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Exam 2015, questions and answers...

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ECON20401 ONE-AND-A-HALF HOURS

THE UNIVERSITY OF MANCHESTER

MACROECONOMICS IIA

THIS PAPER MUST NOT BE REMOVED FROM THE EXAMINATION ROOM

Answer ALL Questions [Note that each correct answer to multiple choice questions receives two marks]

Electronic calculators may be used, provided that they cannot store text. This examination is NOT negatively marked. The last two pages of this exam paper have been left blank for your ‘working out’. Please note your ‘working out’ will not be seen by the marker, therefore will not gain you marks.

P.T.O.

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SECTION A Answer ALL Questions (60 marks) 1. Consider a closed economy that is characterized by the following equations: Y=C+I+G

(1)

C =120 + 0.3(Y-T)

(2)

I = 0.2Y - 1500r

(3)

T = 150

(4)

G = 200

(5)

Ms=Md

(6)

Ms =90

(7)

Md/P = L(r,Y) = 0.6Y – 1200r

(8)

where Y is gross domestic product, C is private consumption expenditure, I is investment expenditure, G is government expenditure, T is tax revenues, Ms is money supply, Md/P is demand for real money balances, r is the interest rate (in % points), and P is the aggregate price level. A1. Derive the IS and LM curves of the economy, expressing Y as a function of r and assuming P is fixed at 1.0 [8 marks] A2. Calculate the short-run equilibrium values of Y and r assuming P is fixed at 1.0 [8 marks] A3. Derive the aggregate demand (AD) curve of the economy, expressing Y as a function of P, assuming P is flexible [8 marks] A4. Calculate the long-run equilibrium values of r and P, assuming that the potential level of output (Y*) is equal to 400 monetary units. Use the IS/LM and AD/AS models to illustrate graphically the short-run and long-run equilibrium, and to explain how the economy moves from the short-run to the long-run equilibrium. [18 marks] A5. Suppose the government decides to intervene to stimulate the economy towards potential output in the short run. Use the IS/LM and AD/AS models to illustrate this intervention, and to explain the difference, if any, of the outcome to that in the previous question. [18 marks]

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SECTION B

Answer ALL Multiple Choice Questions (40 marks) Please use the Multiple Choice Answer Sheet provided. 1. Ask the invigilator if you do not know your registration number. 2. Enter and code your answers in the Economics Multiple Choice Answer Sheet, following the instructions on that sheet. 3. Do not mark the answer sheet anywhere other than in the spaces indicated. 4. Mark your answer options initially faintly in pencil, to allow you to change your answer. 5. When you have finalised your answer, mark your answer options with a thick, dark line.

1. If Y = AK0.5L0.5 and K and L are 100 and A is 80, the marginal product of capital is: A) 40. B) 80. C) 160. D) 4000.

2. Which of the following is not included in the calculation of GDP? A) The sale of a collectable second hand magazine. B) The value added of a software design company. C) The rent on a house paid to the landlord in the home country. D) A jumper bought from Jack Wills clothing store.

3. If a production function has two inputs and exhibits diminishing returns to scale, then doubling both inputs will cause the output to A) decrease by less than 50%. B) remain constant. C) decrease by more than 50%. D) increase by less than100%.

4. In the context of the closed economy flexible-price model, an increase in the real interest rate could be the result of a(n): A) increase in government spending. B) decrease in government spending. C) decrease in desired investment. D) increase in taxes.

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5. The government introduces an increase in investment tax credits. In a closed economy with the national saving fixed, the real interest rate will A) fall. B) remain constant. C) rise. D) first fall and then rise.

6. If net exports are negative, which of the following is false? A) Domestic investment exceeds domestic saving. B) S – I is negative. C) There is a balance of trade surplus. D) Net capital outflow is negative.

7. The dilemma facing the policy maker in the event of an adverse temporary supply shock is that monetary policy can either return output to the natural rate, but with a ______ price level, or allow the price level to return to its original level, but with a ______ level of output in the short run. A) higher; higher B) higher; lower C) lower; lower D) lower; higher

8. The IS curve shifts when all of the following economic variables change except: A) the interest rate. B) government spending. C) tax rates. D) the marginal propensity to consume.

9. According to the theory of liquidity preference, if the supply of real money balances exceeds the demand for real money balances, individuals will: A) sell interest-earning assets in order to obtain non-interest-bearing money. B) purchase interest-earning assets in order to reduce holdings of non-interestbearing money. C) purchase more goods and services. D) be content with their portfolios. 10. An explanation for the slope of the LM curve is that as: A) the interest rate increases, income becomes higher. B) the interest rate increases, income becomes lower. C) income rises, money demand rises, and a higher interest rate is required. D) income rises, money demand rises, and a lower interest rate is required.

