Econ 1120 – INTRO MACRO – Fall-2012 –November 1, 2012Regular PRELIM #2 (Thursday)PRINT YOUR NAME: ____________________________________ Your C.U. Netid: _____________

YOUR C.U. STUDENT NUMBER: ____________________________

Check YOUR TA’s NAME:

_____________TA = Naoko Iida (Tuesday sections)

_____________TA = Yuzheng Sun (Wednesday sections)

_____________TA = Aichatou Fall (Thursday sections)

_____________TA = Yijun Pan (Friday sections)

INSTRUCTIONS:

There are two sections in this exam Part I: 15 multiple choice questions @ 3 points each Part II: 2 short answer question (27 points) + 2 Newspaper Article questions (28 points) ANSWER ALL QUESTIONS. TOTAL POINTS = 100. TOTAL TIME = 90 minutes. Prelim2 score counts for 25% of final grade.

AGAIN, please….

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PRINT YOUR NAME: ____________________________________ Your C.U. Netid: _____________

YOUR C.U. STUDENT NUMBER: ____________________________

_____________TA = Naoko Iida (Tuesday sections)

_____________TA = Yuzheng Sun (Wednesday sections)

_____________TA = Aichatou Fall (Thursday sections)

_____________TA = Yijun Pan (Friday sections)

GRADING----------------------------------------------------------------------------------------------------------

________/ 45 (mc)______/ 15 (short essay 1) ______/ 12 (short essay 2) _________/ 16 (long essay 1)________/1 2 (long essay 2)

TOTAL: ___________/100 -------------------------------------------------------------------------------------------------------------------------

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Part I: Multiple Choice.

1. One possible explanation for involuntary unemployment isa) minimum wages b) the labor market is perfectly competitivec) the firms, knowing the supply and demand curve for labor, implement the equilibrium wage, which happens to be so low that many people prefer to stay at homed) maximum wages which are implementede. None of the above

2. Which of the following will break down the negative relationship between the unemployment rate and the inflation rate as predicted by the conventional short run Phillips Curve? a) Demand-pull inflation b) Cost-push inflation c) The negative relationship between the unemployment rate and the inflation rate never breaks downd) None of the abovee) Not enough information to say

3. Which of the following statements is false?a) Social Security will be unable to make any payments to beneficiaries once its Trust Fund runs out of money.b) Social Security is the most important program we have for disabled people to have some income.c) Half of our seniors rely on Social Security for all or most of their income.d )Social Security benefits depend on how much income you earned during your working years.e) All of the abovef) None of above

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4. When economy is in recession, which of the following policies could the Fed’s economists recommend?

I. FOMC (Federal Open Market Committee) should sell securitiesII. The Fed should decrease the supply of the US DollarIII. The discount rate should be decreasedIV. The treasury should increase taxes

a)I, II and IVb)I, II and IIIc)I and IIId)III only.

5. According to the Laffer Curve, as tax rates increase, tax revenues willa) Increaseb) Decreasec) Increase and then decreased) Decrease and then increase

6. Supply side economics says that cutting tax rates results in higher tax revenue. Which of the following statements is true?a) This can never be trueb) This can be true under some conditionsc) This is always true.d) The tax cuts of the last 12 years proved this to be true.

7. Which of the following factors can lead to a decrease in the equilibrium interest rate level?

I. The Fed decreases the required reserve ratio.II. The Fed increases the required reserve ratio.III. The Fed sells securities in the open market.IV. The Fed purchases of securities in the open market.V. People’s income and wealth decreases.VI. Price level increases.

a) I , III, and V.b) II, IV and VI.c) I, IV and V.d) II, IV and V.

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8. The crowding out effect associated with expansionary fiscal policy will be relatively small when

I. The Fed implements expansionary monetary policy. II. The Fed implements contractionary monetary policy. III. Investment is very sensitive to changes in interest rate.IV. Investment is not sensitive to changes in interest rate.

a) I and III.b) I and IV.c) II and III.d) II and IV.

9. Deficit Targeting would tend toa) negate inflation and stimulate expansionb) reinforce inflationary pressures and deepen recessionary conditionsc) decrease the nation’s importsd) reduce frictional unemployment

10. Refer to the figure above. Originally, the economy was at point C. Suppose now the aggregate demand shits from AD2 to AD1, and the economy moves to B. If the government does not do anything and there is no technology change, which of the following is likely to happen next.a) AD shifts back and the economy will go back to point Cb) LRAS will shift to the right.c) The economy will move to A as wages adjust to changes in price level.d) SRAS will shift to the right so that it will achieve the original price level.

