Exam #3 (Spring 2013) 1/12

Name: _________________________
(Last name, first name)
SID: _________________________
GSI: _________________________


Econ 100B
Macroeconomic Analysis
Professor Steven Wood

Spring 2013

Exam #3 ANSWERS


Please sign the following oath:

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 6:00 p.m. on May 13, 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, 14, 15 and/or
16.

6. The exam will end promptly at 6:00 p.m. 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 (Spring 2013) 2/12
A. Multiple Choice Questions (30 points). Highlight the best answer (3 points each).


1. A negative shock to aggregate demand will likely result in:

a. A permanent change in output if the central bank responds by lowering the real interest rate.
b. No permanent change in equilibrium inflation unless the central bank responds by lowering the
real interest rate.
c. An eventual increase in short-run aggregate supply for any inflation rate if the central bank
responds by lowering the real interest rate.
d. All of the above.
e. None of the above.


2. An emphasis on inflation stability is compatible with a non-activist stance only when the shocks to the
macroeconomy are:

a. Permanent supply shocks.
b. Temporary supply shocks.
c. Aggregate demand shocks.
d. Aggregate demand and permanent supply shocks.
e. Aggregate demand and temporary supply shocks.
f. Temporary supply and permanent supply shocks.
g. All of the above.
h. None of the above.


3. With autonomous changes in the policy interest rate, i.e., changes to r, the Federal Reserve cannot
determine the long-run equilibrium real interest rate or potential output and will only be able to determine
inflation. This statement is consistent with:

a. The long-run neutrality of money.
b. The idea that nominal and real variables are independent of each other in the long-run.
c. Shifts in the MP curve may lead to shifts in the AD and AS curve but the LRAS curve remains
unchanged.
d. All of the above.
e. None of the above.


4. When pursuing short-run stabilization policies, if monetary policy is used to maintain real economic output
at potential, then long-run economic growth will be slower the _____ is fiscal policy and the _____ is the
real interest rate.

a. tighter; higher
b. tighter; lower
c. easier; higher
d. easier; lower

Exam #3 (Spring 2013) 3/12
5. Ricardian Equivalence assumes that:

a. Government spending remains constant.
b. Many people are subject to borrowing constraints.
c. Tax cuts have a positive impact on aggregate supply.
d. An anticipated increase in the income of future generations does not deter saving today on their
behalf.


6. Suppose that both Country A and Country B are initially in general equilibrium with flexible exchange
rates and perfect capital mobility. If Country A then experiences a negative short-run aggregate supply
shock, then Country As currency would:

a. Appreciate in the short-run and appreciate in the long-run.
b. Appreciate in the short-run but depreciate in the long-run.
c. Appreciate in the short-run and not change in the long-run.
d. Depreciate in the short-run but appreciate in the long-run.
e. Depreciate in the short-run and depreciate in the long-run.
f. Depreciate in the short-run and not change in the long-run.


7. In an open economy with a flexible exchange rate and perfect capital mobility, the government expenditure
multiplier would be:

a. Larger than in a closed economy.
b. Smaller than in a closed economy.
c. The same as in a closed economy.
d. Indeterminate; it could be either larger or smaller than in a closed economy.


8. A fixed exchange rate is preferable to a flexible exchange rate because:

a. Fiscal policy is more effective in stabilizing inflation.
b. Monetary policy is more effective in stabilizing inflation.
c. Fiscal policy is more effective in stabilizing economic output.
d. Monetary policy is more effective in stabilizing economic output.
e. All of the above.
f. None of the above.


Exam #3 (Spring 2013) 4/12
9. Which of the following would be a violation of the rational expectations assumption?

a. Over the past 20 years, people have consistently under-predicted the inflation rate for the
following year.
b. Over the past 20 years, people have never (even once) accurately predicted the inflation rate for
the following year.
c. The Feds announcement that it might ease interest rates caused an immediate drop in short-term
rates, even before the Fed took any action.
d. All of the above.
e. None of the above.


10. Assume that rational expectations hold. Now suppose that the central bank announces that it intends to raise
its policy interest rate startingin2014ratherthanin2016.This announcement would likely cause:

a. The current IS curve to shift to the left and the current MP curve to shift down.
b. The current IS curve to shift to the right and the current MP curve to shift down.
c. The current IS curve to shift to the left and the current MP curve to shift up.
d. The current IS curve to shift to the right and the current MP curve to shift up.
e. The current IS curve to shift to the left and the current MP curve to not change.
f. The current IS curve to shift to the right and the current MP curve to not change.
g. No change in the current IS curve but the current MP curve to shift up.
h. No change in the current IS curve but the current MP curve to shift down.


Exam #3 (Spring 2013) 5/12
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 (35 points). Suppose that the economy, which is characterized by sticky wages and
prices, is initially in general equilibrium and that supply-side assumptions hold.

