Econ 102 Midterm (Answer Key)

Chris Surro
August 23, 2017

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Exam Rules
1. The exam starts at 8:30 and ends at 10:30.

2. There are 25 multiple choice questions worth 2 points each, 5 short answer questions
worth 5 points each, and 5 longer questions worth 10 points each (total 120 points). It
is intended to be long. Pace yourself and answer questions you know first.

3. Make sure to fill in the scantron for multiple choice questions. You will not be given
extra time at the end.

4. Simple calculators are allowed (no graphing calculators). If you do not have a calculator
you can leave answers as fractions.

5. Please put all materials other than your calculator, blue book and a pen or pencil in
your bag. If you have a phone or other item out for any reason you will be given a 0
on the exam.

6. If you have a question or need to go to the bathroom raise your hand.

7. All answers should be written in your blue book (or scantron for multiple choice).
Work written directly on the exam will not be graded.

8. On the long questions you must SHOW ALL WORK. No credit will be given for an
answer with no work.

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Multiple Choice (2 points each)
1. Which of the following activities will increase United States GDP this year?

(a) A US citizen mows his neighbor’s lawn in return for the neighbor babysitting his
kids
(b) Samsung (a South Korean company) builds a new factory in California
(c) Apple (an American company) builds a new factory in China
(d) Ford sells a car produced last year from its inventory

2. Who is the current chair of the Federal Reserve?

(a) Ben Bernanke

(b) Alan Greenspan
(c) Paul Volcker
(d) Janet Yellen

3. An economy can be described using a Cobb-Douglas production function. An earth-

quake destroys half of the capital stock (without affecting the labor supply). Which of
the following will occur

(a) Total production in the economy will be cut in half

(b) Wages will fall
(c) The marginal product of capital will decrease
(d) The share of income going to capital will increase

4. The Federal Reserve increases the money supply. At the same time, a wave of new
technological innovation increases the productive capacity in the economy. According
to the AS-AD model, which of the following will happen for sure?

(a) Real output will increase

(b) Prices will decrease
(c) Both (a) and (b)
(d) None of the above

5. Real GDP grows at a constant rate of 3% per year. The Fed increases the money
supply at a constant rate of 5% per year. If the quantity theory of money holds, what
is the inflation rate?

(a) 8%
(b) 2%
(c) 5%
(d) -5%

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 6. A Japanese citizen buys 100 shares of Facebook stock. In the US balance of payments,
this transaction on its own will cause

(a) An increase in the current account

(b) A decrease in the current account
(c) An increase in the capital account
(d) A decrease in the capital account

7. The government increases spending by 1000 and raises taxes by 1000. According to
the loanable funds model, the real interest rate will

(a) Increase
(b) Decrease
(c) Remain the same
(d) Cannot be determined without more information

8. Milton Friedman

(a) Believed business cycle fluctuations were caused by ”animal spirits”

(b) Argued that the money supply should grow at a constant rate
(c) Supported the theory that people consume a fixed percentage of their income
(d) Thought monetary policy had little effect on the economy

9. All of the following are likely to increase the unemployment rate in the short run
EXCEPT

(a) A higher minimum wage

(b) Increased unemployment benefits
(c) Rapid technological change
(d) Decreased legal protection for unions

10. The amount of currency in an economy right now is $500. Everybody decides to put
all of their money in a bank. What happens to the money supply if banks lend 9/10
of their deposits?