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11. An increase in the price level of the economy after an increase in oil price is an example of _____. An increased in the price level of the economy after a tax cut is an example of _____.a) Demand-pull inflation; Demand-pull inflationb) Cost-push inflation; Demand-pull inflationc) Demand-pull inflation; Cost-push inflatione) Cost-push inflation; Cost-push inflation

12. When the AS curve has only a slight upward slope, in the short-run, a rightward shift of AD curve will result in a) A small increase in aggregate output and small inflation.b) A large increase in aggregate output and large inflation.c) A small increase in aggregate output and relatively large inflation.d) A large increase in aggregate output and relatively small inflation.

13. Given the life cycle theory, most of a decrease in income taxes will be______ if perceived as temporary changes and ______ if perceived as a permanent change. a) Spent; spentb) Spent; savedc) Saved; savedd) Saved; spent

14. Real wage has increased. Assuming the substitution effect dominates the income effect, supply of labor will ______ and demand for leisure will ______.a) Increase; decreaseb) Increase; increasec) Decrease; decreased) Decrease; increase

15. Two people have the same consumption function. The one with higher income will have a ______ average propensity to consume than the one with lower income individuals.a) higherb) lowerc) the samed) it depends

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Part II: Short Essays (22 points)1. “Housing’s Wealth Effect to Nudge U.S. Spending: Economy” (10 points)By Alex Kowalski and Elizabeth Dexheimer - Sep 19, 2012Confidence Improves

Confidence has improved. The Thomson Reuters/University of Michigan index of consumer sentiment rose this month to the second-highest level since 2007, before the recession started. The index of home-buying conditions reached its highest level in eight years, with the exception of May 2009, when the homebuyer tax credits may have helped boost the index.In Fannie Mae’s August National Housing Survey, 35 percent of respondents said they believed that home prices would rise in the next 12 months, compared with 20 percent a year earlier. Eighteen percent of those surveyed said it was a good time to sell, compared with 9 percent a year earlier.“Rising home prices also lead people to consider investing more in homes,” Matus said. “Very few people actually get in early in a rally, so price increases could potentially be more encouraging for people to join.”Borrowing against one’s home, nonetheless, is harder for many people in the wake of the recession, damping some of the wealth effect, Meyer said. Only one of the 58 senior loan officers surveyed by the Fed said standards for home equity lines of credit, one way housing wealth can stoke spending, were easier in July than they were in 2005. Forty said they were tighter.“The credit channel is an important part of the story as well,” Meyer said. “That probably made the wealth effect more powerful during the boom, but I would argue that it’s going to make the wealth affect more muted now.”

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1. The article mentions that the credit channel is very important for the rising prices to

boost the economy. What can the Fed do to improve the credit channel such that

investors can finance their investment more easily? (Please provide at least one tool

and explain it briefly.) (3 points)

The fed can make sure that banks give out more loans by lowering the required reserve

ratio or lowering the discount rate

2. The article also mentioned consumer confidence has increased. According to the

article, what components of GDP might you expect to increase as a result? (3 points)

Investment (residential investment)

3. Suppose the investment schedule for this economy is very steep (i.e. nearly vertical)

Which policy – monetary or fiscal – would you expect to be more effective and

why? (For the full credit, you need to draw 3 panel diagrams to illustrate your

answer.) (4 points)

The monetary policy becomes ineffective if investment function is step (verticle), for that change of interest rate can not increase or decrease investment. Hence there is no change of output. As depicted in the following graph, any monetary policy won’t affect investment, and investment remains at Y0 for any level of interest rate.Given investment remains at same level, equilibrium of output is the same.

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The fiscal policy is more effective for improving the economy because fiscal policy doesn’t exert its effect through investment. Therefore, increasing or decreasing government expenditure would shift AE upward or downward, resulting in change of Y. As shown in the following graph, the increase of government spending increases equilibrium output.

MS0 MS1

M

r

r0

r1

M0 M1 I0

I

r

AE=C+I0+G

AE

YY0

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MS0

M

r

r0

M0

I0

I

r

AE=C+I0+G

AE

YY0

AE=C+I0+G1

Y1

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2. “Can the euro be saved through internal devaluation alone – and at what political cost?” By Mats Persson, September 28th, 2012 (12 points)

