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Date Created: 02/14/14
Name Last name first name SID GSI Econ 100B Macroeconomic Analysis Professor Steven Wood Fall 201 1 Exam 3 ANSWERS Please sign the following oath The answers on this test are entirely my own work I neither gave nor received any aid while taking this test I will not discuss the questions on this test until after 230 pm on December 13 2011 Signature Any exam turned in without a signature will be assigned a grade of zero Exam Instructions 1 When drawing diagrams clearly and accurately label all axis lines curves and equilibrium points 2 Explanations should be written in pencil or black Legibility is a virtue practice good penmanship 3 Explanations should be succinct and to the point make use of bullet points and common mnemonics 4 If you have a question go to the aisle and ask one of the GSIS 5 If you need to redraw a diagram or need more room to write your answers use pages 2 11 andor 12 6 The exam ends promptly at 230 pm When time is called STOP writing immediately CLOSE your exam packet and tum it in You WILL BE PENALIZED if you continue to write past the official end of the exam Do NOT open this test until instructed to do so Exam 3 Fall 2011 19 A Multiple Choice Questions 30 points Circle the letter corresponding to the best answer 3 points each 1 Suppose you have money to lend but will do so only if you are compensated for the risk of default If you set a high interest rate on your loan a likely consequence is that a You will be prosecuted for predatory lending b Competition from other lenders will force you to lower your interest rate Safe borrowers will look elsewhere and only risky borrowers will find your terms attractive d Risky borrowers will look elsewhere and only safe borrowers will find your terms attractive 2 When property rights are well de ned and inexpensive to enforce a Little or no collateral is needed to secure a loan b Banks become less dominant among intermediaries c Poor borrowers are at no disadvantage relative to wealthy borrowers Collateral is an ef cient solution to asymmetric information problems 3 Suppose that a country experiences a permanent increase in its in ation rate For the country s nominal exchange rate this will result in a A depreciation in both the shortrun and the longrun b An appreciation in both the shortrun and the longrun c A depreciation in the shortrun but an appreciation in the longrun An appreciation in the shortrun but a depreciation in the longrun 4 Under a xed exchange rate system if an appreciation of a country39s currency develops the monetary authorities must intervene by a Selling foreign exchange Buying foreign exchange c Reducing the foreign interest rate d Buying and selling the domestic currency 5 One of the chief advantages of fixing an exchange rate is that It can be an effective means of reducing in ation b The currency can be used to promote export growth c A country will always be able to pursue an independent monetary policy d It allows the monetary authorities to actively respond to uctuations in either in ation or unemployment Exam 3 Fall 2011 29 6 The primary effect of tax smoothing is to a Reduce income inequality b Keep the tax wedge from shrinking c Avoid uctuations in the government deficittoGDP ratio Shift the debt burden from current taxpayers onto future taxpayers 7 Seignorage is also known as an in ation tax because Money balances lose value in real terms b In ation can be caused by rising energy costs c Budget deficits increase in the size of the national debt d Higher interest rates can crowdout investment spending 8 In the generalized equation for the shortrun aggregate supply curve 712 are yY YP p an improvement in the credibility of monetary policy is represented by a change in Expected in ation ate b The supply shock term p c The magnitude of the output gap Y YP d The sensitivity of in ation to the output gap 7 9 In ation targeting makes more sense than unemployment targeting because a Monetary policies affect in ation but not unemployment Expected unemployment is not a key determinant of the unemployment rate c Most voters and most politicians are more concemed about in ation than unemployment d A commitment to avoid high in ation is inherently more credible than a commitment to avoid high unemployment 10 Which of the following is NOT an aspect of in ation targeting 21 Increased transparency of monetary policy b Increased accountability of the central bank An institutional commitment to a dual mandate d The public armouncement of mediumterm numerical in ation targets Exam 3 Fall 2011 39 B Analytical Questions 70 points Answer BOTH of the following questions based on the standard models developed in class The information in the Various parts of the questions is sequential and cumulative 1 Open Economy AD AS Model with a Foreign Exchange Market 35 points In the early 1990s France and Germany were major trading partners with exible exchange rates Both economies were initially in general