(a) No change
(b) Increase by $500
(c) Increase by $4500
(d) Increase by $5000

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11. The unemployment rate in the United States in July 2017 was
(a) 4.3%
(b) 2.6%
(c) 6.4%
(d) 8.2%
12. The Taylor Rule
(a) Says that the Fed should target 2% inflation
(b) Suggests interest rates should be as low as possible
(c) Offers a guideline for how the Fed sets the interest rate in response to changes in
inflation and output
(d) Has always been the main method the Fed conducts monetary policy
13. A price increase for oranges causes more people to consume apples instead. Which of
the following is most likely to be true.
(a) Nominal GDP will grow less than real GDP
(b) Inflation will be higher using the CPI approach than the GDP deflator approach
(c) Using the CPI to measure inflation will understate the true cost of living
(d) Production of oranges will increase
14. What inflation rate does the Federal Reserve target?
(a) 0%
(b) 2%
(c) 5%
(d) 10%
15. Which of the following is a flow variable
(a) The unemployment rate
(b) The money supply
(c) Government debt
(d) Investment
16. Who is most likely to benefit from higher than expected inflation
(a) A worker who signed a 2 year contract
(b) A store who produces most of its sales through a yearly printed catalog
(c) A college student with student loans
(d) A bank

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17. In countries with high rates of inflation, which is most likely to be true

(a) Inflation will be more volatile than in countries with low inflation
(b) The quantity theory of money is unlikely to be a good assumption
(c) Money supply growth is low
(d) All of the above

18. If nominal GDP in 2015 was 1000, real GDP in 2016 was 1100, and the inflation rate
was 5% from 2015 to 2016, what was nominal GDP in 2016 (assume 2015 is the base
year) in 2016?

(a) 1,155
(b) 1,050
(c) 1,047.62
(d) 952.38

19. Donald Trump passes a large tariff on Chinese goods. Which of the following is LEAST
likely to occur

(a) US imports of Chinese goods will fall

(b) The real exchange rate between the US and China will rise
(c) The trade deficit will go down
(d) Prices of consumer goods in the US will increase

20. Quantitative Easing (QE) refers to

(a) Government spending to increase GDP

(b) Large central bank purchases of treasury bonds and other assets
(c) Reductions in the Federal Funds rate
(d) Increasing the inflation target

21. Which of the following would NOT count as investment in the measurement of GDP

(a) An investor buys a share of Amazon stock

(b) Apple increases the stock of iPhones it holds in its inventories
(c) A family buys a newly built house
(d) All of the above would be included

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22. The world interest rate increases. What happens to the real exchange rate in a small
open economy?

(a) Increases
(b) Decreases
(c) No change
(d) Not enough information to determine

23. Government spending increases. In the classical model of the economy, which of the
following will NOT occur

(a) The real interest rate increases

(b) Investment decreases
(c) National savings falls
(d) Real GDP increases

24. During the Great Recession

(a) The Federal Reserve cut the money supply

(b) Government spending decreased
(c) The velocity of money fell
(d) Banks held almost zero excess reserves

25. The largest component of GDP is

(a) Consumption
(b) Investment
(c) Government Expenditure
(d) Net Exports

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Short Answer (5 Points Each)
Please answer the following questions in 2-3 sentences.

1. List two reasons why the CPI tends to overstate the true cost of living. Briefly explain
why each would cause an upward bias.
There are three reasons. First, when the price of a good rises people can substitute
towards other similar goods so that the price increase does not harm them as much
as CPI implies. Second, since new products cannot be included in the CPI basket,
they will not be included in its measurement, but many new products can significantly
reduce the cost of living. Finally, if a good changes quality, the CPI might observe its
price as constant when really it should be decreasing (a price decrease and a quality
increase both reduce the cost of achieving a certain standard of living)

2. Explain each of the following tools of the Federal Reserve and how each can be used
to expand or contract the money supply. Does each work by changing the monetary
base or the multiplier?

a. Open Market Operations

The Fed buys bonds in order to increase the monetary base and sells bonds to
reduce the monetary base
b. Discount Rate
The discount rate is the rate at which other banks can borrow from the Fed.
By lowering this rate, the Fed can induce banks to borrow more, increasing the
monetary base, and by increasing it they can discourage lending, decreasing the
base
c. Reserve Requirements
The Fed sets the minimum ratio of reserves to deposits held by banks. If they
reduce this requirement, banks can lend a larger portion of their deposits so the
multiplier increases. The opposite occurs if they raise the required reserves

3. Data shows that the share of income going to labor has fallen in the US. Explain one
theory for why this might be happening.
There are three possible answers. First, as technology improves, labor can be substi-
tuted with capital, increasing capital’s share and reducing labor. Second, globalization
has opened the option to use cheap labor from other countries, reducing the need to use
labor in the US. Finally, mismeasurement of depreciation could mean that the decline
is just a statistical illusion.