The Spanish government yesterday presented the toughest budget and set of reforms in the post-Franco era, amid continued discontent across the country. The crux for Spain and other weaker euro countries is familiar: since they don’t have the option of currency devaluation to get their economies back on track, all adjustment must instead be achieved by nominal prices, wages and asset values falling (‘internal devaluation’). In turn, the population will have to pick up all the slack through falling wages, fewer social benefits, less job security and so on. This is where the matter becomes politically explosive, as the recent protests sweeping Athens, Madrid and Lisbon have shown. Economic imperatives and deep-rooted political forces are clashing head-on.It is clear that Spain, Greece and others need to undergo far-reaching structural reforms to improve their labour and product markets in order to regain competitiveness, and correct the brutal imbalances that have built up in the Eurozone. Failing this, the euro will have to either break up or go for a full fiscal union. But is it possible to achieve such adjustment – and save the euro – through internal devaluation alone? This is the question Open Europe revisits in a briefing published yesterday (drawing from research by Europe Economics).….

1. Please list 2 reasons which lead to wage rigidity, with brief explanations. (6 points)

Imperfect information: firms may not have enough information about market clearing

wage such that firms can set the wage at wrong level which is above equilibrium

prices. It takes time for firms to learn the related information.

Regulation of minimum wage: the government may setup a regulation of minimum

wage above equilibrium wage rate. Given this, firms has no way to reduce the wage,

and downward rigidity is formed.

(Please check textbook for other factors.)

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2. Please use labor supply and labor demand to explain why wage falling is one of the tools that could reverse increasing unemployment. (For the full credits, you need to draw the diagram for illustration.) (6 points)

Assuming before Euro debt crisis, original labor demand Ld0 and labor supply Ls0. The original equilibrium is L0 and W0.In Euro debt crisis, economy is struggling, and market demand is low. Labor demand shift from Ld0 to Ld1. However, if the wage can adjust quickly to lower level w1, the market reaches a new clearing equilibrium where people, who don’t want to work, are voluntarily. However, wage rigidity, caused by people declining fewer social security, benefit and wage, results in excess supply. Given wage is sticky at W0, the supply is L0 and demand is L0’. This is one of reasons why we observe increasing unemployment in Euro. If we can let wage fall, then the quantity of labor demanded will increases along the line Ld1 and labor quantity increase from L0’ to L1. This will help the Euro to revert the increasing unemployment.

Real Wage

L

Ls0

Ld0

L0

E1W0

W1

Ld1

L1

L0’

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Part III: Long Essay (33 points)1. Monetary Policy and Fiscal Policy (17 points)

“Japan Eases Monetary Policy in Surprise Move”By Wall Street Journal, September 19, 2012

TOKYO—The Bank of Japan announced an aggressive expansion of its monetary-easing program, acting with surprising speed after its analysis suggested that any economic recovery is at least six months away amid a global slowdown.

The BOJ's move Wednesday follows similar actions by other major central banks. The Federal Reserve last week announced another round of quantitative easing, and earlier this month the European Central Bank established an open-ended program sovereign debt buying program in an attempt to end the euro crisis.

"The BOJ deemed it necessary to act so that Japan's economy will not be derailed from a track toward sustainable growth under price stability," Gov. Masaaki Shirakawa said at a news conference after a two-day meeting of the central bank's policy board. He said that a recovery was unlikely before the end of the fiscal year next March.

The Bank of Japan has joined two other central banks in easing monetary policy. Are central banks hinting at more long-term changes? Vincent Cignarella discusses on Markets Hub.

The central banks' actions have raised market concerns that they are engaging in "competitive easings"—each trying to pump more money into its own economy, despite the potential negative impact elsewhere. The persistent high value of the yen, for example—a bane of

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Japanese policy makers—has been attributed in large part to sharply lower U.S. rates caused by the Fed's quantitative easing.

The BOJ policy board Wednesday increased the size of its asset-purchase program to ¥80 trillion ($1.01 trillion) from ¥70 trillion, and extended its deadline by six months to the end of 2013. With interest rates near zero, the central bank's main tool for pumping money into the economy—and stimulating demand—is buying government bonds and other securities.

a) Suppose that in the monetary market, the equilibrium interest rate is positive. What

is expected to happen to Japan’s economy after its government implements an

expansionary monetary policy? Explain in words and using 3 panel diagrams of the

“money market”, “investment market” and “aggregate expenditure and real output”.

(5 points)

b) Suppose now in the monetary market, the equilibrium interest rate is zero. What is

expected to happen to Japan’s economy after its government implements an

expansionary monetary policy? Explain in words and using 3 panel diagrams of

“money market”, “investment market” and “aggregate expenditure and real output”.

(6 points)

c) Suppose now in the monetary market, the equilibrium interest rate is zero. If you

were a policy maker in Japan and your goal is to increase real output, would you use

monetary policy or fiscal policy? Choose one policy that you think is more effective

to increase real output under these conditions and explain how it is expected to work

through 3 panel diagram as well as aggregate demand and aggregate supply curve.