equilibrium and could be characterized with sticky wages and prices a Based only on this information use an open economy AD AS model diagram for each country as well as a diagram of the foreign exchange market for the Germany mark to clearly and accurately show each economy s initial equilibrium and equilibrium in the foreign exchange market These diagrams should be drawn in BLACK Germany LRAS France LRAS SRAS1 4 T nl 73950 73952 AD AD0 AD1 AD2 E1 H E1E0 DMI DM0 DM2 EmmGWMmD M 0 M9 b The following year the Bundesbar1k Germany s central bank conducted a contractionary monetary policy because Germany s in ation rate was judged to be too high On your diagrams above clearly and accurately show what happens to economic output and in ation in each country as well as to the German mark exchange rate These changes should be drawn in F c Provide an economic explanation of what you have drawn in your diagrams above Be sure to discuss what happens to economic output and in ation in each country as well as to the German mark exchange rate and explain why these changes take place When the German central bank conducts a contractionary monetary policy it will increase the German real interest rate for any level of in ation This will cause the German AD curve to shift to the left from AD0 to AD1 resulting in a lower level of economic output at Y1 lt YP and lower in ation at 211 lt no A higher German real interest rate would make the return on German markdenominated assets more attractive to investors and the return on French francdenominated assets less attractive to investors increasing the demand for German markdenominated assets and shifting the demand curve for Germanmark denominated assets to the right from DM0 to DM1 This would cause an increase in the foreign exchange value of the German mark ie the German mark has appreciated from E0 to E1 Because this appreciation of the German mark was an endogenous event in Germany it has no further effects on the German AD or German SRAS curves However an appreciation of the German mark is also a depreciation of the French franc From France s perspective the increase in the German real interest rate is an exogenous event Consequently the depreciation of the French franc will make French exports less expensive to foreigners and thereby increase the foreign demand for French exports As a result the French AD curve will shift to the right from AD0 to AD1 resulting in a higher level of economic output at Y1 gt YP In addition the depreciation of the French franc will increase the price of French imports causing the SRAS curve to shift up from SRAS0 to SRAS1 resulting in higher in ation at in gt no Exam 3 Fall 2011 59 d Immediately following the German contractionary monetary policy but in the same year France decides to x its exchange rate with Germany at its initial fundamental level a level that France is committed to maintaining On your diagrams above clilrlv and accurate show how this decision would affect economic output and in ation in each country as well as to the German mark exchange rate These changes should be drawn in BLUE e Provide an economic explanation of what you have drawn in your diagrams above Explain exactly what the Banque de France France s central bank must do to maintain this xed exchange rate Be sure to discuss wh21tl121ppens to economic output and in ation in each country as well as to the exchange rate and explain why these changes take place Once France commits to a xed exchange rate with the German mark at its initial fundamental level of E0 the Banque de France will have to supply the excess demand for German markdenominated assets by selling some of its international reserves in exchange for its domestic currency This will reduce the Banque de France s holdings of international reserves and decrease France s domestic money supply The decrease in the French domestic money supply would increase the French real interest rate for any level of in ation A higher French real interest rate would make the return on French francdenominated assets more attractive to investors and the return on German markdenominated assets less attractive to investors reducing the demand for German mark denominated assets and shifting the demand curve for Germanmark denominated assets to the left from DM1 back to DM0 This action will returned the foreign exchange value of the German mark from E1 to E0 The exchange rate has now been xed at E0 Because the French central bank acted immediately to x the exchange rate at its initial fundamental level of E0 the price of French imports did not increase Consequently the French SRAS curve would now be at SRAS2 SRAS0 or have shifted back from SRAS1 to SRAS2 SRAS0 The decrease in the French domestic money supply would also cause the French AD curve to shift to the left from AD1 to AD2 reducing economic output from Y1 to Y2 lt YP and reducing in ation from 21 to 212 Because the decrease in in ation would also cause the French domestic real interest rate to decline endogenously