QUIZ #1: Fall 1997 (10/9/97)

Answer any 6 of 8 questions (30 points)

1. GDP is the sum of all business sales.
2. There is a very close relationship between GDP growth and changes in unemployment.
3. Changes in consumer confidence are the main source of fluctuations in output.
4. A high savings rate automatically leads to high investment.
5. All money in the U.S. economy is created by the Federal Reserve.
6. An attempt to reduce the budget deficit will necessarily raise unemployment.
7. Other things being the same, higher inflation leads to higher real output.
8. Because consumers have a long time horizon, there is very little relationship between current income and current consumption.

Part B: SHORT PROBLEMS (15 points each)

1. In a surprise announcement, Bill Clinton and Newt Gringrich say that they have agreed to a package of spending cuts and tax increases that will balance the budget much sooner than previously planned - in fact, they can do it right away. Alan Greenspan also attends the press conference, and indicates that this move will allow him to loosen monetary policy - although he also warns that given the current tightness of labor market it remains important to remain vigilant against inflation.

(a) Using the IS-LM framework, show how the proposed package would affect the economy.
(b) What will happen to the following variables: investment; consumption; unemployment?
(c) What will happen to stock and bond prices? Why?
(d) Suppose the agreement does not take effect immediately but will go into effect two ears from now. What will happen to today's stock and bond prices? Why?

2. Recently the Consumer Price Index has been criticized by many economists.

(a) Explain how the CPI is constructed.
(b) Give at least three reasons for believing that it overstates the true rate of inflation.
(c) Some critics have pointed out that because different income groups have different consumption patterns, they really should have separate consumer price indexes. Which so you think has risen more over the last ten years: the (true) consumer price index for families living on welfare, or that for well-off yuppies? Explain your answer, or why you aren't sure.

Part C: LONG QUESTION (30 points)

Consider the following model:

C = c0 + c1*(Y-T)

I = d0 + d1*Y - d2*i

M = k*Y - h*i

with c1 + d1 < 1, and G, T are exogenous. Assume there is no inflation. Notice that both the investment and the money demand functions are little bit different from those n this textbook.

1. Write an expression for the IS curve of this economy. Please also calculate the slope of the IS curve.
2. Write an expression for the LM curve. Also, for its slope.
3. Derive an overall expression for Y as a function of G, T, and M, along with other relevant parameters.
4. How would you represent a decline in consumer confidence in this model? Then, show its effect on the economy, using the IS-LM diagram. What happens to each component of GDP (i.e. consumption, investment, government spending)?
5. There used to be a debate over the responsiveness of money demand to the interest rate, with some economists arguing that it was very small, others that it was very large. How would this responsiveness affect the IS-LM diagram? How would it affect your assessment of the importance (or the effectiveness) of monetary policy? Of fiscal policy?
6. In the first few lectures of this course we learned that "multiplier" is always greater than 1. Is that true here? Why or why not? (Give some economic intuition).

Updated 15-Oct-97 at 14:35 EDT by ythai@mit.edu