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MIT 14 02 - Study Notes

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14.02 Principles of Macroeconomics Quiz #3, Answers Name: _________________________________________ Signature: _________________________________________ Date : _________________________________________ Read all questions carefully and completely before beginning the exam. There are four sections and ten pages – make sure you do them all. The quiz has a total of 100 points. Show your work on all questions if you want to receive partial credit. If your answer involves a graph, please label all curves and axes clearly; if we can’t read the graph you will loose points on your answer. No notes, calculators or books may be used during the quiz. You have 2 hours to complete the quiz. There are no blue books, you must respond in the space allotted to each question.Part I (Short Questions, 2 points each, 10 points total) 1. What is an automatic stabilizer? It is something that diminishes automatically the volatility of the economy. It diminishes the multiplier so that shocks do not deviate the economy very far from normal growth levels and hence from the natural level of unemployment. This is the case of progressive tax schemes or unemployment benefit systems 2. What is the money multiplier? The increase in the money supply resulting from a one-dollar increase in central bank money. This proportion is equal to (c+θ(1-c))-1 where c is the proportion of money held in currency by individuals and θ is the ratio of reserves to deposits held by banks. 3. What is Walras’ Law? What role does it play in the way we construct the IS-LM? The finding that if all but one of the conditions for general market clearing hold, then the final one must hold as well; this result follow because households’ budget constraints must be satisfied. When we construct the IS-LM model we assume an economy with a bonds market, a money market and a goods market. The IS represents equilibrium in the goods market. The LM represents equilibrium in the money market. If household’s budget constraints hold, then we know that the bonds market must clear and the IS-LM will represent macroeconomic equilibrium. 4. What is Okun’s Law? How do we incorporate it into the general model of inflation and unemployment? Okun’s law is the observed relation between GDP growth and the change in the unemployment rate. We use Okun’s law to close the macroeconomic model composed of the Phillips curve (relating unemployment and inflation) and the aggregate demand (relates gdp growth with inflation). 5. What is the Fischer hypothesis? The proposition that in the medium run an increase in inflation is reflected in an identical increase in the nominal interest, leaving the real interest rate unchanged.Part II (True-False-Uncertain, 5 points each, 40 point total) Explain your answer, use graphs if possible and show calculations if necessary. 1. Through a typical business cycle, we expect that each 1% increase in GDP will be associated with a 1% change in business investment and 1% change in private consumption. False. Both investment and consumption move together during the business cycle, but historically investment has been much more volatile than consumption. However, the level of investment is much smaller than the level of consumption, so that it turns out that both investment and consumption contribute roughly equally to fluctuations in output over time. 2. In the medium run, a permanent monetary expansion coupled with a permanent fiscal expansion causes both output and the interest rate to increase for sure. False. Adjustment i P Initial LM expansion Initial IS expansion A Back to Natural Output B .. Y Initial AD Expansion Adjustment of the AS Y In the medium run a monetary expansion and a fiscal expansion will have no effect on output. Output will return to the natural level once the economy adjusts its price expectations. The interest rate, on the other hand, should increase in the medium run. Since the economy has to return to the same level of output with greater government demand, investment must fall. The only way that investment can fall is if the interest rate increases permanently. In the graph, once government spending has increased the economy (originally at A) can only get back to natural output at a point like B.3. An increase in the budget deficit inevitably leads to a reduction in private investment, regardless of whether the economy is open or closed. False An economy that has a money demand that is very sensitive to the interest rate (so that the LM is flat) can have changes in the budget deficit with no effect on investment, since the interest rate will not change. Open economy IS y Increase in Government Spending If the economy is open to trade flows it will have a marginal propensity to import. This will increase the absolute value of the slope of the IS. The result is that, for a given non-zero slope of the LM curve. An expansion in, lets say, government spending will increase the interest rate by more. The reason is that the economy needs to compensate for the increased multiplicator effect generated by the marginal propensity to consume. Closed economy IS 4. Higher monetary growth will never affect unemployment, rather, it will be reflected in higher inflation. False Higher monetary growth can affect unemployment in the short term as long as inflation expectations do not perfectly foresee the increase in the growth rate of money. In the medium term, however it is true that unemployment will not deviate form its natural rate and monetary growth will be fully reflected in inflation. i5. An increase in the markup will tend to reduce unemployment. False An increase in the markup will, by definition, make the real wage fall. The result is a increase in w p the natural unemployment rate. The only way we can make workers accepts their new lower wages is if they have a greater probability of staying for WS 1 1 +µ1 1 1 +µ2 a long period unemployed if they fall out of their PS1 current job. PS2 u 6. The natural interest rate is not affected by any policy instruments of the government. False. The natural interest rate is the interest rate that is consistent with equilibrium in the goods market when the economy is at the natural level of income. Hence it is the solution for rn to: Yn = C(Yn − T )+ I (rn )+ G it is easy to show that ∂C ∂rn =∂YD < 0 and ∂rn =−1 > 0 ∂T ∂I ∂G ∂I ∂r ∂r so an increase in taxes will decrease the natural interest rate and an increase in government


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