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11. The quantity equation MV = PY implies that the AD curve is A) horizontal. B) vertical. C) upward sloping. D) downward sloping.

12. When drawn with the interest rate on the vertical axis and income on the horizontal axis, the IS curve will be steeper the: A) larger the level of government spending. B) smaller the level of government spending. C) greater the sensitivity of investment spending to the interest rate. D) smaller the sensitivity of investment spending to the interest rate.

13. The LM curve is steeper the ______ the interest sensitivity of money demand and the ______ the effect of income on money demand. A) greater; greater B) greater; smaller C) smaller; smaller D) smaller; greater

14. If the slope of the IS curve is close to zero then the IS curve is drawn _______ and monetary policy is said to be _________. A) vertical; effective B) horizontal; ineffective C) vertical; ineffective D) horizontal; effective

15. If the economy suffers an adverse supply shock then the central bank can stabilize output by A) decreasing the money supply. B) increasing the money supply. C) decreasing government spending. D) increasing government spending.

16. According to the Mundell Fleming model an appreciation of the exchange rate will cause the LM* curve to A) shift to the right. B) shift to the left. C) remain unchanged. D) become flatter.

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17. If expected inflation falls due to the introduction of an independent central bank then the Phillips curve A) shifts upward. B) shifts downward. C) becomes flatter. D) becomes steeper.

18. A fall in consumer confidence about the future, which induces consumers to spend less and save more, will, according to the Mundell-Fleming model with floating exchange rates, lead to: A) a fall in consumption and income. B) no change in consumption or income. C) no change in income but a rise in net exports. D) no change in income or net exports.

19. Based on the sticky-price model, the short-run aggregate supply curve will be steeper, the greater the: A) target nominal-wage rate. B) target real-wage rate. C) proportion of firms with flexible prices. D) proportion of firms with sticky prices.

20. If the government raises taxes and the central bank increases the money supply, then the combined effect of these two policies would cause income to A) rise. B) remain unchanged. C) fall. D) can not be determined from the information given.

END OF EXAMINATION

ANSWER GUIDELINES TO ECON20401 MACROECONOMICS IIA IMPORTANT NOTE: THE FOLLOWING REPRESENTS GUIDLINE ANSWERS TO THE EXAM AND SHOULD NOT BE ASSUMED TO BE ‘MODEL’ ANSWERS SECTION A: Question A1: To derive the IS equation, insert (2)-(5) into (1) and solve for Y: Y=4000-100r (IS equation)

(1)

To derive the LM equation, insert (7)-(8) into (6) and solve for Y: Y=

2000 +100r (LM equation) P

(2)

Now set, by assumption, P=1: Y=2000+100r (LM equation)

(3)

Question A2: To calculate the equilibrium level of output, you first need to rewrite the LM equation with the rate of interest on the left side and everything else on the right: r=0.01Y-

20 (LM equation) P

(4)

Now insert the LM equation (4) into the IS equation (1) and solve for output: Y=2000+

1000 P

(5)

Now set, by assumption, P=1: Y=3000 (short-run equilibrium level of output)

(6)

Now insert the short-run equilibrium level of output into either the IS or LM equations and solve for the rate of interest to calculate its equilibrium value: r=10 percent

(7)

(Note that this is only one of several ways to calculate the short-run equilibrium values of output and interest rates. All correct answers will receive maximum marks). Question A3:

1

As equation (5) above.

Question A4: To calculate the long-run equilibrium level of prices, insert the level of potential output ( Y *  3500 ) into the aggregate demand curve (5) and solve for P: P *  0.67 (long-run equilibrium level of prices)

(8)

To calculate the rate of interest that is consistent with this long-run equilibrium level of output and prices, substitute the long-run equilibrium values of output ( Y *  3500 ) and prices ( P *  0.67 ) into the LM equation (4): r *  5 percent

(9)

At Y=3000, the economy operates below potential hence prices will gradually fall. As the aggregate price level falls, real money supply increases and the rate of interest declines shifting the economy along the AD curve. The process of adjustment will come to a halt when the output gap has been eliminated. At the end of the process, output is 500 units higher, interest rates are 5 percent lower, and prices have fallen by 33 percent. Students are expected to carefully describe and graphically illustrate the process using the IS/LM and AD/AS tools. Marks are awarded for clarity of presentation. Marks awarded for discussing the performance of the model during the financial crisis.

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SECTION B: Answer Key 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

D A D B A C C B B A B C D A A D D A C B

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