ECON 322.13334 Intermediate Macroeconomic TheoryHomework 3 Answer Key

Due by Friday, June 7, 2013Please hand in both your scantron and this homework IN CLASS.

Full Score: 25 points

Multiple Choice (There exists one and only one correct choice. Each question is worth 0.5 points. Total score: 30*0.5=15)

1) Which of the following is NOT constant when balanced growth is obtained?A) Y/NA (constant)B) NA (grows at g_A+g_N)C) K/NA (constant)D) all of the aboveE) none of the aboveAnswer: BDiff: 2

2) Assume that an economy experiences both positive population growth and technological progress. Once the economy has achieved balanced growth, we know that the output per effective worker ratio (Y/NA) is (constant)A) growing at a rate of 0.

B) growing at a rate of gA + gN.

C) growing at a rate of gN.

D) growing at a rate of gA.

E) none of the aboveAnswer: ADiff: 2

3) Convergence of output per capita across countries has come fromA) a convergence of saving rates.B) a convergence of the accumulation of capital.C) higher technological progress from the countries that started behind. (see textbook)D) all of the aboveAnswer: CDiff: 1

4) Based on price setting behavior, which of the following will cause an increase in the price level? (use relation P=(1+m)*W/A, also think about the underlying

intuition.)A) a reduction in productivity (P increases)B) an increase in the nominal wage (P increases)C) an increase in the markup (P increases)D) all of the aboveE) none of the aboveAnswer: DDiff: 2

5) For this question, assume that the aggregate production function is represented by Y = AN. Which of the following represents the price setting relation for this economy? (see question (4))A) (1 + m)AB) (1 + m)A/WC) (1 + m)WD) W/AE) none of the aboveAnswer: EDiff: 2

6) Employment will increase as a result of an increase in productivity when which of the following occurs? (recall from Topic 11 that % change in N=% change in Y-% change in A)A) the AS curve shifts upwardB) output growth is more than productivity growthC) productivity growth is more than output growthD) the AD curve shifts to the leftE) none of the aboveAnswer: BDiff: 2

7) Suppose that the nominal interest rate increases while the expected inflation rate rises. Given this information, we know with certainty that the real interest rate (real rate=nominal rate-expected inflation)A) will not change.B) will fall.C) will fall, but only if the increase in the nominal rate is smaller than the increase in expected inflation.D) will fall, but only if the increase in the nominal rate is greater than the increase in expected inflation.E) none of the aboveAnswer: CDiff: 2

8) A consol bond promises to pay $1000 each year, forever, starting next year. If the nominal interest rate is 5%, the present discounted value of this consol is (V=1000/(1+5%)+1000/(1+5%)^2+1000/(1+5%)^3+…)A) $900.00.B) $995.00.C) $2,500.00.D) $20,000.00.E) $25,000.00.Answer: DDiff: 2

9) For a given nominal interest rate, a reduction in expected inflation will cause (real rate=nominal rate-expected inflation)A) a reduction in the real interest rate.B) an increase in the real interest rate.C) an increase in investment.D) an increase in money demand.Answer: BDiff: 2

10) Let: (1) Pt be the price of one unit of a market basket of goods (i.e., a composite

commodity) in year t; (2) Pet+1 be the expected price of one unit of a market basket

of goods in year t+1; (3) πet+1 be the expected rate of inflation between period t and

t+1; and (4) it be the one-year nominal interest rate. Suppose an individual borrows

the equivalent of one unit of a composite commodity today. Given this information, which of the following expressions represents (i.e., is equal to) the real interest rate

(rt)?

A) (1 + it)(Pet+1)/(Pt)

B) (1 + πet+1)/(1 + it)

C) {(1 + πet+1)/(1 + it)} - 1

D) {(1 + it)(Pt)/(Pet+1)} – 1 (see the derivation in Topic 12)

E) none of the aboveAnswer: DDiff: 2

11) Suppose there is an increase in government spending. Such a fiscal policy action will cause (recall that in the medium run, Y_n=C(Y_n-T)+I(Y_n,r_n)+G, where Y_n is independent of G. If G increases, r_n has to increase so as to rebalance the above equation.)A) the natural real interest rate to riseB) the natural real interest rate to fallC) ambiguous effects on the natural real interest rateD) no effect on the natural real interest rateAnswer: ADiff: 2

