14.02 QUIZ ONE: PRINCIPLES OF MACROECONOMICS

STOP!! READ INSTRUCTIONS FIRST.

Read all questions carefully and completely before beginning the exam. There are 5 pages, and 4 sections of the quiz – make sure you do them all.

Show your work on all questions in order to receive partial credit.

If your answer includes a graph, label all curves and axes clearly; if we can’t read the graph, you will lose points on your answer.

The quiz is worth a total of 80 points.

Please use two blue books, one for Part I & II, and one for Part III & IV. Write your name, TA name, and section or recitation time on each book. Also, return your signed copy of the quiz to the TA’s when you complete the test.

No notes, calculators, or books may be used during the quiz.

You will have 2 hours to complete the quiz. Good luck!

PART I: TRUE OR FALSE? (2 points per question, 30 points total)

Explain your answer briefly, in one or two sentences.

1. Increases in government spending are more stimulative to GDP if the Fed has a strict target rather than a loose target.
2. If the government cuts spending in order to reduce the deficit, this always leads to an increase in investment.
3. The higher the rate of voluntary unemployment, the higher the NAIRU.
4. The NAIRU, also called the natural rate of unemployment, is the level of unemployment at which everyone who wants a job has one.
5. The greater the sensitivity of investment and consumer demand to interest rates, the more stimulative is a given increase in the money supply.
6. The LM curve slopes downward because at higher interest rates consumers save more.
7. The growth rate of output can increase without any growth of the capital stock.
8. Today’s capital stock is fully determined by yesterday’s capital stock and today’s investment.
9. In an econometric equation estimation, both the average value of the true error in the sample and the actual mean value of the residuals are equal to zero.
10. A high R² in a traditional consumer spending regression means that high income causes higher consumption.
11. GNP is the sum of all transactions in the economy.
12. The NNP (Net National Product) equals after-tax GNP (Gross National Product).
13. An increase in G shifts the IS curve to the left by the change in G multiplied by the inverse of the marginal propensity to spend GDP on domestic output.
14. The demand for money is positively related to income and interest rates.
15. The Phillips Curve observed in the 1960s in the United States offers a reliable guide to policymakers, establishing the tradeoff they must make between inflation and unemployment for the nation.

PART II: MULTIPLE CHOICE (3 points per question, 18 points total)

Clearly indicate the letter of your answer, and explain your choice in a few sentences.

Consider the following model economy for questions 1 and 2:

C = c₀ + c₁(Y-T)

I = d₀ + d₁Y – d₂i

G = 50

T = 50

X = x₁(Y_foreign)

M = m₀ + m₁Y,

0< c₁ < 1

0< d₁ < 1

0< m₁ < 1

1. Changes in which of the following parameters change the multiplier?

(a) c₁ only

(b) c₁ and c₀

(c) d₁ and c₁

(d) d₁, c₁, and m₁

(e) d₀ and c₀

2. In the above model economy, the most effective way for the government to promptly increase output – holding all else constant – is to

(a) cut taxes (T) by 10.

(b) raise government spending (G) by 10.

(c) encourage consumers to save, thus increasing the marginal propensity to save.

(d) have the Federal Reserve raise interest rates.

(e) put tariffs on exports.

Multiple Choice Continued on Next Page

Multiple Choice Continued

3. Productivity growth comes directly from

(a) increased autonomous consumption.

(b) increased government transfer payments.

(c) a larger fiscal multiplier.

(d) construction of new domestic infrastructure.

(e) an influx of low-skilled labor into the economy.

4. If the Federal Reserve increases the money supply and the government raises taxes,

(a) the effect on output is positive and the effect on interest rates is ambiguous.

(b) the effect on output is negative and the effect on interest rates is ambiguous.

(c) the effect on output is ambiguous and the effect on interest rates is negative.

(d) the effect on output is ambiguous and the effect on interest rates is positive.

(e) the effect on output is positive and the effect on interest rates is negative.

5. Which of the following will have the largest deflationary impact on the economy?

(a) An increase in government expenditures.

(b) An increase in the money supply.

(c) An increase in voluntary unemployment.

(d) An increase in involuntary unemployment.

(e) An increase in the markup of prices over costs.

6. With respect to an ordinary least squares regression of consumption on income, which of the following is an estimate of the income elasticity of consumption?

(f) cov(ln(C),Y)/var(ln(C))

(g) cov(C,ln(Y))/var(C)

(h) cov(ln(C),ln(Y))/var(ln(Y))

(i) cov(ln(C),ln(y))/var(Y)

(j) none of the above

PART III: LONG QUESTION ONE (17 points)

Build a basic model of an economy from the following description:

Businesses:

n On average, buy $190 of new equipment each year

n They reduce purchases by $10 for each 1 percentage point interest rates exceed 5%, and raise them symmetrically for lower interest rates. (Hint: r, the interest rate, enters the equations as a whole number like 4,5, or 6 and not .04, .05, .06.)

Consumers

n Receive all gross income (GDP) in the economy as either wages or dividends.

n Pay 30% of gross income in taxes.

n Receive 10% of GDP as transfer payments from the government such as social security benefits (which aren't taxed).

n Spend 75% of their after-tax income on consumer goods.

n 1/6 of their consumer purchases are imports.

Government

n The Government buys $200 in goods.

n No taxes other than income taxes are collected.

Foreign Buyers and Sellers

n Imports as noted above.

n $100 in exports are made each year.

1. (7 points) Begin by simply writing out the set of simultaneous behavioral equations describing this economy based on the text above:
1. Investment Spending (I=…)
2. Consumer Spending (C=…)
3. Taxes (T=…)
4. Transfers (Tr=…)
5. Disposable Income (YD=…)
6. Imports (M=…)
7. Plus the core definition, GNP=…
2. (5 points) Combine the simultaneous equations and the basic definitional equation for GNP, and then solve for the key reduced form equation for GDP. Write this derived "IS" curve equation.
3. (3 points) Assume the central bank initially sets the interest rate = 4%. Solve the equations to produce the initial equilibrium values for:
1. GDP (Y)
2. Consumption (C)
3. Investment (I)
4. (2 points) Calculate the government budget surplus, showing the steps below:
1. Taxes
2. Transfers
3. Purchases of Goods and Services
4. Total Outlays
5. Surplus

PART IV: LONG QUESTION TWO (15 points)

Fill in the blanks for 1 and 2, and give a short answer for 3. (Elaborate on your answer as necessary to resolve any unintended ambiguity about which you are concerned—none is intended.)

1. (3 points)The IS Curve created above describes equilibrium pairs of ________ and ________that correspond to balance in the______________________ market, given assumptions for ______ policy.

2. (3 points) The LM Curve, in contrast, describes equilibrium pairs of the same variables with respect to the______________________ market, given assumed values for the ____________ and the ____________.

3. (9 points) Explain concisely (that is, in approximately 40 words or less) the very basic demand concepts that interact to create the expected slope of the LM curve.