Exam #3 (Fall 2013) 1/10

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Econ 100B
Macroeconomic Analysis
Professor Steven Wood

Fall 2013

Exam #3 ANSWERS


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On my honor, the answers on this exam are entirely my own work. I neither gave nor received any aid while taking
this exam. I will not discuss the questions on this test until after 2:30 p.m. on December 17, 2013.

_______________________________________
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Exam Instructions

1. When drawing diagrams, clearly and accurately label all axes, lines, curves, and equilibrium points.

2. Explanations should be written in pencil or black. Legibility is a virtue; practice good penmanship.

3. Explanations should be succinct and to the point; make use of bullet points and common mnemonics.

4. If you have a question, ask one of the GSIs. The GSIs have not seen the exam beforehand and can only
provide general guidance. You are totally responsible for your answers regardless of what a GSI has said to you.

5. If you need to re-draw a diagram and/or need more room to write your answers, use pages 2, 11 and/or 12.

6. If you finish your exam before 1:55 p.m. you may turn in your exam and quietly exit the room.

7. If you finish your exam after 1:55 p.m., close your exam packet but remain seated until time is called.

8. When time is called, STOP writing, immediately CLOSE your exam packet and TURN IN your exam. You
WILL BE PENALIZED if you continue to write past the official end of the exam.



Do NOT open this test until instructed to do so.
Exam #3 (Fall 2013) 2/10
A. Multiple Choice Questions (30 points). Highlight the best answer (3 points each).

1. During the Great Depression, deflation caused real interest rates to increase. As a result, people and
businesses that were considered good credit risks became less likely to seek loans. This process illustrates:

a. Moral hazard.
b. Debt deflation.
c. Adverse selection.
d. Poorly designed fiscal policy.
e. Poorly designed monetary policy.

2. The zero-lower-bound eliminates the ability of the Fed to use the following monetary policy tool(s):

a. Discount lending.
b. The federal funds rate.
c. Open market operations.
d. The required reserve ratio.
e. All of the above.

3. Suppose that the economy experiences a sharp increase in energy costs and, in response, the central bank
engages in a discretionary policy to increase the real interest rate. Then:

a. The central bank is likely adopting a policy to stabilize inflation in the short-run.
b. Inflation fluctuates around its long-run level, first going above it and then going below it.
c. The central bank will eventually need to reduce the real interest rate to its original value in order to
ensure that inflation returns to its original rate.
d. All of the above.
e. None of the above.

4. Suppose the economy is in a long-run equilibrium when the central bank decides that its inflation target is
too low. If the central bank then acts to increase it, monetary policy would ultimately lead to:

a. Higher interest rates, higher potential output, and higher inflation in the long run.
b. Higher interest rates but potential output and inflation would be unaffected in the long run.
c. Higher potential output but real interest rates and inflation would be unaffected in the long run.
d. Higher inflation but real interest rates and potential output would be unaffected in the long run.
e. None of the above.

5. Taxes distort economic behavior because they:

a. Change the composition of income and spending.
b. Change the balance between public and private expenditures.
c. Cause deviations in economic behavior from the efficient free-market outcome.
d. Change the composition of consumption, investment, government purchases, and net exports.
e. None of the above.
Exam #3 (Fall 2013) 3/10
6. According to supply-side theory, if the government begins with a balanced budget, then a permanent
increase in marginal income tax rates will tend to cause:

a. A budget deficit.
b. A budget surplus.
c. No change in the budget balance.
d. An indeterminate change in the budget balance.
e. An increase in aggregate supply and a decrease in aggregate demand.

7. Which of the following changes would cause U.S. net exports to increase?

a. An increase in U.S. economic output.
b. An increase in foreign economic output.
c. An increase in the real value of the dollar.
d. A shift in demand by foreign consumers away from U.S. produced goods.
e. A shift in demand by U.S. consumers away from domestically produced goods.

8. If a country has an overvaluation problem, the best solution is to:

a. Increase the official rate.
b. Increase the money supply.
c. Decrease the money supply.
d. Buy less of its currency in the foreign exchange market.
e. Sell more of its currency in the foreign exchange market

9. Consider two similar economies hit by the same temporary negative supply shock. In the economy with the
more credible monetary policy there will be:

a. Larger increases in both inflation and the real interest rate.
b. Smaller increases in both inflation and the real interest rate.
c. A smaller increase in inflation but a larger decrease in output.
d. A smaller increase in output but a larger increase in the real interest rate.
e. A smaller increase in inflation but a larger increase in the real interest rate.