12) In the IS-LM model, a reduction in expected inflation will cause which of the following? (given any nominal interest rate, the real interest rate increases and the IS curve shifts to the left.)A) a reduction in outputB) a reduction in the nominal interest rateC) an increase in the real interest rateD) all of the aboveE) none of the aboveAnswer: DDiff: 2

13) Assume that the current one-year rate is 5% and the two-year rate is 7%. Given this information, the one-year rate expected one year from now is (recall the term structure of interest rates (or yield curve) from Topic 12.)A) 5%.B) 6%C) 7%D) 9%E) 12%Answer: DDiff: 2

14) A share of stock will pay a dividend of $25 in one year, and will be sold for an expected price of $500 at that time. If the current one-year interest rate is 5%, the current price of the stock will be approximately equal to (V=25/(1+5%)+500/(1+5%).)A) $100.B) $475.C) $500.D) $525.E) none of the aboveAnswer: CDiff: 2

15) Which of the following represents a stock's fundamental value? (see Topic 12.)A) the price the stock would sell at in the midst of a rational bubbleB) the price the stock would sell at if the interest rate were zeroC) the present value of its expected future dividend paymentsD) the simple sum of its future dividend paymentsE) none of the aboveAnswer: CDiff: 1

16) An expected tax cut will tend to cause (since the tax cut is fully anticipated, stock prices remain unchanged)A) an increase in stock prices.B) a reduction in stock prices.C) no change in stock prices.D) an ambiguous effect on stock prices.Answer: CDiff: 2

17) Suppose that financial market participants now expect a future tax cut and that the yield curve is initially upward sloping. Given this information, we would expect which of the following to occur? (expectation about future tax cut implies higher expected future interest rate anticipated by the financial markets, making the yield curve even steeper. Note here the IS curve shifts to the right.)A) the yield curve will become steeperB) the yield curve will become flatterC) the yield curve will become horizontalD) the yield curve will become downward slopingAnswer: ADiff: 2

18) A bond has a face value of $10,000, a price of $12,000, and coupon payments of $2000 for two years. The current yield of this bond is (12000=2000/(1+yield)+(2000+10000)/(1+yield)^2 and solve for yield, which is a “constant”.)A) 10%.B) 16.7%.C) 20%.D) 30%.E) none of the aboveAnswer: BDiff: 1

19) Which of the following people–none of whom has any financial or housing wealth–is most likely to be spending all of their current income? (people normally

“smooth” their consumption over time.)A) a low income person expecting continued low income throughout lifeB) a low income person expecting a dramatic rise in income in the future (to avoid a sharp increase in consumption tomorrow, he or she consumes all his or her income today.)C) a high income person expecting continued high income throughout lifeD) a high income person expecting a dramatic drop in income in the futureE) a high income person expecting to retire soon, and live for a long time afterwardAnswer: BDiff: 1

20) A painting is currently worth $100,000, and is expected to maintain its real value for three years. The real interest rate is expected to remain constant at 10%. What is the present value of the painting's expected price at the end of the third year? (V=100000/(1+10%)^3)A) $75,131B) $88,899C) $96,153D) $100,000E) $70,000Answer: BDiff: 2

21) Suppose current sales increase by $100 million. Investment theory suggests that current investment must (increase, but by how much is unknown)A) decrease exactly by $100 million.B) increase by exactly $100 million.C) increase by less than $100 million.D) decrease, but by less than $100 million.E) none of the aboveAnswer: EDiff: 2

22) Human wealth is a function (i.e., affected by changes in) of which of the following variables? (see Topic 14)A) future expected incomeB) future expected taxesC) current interest ratesD) all of the aboveE) none of the aboveAnswer: DDiff: 2

23) Suppose there is an increase in profitability. This suggests that

A) firms have increased their expectations of future profits.B) the real interest rate has increased. (profitability decreases)C) the rate of depreciation has increased. (profitability decreases)D) all of the aboveAnswer: ADiff: 2

24) Investment depends on (see Topic 14 equation (4))A) current profit.B) present value of of expected future profits.C) user cost of capital. (real rate+depreciation rate)D) all of aboveE) both A and BAnswer: DDiff: 2