the foreign exchange intervention above would have to account for this effect At the end of the year France will have maintained a xed exchange rate with the German mark at E0 However in order to do so France had to have a higher domestic real interest rate which reduced economic output to below its potential level at Y2 lt YP leaving France with a negative output gap In addition in ation has been reduced to below its initial level at T52 lt T50 In Germany the actions of the Banque de France to xed the exchange rate means that the foreign exchange value of the German mark did not appreciate and therefore there was no reduction in net exports because of a stronger German mark This would cause the German AD curve to shift to the right from AD1 to AD2 increasing German economic output from Y1 to Y2 However because the German real interest rate has increased from the initial contractionary policy economic output is still below its potential level ie Y2 lt YP In addition in ation has been reduced to below its initial level at 212 lt 210 In the nal analysis both Germany and France have higher real interest rates lower levels of economic activity and lower in ation By maintaining a xed exchange rate France is forced to match whatever monetary policy changes that Germany makes Exam 3 Fall 2011 69 2 AD SRAS LRAS Model 35 points Suppose that the economy is initially in general equilibrium that complete Ricardian equivalence holds and that the economy can be characterized by sticky wages and prices 21 Based only on this information use an ADAS model diagram to clearly and accurately show the economy s initial general equilibrium situation This diagram should be drawn in BLACK LRAS TC LRAS1 T f T 73951 T52 T50 Exam 3 Fall 2011 SRAS2 SRAS SRASquot AD0 79 b In the following year the government enacts a contractionary fiscal policy by increasing personal tax rates because of concerns over a rising debttoGDP ratio This results in a sharp reduction in the labor force participation rate On your diagram above clearly and accurately show what happens to economic output and in ation These changes should be drawn in D c Provide an economic explanation of what you have drawn in your diagram above Be sure to discuss what happens to economic output and in ation and explain why these changes take place When complete Ricardian equivalence holds taxpayers perfectly foresee and perfectly compensate for all changes in future tax liabilities Thus while a contractionary scal policy of increasing personal tax rates would increase government saving it would also reduce private saving by exactly the same amount As a result there would be no change in national saving and the AD curve would remain at AD0 The contractionary scal policy would shift the AD curve to the left but an exact compensating change in consumption would shift the AD curve to the right However this increase in personal tax rates caused a sharp reduction in the labor force participation rate resulting in a decrease in the size of the labor force A reduced labor supply would reduce the economy s potential economic output causing the LRAS curve to shift left from LRAS0 to LRAS1 The reduced labor supply would also increase the real wage and therefore the cost of production at any level of economic output causing the SRAS curve to shift up from SRAS0 to SRAS1 As a result of these supplyside changes potential economic output would decline from YP0 to YP1 actual economic output would decline from YP0 to Y1 and in ation would increase from no to 11 Exam 3 Fall 2011 89 d In the following year the central bank begins targeting in ation at the initial in ation rate On your diagram above EIFIV and accurately show what happens to economic output and in ation These changes should be drawn in BLUE e Provide an economic explanation of what you have drawn in your diagram above Be sure to discuss what happens to economic output and in ation and explain why these changes take place Because there is now a positive output gap actual in ation is greater than expected in ation This will cause expected in ation to increase shifting the SRAS curve up from SRAS1 to SRAS2 SRAS2 will intersect the LRAS curve LRAS1 at YP1 and n1 If the central bank now begins to target in ation at its initial level of no it will have to engage in a contractionary monetary policy increasing the real interest rate for any level of in ation This will cause the AD curve to shift to the left from ADo to AD2 where the intersection of AD2 and SRAS2 equals no As a result of this contractionary monetary policy economic output is now below its potential level ie Y2 lt YP1 and in ation is at its targeted level of no In subsequent years in order to maintain in ation at its target level of no the central bank will have to adjust its monetary policy to account for the changes in expected in ation that result because actual in ation is less than expected in ation due to a negative output gap Exam 3 Fall 2011 99
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