(6 points)

Answer key.1.

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2.

3.(Expansionary)Fiscal policy. An increase in government expenditure or a tax cut will shift up the planned aggregate expenditure curve and as a result increases real out put. There will be a clouding-out effect (money demand goes up -> interest rate goes up -> investment goes down), but overall effect is positive.

Expansionary money policy would not work here. Since the interest rate is already zero, the Japan’s government cannot increase investment by lowering the interest rate.

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2. Aggregate demand and aggregate supply (16 points)

“Kocherlakota: Plan Suggests Easy Fed Policy For Four Or More Years”By Wall Street Journal, October 10, 2012

A key U.S. central bank official refined a plan that could keep monetary policy easy for years to come, in a speech that acknowledged "mixed reactions" to what he has been proposing.Speaking in Great Falls, Mont., on Wednesday, Minneapolis Fed President Narayana Kocherlakota again argued in favor of a policy that would keep central bank policy very easy until the unemployment rate hit 5.5%, as long as inflation stayed under 2.25%. Under such a plan, rate hikes "may not take place for four or more years," he said in the text of a speech prepared for delivery before a local growth.…………………………….....Mr. Kocherlakota noted reactions to his plan was all over the map, saying many observers had misunderstood the case he was trying to make. He argued there's some confusion regarding the true dynamics surrounding the central bank's official mandate to promote job growth while keeping prices stable. Mr. Kocherlakota said in his speech as long as central bankers see "no tension" between the two poles of their mandate, they should keep monetary policy aggressively easy.………………………………..

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Meeting minutes released last week covering the September FOMC gathering showed central bankers devoting considerable attention to the possibility of employing a set of economic variables to greater describe how monetary policy will be conducted. One of the most public advocates for such a system has been Chicago Fed President Charles Evans, who has argued monetary policy should stay very easy until unemployment hits 7% or inflation moves well above the Fed's current target rate of 2% to 3%.

Mr. Evans has argued it's pretty unlikely inflation would go that high with unemployment over 7%. Mr. Kocherlakota offered a similar defense: "Violations of price stability are unlikely to occur until the unemployment rate is considerably lower than its current level of 7.8%." He added, "even though the unemployment rate was at times below 5%, the medium-term inflation outlook based on material prepared for FOMC meetings has not risen above 2 1/4% percent in the past 15 years."…….

Mr. Kocherlakota said the considerable amount of slack in the economy generated by high unemployment rates means there's little chance inflation will flare any time soon. "There is no such tension at this time" between the jobs and inflation mandates, and this lack of tension between its two mandates is likely to continue for some time, he said.

a) Now the economy has a high unemployment rate. Please use an AD and AS diagram

to illustrate why Mr. Kocherlakota and Mr. Evans do not worry that easy monetary

policy will result in high inflation. (6 points)

b) Please explain briefly why the short run aggregate supply curve has a positive slope,

and why the short run aggregate supply curve will eventually turn into a vertical line

as output increases. (4 points)

c) For a new classical economist, who believes the market is efficient and the economy

is always at full employment, what suggestion might this economist make for the

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Fed about monetary policy? (For the full credits, you need to explain why this

economist gives the related suggestions.) (6 points)

a. Because economy has a high unemployment, we are still now having high capacity to

produce. Hence we are at relatively flat segment of AS curve. As shown in the following graph,

given we are at the flat segment of AS, the easy monetary policy, which shifts AD curve to right

from AD0 to AD1, won’t greatly increase our price level. Therefore, we should now worry

about high inflation given the us has high unemployment.

b. the short run aggregate supply curve is positive slope because there is lag between the

change of the price of output and the change of the price of input. The most obvious example

is sticky wage theory. If the output price increases relatively to cost of input, the optimal

strategy for the firm is to produce more output.

Price

Y

AS

AD1

L0

P0P1

AD0

L1

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However, our resource in the word is limited so that supply curve can not go to unlimited. Starting from certain point, we can not increase output no matter how high the price is.

c. The new classical economist would suggest Fed do nothing because they believe labor

market is efficient, and no wage rigidity problem in the labor market. Therefore, the AS curve

is vertical, and shifting of AD curve has no impact on output but price level. Moreover, if As

curve is not perfectly vertical, there is still problems related to recognition, implementation

and response lags. Owing to those lags, policy may take effect when the economy is already

out of the situation we don’t want. Hence policy could instead worsen the fluctuation of

business cycle.

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