10. An economic policy change has a decent change of working as intended if::

a. Mistaken expectations are not very costly.
b. The policy change causes no changes in expectations.
c. The rationale behind the policy change is well-understood by the public.
d. Expectations are formed in the same way by both the public and the policymakers.
e. All of the above.

Exam #3 (Fall 2013) 4/10
B. Analytical Questions (70 points). Answer BOTH of the following questions based on the standard models of analysis developed in class. The information
in the various parts of the questions is sequential and cumulative.

1. The AD AS Model with a Foreign Exchange Market (35 points). Suppose there are only two countries: Country A and Country B. Both Country A
and Country B have open economies that are initially (i.e., in Year 0) in general equilibrium and are characterized by perfect capital mobility, flexible
exchange rates, and sticky wages and prices. The foreign exchange market uses a direct quotation for Country Bs currency.

a. Based only on this information, use an AD AS diagram for Country A (on the left), an AD AS diagram for Country B (on the right), and a
Foreign Exchange Market diagram (in the middle) to clearly and accurately show both economies initial (1) economic output, (2) inflation,
and (3) exchange rate. These diagrams should be drawn in BLACK.
























E
(A/B)





E
1



E
0
= E
2

SRAS
1

SRAS
0
=
SRAS
2

SRAS
2
=
SRAS
0

SRAS
1

Y
1
Y
0
=Y
2a
Y
2
Y

2a
=
0

1a
=
2

Y
1a
= Y
2
Y
1
Y
0
Y
AD
0
AD
1a
= AD
2

AD
1

AD
0
= AD
2a

AD
1
AD
2

LRAS LRAS S
B
Q
B
Q
B
D
B0
= D
B2
D
B1
Exam #3 (Fall 2013) 5/10
b. In Year 1, Country A experiences a sharp decline in household wealth. Incorporating only this
additional information, clearly and accurately show in your diagrams above what effects this
would have on both economies (1) economic output, (2) inflation, and (3) exchange rate. These
effects should be drawn in RED.


c. Provide an economic explanation of what you have shown in your diagrams above. Discuss
what, if anything, happens to both economies (1) economic output, (2) inflation, and (3) exchange
rate. Be sure to explain why these changes take place.

A sharp decline in household wealth causes a decrease in autonomous consumption, total
spending and aggregate demand. This is represented by a leftward shift in the AD curve
from AD
0
to AD
1a
. The decrease in aggregate demand causes a decline in economic output
from Y
0
to Y
1a
, resulting in a negative output gap. The negative output gap causes inflation
to decline from
0
to
1a
along the SRAS curve, SRAS
0
(
e
=
0
).

The decrease in inflation from
0
to
1a
causes the central bank to decrease the real interest
rate according to the Taylor Principle, represented by a movement along the MP curve.

Because the real interest rate declines, Country As currency denominated assets are now
relatively less attractive to Country Bs investors while Country Bs currency denominated
assets are now relatively more attractive to Country As investors. Because the foreign
exchange market uses a direct quotation for Country Bs currency, this causes an increase in
the demand for Country Bs currency denominated assets. This is represented by an upward
shift of the demand curve for Country Bs currency denominated assets from D
B0
to D
B1
.

Once this shift occurs, there is excess demand for Country Bs currency denominated assets
at the initial exchange rate E
0
. To return the foreign exchange market to equilibrium,
Country Bs currency appreciates and Country As currency depreciates from E
0
to E
1
.

Because of Country As currency depreciation, Country As exports are now less expensive
to Country Bs residents who buy more of them. In addition, Country Bs exports are now
more expensive to Country As residents who buy less of them. Country As net exports
increase, represented by a rightward shift of Country As AD curve from AD
1a
to AD
1
.

In addition, Country As currency depreciation increases the domestic currency
costs of imports from Country B. This is a negative short-run aggregate supply
shock, represented by an upward shift of Country As SRAS curve from SRAS
0
(
e
=

0
) to SRAS
1
(
e
=
0
).

Because of Country Bs currency appreciation, Country Bs exports are now more expensive
to Country As residents who buy less of them. In addition, Country As exports are now less
expensive to Country Bs residents who buy more of them. Country Bs net exports decrease,
represented by a leftward shift of Country Bs AD curve from AD
0
to AD
1
.

