14.02 Principles of M acroeconomicsSpring 06Quiz 1Wednesda y March 8, 20067:30 pm - 9:00 pmPlease answer the follo w ing questions. Write y our answers directly onthe quiz. There are 6 True/False/Uncertain questions, follo wed b y 2 shortquestions and 1 long question. The quiz is for a total of 100 poin ts. Thereis a blank page at the end of the quiz to be used for scratc h paper. Goodluck!NAME:MIT ID NUMBER:TA:CLASS TIME:EMAIL:(Table is for corrector use only.)1 2 3 4 TotalI. T/F/UII. SQ 1II. SQ 2III. LQ 1Total1I. Answer eac h a s True, False, or Uncer tain, and explain your c h oice. (30 points. Eachquestion coun ts for 5 poin ts.)1. After Hurrican e Katrina the Go vernm ent spent $500 million rebuilding New Or-leans and $100 million in transfers to displace d individuals. The direct effect ofthese policies was an increase in GDP of $600 million.2. If a country produces all the oil tha t it consu m es, an increase in the price of oilwill lead to an equal increase in CPI and GD P inflation.23. If nominal GDP is higher than real GDP in a giv en year, the economy is under-going inflationinthatyear.4. Fiscal policy is more effective in c hanging GDP if investmen t is more sensitiv e toa change in the interest rate.35. The nominal demand for money only depends on the nominal interest rate andthe quantity of final goods produced in the economy.6. John was fired from his job last year, and gave up looking for a job three w eeksago. He is no w officia lly unemployed.4II. Short Questions (40 points)1. TheGoodsMarket (25 points)Consid er the IS model:Extend the consumption function to be:C = c0+ c1(Y − T )+c2(Ye− Te) ,where C is ann ual consumption, Y is curren t annual income, Yeis expected futureannual income (think of it as the ann ual income that people expect to receive ona verage in the future), T is current annual taxes and Teexpected future annu altaxes. Assum e c1+ c2< 1.a. Is this new specification an improvemen t upon th e specification we u sed inclass? (3points)b. Is the restriction on c1+ c2reasonable? (H in t: Suppose your current andexpected future annual income both go up b y 1 unit. By ho w m u ch will youincrease consumption?) (5points)c. Assum e I =¯I,andG given. Also, take Te, Yeas given. Write down theequilibrium condition. (3points)5d. Sho w , algebraically and graphically, the effects of an increase in Yeon Y .Explain in w ords. (9points)6e. “Op tim ism is self fulfilling. If people are more optimistic about the future,then things will improv e today.” Do yo u agree? Why? (5points)72. The “liquidity trap.” (15 poin ts)Consider an economy where money demand is giv en byMd= a$Yia. Wha t happens to the demand for money as the interest rate goes to zero? Is it areasonable assumption? (5points)b. “All the central bank can do b y increasing the money supply is to decrease the in-terest rate v ery close to zero, but no further.” Do y ou agree or disagree? (5points)8c. Look at the figure belo w, whic h plots the interest rate and the rate of moneygrowth in Jap an. Discuss the following proposition: “Monet ary policy has beenused to decrease the interest rate to zero in Japan. If this is not sufficien t toincrease demand and output, there is nothing more monetary policy can do”(5points)Japan051015202530351990199119921993199419951996199719981999200020012002200320042005(%)The Growth Rate of M1 The Interest Rate9III. Long Question (30 poin ts)Consider the follo wing economy:C = c0+ c1(Y − T )I = b0+ b1Y − b2iMdP= Y (d0− d1i)c0, c1, b0, b1, b2, d0, d1are positive constan ts, and c1+ b1< 1. The price level is giv en.So are G and T .The central bank chooses the money stock M so as to ac h ieve a given in terest rate i0(in other wo rds, the mon ey stock is endog enou s).Note: For all questions, assume that the central bank maintains the interestrate equal to i0.a. Determine equilibrium Y , C and I. Determ ine in turn th e level of the moneystoc k, M. (6points)10b. Suppose the government w an ts to increase output b y ∆Y .Itwantstodosobyincreasing governm ent spending G. Der ive the required change in G, ∆G.Derivethe change in the budget deficit. (6points)c. Suppose again the gov ern m ent wants to increase output by ∆Y .Itnowwantsto do so b y decreasing taxes T . Derive the requ ired c han ge in T , ∆T .Derivethe c hange in the go v ernment deficit. Explain the different implications of thispolicy from the previous one for the budget deficit. (6points)11d. Suppose again the go vernm ent w ants to increase output b y ∆Y .Itnowwantstodo while maintaining budget balance, i.e. ∆G = ∆T . Derive the required c ha ngein spending (and in taxes). Com pare ∆G in this case to ∆G in quest ion (b).Explain the difference in words. (6points)e. Suppose again the gov ern m ent wants to increase output by ∆Y .Itnowwantsto do so witho ut increasing con sum p tion. Derive the combination of c h ang es intaxes ∆T, and c hanges in spending, ∆G, whic h leads to an increase in outputwith no chan ge in consumption . What happens to investm ent?
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