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














































AD
2
LRAS
0
AD
0

SRAS
0
(
e
=
0
)
Y
P
0
Y
2
Y
1
Y
0
= Y
P
0
Y

2
=
0

1a

LRAS
1

AD
1a
AD
1
SRAS
1
(
e
=
0
)
SRAS
2
(
e
=
1
)
Exam #3 (Spring 2013) 6/12
b. In Year 1, because of massive budget deficits and a rapidly rising debt-to-GDP ratio, the
government compromised by (1) permanently reducing government purchases by $200 billion and
(2) permanently increasing marginal income tax rates to generate an additional $200 billion in tax
revenue. Incorporating only this additional information, clearly and accurately show in your
diagram above the Year 1 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 diagrams above. Discuss
what, if anything, happens in Year 1 to the economys (1) economic output and (2) inflation. Be
sure to explain why these effects take place.


In Year 1, the reduction in government purchases by $200 billion would reduce aggregate
demand for any given inflation rate. This can be represented by a leftward shift of the
aggregate demand curve from AD
0
to AD
1a
.

The permanent increase in the marginal income tax rate that would generate $200 billion of
additional tax revenue would reduce disposable income, causing a decline in consumer
spending by the marginal propensity to consume multiplied by $200 billion. This would
reduce aggregate demand at any given inflation rate. This can be represented by a leftward
shift of the aggregate demand curve from AD
1a
to AD
1
(which is smaller than the leftward
shift of the aggregate demand curve from AD
0
to AD
1a
.)

Because supply-side assumptions hold, the permanent increase in the marginal income tax
rate would also reduce the incentives to work and investment, resulting in a negative long-
run aggregate supply shock. This can be represented by a leftward shift of the long-run
aggregate supply curve from LRAS
0
to LRAS
1
and an upward shift of the short-run
aggregate supply curve from SRAS
0
(
e
=
0
) to SRAS
1
(
e
=
0
).

As a result of these various changes to aggregate demand and aggregate supply, a new short-
run equilibrium is established with economic output declining from Y
0
to Y
1
and with
inflation declining from
0
to
1
.
Exam #3 (Spring 2013) 7/12
d. In Year 2, the central bank decides to target the inflation rate at its initial general equilibrium
level. Incorporating only this additional information, clearly and accurately show in your
diagram above the Year 2 effects, if any, 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 diagrams above. Discuss
what, if anything, happens in Year 2 to the economys (1) economic output and (2) inflation. Be
sure to explain why these effects take place.


In Year 2, two separate events occur.

First, because of the leftward shift of the long-run aggregate supply curve, expected
inflation in Year 1 has declined to
1a
which is below actual inflation of
1
. Because
inflation expectations are formed by a one-period (year) adaptive process, in Year 2
expected inflation will increase from
1a
to
1
. This can be represented by an
upward shift of the short-run aggregate supply curve from SRAS
1
(
e
=
0
) to
SRAS
2
(
e
=
1
).

Second, the central bank decides to target the inflation rate at its initial general
equilibrium level. In order to do so, the central bank will conduct a contractionary
monetary policy, increasing the real interest rate for any given inflation rate. This
increase in the real interest rate would reduce aggregate demand for any given
inflation rate. This can be represented by a leftward shift of the aggregate demand
curve from AD
1
to AD
2
.

As a result of these changes, economic output has declined from Y
1
to Y
2
and inflation has
increased from
1
to
2
=
0
.

Exam #3 (Spring 2013) 8/12
2. The Open Economy AD/AS Model with a Foreign Exchange Market (35 points).

a. Suppose that Country A has an open economy which is characterized by perfect capital mobility and sticky wages and prices. Country A is
initially in general equilibrium and has a flexible exchange rate. Based only on this information, use an AD AS diagram (on the left) and a
Foreign Exchange diagram (on the right) to clearly and accurately show Country As initial (1) economic output, (2) inflation, and (3)
exchange rate (using a direct quotation). These diagrams should be drawn in BLACK.































Y
2
Y
1
Y
0
= Y
P
Y

2

AD
0
SRAS
0
(
e
=
0
)
LRAS
E







E
2
=
E
1
=
E
par




E
0

Q
$
Q
$
D
$0

S
$
D
$1

SRAS
1
(
e
=
0
)
AD
1
SRAS
2
(
e
=
1
)
AD
2a
AD
2

Exam #3 (Spring 2013) 9/12
b. In Year 1, Country As government decides to peg the exchange rate at an overvalued level, a
level that the central bank commits to maintaining. Incorporating only on this additional
information, clearly and accurately show in your diagrams above the Year 1 effects of this
decision on Country As (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 drawn in your diagrams above. Be sure to
discuss what happens to Country As (1) economic output, (2) inflation, (3) exchange rate, and
(4) net exports and explain why these changes take place.

In Year 1, Country A pegs the exchange rate at an overvalued level. In order to do so, the
central bank must sell some of its international reserves and buy its domestic currency. This
will reduce the domestic money supply and increase the real interest rate for any given
inflation rate. This can be represented by a leftward shift of the aggregate demand curve
from AD
0
to AD
1
.