In addition, Country Bs currency appreciation decreases the domestic currency
costs of imports from Country A. This is a positive short-run aggregate supply
shock, represented by a downward shift of Country Bs SRAS curve from SRAS
0
(
e

=
0
) to SRAS
1
(
e
=
0
).

The net result of Country As decline in household wealth and subsequent currency
depreciation is that economic output falls from Y
0
to Y
1
and inflation declines from
0
to
1
.

The net result of Country Bs currency appreciation is that economic output falls from Y
0
to
Y
1
and inflation declines from
0
to
1
.
Exam #3 (Fall 2013) 6/10
d. Subsequent to the decline in household wealth in Country A but also in Year 1, Country B decides
to fix the exchange rate with Country A at its initial (i.e., Year 0) value. Incorporating only this
additional information, clearly and accurately show in your diagrams above what effects, if any,
this would have on both economies (1) economic output, (2) inflation, and (3) exchange rate.
These effects should also be drawn in BLUE.


e. Provide an economic explanation of what you have shown in your diagrams above. Discuss
what, if anything, happens to both economies (1) economic output, (2) inflation, and (3) exchange
rate. Be sure to explain why these changes take place.

When Country B decides to fix its exchange rate at its initial Year 0 value it will buy
Country As currency in the foreign exchange market in exchange for its own currency. This
increases Country Bs domestic money supply at any given inflation, represented by a
downward shift of the MP curve. Country Bs real interest rate declines, causing an increase
in borrowing, spending, and economic output. This can be represented by a rightward shift
of Country Bs AD curve from AD
1
to AD
2a
.

Because Country Bs real interest rate decreases, County Bs currency denominated assets
are now relatively less attractive to Country As investors. As a result, the demand curve for
Country Bs currency denominated assets shifts to the left from D
B1
to D
B2
. Because Country
B is fixing its exchange rate at its initial value of E
0
, D
B2
= D
B0
and Country Bs currency
depreciates from E
1
to E
2
which equals E
0
.

In Country B, the currency depreciation makes Country Bs exports less expensive to
Country As residents who buy more of them. In addition, imports from Country A are now
more expensive to Country Bs residents who buy less of them. As a result, net exports
increase, represented by a rightward shift of Country Bs AD curve from AD
2a
to AD
2
.

Country Bs currency depreciation increases the domestic currency cost of imports
from Country A, resulting in a negative SRAS shock. This can be represented by an
upward shift of Country Bs SRAS curve from SRAS
1
(
e
=
0
) to SRAS
2
(
e
=
0
).
Because the exchange rate has returned to its initial value, i.e., E
2
= E
0
, SRAS
2
(
e
=

0
) is identical to SRAS
0
(
e
=
0
), i.e., there has been no net shift of the SRAS.

In Country A, the currency appreciation makes Country As exports more expensive to
Country Bs residents who buy less of them. In addition, imports from Country B become
less expensive to Country As residents who buy more of them. As a result, net exports
decrease, represented by a leftward shift of County As AD curve from AD
1
to AD
2
. Because
the exchange rate has returned to its initial value, i.e., E
2
= E
0
, there has been no net shift in
the aggregate demand curve from the currency changes, i.e., AD
2
is identical to AD
1a
.

Country As currency appreciation also decreases the domestic currency cost of
imports from Country B, resulting in a positive short-run aggregate supply shock.
This can be represented by a downward shift of Country As SRAS curve from
SRAS
1
(
e
=
0
) to SRAS
2
(
e
=
0
). Because the exchange rate has returned to its
initial value, i.e., E
2
= E
0
, there has been no net shift of the short-run aggregate
supply curve, i.e., SRAS
2
(
e
=
0
) is identical to SRAS
0
(
e
=
0
).

The net result of Country Bs decision to fix its exchange rate at its initial value is:

1. In Country A, economic output falls even further from Y
1
to Y
2
and the resulting
larger negative output gap reduces inflation even more from
1
to
2
. Country A
experiences lower economic output and lower inflation.

Exam #3 (Fall 2013) 7/10
2. In Country B, economic output increases from Y
1
to Y
2
and the resulting positive
output gap raises inflation from
1
to
2
which is greater than
0.
Country B
experiences higher economic output and higher inflation.

