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MIT 14 02 - Quiz 1 Solutions

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1 14.02 Quiz 1 Solutions Fall 2004 Multiple-Choice Questions (30/100 points) Please, circle the correct answer for each of the following 10 multiple-choice questions. For each question, only one of the answers is correct. Each question counts 3/100 points. 1) Consider two economies that are identical, with the exception that one has a high marginal propensity to consume (MPC) and one has a low MPC. If the money supply is increased by the same amount in each economy, the high MPC economy will experience A) A larger increase in output and a smaller decrease in the interest rate. B) A smaller increase in output and a smaller decrease in the interest rate. C) A larger increase in output and a larger decrease in the interest rate. D) A smaller increase in output and a larger decrease in the interest rate. E) None of the above. Answer: A). There is a flatter IS curve in the high MPC economy. 2) Which of the following policy options would simultaneously increase interest rates and decrease output? A) The Federal Reserve Board sells bonds through open market operations. B) The federal government increases its defense purchases. C) The Federal Reserve Board expands the money supply. D) The federal government increases the tax rate. E) Actions described in both A) and D). Answer A). Selling bonds reduces the money supply in the economy. The lower money supply results in a higher interest rate and lower output level (i.e., an upward shift in the IS curve for high MPC economy IS curve for low MPC economy Original LM LM after increase in MS i Y2 LM curve); investment unambiguously declines. Option C always increases investment, while options B and D have uncertain implications for investment. 3) Suppose an economy is running a government budget deficit. Assume that C = c0 + c1(Y-T). Which one of the following will cause this deficit to become larger? A) Expansionary monetary policy. B) An increase in exports. C) A decrease in equilibrium GDP. D) A decrease in taxes. E) A decrease in government purchases. Answer: D). A government budget deficit means that T-G<0. Therefore, lower taxes will imply lower revenues for the government and a higher government budget deficit. 4) If the interest rate is higher in the US than in the UK, then A) The dollar is expected to appreciate with respect to the pound. B) The pound is expected to appreciate with respect to the dollar. C) The interest rate in the US is expected to increase. D) The interest rate in the US is expected to decrease. E) Uncertain. Answer: B). Uncovered interest rate parity implies that: tetUKUStetUKUSEEiiEEii11)1()1()1()1(++=++⇔+=+ . So if )1()1(UKUSii +>+ , then tetEE1+ has to be greater than 1. So, we expect the dollar to depreciate, or the pound to appreciate with respect to the dollar. 5) Consider a small economy where the total population is 10,000. The size of the labor force is 8,000, while the number of people employed is 7,000. What is the unemployment rate in this economy? A) 10% B) 12.5% C) 20% D) 30% E) 37.5% Answer: B). Given the labor force of 8,000 people, 1000 people are unemployed. Thus the unemployment rate is (1,000/8,000)*100 = 12.5%. The number of people in the entire population is irrelevant for this question.3 6) Assume that C = c0 + c1(Y-T). Suppose that taxes increase and money supply increases in such a way that output is constant in equilibrium (assume c1<1). These policy changes will produce A) An increase in investment and a decrease in private consumption. B) An increase in investment and a decrease in government spending. C) An increase in investment and an increase in private saving. D) A decrease in investment and an increase in public saving. E) Uncertain. Answer: A). In equilibrium, Y is constant and i decreases (IS moves to the left and LM shifts down). Recall that investment, given by I(i,Y), depends negatively on the interest rate. So, as the interest rate decreases, investment increases. Also, we know that: C=c0+ c1(Y-T), and private saving is given by Y-T-C = (1- c1)(Y-T)- c0. Therefore, because T increases, private consumption and private saving both decrease. (G is constant, T-G increases.) So, B) is incorrect because government spending is constant; C) is incorrect because private saving decreases; and D) is incorrect because investment increases and public saving decreases. 7) In 2000, the nominal GDP growth of a country was 8% and the real GDP growth was 4%. What was the rate of inflation for this country? A) - 4% B) 2% C) 4% D) 8% E) 12% Answer: C). Nominal GDP growth = real GDP growth + inflation. Thus, inflation = 8% - 4% = 4%. 8) Suppose the United States has no exports. The only imports of the US are 200 Mercedes Benz cars worth US$50,000 each from Germany. Germany has no imports and only exports those 200 cars to the US. Neither the US nor Germany trade with any other countries or engage in any transactions with other countries. Which one of the following statements must be true? A) The US has a capital account deficit. B) Germany has a current account deficit. C) Germans are buying US assets. D) The exchange rate of US Dollars per Euros (the currency in Germany) is bigger than 1. E) None of the above. Answer: C). The US has a current account deficit. In order to finance the current account deficit, they need to have a capital account surplus. Since the US doesn’t engage in any4 financial transactions with other countries, having a capital account surplus implies that Germans are buying US assets. In fact, if there is no statistical discrepancy, Germany needs to buy $100 million more in US assets than the US is buying in German assets. These $100 million are like a loan from Germany to the US, and the US uses this money to buy the Mercedes Benzes. 9) Suppose that investment (I) in the goods market is not responsive to the interest rate (that is, I does not depend on the interest rate at all). Then A) The IS curve is a vertical line and monetary policy is very effective in raising output. B) The IS curve is a horizontal line and monetary policy is very effective in raising output. C) The IS curve is a vertical line and monetary policy does not affect output in the IS-LM model. D) The IS curve is a horizontal line and monetary policy does not affect output in the IS-LM model. E) The IS curve still has a negative slope, but monetary policy monetary policy does not affect output in the


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MIT 14 02 - Quiz 1 Solutions

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