4. Explain what has happened to the share of labor working in agriculture, manufacturing,
and services in the US since 1900. Drawing a graph would be an acceptable answer
(does not have to be perfectly scaled, but direction must be correct).
Agriculture has steadily declined. Services have steadily increased. Manufacturing
increased in the first half of the century, decreased in the second.

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5. Give two reasons why GDP is not a perfect measure of well-being. Be sure to explain
why each is not captured by GDP but still affects welfare.
Home production is not a market transaction but it still produces goods for the econ-
omy. Negative externalities like pollution cause harm to many people but are excluded
from GDP. Some products included in GDP are harmful to the people that consume
them (cigarettes, fast food, etc.), but these harmful effects are ignored. Inequality is
also ignored, but average welfare doesn’t go up if all the wealth accrues to the rich.
Many other reasons are possible

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Numeric Questions (10 Points Each)
1. Two countries, country A and country B produce using three factors of production:
land (T), labor (L), and capital (K) with the same production function:
Y = ZT 1/3 L1/3 K 1/3 , where Z is the level of technology in each country.

(a) (2 Points) Is this production function constant, increasing, or decreasing returns

to scale?
Constant

F (aT, aL, aK) = Z(aT )1/3 (aL)1/3 (aK)1/3 = aF (T, L, K)

(1 point for correct answer - 1 point for derivation)

(b) (2 Points) Show that the share of income going to each factor of production is the
same. What share goes to each factor?

The share of income going to labor is:

wl (M P L)L 1 L 1Y L
= = ZT 1/3 L−2/3 K 1/3 = = 1/3
Y Y 3 Y 3LY
The other two factors would be the exact same calculation with each marginal
product. Each gets 1/3 of total income
(1 point for correct answer - 1 point for derivation)
For the remainder of the problem assume that each country has the same level of
land and capital, K = 8 and T = 27 and that these factors are immobile. The
two countries also begin with the same level of labor L = 64, but differ in their
technology. Country A has Z = 60 and country B has Z = 20

(c) (2 Points) Find the wage in each country if labor is immobile. Which country
would have more workers if labor were free to move to either country costlessly?
Wage is equal to MPL and we have
1
M P LA = (60)(27)1/3 (64)−2/3 (8)1/3 = 7.5
3
1
M P LB = (20)(27)1/3 (64)−2/3 (8)1/3 = 2.5
3
Country A will have more workers since workers will move to seek the higher wage
(1 point for correct wage numbers, 1 point for saying A will have more workers)
(d) (4 Points) Find the long run equilibrium wage and the number of workers in each
country if labor can move freely (decimals are ok and remember the total number
of workers is 128)
Set MPL equal in each country:
1 1
M P LA = (60)(27)1/3 (LA )−2/3 (8)1/3 = (20)(27)1/3 (LB )−2/3 (8)1/3 = M P LB
3 3
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  2/3
−2/3 −2/3 LA
120(LA ) = 40(LB ) =⇒ 3 = =⇒ LA = 5.2LB
LB
LA + LB = 128 =⇒ 5.2LB = LB = 128 =⇒ 6.2LB = 128 =⇒ LB = 20.65
LA = 128 − 20.65 = 107.35
Plugging labor into the MPL for either country gives the wage

w = 120(107.35)−2/3 = 5.31

(2 Points for setting MPL equal. 2 points for correct labor and wage numbers

2. You are given the following data on an economy. Assume the assumptions of the
classical model of the economy hold.

Y = 10, 000

C = 300 + .75(Y − T )
I = 1500 − 30r
G = 2500
T = 2000

(a) (2 Points) Explain why the investment curve is downward sloping.