Exam #3 (Fall 2013) 8/10
2. The AD/AS Model with (Complete) Ricardian Equivalence (35 points). Suppose that the economy,
which is characterized by sticky wages and prices and complete Ricardian Equivalence, is initially (i.e., in
Year 0) in general equilibrium. (HINT: Be sure to show any intermediate effects, i.e., first without the
Ricardian Equivalence effects and then with the complete Ricardian Equivalence effects.)

a. Based only on this information, use an AD AS model diagram to clearly and accurately show
the economys initial (1) economic output and (2) inflation. This diagram should be drawn in
BLACK.



















































2

0

AD
1a

AD
2a
AD
0
= AD
1
= AD
2

SRAS
0
(
e
=
0
)
SRAS
1
(
e
=
0
)
SRAS
2
(
e
=
1
)
Y
P
1
Y
2
Y
1
Y
0
= Y
P
0
Y
LRAS
1
LRAS
0
Exam #3 (Fall 2013) 9/10
b. In order to reduce a massive budget deficit, the government in Year 1 increases personal income
tax rates and decreases government purchases, particularly spending on large infrastructure
projects. Incorporating only this new information, clearly and accurately show in your diagram
above what effects, if any, this would have on the economys (1) economic output and (2)
inflation. These effects should be drawn in RED.


c. Provide an economic explanation of what you have shown in your diagram above. Discuss what,
if anything, happens to the economys (1) economic output and (2) inflation. Be sure to explain
why these effects take place and what causes them.

The governments decision to reduce its massive budget deficit in Year 1 has two effects:

First, the governments decision to increase personal income tax rates reduces
disposable income and results in a decline in consumption and aggregate demand.
The governments decision to decrease government purchases also reduces
aggregate demand. These effects are represented by a leftward shift of the AD curve
from AD
0
to AD
1a
.

However, when Ricardian Equivalence is complete, private saving decreases by the
exact same amount that government saving increases. This is represented by a
rightward shift of the AD curve from AD
1a
to AD
1
which is identical to AD
0
, i.e.,
AD
1
= AD
0
.

Second, because the reduction in government purchases is concentrated on large
infrastructure projects the economys stock of productive assets is reduced. This is a
permanent negative supply shock, represented by a leftward shift of the long-run
aggregate supply curve from LRAS
0
to LRAS
1
.

In addition, fewer productive assets increases the cost of producing any given level
of economic output. This can be represented by an upward shift of the SRAS curve
from SRAS
0
(
e
=
0
) to SRAS
1
(
e
=
0
).

[This SRAS curve must intersect the LRAS curve at
0
because of the
assumption that inflation expectations are determined by a one-period
adaptive process.]

The net result of these changes is that (1) potential economic output falls from Y
P
0
to Y
P
1
,

(2)
actual economic output declines from Y
0
(=Y
P
0
) to Y
1
, and (3) the resulting positive output
gap (Y
1
Y
P
1
) increases inflation from
0
to
1
.


Exam #3 (Fall 2013) 10/10
d. In Year 2, the government reverses the increase in personal income tax rates that had been
imposed in Year 1. Incorporating only this new information, clearly and accurately show in your
diagram above what effects, if any, this would have on the economys (1) economic output and (2)
inflation. These effects should be drawn in BLUE.


e. Provide an economic explanation of what you have shown in your diagram above. Discuss what,
if anything, happens to the economys (1) economic output and (2) inflation. Be sure to explain
why these effects take place and what causes them.

Two events occur in Year 2:

First, in Year 1 there was a positive output gap given by Y
1
Y
P
1
and actual
inflation was greater than expected inflation, i.e.,
1
>
e
=
0
. Because inflation
expectations are determined by a one-period (i.e., one-year) adaptive process,
expected inflation in Year 2 increases from
0
to
1
. This is represented by an
upward shift of the SRAS curve from SRAS
1
(
e
=
0
) to SRAS
2
(
e
=
1
).

Second, the government decision to reverse the prior years increase in personal
income tax rates increases disposable income, increasing consumption expenditures
and aggregate demand. This is represented by a rightward shift of the AD curve
from AD
1
to AD
2a
.

However, when Ricardian Equivalence is complete the decline in government saving
is exactly matched by an increase in private saving as taxpayers perfectly foresee
their future tax liabilities. This is represented by a leftward shift of the AD curve
from AD
2a
to AD
2
.

The net effect of these two events in Year 2 is that (1) actual economic output declines from
Y
1
to Y
2
but (2) the resulting positive output gap of Y
2
Y
P
1
causes inflation to increase from

1
to
2
.