ECON 2123: Macroeconomics Final Exam Practice Questions Instructor: Fei DING

Practice Questions for the Final Exam

Macroeconomics, ECON 2123
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Unless otherwise specified, assume that
1. Free capital flow and investors only care about expected returns in choosing between domestic and
foreign assets.
2. The Marshall Lerner (ML) condition holds.
3. The J-curve effects are negligible.
4. Nominal exchange rate is flexible.
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Part A: Multiple-choice questions.

Please refer to the MC practice file on canvas.

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ECON 2123: Macroeconomics Final Exam Practice Questions Instructor: Fei DING

Part B: Short and Long Questions

Please fill in the blanks or answer the questions. Explain your answers and upload your handwritten
solutions along with your student ID card onto the system before the deadline. You may explain using graphs,
words, examples, and/or equations. Incomplete and unclear handwriting that leads to misunderstanding of
your logic would be at your own disadvantage.

1. Can the nominal exchange rate and real exchange rate move in different directions? Explain.

Answer: Yes! Check lecture slides 16-17 from Ch18.

2. Focusing on the goods market only (you can ignore changes in i and E), we will generally observe
that the more open an economy, the ____________________ (larger/smaller/same/uncertain) the
effect of fiscal policy on output, and the ____________________ (larger/smaller/same/uncertain) the
effect of fiscal policy on the trade position.

Answer: The smaller the effect of fiscal policy on output and the larger the effect of fiscal policy on
the trade position.

More open economy means more trades with the rest of the world and larger import and export
demands relative to its GDP. The demand curve ZZ is flatter (the multiplier is smaller) because a larger
leakage of domestic demand to imports. Thus, a shift of ZZ in either direction will result in a smaller
impact on Y.
At the same time, a given shift in domestic demand due to fiscal policy shocks will result in a larger
change in import demands the more open the economy, and thus a larger impact on the trade balance.

3. Suppose there are two countries that are identical in every way with the following exception.
Country A is pursuing a fixed exchange rate regime and country B is pursuing a flexible exchange rate
regime. Suppose both countries want to reduce budget deficit and taxes are increased in both countries
by the same amount. Given this information, we know that the change in output in A will be
____________________ (larger/smaller/same/uncertain) than the change in output in B.

Answer: Fixed exchange rate regime will have a larger change in output in response to fiscal policy
shocks. This is because, in order to maintain the same exchange rate, domestic interest rate must
follow foreign interest rate and cannot freely change by itself. Thus, any fiscal policy must trigger a

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ECON 2123: Macroeconomics Final Exam Practice Questions Instructor: Fei DING

monetary accommodation in the same direction to cancel out the movement in domestic interest rate.
The overall effect is a larger impact in Y.

4. Explain how a reduction in each of the following variables affects the aggregate price level (P): (1)
the expected price level; (2) employment; (3) the markup; and (4) unemployment benefits.

Answer: A drop in the expected price level will cause wage setters to seek a lower nominal wage. As
W falls, firms' costs fall. As firms' costs fall, they will set their price lower (as a markup over the now
lower W). So, P will fall as the expected price falls. An increase in output requires firms to increase
employment. An increase in N causes a reduction in the unemployment rate. As the unemployment
rate decreases, workers have more bargaining power so the nominal wage will rise. The increase in
the nominal wage will cause an increase in firms' costs. As firms' costs rise, they will increase the
prices as determined by price setting behavior. So, an increase in Y causes an increase in P. A
reduction in the markup means that firms are setting prices lower above given costs. So, the drop in
the markup will cause a reduction in the price level. A reduction in unemployment benefits will cause
the WS curve to shift down and cause wage setters to seek lower nominal wages. As W falls, firms'
costs fall. As firms' costs fall, they will set their price lower (as a markup over the now lower W).
So, P will fall as unemployment benefits fall.

5. Analysis of the macroeconomic effects of changes in the money supply indicates that money is
"neutral" in the medium run. Suppose there is a reduction in government spending. Will this fiscal
policy action also be neutral in the medium run? Explain.

Answer: Changes in G are not neutral in the medium. Despite the fact that Y returns to its original
level, two other real variables are affected by G in the medium run: the interest rate and investment.
Specifically, the interest rate will be permanently lower causing I to rise. So, changes in government
spending, while causing some real variables to return to their original levels, does cause changes in
some other real variables.