When the interest rate is high, firms need to pay a higher cost to borrow money
to invest. Therefore they will only invest in projects that have a very high return.
As the interest rate decreases, more projects become profitable so investment
increases. Equivalently, you could say that the interest rate represents the oppor-
tunity cost of investing (i.e. you could have put your money in the bank rather
than invest it). Therefore a higher interest rate increases the cost of investing.
(b) (2 Points) Solve for the equilibrium interest rate
Plugging in the equations above to Y=C+I+G we get

10, 000 = 300 + .75(10, 000 − 2000) + 1500 − 30r + 2500

300 = 30r
r = 10
(1 point for plugging the equations into GDP, 1 point for the correct r)
(c) (2 Points) The government wants to increase GDP by spending more. Is it pos-
sible? Why or why not? For full credit your answer must explain any changes in
other components of GDP (if any) and why they occur.
No it is not possible. If government spending increases, public saving falls (so
national saving falls). This causes an increase in the real interest rate which
reduces investment by the same amount as the increase in government spending
(1 point for saying GDP will not increase. 1 point for saying real interest rate
will increase causing investment to decrease)

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(d) (4 points) On a properly labeled graph (does not have to be scaled correctly) of
the loanable funds market, show how each of the following changes would affect
real interest rates and the quantity of saving and investment
i. (1 Point) A decrease in taxes
Savings curve shifts left, causing interest rates to rise and investment and
saving to fall
ii. (1 Point) An increase in business confidence
The investment demand curve shifts right, causing real interest rates to in-
crease, but no effect on the quantity of savings and investment
iii. (1 Point) An increase in the marginal propensity to consume
Savings curve shifts left, interest rates rise and investment and savings fall
iv. (1 Point) A reduction in the labor force
Savings curve shifts left (since Y decreases), interest rates rise and savings
fall

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3. A small open economy faces a world interest rate of 5%. You are given the following
information
Y = 8, 000
C = 1500 + .5(Y − T )
I = 2000 − 100r
G = 3000
T = 2000
N X = 2500 − 500ε
(a) (2 Points) What is national saving in this economy? What is investment? Explain
why they are not equal.
Saving = Y - C - G = 8000 − 1500 − .5(8000 − 2000) − 3000 = 500
Investment = 2000 − 100(5) = 1500
They are not equal because we are in an open economy so we need to consider
NCO. In this case, foreigners are investing in the domestic country, which causes
investment to be greater than domestic saving.
(1 point for correct saving and investment numbers. 1 point for explaining why
savings does not equal investment
(b) (2 Points) Solve for the equilibrium real exchange rate ε
Plug into Y = C + I + G + NX:
8000 = 1500 + .5(8000 − 2000) + 2000 − 100(5) + 3000 + 2500 − 500ε
3500 = 500ε
ε=7
(1 point for setting up equation correctly. 1 point for correct exchange rate. Full
credit also given if you noticed NC)=-1000 and NX=NCO and plugged that into
the NX equation directly)
(c) (2 Points) Solve for NX. Does the country have a trade deficit or surplus?
NX=NC) = S - I = -1000. Trade deficit (1 point for number. 1 point for saying
it is a deficit)
(d) (2 Points) The government wants to increase net exports so it imposes a tariff on
imports, which changes the NX curve to
N X = 1500 − 500ε
Explain why the policy does not accomplish the government’s goal.
If NCO does not change, then the trade deficit will not change. Any adjustments
will occur through the real exchange rate (Note: the equation above is not quite
right. I meant for NX to shift right but the above curve is a shift left. If you
cited that as the reason the policy didn’t work I’ll give credit for that too, but
that was an error on my part. Regardless you should know that no government
policy works unless it changes NCO

