*14.02 PRINCIPLES OF
MACROECONOMICS, CONFLICT QUIZ 3*

**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, and is two pages.

**Please use two blue books. Put
questions 1 & 2 in the first book.
Put question 3 in the second book.
** 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
FALSE** Explain your answer
fully.

* *

a. The Phillips Curve tells us that as long as we don't mind high inflation, we can maintain as low a level of unemployment as we want.

b. In order to disinflate, the Central Bank must eventually reduce money growth.

c. In the AS-AD framework, when government spending rises, only the AS and IS curves move immediately.

d. In an open economy with credible fixed exchange rates, since the interest rate is fixed, the price level has no effect on output. Therefore, the aggregate demand curve is vertical.

e. A monetary expansion decreases nominal interest rates both in the short- and the medium-run.

**QUESTION 2: OPEN
ECONOMY AS-AD ***(20 points)*

** **

A small country implements a fixed exchange rate at a credible level and unemployment is at its natural rate.

a. Draw the aggregate demand and aggregate supply curves. Explain the sign of the slopes in each curve.

b. What happens if investors expect a devaluation in this country? Explain in words and through a graph.

c. What will happen to real exchange rates? Explain.

d. What are the chances that this country will need to devalue? Explain in words and with a graph.

** **

** **

** **

A country has the following characteristics:

C = 24 + 0.6(Y - T)

I = 40 - 0.8i (for simplicity, assume that Investment depends on nominal interest rates)

T = G = 20

M = 60

Real Money Demand = Y - i

Bargaining function = F(u,z) = z - 180u

Wage setting equation: W= P^{e}F(u,z) (Note that
productivity does not enter wage setting.)

z = 360

Markup over costs is 100%: m = 1

Labor productivity = A = 120

Labor force is normalized to one: L= 1

a. Calculate the goods market equilibrium equation.

b. Calculate the money market equilibrium equation.

c. Draw the IS-LM curves, and calculate the equilibrium output for P = 1.

d. Calculate the aggregate demand curve. Graph it, and explain in words the sign of the slope.

e. Calculate the wage setting, price setting and aggregate supply equations. Graph the aggregate supply equation, and explain in words the sign of its slope.

f. Draw the AD-AS curves and calculate the natural rate of unemployment. (You can leave this number as a fraction.)

g.
Assume that currently the expected price level, P^{e},
is equal to ½. Calculate and graph
output.

h. If there is no type of intervention by authorities, what mechanism will move this country to its natural rate of unemployment? Calculate the price and output levels associated with this new equilibrium.

i. Give four different policies that could take the economy back to its long run equilibrium in a shorter period of time. (Think of two policies associated with the 'demand' side and two associated with the ‘supply’ side.)

j. Let's go back to the scenario in part (g). Authorities decide to apply monetary policy to get back to the natural rate of unemployment. By how much should they change the money supply? What price level will they get by implementing this policy?

k. What happens if, given your change in money supply, people anticipate the policy and lower their price expectations immediately? Explain your result in words and through a graph.

l. Based on the previous scenario, explain the significance of expectations in policy making.