14.02 PRINCIPLES OF MACROECONOMICS, QUIZ 1

STOP!  READ INSTRUCTIONS FIRST:

Read all questions carefully and completely before beginning the exam.

Label all of your graphs, including axes, clearly; if we can’t read the graph, you will lose points on your answer.

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

The quiz is worth a total of 100 points.

Please use two blue books, one for questions 1 and 2, and one for 3 and 4.   Write your name, TA name, and section or recitation time on each book.  Also, return your 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!

# QUESTION 1:TRUE OR FALSEExplain your answer fully.   20 points (4 pts. each)

1. A shirt manufacturer’s balance sheet is as follows:

1.      Cloth (raw materials) purchased from weavers  \$130

2.      Wages paid to labor                                                     \$80

3.      Profits kept by owners of the firm                                  \$40

4.      Total sales of finished shirts                                           \$250

The value added to GDP in this economy is \$80.

1. If the consumption function is C = c0 + c1(Y-T), and c1 rises, the private savings rate in the economy decreases.
2. The IS-LM model is a good description of the way the economy works in the long

run.

1. If the GDP deflator P is 0.8 in 1999, real GDP is \$8.8 billion in 2000, and nominal GDP is \$10 billion in 2000, then inflation from 1999-2000 is 10%.
2. In an economy where individuals demand half of their money as currency and half as checkable deposits, an expansionary increase in high-powered money by the Central Bank has a larger effect than in an economy where individuals hold all of their money as cash.

# QUESTION 2:THE GOODS MARKET 20 Points (5 pts. each)

Z = C + I + G

C = 10 + 0.8 (Y - T)

T = G = 50

I = 20

1. Solve for the equilibrium level of output.  What is the value of autonomous spending?  What is the value of the multiplier?  Briefly explain the role of the multiplier in the economy.

1. Graph aggregate demand, Z, as a function of income, Y, and plot the equilibrium point from part (a) on the graph.

Now, assume that investment is a function of the interest rate, i:

I = 40 - 100i

Note that the investment level in part (a) corresponds to an interest rate of i=0.2.

1. Find the new equilibrium level of output, Y, if the interest rate falls to i=0.1.  Show this change on your graph from part (b).  Please be sure to clearly label the curves on your graph.

1. Given your answers to (a) and (c), what is the relationship between equilibrium output and the interest rate?  Sketch a graph with i and Y on the axes which contains the equilibrium points from parts (a) and (c).  How does this relationship change when the sensitivity of investment to the interest rate changes?  Explain.

# QUESTION 3: FINANCIAL MARKETS20 Points (5 pts. each)

Md = PY/50i

Ms = 25

P = 1,  Y = 100

1. Solve for the equilibrium value of the interest rate, i.

1. Graph money supply and money demand, and plot the equilibrium point from part (a) on the graph.

Now, assume that output falls to 75.

1. Find the new equilibrium interest rate.  Show this change on your graph from part (b).  Please be sure to clearly label the curves on your graph.

1. Given your answers to (a) and (c), what is the relationship between equilibrium output and the interest rate?  Sketch a graph with i and Y on the axes which contains the equilibrium points from parts (a) and (c).  How does this relationship change with changes in the sensitivity of money demand to the interest rate?  Explain.

# QUESTION 4:IS- LM MODEL   40 Points

Z = C + I + G

C = 100 + .75(Y-T)

I = 80 + .1Y - 150i

G = 60,  T = 40

Md = Y - 3000i

Ms = 1000

1. (6 pts.) Derive the IS curve.

1. (6 pts.) Derive the LM curve.

1. (6 pts.) Find the equilibrium values of i and Y.  Graph your answers to (a) and (b) (recall that i should be on the vertical axis).  Be sure to label the curves IS and LM.

1. (6 pts.) Assume the government adjusts taxes to eliminate the budget deficit.  On a new graph, show the effects of this change on the  model.  Do not redo the algebra, simply show how the curves move as a result of the change.  Show both the old and the new equilibrium levels of Y and i.  What is the effect of the policy on equilibrium output and interest rate?  Is this a fiscal expansion or contraction?

1. (8 pts.) What can the central bank do to offset the effect of the tax change on equilibrium output?  How will the central bank intervene in the bond market to accomplish its goal?  Using the IS-LM model, show the effects of the central bank's actions on a new graph that also includes all of the lines from your graph in part (d).  What is the effect on equilibrium output and interest rate relative to part (d)?

1. (8 pts.) Now return to the original assumptions of the model, where G and T are fixed.  The leaders of the government decide that they would like to increase investment in the economy.  They institute successful policies – such as advertisements, speeches,  etc.— that increase the personal savings rate (i.e. lower the marginal propensity to consume.)  At the same time, they ask the Fed to use monetary policy to lower interest rates.  After these policies take effect, the government is surprised to find that output has not changed at all.  Are you surprised?  Why or why not?  Why might the government want to encourage investment?