UT ECO 320L - midterm2-practice-key (7 pages)

Unformatted text preview:

University of Wisconsin Madison Department of Economics Eco 302 Intermediate Macroeconomics Midterm Two Practice Key You have 1 15 to complete this exam The highest score is 100 points Good Luck 1 2 1 Short Answer 10 Points Each 50 Total 1 1 Suppose that in 2016 the real interest rate is r 1 and people expect inflation to be e 2 In 2017 the real interest rate is still r 1 but expected inflation rises to e 3 What happens to real balance demand in 2017 relative to 2016 What role of money explains this change Real balance demand falls in response to the increase in expected inflation could draw this in the diagram The store of value role of money is what explains this since higher inflation makes money a worse store of value 1 1 2 Suppose that consumption demand is given by C d 45 Y 1 r Y f where r is in decimals Y is current income and Y f is future income Investment 100 demand is given by I d 1 r Solve for the IS Curve i e solve for the market clearing interest rate as a function of Y keeping Y f fixed Draw the e ect of an increase in Y f on the IS Curve First step is to put S pvt Y demand C d 15 Y 1 Y 5 4 1 f 5 1 r Y Then set this equal to investment 4 1 100 Yf 51 r 1 r This gives rIS Y as 500 4Y f 1 Y This looks like a convex curve plotting r against Y and increasing Y f shifts the curve upward rIS Y 3 1 3 Suppose that inflation is 2 depreciation is 10 and the nominal interest rate is 5 all per year An entrepreneur currently has 10 000 worth of capital and revenues of 100 000 and is considering buying an additional 1000 worth of computers If she buys these machines then her revenue next year will be 100 000 X and she will sell o the undepreciated computers What is the smallest value of X for which she buys these machines The user cost of the machine is 0 05 0 02 0 10 1000 130 The marginal product of the machines is 100 000 X 100 000 X The firm will buy the machines if the marginal product is larger than the user cost that is if X 130 1 4 Show the e ect of each of the following on the IS curve 1 an increase in inflation expectations 2 a decrease in initial wealth and 3 a decrease in the depreciation rate The first one has no e ect on the investment savings market The second one reduces current consumption which means that savings rises This causes the investment savings market s real interest rate to fall therefore the IS curve shifts downward The third one causes investment demand to rise which means that