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 (e) (2 Points) How could the government increase net exports (there are many possible
correct answers and you may want to use a graph to help explain your answer)?
Anything that causes an increase in NCO would be acceptable. For that we need
either saving to increase or domestic investment to decrease. The easiest way to
do this would be through increasing taxes or decreasing government spending.
Taxing investment would also work, or some sort of growth policy that boosts
GDP. As long as you justify why the policy would increase NCO you get credit
4. The Federal Reserve sets the monetary base at 10,000
(a) (2 Points) If banks hold 10% of their deposits as reserves and consumers hold
5,000 as currency, what is the money supply? What is the money multiplier?
We know that rr = 1/10, C = 5000, and B = 10,000. Therefore R = 5000 since
B = C + R. Banks are holding 1/10 of deposits as reserves so D must be 50,000.
Then M = C + D tells us the money supply must be 55,000. We can then get the
multiplier by dividing M/B = 55,000/10,000 = 5.5. Plugging into the multiplier
equation would also work.
(1 point for money supply, 1 point for multiplier)
(b) (3 Points) The Fed sets the reserve requirement at 10% and increases the monetary
base by 5,000. The money supply increases by 10,000. If currency remains at
5,000, how much are banks holding as excess reserves? What is the multiplier?
Now we know M = 65,000, B = 15,000, and C = 5,000. Immediately we can
see R = B - C = 10,000 and D = M - C = 60,000. Since required reserves are
10% of deposits that would tell us that with 0 excess reserves banks should be
holding 6,000 in reserves. Therefore excess reserves are 4,000. The multiplier now
is 65,000/15,000 = 13/3
(2 points for excess reserves. 1 point for multiplier)

For the remaining parts, assume banks hold no excess reserves and currency is 0.
The required reserve ratio is still 10% and the monetary base is 10,000
(c) (2 Points) Assume the quantity theory of money holds. If real GDP is 50,000 and
the price level is 2, what is the velocity of money?
We can get the money supply from the above information as 10,000/.1 = 100,000.
Then using the quantity equation:

M V = P Y =⇒ 100, 000V = 50, 000(2) =⇒ V = 1

(1 point for writing down the quantity equation. 1 point for correct velocity)
(d) (3 Points) Real GDP decreases 10% from its value in the previous question. If the
money supply and price level did not change, what is the new value of velocity?
If the Fed wants to return to the previous level of nominal GDP, where should it
set the monetary base?
Again using MV = PY, we now have:

100, 000(V ) = 45, 000(2) =⇒ V = 0.9

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To return to the previous level of nominal GDP we need:

M (.9) = 100, 000 =⇒ M = 111, 111.111 =⇒ B = 11, 111.111

11,000 would also be an acceptable answer (if you used growth rates)
(1 point for the new velocity, 1 for the correct money supply. 1 for recognizing
that I said monetary base and the multiplier is 10, so the base should be 1/10 of
M

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5. In the long run equilibrium of an economy the money supply is 10,000, velocity is 10,
the price level is 5, and real GDP is 20,000

(a) (4 Points) Derive the AD curve and sketch an AS-AD graph of this economy in
long run equilibrium (it does not have to be perfectly scaled, but the equilibrium
point must be properly labeled at the correct value and the curves must be the
correct shape).
The AD curve is:
MV 100, 000
P = =
Y Y
The graph is just the standard AS-AD model curves (AD, SRAS, LRAS) inter-
secting at P=5 and Y=20,000
(1 point for AD curve equation. 3 points for graph)
(b) (2 Points) The Fed increases the money supply. Show the short run and long run
effects of the policy on a graph.
AD shifts to the right. Short run: Y increases and P is constant. Long run: P
increases and Y returns to original level
(c) (2 Points) The baby boomers retire, reducing the size of the labor force. Show
the effects on a graph.
LRAS shifts left. No short run effects. In the long run prices rise and output falls
(d) (2 Points) The Fed wants to keep the price level stable. Given the change in part
c, what should it do? Show on a graph.
Decrease aggregate demand by reducing the money supply

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