The increase in Country As real interest rate makes Country As domestic currency
denominated assets more attractive. This can be represented by a rightward shift of the
demand curve for Country As domestic currency denominated assets from D
$0
to D
$1
. As a
result, the exchange rate will appreciate from E
0
to E
1
= E
par
, the pegged (or fixed) exchange
rate value.

The appreciation of Country As currency from E
0
to E
1
= E
par
reduces the cost of foreign
goods imported into Country A. As a result, Country A experiences a favorable short-run
aggregate supply shock. This can be represented by a downward shift of the short-run
aggregate supply curve from SRAS
0
(
e
=
0
) to SRAS
1
(
e
=
0
).

As a result of these changes, Country As economic output has declined from Y
0
= Y
P
to Y
1
,
inflation has declined from
0
to
1
, the exchange rate has appreciated from E
0
to E
1
= E
par
,
and net exports have declined (because the stronger currency reduces exports and increases
imports).
Exam #3 (Spring 2013) 10/12
d. Clearly explain the specific steps that Country As central bank must undertake in order to
maintain the countrys fixed exchange rate. Be sure to discuss what happens to the central banks
balance sheet.

In order to maintain the countrys fixed exchange rate the central bank must sell some of its
international reserves and buy its domestic currency. This will reduce the domestic money
supply and increase the nominal and real interest rate.

The central banks balance sheet will declinethe central bank loses assets (the
international reserves that it had been holding) and also loses liabilities (the domestic money
supply is smaller so there has been a decline in currency outstanding and/or in bank reserves
held at the central bank).

Exam #3 (Spring 2013) 11/12
e. In Year 2, Country A experiences a large negative aggregate demand shock. Incorporating only
this additional information, clearly and accurately show in your diagrams above the subsequent
Year 2 effects of this negative aggregate demand shock on Country As (1) economic output, (2)
inflation, and (3) exchange rate. These effects should be drawn in BLUE.


f. Provide an economic explanation of what you have drawn in your diagrams above. Be sure to
discuss what happens to Country As (1) economic output, (2) inflation, (3) exchange rate, and
(4) net exports and explain why these changes take place.

In Year 2, three separate events occur.

First, expected inflation in Year 1 was greater than actual inflation in Year 1, i.e.,

e
1
=
0
>
1
. Because inflation expectations are formed by a one-period (year)
adaptive process, in Year 2 expected inflation will decreases from
0
=
1
. This can
be represented by a downward shift of the short-run aggregate supply curve from
SRAS
1
(
e
=
0
) to SRAS
2
(
e
=
1
).

Second, the large negative aggregate demand shock would reduce economic output
at any given inflation rate. This can be represented by a leftward shift of the
aggregate demand curve from AD
1
to AD
2a
.

Third, both the downward adjustment of expected inflation and the negative
aggregate demand shock would lead to lower inflation and to a lower real interest
rate (along the MP curve).

If left unchecked this would reduce the demand for Country As domestic currency
denominated assets and cause a depreciation of Country As currency.

In order to maintain the fixed exchange rate at E
par
, the central bank must sell some
of its international reserves and buy its domestic currency. This reduces Country
As domestic money supply, causing the real interest rate to increase, maintaining
the demand for Country As domestic currency denominated assets.

However, this also reduces aggregate demand for any given inflation rate. This can
be represented by a leftward shift of the aggregate demand curve from AD
2a
to AD
2
.

As a result of these changes, Country As economic output has declined from Y
1
to Y
2
,
inflation has declined from
1
to
2,
the exchange rate remained at its fixed value so E
2
= E
par
,
and net exports were unchanged (because the fixed exchange rate was maintained).

Exam #3 (Spring 2013) 12/12
g. Identify and clearly explain two advantages and two disadvantages of Country A having a fixed
exchange rate.

Advantages of having a fixed, overvalued currency:

1. The fixed exchange rate provides a nominal anchor for the central bank, helping the
central bank establish its credibility.

2. The fixed exchange rate helps maintain low inflation if the anchor currency country
has low inflation.

3. Increased imports because foreign goods are now less expensive. This benefits
domestic consumers that buy imported goods and benefits domestic businesses (and
their employees) that depend on imported goods and/or inputs.



Disadvantages of having a fixed, overvalued currency:

1. Country A gives up its ability to have an independent monetary policy by having
both a fixed currency and perfect capital mobility. This means that monetary policy
cannot be used to offsets either domestic aggregate demand shocks to the economy.

2. Country As gives up its ability to have an independent monetary policy by having
both a fixed currency and perfect capital mobility. This means that monetary policy
cannot be used to offset aggregate demand or aggregate supply shocks in the anchor
currencys economy.

3. Reduced exports because Country As exports are now more expensive in the rest of
the world. This disadvantages businesses (and their employees) of export-oriented
businesses.