Final Exam for ECON 204 – Fall 2019 The final exam on December 18, 8:00 – 10:00 AM, Boyden Phys. Ed. Gym, will consist of three questions randomly selected from the 15 listed below. You will not be permitted to bring any materials to the exam; bring only some paper to write on and some pens to write with. You must write your answers from memory. You can, of course, prepare yourself by working out the answers to the questions below. Be sure to incorporate the diagrams of relevant models into your answers, and use those diagrams to illustrate the changes suggested in the questions. 1. Measuring economic activity (a) Define the term Gross Domestic Product (GDP). What is included in this measurement? What types of production and exchange are not counted in GDP? (b) How might we better measure the true value of economic activity? What alternative measures are available? Can you suggest any alternative measures that might better capture well-being? a. Gross Domestic Product (GDP) is the monetary value of all finished goods and services made within a country during a specific period. Foreign, used, intermediate and illegal goods do not get counted. b. Environmental quality, levels of health and education and happiness measures could all capture well-being better. 2. Explain the concept of an aggregate production function. The textbook uses the production function in a two-dimensional diagram by explicitly showing the relationship between output and labor input in the classical model, under the assumption that all other inputs remain the same. In such a diagram, how would you expect the production function to shift in response to an increase in the productivity of labor? Use such a model to explain how the classical economists described the effects of a change in labor productivity on the levels of output and employment. The aggregate production function describes how total real gross domestic product (real GDP) in an economy depends on available inputs. Graph shifts based on level of labor, changing output.3. How is the interest rate determined in the classical model? What specific assumptions of the classical model are important for your answer? Finally, what is the role of the interest rate in the classical model? In the classical model of economics, the interest rate is determined by the amount of savings and investment in an economy. Classical theory assumptions include the beliefs that markets self-regulate, prices are flexible for goods and wages, supply creates its own demand, and there is equality between savings and investments. The interest rate adjusts so that the quantity of funds saved is equal to the quantity of money invested. 4. The Keynesian Model (a) Illustrate the “Keynesian cross” diagram and then explain exactly how Keynes modeled aggregate demand in the macroeconomy. According to Keynes, what is the macroeconomic effect of a sudden decrease in government purchases? (Show this in your diagram) (b) Specifically, if the marginal propensity to consume is 0.75, explain what will be the eventual effect on output of a decline in government expenditure of $1 billion? (Show your calculations) A. (draw in change)B. Y = 1/(1-0.75) x -1 billion = -$4 billion 5. Discuss the relationship between investment and the interest rate according to: a. The classical model b. John Maynard Keynes in The General Theory of Employment, Interest, and Money c. The IS-LM-BP model A. investment expenditures varied inversely with the rate of interest. People save more at higher interest rates. B. As the interest rate rises, Keynes argues that consumer spending and investment will fall C. The increase in the interest rate reduces investment and “crowds out” 6. Derive the LM curve in Hick’s IS-LM model. Start with the basic essentials of the model, and then explain the main relationships that determine the shape of the LM curve. How would the monetarists draw the LM curve? How would Keynes draw the LM curve? Explain the reason for the different shapes. The larger the consumption, the steeper the curve. Keynes’ is same as Hick’s but objects to the simplicity and prefers not to draw out the curves.Monetarists believe the LM curve LM curve is near vertical. It is a near-full employment situation where the IS curve is interest-elastic because increase in money supply reduces the interest rate 7. How effective is monetary policy? Answer this question from the perspective of (a) Keynes, (b) the classical economists, (c) the monetarists, and (d) modern money theory. How would you judge “effectiveness”? a. Keynesians are skeptical about the effectiveness of monetary policy but believe that increasing loanable funds can drop interest rates, thus indirectly increasing GDP as more people become willing to consume b. the money supply leads to an increase in the price level, but the real income, the rate of interest and the level of real economic activity remain unaffected. c. monetarists argue that expansionary monetary policies may increase the level of real GDP by increasing aggregate demand in the short run, but in the long run it creates inflation and doesn’t help GDP d. fiscal policy is effective while monetary policy is ineffective 8. The simultaneous increases in unemployment and prices, or what came to be called stagflation, in the 1970s are usually thought to have been caused by the supply shock of OPEC’s tripling of oil prices. Provide a more complete explanation using the aggregate demand/aggregate supply model. Show how events of the 1970s caused shifts in the AD and AS curves that resulted in stagflation. What could have been done to avoid stagflation?Monetary policy and fiscal policy combined can create new equilibrium to take economy out of stagflation. 9. Expectations are an important determinant of economic behavior because most economic activities have costs and benefits that extend far into the future. Hence, decisions require an assessment of future costs and benefits that can only be described as expectations. Different models make very different assumptions about what those expectations consist of and how those expectations are arrived at. a. Explain how