MIT - 14.02 Principles of Macroeconomics

14.02 PRINCIPLES OF MACROECONOMICS
FINAL EXAM: Fall 1997 (12/17/97)

Instructions:

Please do not turn to the exam questions until being told to do so.
The exam consists of two parts (T/F/U, and Long Questions).
In the first part (T/F/U), answer all 8 questions in a blue book. Please write on the top right hand corner of the cover page T/F/U.
In the second parts (Long Questions), answer only 4 out of 5 questions. Please answer each question in a separate blue book. Also write on the top right hand corner of the cover page of each blue book the question number (e.g. putting Q1 for question 1, and so on). (Note that if you answer more than four questions in part two, we will drop the highest score.)
Please put your name, your TA's name, and section time on each blue book.
You will have three hours to work on your exam. The total points for the exam is 180 points with score on each part listed inside. Please allocate time you spend on each accordingly.
If you have any questions regarding to the questions in the exam, simply raise your hand and one of the TA will come assist you.
No use of calculator, notes, or books allowed during the exam.

PART ONE: True, False, Uncertain (40 total points)

Answer all 8 questions (5 points each)

Note: Your score will be based on quality and relevance of your argument, not on its length. All of the questions here can be fully answered with three or four sentences and/or a simple graph.

1. A permanent 4 percent increase of nominal money growth rate would lower both the real and nominal interest rates in the short run, and lead to a 4 percent increase in both rates (than their initial levels) in the long run.

2. An increased budget deficit causes a country's currency to depreciate, and its trade balance to improve.

3. A higher savings rate cannot permanently increase a country's growth rate.

4. There is no way to assign a number to the importance of technological progress in economic growth.

5. Expectations of future inflation tend to raise all prices, including bond prices.

6. The main reason for disappearance of the relation between inflation and unemployment rate in the US after 1960s is the large increase of oil price in 1970s.

7. An one-time, 20 percent increase in the nominal money supply would lower the nominal interest rate in the short run, but raise it in the long run.

8. As use of wage indexation becomes more prevalent in the economy, the sacrifice ratio during any disinflation process will be larger.

PART TWO: Long Questions (140 total points)

Answer only 4 out of the following 5 questions (35 points each)

Question 1

Suppose that the U.S. government were to start a new program of greatly expanded aid to the unemployed: unemployed workers would now receive benefits equal to, say, 75 percent of their previous wages, and these benefits would continue as long as the unemployed worker was unable to find a job. The new benefits would not be financed by any new taxes: the government would simply borrow the money.

Using the models developed in this course, show what you think would be the results of this policy for output, unemployment rate, interest rates, and the price level in the short run and in the long run. (Assume a closed economy here.)

Question 2

Suppose an economy is described by the following three equations:

ut - u t-1 = - .5 (gyt - .03) (Okun's law)

Pt - Pt-1 = -(ut - .05) (Modified Phillips Curve)

gyt = gmt - Pt (Aggregate demand relation)

Suppose at the present time (year t), the inflation is running at 10%, and the economy is operating at the natural rate of unemployment

(a) What is the growth rate of output and the growth rate of the money supply in year t?

(b) Suppose now the government tries to use monetary policy to reduce the inflation to 7% in year t+1, to 3% in year t+2, and keep it there after year t+2. What will happens to the unemployment rate and output growth in years t+1, t+2, t+3, and t+4? What money growth rate in years t+1, t+2, t+3, and t+4 will accomplish this goal?

(c) Let define the total sacrifice be the sum of number of point-years of excess unemployment during disinflation process. What is the total sacrifice for the disinflation process described in (b)?

(d) Suppose now instead of disinflation plan in (b), the government wants to reduce inflation from 10% in year t to 3% by year t+1, and keep it there. What should be the total sacrifice in this case? Would your answer change if you were to take into consideration the issue of government's credibility? Explain.

Question 3

Due to financial turmoil in its neighboring countries, the central bank Governor of Siam, a small country with flexible exchange rate regime, decides that it is prudent to increase reserve requirements for all operating commercial banks. This is aimed to assure that commercial banks would have adequate cash to meet a possible rise in deposit withdrawal by the public. In effect, it raises the reserve ratio, the ratio of commercial bank reserves (in the accounts at the central bank) to checkable deposits. Suppose also that the central bank does not change the monetary base.

(a) Explain the effects of this decision on the Siamese money supply.

(b) Ignore, for a moment, the role of international trade and capital movements, and treat Siam as a closed economy. Explain the short run and long-run effects of the increase in reserve ratio on Siamese interest rates, prices, and output (along with the effects on compositions of output).

(c) Assume that the decision to increase the reserve ratio comes as a total surprise to the market. What are the effects of the policy on bond and stock prices on the day of the policy change announcement? What if the increase in reserve ratio has been fully anticipated before the announcement date?

(d) Now bring the international side back in. Explain the short run effects of the increase in reserve ratio on the value of the Siamese currency, and on its trade balance.

Question 4

Suppose that starting from an initial equilibrium at the natural level of output, a country under a fixed exchange rate regime revalues its currency (that is, it decreases its nominal exchange rate and makes its currency more expensive in terms of foreign currency).

(a) Draw an AS-AD diagram illustrating the short-run impact of this policy. Make sure to explain briefly rational for any shifts or movements of AS-AD curves.

(b) In the short run, what happens to the real exchange rate, net exports, and output?

(c) After all adjustments have taken place, indicate the final long-run equilibrium of the economy on your diagram. Again with explanation of any shifts or movements of AS-AD curves.

(d) In the long run, what happens to the real exchange rate, net exports, and output (compared to the initial equilibrium)?

(e) In light of results from (a) to (d), what is then the appropriate combination of policies if the government wants to achieve a lower trade surplus while maintaining output at its initial level (Yn) during adjustment process?

Question 5

Since 1990 the US economy has grown at an average rate of 2 percent. Half of this growth represents growth in employment, the other half from growth in productivity. During the period 1990-1992, growth was less than 2 percent, and the unemployment rate rose to almost 8 percent. Since then growth has averaged a bit less than 3 percent, and unemployment has steadily fallen back to roughly where it was at the start.

(a) What does this experience suggest about the potential long-run growth rate of the economy?

(b) Suppose that someone offers evidence suggesting that official measures of productivity understate the rate of productivity growth by at lest 1, maybe 2 percentage points. How does this affect your estimate of potential growth of the economy?

(c) The advocates of the high-productivity thesis claim as evidence for their case the surprising fact that US inflation rate - as currently measured using the GDP deflator - has stayed low despite the current low unemployment rate. Discuss the view expressed in this statement briefly.