,50 + 50* €15,-= €50,-+ €750,- = €800,-

and produces 1000 hamburgers. 900 hamburgers are sold to final consumers: 900 * €2,- = €1800,-

Total value added: = € 3700.-

Bread: 100 sold to final consumers: 100 * €1,- = €100,- 100 sold to Hamburger seller: 100 * €0,50- = € 50,-Meat: 50 kg sold to final consumers: 50 * €20,- = €1000,- 50 kg sold to Hamburger seller 50 * €15,- =€ 750,-Hamburgers: 100 loafs of bread and 50 kg produces 1000 hamburgers. 1000 hamburgers are produced: 1000 * €2,- = €2000,-Total value added: = € 3900.-

Exercise 2.

Suppose an economy’s production function has the property of constant returns to scale. Production is determined by technology and the availability of labour and capital. Individual profit-maximizing firms are competitive. If the marginal product of labour increases, with production and technology remaining constant, one of the following events will have occurred:

a. the number of workers has increased, while the amount of rented capital has increased as well,

b. the number of workers has decreased, while the amount of rented capital has increased,

c. the number of workers has increased, while the amount of rented capital has decreased,

d. the number of workers has decreased, while the amount of rented capital has decreased as well.

Answer

b

Exercise 3.

Currently, governments all over the EU are cutting down on their purchases. If you consider the EU as a closed economy with flexible prices (classical model) this will lead to:

a. a lower rate of interest and a lower total output, b. a lower rate of interest and a constant total output,c. a higher interest rate and a constant total output,d. a higher rate of interest and a higher total output..

Answer

b

Exercise 4.

According to the Fisher equation, which of the following is true?

a. If inflation is higher than the real interest rate, the nominal interest rate must be negative

b. If the nominal interest rate is higher than inflation, then the real interest rate must be positive.

c. If the real interest rate is higher than the nominal interest rate, we must be witnessing rapid price increases.

d. If the real interest rate equals the inflation rate, the nominal interest rate must be zero.

Answer

b

Exercise 5.

According to the quantity equation it holds that MxV=PxY, where M is money supply, V is the constant income velocity of money, P is the price of a typical transaction and Y, total output of the economy. In the classical theory Y is determined by the availability of capital and labour in the economy and the existing technology. Suppose that due to (exogenous) innovation in technology total output grows by 2% and the rate of inflation is 1%. The increase in the money supply equals:

a. 0%, b. 1%, c. 2%, d. 3%.

Answer

d

Exercise 6.

The real exchange rate is the relative price of the goods of two countries, say a small-open domestic country H and a foreign country F. The equilibrium real exchange rate equates the supply of domestic currency available from the net capital outflow and the demand for domestic currency by foreigners buying net exports from H. Consider the case of flexible prices. Suppose the real exchange rate of country H decreases. Which of the following events can explain this decrease?

a. A rise in consumer confidence about the future induces consumers in country H to consume more.

b. An increase in the world interest rate.

c. Expansionary fiscal policy in country H. d. The introduction of protectionist trade policies in country H.

Answer

The equilibrium real exchange rate ε is given by the intersection of the net-exports schedule and the vertical S-I=line (figure 5-9).If savings decrease (option a), the S-I-line shifts to the left and ε increases. An increase in the world interest rate, decreases investment and so the S-I-line shifts to the right and ε increases. Expansionary fiscal policy in country H has the same effects as a decrease in savings and so ε increases. Protectionist trade policies in country H shifts the net-exports schedule outward and, therefore increases ε (Figure 5-13).

b

Exercise 7.

In many countries unemployment insurance programs have been introduced in the past. Typically, under this program unemployed workers are eligible for receiving an unemployment benefit equal to a fraction of their wage over a certain period. One of the following possible effects of the introduction unemployment insurance (UI) will not increase the natural rate of unemployment.

a. UI reduces workers’ uncertainty over their income.b. UI reduces the rate of job finding.c. UI raises the rate of job separation.d. UI makes it less likely that workers seek jobs with stable employment

prospects.

Answer

a

Exercise 8.

Suppose goods are produced using the Cobb-Douglas production function Y=AK ۫αL1-α where initially A=2, K=9 and α=0.5. Labour supply equals 50. Suppose P=2 and the nominal minimum wage equals 1. Now suppose a new production process is invented, such that less labour is needed to produce a given output and this is reflected by A rising with 0.5 to 2.5. How will this affect structural unemployment?

a. Structural unemployment rises.b. Structural unemployment is unaffected.c. Structural unemployment falls but remains positive.d. Structural unemployment falls to zero.

