14.02 Principles of M acroeconomicsSpring 06Quiz 3Tuesda y May 23, 20069:00 am - 10:30 amPlease answer the follo w ing questions. Write your answ ers directly onthe quiz. There are 5 True/False/Uncertain qu estion s, follo wed by 2 longquestions. The quiz is for a total of 90 points. Keep the point distributionin mind as y ou allocate your time across the questions. There is a blankpage at the end of the quiz to be used for scratc h paper. G ood luck!NAME:MIT ID NUMBER:TA:CLASS TIME:EMAIL:(Table is for corrector use only.)1 2 3 4 TotalI. T/F/UII. LQ 1II. LQ 2Total1I. Answer each as True, False, or Uncer tain , and explain y o ur c h oice. (30 poin ts. Eachquestion counts for 6 points.)1. If individuals are forw ard-looking, current money demand should depend on bothcurrent and expected future nominal interest rates.2. A monetary expansion alw a ys shifts up the LM curv e and leaves the IS curveunc h anged.23. A fiscal contra ction alw ays reduces output in the short run.4. Under fixed exc hange rates, fisca l policy is mor e po werful in moving output thanit is under flexible exchan ge rates.35. The effect of fiscal policy on output is stronger in an open economy with fixedexc h ange rates than in a closed economy.4II. Long Questions: (60 points)1. Expectations: (20 poin ts)Consid er the follo w ing description of an economy:IS: Y = A(Y,r, T, Y0e,r0e,T0e)+GLM:MP= YL(r)There are two periods: the curren t period (the short run) and the future period(the medium run). Primes denote future period values, and “e” denotes anexpectation. For simplicity, assum e that current and future inflation, actual andexpected, are equal to zero, so the real and the nominal interest rates are equal.Assume initially that Y = Y0e= Yn= Y0n,r= r0e= rn,T= G = T0e=¯T .In w ords, output, current and expected, is equal to the natural level of output,which is itself constan t. The real int erest rate, current and expected, is equal tothe natura l interest rate — the real interest rate associated with the natural lev elof output. Taxes, current and expected, are constan t, and equal to governmentspending.No w suppose that a major technological disco v ery is made, which leads peopleand firms to expect a higher natural level for output in the future: Y0nincreases,and so does Y0e. Assume r0e= r0nis unc han ged, and so are taxes, curren t andexpected.a. What will be the effect on output (Y ) and the interest rate (r) in the currentperiod (or in the short run)? Sho w the result graphically. Explain in words.(10 poin ts)5b. Suppose y ou are in c harge of monetary policy. W hat should y ou do? (Hin t:You want to increase the in terest rate through a con tractionary open marketoperation. Wh y?) (10 points)62. The Mu n dell-F lem in g Model: (40 points)Consider the follow ing description of an open economy in the short run:IS: Y = C(Y − T )+I(i, Y )+G + NX(Y∗,Y,E)LM:MP= YL(i)UIP: E =(1+i)(1+i∗)¯Eea. Characterize graphically the equilib rium, and the equilibrium values of Y, i, Efor given values of T,G,Y∗,MP,i∗,¯Ee.(6points)7Now suppose that inv estors in the foreign exchange m arket start expecting a largedepreciation of the domestic currency (e.g., the US dollar) in the future.b. Char acterize graphically the effects on Y, i and E. Exp la in in w o rds. (10points)8Assum e that initially (before the cha nge in expectations), output w a s equal to itsnatural level Yn.c. How can y ou use monetary policy to k eep output unchanged? What are theimplica tio ns for the in terest rate and for the exc hang e rate? (8 poin ts)d. How can y ou use fiscal policy to keep output unchanged? What are theimplica tio ns for the in terest rate and for the exc hang e rate? (8 points)9e. Suppose that there is initially a large trade deficit (e.g., the United States).Would you want to use fiscal or monetary policy in this case? (8 poin
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