25) A change in which of the following will have a direct effect on the amount of money individuals wish to hold in the current period? (recall that the LM curve does not change even when we take expectations into account. What enters the LM relation is the nominal rate rather than real rate. Expectations about the future do not affect current decision on money holding.)A) the current nominal interest rateB) the current real interest rateC) the expected future nominal interest rateD) the expected future real interest rateE) all of the aboveAnswer: ADiff: 2

26) Adaptive expectations assumes that individualsA) can accurately predict the future. (this is what perfect foresight means)B) base predictions on random events (i.e., animal spirits).C) form their predictions of macroeconomic variables randomly.D) use all available information in predicting the future. (rational expectations)E) none of the aboveAnswer: EDiff: 1

27) Suppose there is an increase in expected future output. This will cause which of the following to occur? (IS curve shifts to the right. See Topic 15 Figure 1-1 for a summary.)A) the IS curve to shift left in the current periodB) the IS curve to shift right in the current periodC) the LM curve to shift up in the current period

D) the LM curve to shift down in the current periodAnswer: BDiff: 2

28) Assume individuals consider only the short run effects of changes in future macro variables when forming expectations of future output and future interest rates. Suppose individuals expect future taxes to decrease. Given this information, individuals will expect (IS curve shifts to the right, leading to an increase in current interest rate and an increase in current output. Observing the higher interest rate and output, people would expected higher future interest rate and future output.)A) an increase in the expected future interest rate and no change in expected future output.B) an increase in the expected future interest rate and an increase in expected future output.C) an increase in the expected future interest rate and a reduction in expected future output.D) an increase in the expected future interest rate and an ambiguous effect on expected future output.Answer: BDiff: 2

29) Assume individuals consider only the short run effects of changes in future macro variables when forming expectations of future output and future interest rates. Suppose individuals expect the central bank to pursue a monetary expansion in the future. Given this information, we know with certainty that (this implies higher expected future output+lower expected future interest rate, shifting the IS curve to the right in current period.)A) current output and the current interest rate will both increase.B) current output will decrease.C) the current interest rate will decrease.D) the current output effects are ambiguous.Answer: ADiff: 2

30) Suppose there is a reduction in expected future output. This will cause which of the following to occur? (see Topic 15 Figure 1-1 again.)A) the IS curve to shift left in the current periodB) the IS curve to shift right in the current periodC) the LM curve to shift up in the current periodD) the LM curve to shift down in the current periodAnswer: ADiff: 2

Short Essay (Each question is worth 2 points. Total score: 5*2=10)

1) There are some concerns that technological progress can lead to an increase in unemployment. Explain the two related but separate dimensions of technological progress.Answer: First, TP allows for a greater quantity of goods produced with the same inputs. Second, TP results in the production of new goods and the disappearance of old ones.

2) First, explain what the nominal interest rate represents. Second, explain what the real interest rate represents.Answer: The following expressions, where i the nominal interest rate, represents the amount of dollars one must repay in the future in exchange for borrowing one dollar today: 1 + i. Therefore, i represents the cost of borrowing dollars in terms of dollars. The following expressions, where r the real interest rate, represents the amount of goods one must repay in the future in exchange for borrowing one unit of a good today: 1 + r. Therefore, r represents the cost of borrowing goods in terms of goods.

3) Explain what the term structure of interest rates represents.Answer: The term structure of interest rates illustrates the relationship between the yield to maturity on bonds (with the same risk characteristics) and maturity.

4) Explain what decisions and calculations a very foresighted consumer must make to determine her consumption decisions in any period.Answer: An individual would have to calculate her financial wealth, housing wealth, and human wealth. Of course, this implies that the individual would have to form expectations of future interest rates, income, and taxes for the remainder of her working life. Once done, the individual would then calculate the amount of consumption per year she preferred given this total wealth. If in the current period, current disposable income is less than this level of C, she would borrow the difference.

5) Explain why the new IS curve that takes into account expectations is likely steeper than the original IS curve that ignored expectations.Answer: There are several factors that determine the size of the slope of the IS curve: the multiplier and the interest rate sensitivity of investment. The multiplier is now smaller because changes in current Y do not have as large an effect on current C. So, the mpc is smaller, the multiplier smaller, and the IS curve steeper. Also, a drop in the interest rate that is now temporary will not cause I to increase as much so the IS curve will be steeper. In the original IS-LM model, changes in Y and the interest rate were implicitly assumed permanent.