Answer

d

by the following

MPL=1.5AL-0.5=0.5=W/P L=(3A)2

For A=2: L=36 positive unemployment

For A=2.5: L=56.25 no unemployment

Exercise 9.

Aggregate demand (AD) is the relationship between the quantity of output demanded and the aggregate price level. The AD-curve, for a given money supply and a given fiscal policy, slopes downward. Consider a closed economy where prices are sticky in the short run. Starting from long-run equilibrium, an increase in aggregate demand, for example induced by an increase in the money supply, will:

a. increase the level of output in the short run, lower the price level in the long run, but will leave the long equilibrium output level unaffected,

b. increase the level of output in the short run and in the long run,c. have no short run effects and in the long run will only have an effect on the

price level, d. increase the level of output in the short run, increase the price level in the long

run, but will leave the long equilibrium output level unaffected.

Answer

d (see Figure 9-11).

Exercise 10.

An adverse supply shock such as the sudden reduction of oil supply in the 1970s leads to an upward shift of the short run aggregate supply (AS) curve. Starting from long-run equilibrium and with a given and unchanged AD-curve (see previous exercise), a given money supply and a given fiscal policy, this supply shock will

a. in the short run lead to a rising price level and falling output; in the long run prices and output are back at the their pre shock price and output level,

b. in the short run lead to falling output with a constant price level; in the long run output is back at the pre shock output but the price level has fallen,

c. in the long run lead to a higher price level without any output effects, d. in the long run lead to a permanently lower output at a higher price level.

Answer

a

Exercise 11.

Consider the Keynesian-cross model of a closed economy. Take planned investment as a negative function of the rate of interest. Consumption is a linear function of disposable income. Suppose that the rate of interest decreases. The effect is that equilibrium income will increase by

a. less than the increase of investment,b. exactly the increase of investment, c. more than the increase of investment, d. an arbitrary amount, depending on the marginal propensity to consume.

Answer

c

Exercise 12.

Consumption and investment are two major components of GDP. Which of the following statements about the behaviour of consumption and investment over the business cycle is correct?

a. Both growth in consumption and investment decline in recessions, and over the business cycle, investment is more volatile than consumption and GDP.

b. Both growth in consumption and investment decline in recessions, and over the business cycle, investment is less volatile than consumption and GDP.

c. In recessions, growth in consumption declines, growth in investment increases and over the business cycle, investment is more volatile than consumption and GDP.

d. In recessions, growth in consumption declines, growth in investment increases and over the business cycle, investment is less volatile than consumption and GDP.

Answer

a

Exercise 13.

Consider a closed economy, in the framework of the IS-LM model with sticky prices. Suppose that investment depends on the ex ante real interest rate, but money demand depends on the ex ante nominal interest rate. Starting from an equilibrium where no one expects

inflation, suppose that everyone suddenly expects that the price will fall in the future. This change in expectations leads to

a. a decrease in the nominal interest rate by less than the expected deflation rate and a decrease in national income,

b. a decrease in the nominal interest rate by more than the expected deflation rate and a decrease in national income,

c. a decrease in the nominal interest rate by less than the expected deflation rate and an increase in national income,

d. an increase in the nominal interest rate by more than the expected deflation rate and an increase in national income.

Answer

Changes in expected inflation shift the IS-curve as investment is a function of inflation expectations, but not the LM-curve as money demand depends on the nominal and not the real interest rate. An expected deflation increases the real interest rate and so investment will be lower for any given nominal interest rate, so that the IS-curve shifts inward (Figure 11-8).

a

Exercise 14.

Consider the IS-LM framework. If investment becomes more sensitive to the interest rate, which of the following is true?

a. The IS curve becomes less steep.b. The IS curve becomes steeper.c. The LM curve becomes less steep.d. The LM curve becomes steeper.

Answer

a

Exercise 15 .

The IS-LM-model is designed to explain the economy in the short run. In the long run the economy adjusts so that the economy is at the natural level of output. If the output in the short run falls short of the natural output level, the adjustment is achieved by

a. shifts of the IS-curve to the right and a downward shift of the short-run aggregate supply curve,

b. shifts of the LM-curve to the right and a downward shift of the short-run aggregate supply curve,

c. shifts of the IS-curve to the right and a fall in the price level,d. shifts of the LM-curve to the right and an upward downward shift of the

aggregate demand curve.Answer

b

Exercise 16.

Consider the IS-LM model of a closed economy. The IS-curve is downward sloping and the LM curve is upward sloping. Suppose, the government raises taxes, but the central bank wants to hold income constant after the fiscal policy has taken effect. One of the following statements on the form and effects of the central bank policy is true.

a. The central bank decreases the money supply and the interest rate decreases. b. The central bank decreases the money supply and the interest rate increases. c. The central bank expands the money supply and the interest rate decreases. d. The central bank expands the money supply and the interest rate increases.

