14.02 Principles of Macroeconomics Spring 03 Quiz 3 Thursday, May 8, 2003 7.30 pm – 9:00 pm Please answer the following questions. Write your answers directly on the exam. You can achieve a total of 100 points. There are 7 multiple- choice questions, followed by 2 long questions. Good luck! NAME: MIT ID NUMBER: TA: CLASS TIME: EMAIL:23Multiple Choice Questions (28/100): Please circle the correct answer for each of the 7 multiple-choice questions. In each question, only one of the answers is correct. Each question counts 4 points. 1. Which of the following factors might cause investment to depend very heavily on current profits? I. Current profits are a bad predictor of future profits. II. Most companies find it difficult to raise finance externally at low interest rates. (a) I. only. (b) II. only. (c) Both I. and II. (d) Neither I. nor II. 2. Which of the following two statements is correct? I. A farsighted consumer will try to base her consumption decisions on the present discounted value of her current wealth plus future pre-tax income. II. A permanent change in income of 1 will generally result in a change in consumption of much less than 1. (a) I. true, II. true (b) I. true, II. false (c) I. false, II. true (d) I. false, II. false 3. In an open economy with a floating exchange rate, an increase in the money supply will: (a) Increase output, decrease the interest rate and cause exchange rate appreciation. (b) Increase output, decrease the interest rate and cause exchange rate depreciation. (c) Increase output, not affect the interest rate and cause exchange rate depreciation. (d) Not affect output, decrease the interest rate and cause exchange rate appreciation.4 4. The current exchange rate between the US$ and the Euro is 1.1 (i.e. E = 1.1 from the US perspective). E is expected in one year’s time to be 1.0. Inflation in the US is 4 per cent. Inflation in Europe is 2 per cent. Which of the following statements is true? (a) The nominal exchange rate is expected to DEPRECIATE, and the real exchange rate is expected to depreciate by a GREATER percentage than the nominal exchange rate. (b) The nominal exchange rate is expected to DEPRECIATE, and the real exchange rate is expected to depreciate by a LESSER percentage than the nominal exchange rate. (c) The nominal exchange rate is expected to APPRECIATE, and the real exchange rate is expected to appreciate by a GREATER percentage than the nominal exchange rate. (d) The nominal exchange rate is expected to APPRECIATE, and the real exchange rate is expected to appreciate by a LESSER percentage than the nominal exchange rate. 5. Which of the following statements characterizes the response of the world economy to the end of the war in Iraq? I. The stock market in the US increased, as the end of the war boosted future expected profits. II. Oil prices fell, which reduced the cost for firms. III. Growth in Europe remained above its long-run average. (a) I. and II. are true (b) II. and III. are true. (c) I. and III. are true. (d) I. and II. and III. are true.5 6. The IMF has recently revised its growth forecast for the world economy downward for the following reasons: (a) Deflation in Europe is a continuing problem, Japan faces inflation, and the US faces corporate governance problems. (b) Corporate governance problems in Japan continue to drag profits down, the US faces the risk of inflation, and the EU is growing faster than the rest of the world. (c) The EU is facing structural economic problems that hamper growth, the US is struggling to recover from the burst of the stock market bubble, and Japan continues to face the risks of deflation. (d) The risk of overheating in the US has led to an increase in interest rates, the bad loan problems in Japan have not yet been solved, and the deflation in Europe has caused Europe to be in a recession for years. 7. The Bush tax cut has been criticized for the following reasons: I. The tax cut would cause the budget deficit to increase rapidly, putting pressure on long term interest rates to rise. II. Even though the tax cut is large relative to GDP, the average household does not profit much from it, and the impact on aggregate demand is expected to be small. III. The tax cut should be larger in order to finance the costs of war. (a) I. and II. are true. (b) II. and III. are true. (c) I. and III. are true. (d) I., II. and III. are true.6Long Question 1 (36/100): Expectations in the US Economy Please read the following instructions and questions carefully. Answer each of the 6 questions as precisely as you can. Each question counts 6/100. To answer this question, you should have in mind the extended IS-LM model which includes a role for expectations. Recall the basic structure of this model: IS: Y = A(Y, T, r, Ye, Te, re) + G LM: M/P = Y L(r) where Y: Output, T: Taxes, r: the interest rate and the superscript `e’ stands for an expectation about the future value of a variable. A is the sum of consumption and investment, which depends on current Y, T and r, as well as expected future Y, T and r. 1) Is the IS curve in this model steeper or flatter relative to the basic IS-LM model? Explain why in 3-5 lines, being as precise as you can. Following the end of the war in Iraq, and excitement about the new series of ‘American Idol’, expectations about future output improve (i.e. Ye increases). 2) Draw an IS-LM diagram, and show how the change in Ye affects Y and r. [Assume all other variables (M/P, T, Te, re, G) stay the same.]73) What is the effect of the change in Ye on (i) current investment and (ii) the stock market (increase, decrease or ambiguous)? Explain why in 3-5 lines, be as precise as you can. 4) Following the increase in Ye, how must the Fed change the size of the money supply (M/P) to return the interest rate to its old level (increase M/P, decrease M/P, ambiguous)? Use a diagram to help answer this question.8Assume for the next two questions that the Fed has undertaken the action you suggested in the previous question 4), so the interest rate has remained unchanged following the increase in Ye. 5) What is the effect of the increase in Ye on (i) current consumption and (ii) current investment (increase, decrease, ambiguous)? [Again, assume all other variables (r, T, Te, re, G) stay the same.] Explain why in 3-5 lines, be as precise as you can. Suddenly, concerned about the
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