Answer

c

Exercise 17.

In the Mundell-Fleming model of a small open economy with perfect capital mobility suppose an exogenous decrease in the demand for money occurs. What happens in the short run under fixed and floating nominal exchange rates to equilibrium income Y?

a. Under floating rates Y will rise, under fixed rates Y will not change.b. Under floating rates Y will not change, under fixed rates Y will rise. c. Under both fixed and floating rates, Y will rise.d. Under both fixed and floating rates, Y will not change.

Answer

In a closed economy the exogenous decrease in money demand would imply a shift of the LM-curve to the right. In an open economy the vertical LM-curve shifts to the right as well. As a result under a floating exchange rate national income will increase and the exchange rate will decrease (Figure 12-5), but under a fixed exchange rate intervention by the Central Bank will restore the initial exchange rate and, therefore, national income as well.

a

Exercise 18.

Suppose that in the short run prices are sticky and in the long run they are flexible. The nominal exchange rate is defined as foreign currency per unit of domestic currency. Which of the following statements is correct?

a. In the short run, if the nominal exchange rate increases by a particular percentage, the real exchange rate must have increased by the same percentage.

b. In the long run, if the nominal exchange rate increases by a particular percentage, the real exchange rate must have increased by the same percentage.

c. Keeping the real exchange rate and foreign price level constant, increases in the domestic price level will lead to increases in the nominal exchange rate.

d. Keeping the real exchange rate constant, equal percentage increases in the domestic and foreign price levels will lead to an increase in the nominal exchange rate.

a (the trick here is that in the short run, prices are sticky, slide 5 of lecture 7 points this out)

Exercise 19.

In the Mundell-Fleming model of a small open economy with perfect capital mobility suppose that the home country operates a fixed exchange rate. Moreover, everything else remaining unchanged, investments in the home country become less risky. As a consequence, the risk premium of making loans to the home country falls. For the home country the effect of the decreasing risk premium will be that

a. the foreign-currency reserves will decrease and national income will fall,b. the foreign-currency reserves will increase and national income will fall,c. the foreign-currency reserves will decrease and national income will remain

constant,d. the foreign-currency reserves will increase and national income will increase.

Answer

In an open economy a decrease in the risk premium shifts the LM-curve shifts to the left and the IS curve to the right. As a result under a floating exchange rate national income will decrease and the exchange rate will increase. However, as we assume a fixed exchange rate the Central Bank will buy foreign currency in exchange for home currency, so that foreign-currency reserves will increase. Moreover, the LM-curve will shift more to the right as the initial shift to the left of the LM-cruve so that national income will increase.

d

Exercise 20.

In the Mundell-Fleming model of a small open economy with perfect capital mobility suppose that the country has a floating exchange rate and an equilibrium output below its natural level. Suppose that over time low demand causes the price level to fall. During this process of falling prices the following effects occur.

a. The LM curve shifts to the left and the real exchange rate depreciates.b. The LM curve shifts to the right and the real exchange rate depreciates.c. The LM curve shifts to the left and the real exchange rate appreciates.d. The LM curve shifts to the right and the real exchange rate appreciates.

Answer

This is the case described by Figure 12-14.Prices have to fall so that the LM-curve shifts to the right and the real exchange rate depreciates.

b

Answers versionExercise A B C

1 b b b2 b d d3 b d d4 b d d5 d d d6 b c c7 a c c8 d b b9 d b b

10 a b b11 c c d12 a a c13 a a b14 a a c15 b b a16 c c a17 a a c18 a a d19 d d a20 b b d

Open question 1.

Suppose that we find ourselves in a long-run equilibrium and the government implements a fiscal expansion (G rises). Assume initially that the classical model applies (flexible prices, closed economy) where consumption is determined by disposable income and investment is a function of the real interest rate.

a. Explain which mechanism takes care of equilibrium after the change in policy. In particular explain which price(s) change(s) after the shock to restore equilibrium. Moreover, discuss which of the following macroeconomic variables remain constant: output, consumption, investment, saving. Motivate your answer. (Notice that in this open question you are not asked to give calculations or to draw graphs, you only need to discuss in words how the economy reacts to a change in policy)

Answer: If G rises, national saving decreases. As national output is given by the supply of capital and labour, and consumption is fixed by national output and taxes, the only remaining variable that can change is investment. Investment is a function of the interest rate. The change in investment takes place in the loanable funds market where the decrease in saving lead to an increase in the interest rate. The decrease in investment obviously has to be as large as the decrease in saving.

Assume next that we are in the case of the classical model of an open economy (flexible prices, closed economy).

b. Answer the same question as under a. 

Answer: The same starting position as in the closed economy occurs. If G rises, national saving decreases. National output is given by the supply of capital and labour, and consumption is fixed by national output and taxes. Investment is a function of the interest rate as before, but in the (small) open economy the interest rate is given by the global loanable funds market and so has to be taken as given. As a result, investment has to be taken as given as well. However, saving and investment do not have to be equal to each other in an open economy. In particular, if S-I>0 there will be a net outflow of capital equal to the trade balance. A decrease in saving therefore leads to a decrease in the trade balance. The equality of S-I and trade balance is maintained by the real exchange rate that will adapt following a change in S or I. In particular, the decrease in saving will lead to a rise of the exchange rate.

You might have concluded from question b that in the context of an open economy the change in investment will not be equal to the change in investment in a closed economy (question a).

c. Give an explanation of these different effects on investment of the impulse in G in a closed economy (question a), versus an open economy (question b) with flexible prices. 

Answer: Investment is a function of the interest rate in both the open and the closed economy. However, in the open economy the interest rate is given by the global loanable funds market and so is given to the (small) open economy, or reacts by less than in the case of a closed economy if the economy is large. In a closed economy the rate of interest is set such that investment and saving are always equal.

Assume next that we are in the case of a closed economy with sticky prices so that the IS-LM model for the short run applies.

d. Answer the same question as under a. 

Answer: In the short run equilibrium in the goods market is described by the IS-curve. If G rises the IS-curve shifts outward, leading to an increase in short-run national income. However, the increase in national income also implies a rise in the demand for money, leading to an increasing interest rate and thus to a decrease in investment. The decrease in saving leads to a decrease in investment, just as in the classical model. However, the decrease in investment does not have to be equal to the initial decrease in saving as national income will change. In particular, national income increases following the rise in G, so that the investment will decrease by less than the initial decrease in saving.

You might have concluded from question d that in the context of the IS-LM model of a closed economy the change in investment will not be equal to the initial change in national saving. In the case of a closed economy with flexible price (question a), however, the change in investment is always equal to the initial change in saving.

e. Give an explanation of these different effects on investment of the impulse in G in the context of a closed economy with flexible versus sticky prices. 

Answer: In the short run an impulse in G (leading to a decrease in S) will lead to an increase in national income with sticky prices. Investment will react only if a change in national income affects the money demand (so that the rate of interest rate changes). With flexible prices the economy is in long-run equilibrium and so by definition the change in saving has to equal the change in investment.

Open question 2.

Use the Mundell-Fleming model to answer the following questions: Suppose that we find ourselves in a long-run equilibrium and the government implements a fiscal expansion (G rises)

a. Draw the IS* and LM* curves and show how these curves shift as a response to this shock.

b. What would happen to equilibrium income, the nominal exchange rate and trade balance (NX) in the short run as a response to this shocks if nominal exchange rates were floating?

As one can see from the figure in (a): Y does not change, e increases. By the increase in e, NX falls

Y eY1 e1 1 *

LM

1 *IS

2 *IS

e2

c. What would happen to equilibrium income, the nominal exchange rate and trade balance (NX) as the economy moves from the short to the long run if nominal exchange rates were floating?

As Y has not changed in the short run, income is still at the long-run equilibrium, so we see no changes in prices, Y, e or NX.

d. What would happen to equilibrium income, the nominal exchange rate and trade balance (NX) in the short run as a response to this shock if nominal exchange rates were fixed?

If the exchange rate were fixed, e and thus NX will not change. Y will increase

e. Explain, in words, the mechanism behind the effects described in (d). So explain by economic reasoning why the increase in G has the effect on equilibrium income, the nominal exchange rate and prices you describe.

The increase in government expenditures reduces domestic savings. This reduction in the supply of savings (funds available for investment) puts upward pressure on the interest rate

Higher interest rates cause foreign funds to flow in the economy, increasing the supply of funds available for investment, such that domestic interest rate = world interest rate

This inflow of funds causes upward pressure on the exchange rate (foreign investors need to trade their $ for €) , as the CB wishes to maintain a fixed exchange rate, it will start buying foreign currency, and selling domestic currency to make sure the exchange rate is unchanged – or, alternative explanation – foreign investors directly trade their $ for € at the CB (this constitutes an increase in the money supply).

The unchanged exchange rate leaves net exports unaffected, and as the interest rate is determined on the world market, the increase in government expenditures increases income.