Form 1

Exam 2, Principles of Macroeconomics (Econ 102)

University of Michigan, Fall 2012
November 5, 2012

DO NOT OPEN THIS TEST OR LOOK AT THE SHORT ANSWER QUESTIONS UNTIL YOU ARE
INSTRUCTED TO DO SO. PLACE YOUR SHORT ANSWER BOOKLET UNDER THIS FORM
UNTIL THE TIME YOU ARE ALLOWED TO BEGIN.

This exam has two parts: a multiple choice section consisting of 15 questions (for which every correct
answer earns you two points) and 3 short answer questions, worth 30 points in total. Submit your
scantron and completed short answer booklet when you have finished. Keep this booklet of multiple
choice questions.

Before exam time starts, you must bubble in the following three pieces of information on your scantron
• Failure to do any of the below three will result in a one-point deduction from your exam score
• You will NOT be given extra time to fill in bubbles after exam time is over. Do it now.

Bubble in:
1) your name,

2) that you have been given EXAM FORM #1, and

3) your section number, as given in the table below:

Section Section
number time GSI
201 Th, 11:30 Gaurav Khanna
202 Th, 1 Rishi Sharma
204 Fri, 11:30 Paul Brehm
205 Fri, 2:30 Sreyoshi Das
206 Fri, 10 Sreyoshi Das
207 Th, 4 Eric Ohrn
208 Th, 4 Gaurav Khanna
209 Fri, 1 Paul Brehm
211 Fri, 10 Rishi Sharma
On your short answer booklet, you must write down (or else you will take a one-point penalty) the
following two pieces of information:
4) your name, and

5) your GSI’s name and the time of your GSI section (as given in the table above).

You will have 90 minutes to complete the exam. Good luck.

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Multiple Choice, 15 questions. Choose the best answer. Each correct answer is worth two points.

1. Suppose that Curtis and Dylan, two stay-at-home fathers, initially are not in the labor force. They
agree to switch houses and pay each other the $500 at the end of each week in compensation for
these house care services. Which of the following is true?
a. The unemployment rate has decreased.
b. Each household will have more money to spend on consumption goods at the end of the week.
c. GDP remains the same.
d. The unemployment rate does not change.

2. The unemployment rate from 1985-2012 in France was on average 3% higher than in the US, even
though both experienced the same recessions and expansions. Unemployment due to time spent in
job search is roughly the same between the countries. What drives this difference?
a. Frictional unemployment is higher in France.
b. Structural unemployment is higher in France.
c. Labor force participation is higher in France.
d. Shoeleather costs are higher in France.

3. The annual interest offered by a bank is 10%. You deposit $100 now. In one year, you withdraw all
funds, principle and interest, from the account. In the year that the money is in the bank, the
inflation rate will be 12%. Then
a. the purchasing power of the money you withdraw in one year will be bigger than the purchasing
power of your $100 now.
b. the purchasing power of the money you withdraw in one year will be smaller than the purchasing
power of your $100 now.
c. the purchasing power of the money you withdraw next year will be the same as the purchasing
power of your $100 now.
d. we can’t compare purchasing power in the two years.

4. The Fisher Effect is correctly described by saying that when all individuals in the market
simultaneously update their inflation expectations by the same amount,
a. the real interest rate will change such that the equilibrium quantity of funds remains constant.
b. the equilibrium quantity of funds will change so that the nominal interest rate remains constant.
c. the real interest rate will change so that the nominal interest rate remains constant.
d. the nominal interest rate will change so that the real interest rate remains constant.

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5. Compared to last month, the quantity transacted in the market for private loanable funds has
increased but the interest rate has decreased. Which of these could be a possible explanation for this
change?
a. Firms became more optimistic about the future.
b. Firms became less optimistic about the future.
c. Households care less about current consumption relative to future consumption.
d. Households care more about current consumption relative to future consumption.

6. The interest rate in the market for private loanable funds decreases. Which of the following
CANNOT explain what happened?
a. US exports decreased
b. US imports decreased
c. Government deficit decreased
d. Firms were pessimistic about the future and invested less

7. In the Keynesian Cross model, when rGDP is less than equilibrium rGDP, which of the following
statements is true.
a. AEp < rGDP and unplanned investment is negative.
b. AEp > rGDP and unplanned investment is negative.
c. AEp < rGDP and unplanned investment is positive.
d. AEp > rGDP and unplanned investment is positive.

8. Pizzlandia and Burgerville are both economies where there’s no government, investment or
international trade. Autonomous spending in Pizzlandia is double of that in Burgerville. The MPC in
Pizzlandia is 0.5 and Burgerville is 0.75. We know that
a. the rGDP in Pizzlandia is double of Burgerville.
b. the rGDPs are the same in both economies.
c. aggregate savings (i.e. MPS*rGDP) is the same in both.
d. Burgerville has a smaller spending multiplier.

9. Why is the sticky wage SRAS upward sloping?

a. The prices of neither input nor output goods can adjust in the short run.
b. The prices of output goods can adjust, but the prices of input goods can not adjust in the short
run.
c. The prices of input goods can adjust, but the prices of output goods can not adjust in the short
run.
d. The price of both input and output goods can adjust.

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10. Suppose a country starts with zero national debt. Following the start of a recession, the government
engages in countercyclical fiscal policy and runs a deficit of 100, funded by issuing a one-year bond
at 5% annual interest. One year later, the government pays off the money it owes by issuing another
one-year 5% bond. At the end of these two years, the government pays off all its debt obligations.
What is the nominal payment (that is, the national debt) at this point, two years after the recession?
a. 109
b. 105.5
c. 111
d. 110.25

Use the following setup to answer questions 11-13. Consider an economy that starts in long-run
equilibrium. In this initial state, GDP = $500, MPC=0.5, Ip =10, T = $150, G = $300, TR = $50, and
t = 0.4. The price level is perfectly sticky.

11. What is the budget deficit in this economy?

a. deficit = $0
b. deficit = $150
c. deficit = $200
d. deficit = $250

12. Relative to the initial setup, output falls by $100, to $400. We know that this fall occurred because
of a negative shock to autonomous consumption, A. By how much did A change?
a. ΔA = -200
b. ΔA = -140
c. ΔA = -70
d. ΔA = -50

13. Relative to the initial setup, output falls by $100, to $400. The government decides to close the
output gap by changing government spending G and/or lump-sum taxation T (while leaving TR and t
unchanged). Which of the following options exactly closes the output gap?
a. ΔG = 50, ΔT = 0
b. ΔG = 35, ΔT = -70
c. ΔG = 210, ΔT = 210
d. ΔG = 0, ΔT = -170

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14. If the potential money multiplier is 3, a bank has 6 million dollars in checkable deposits, and has
loaned out all the money that it is legal for it to loan, what is the value of this bank’s reserves, in
millions of dollars?
a. 1
b. 2
c. 3
d. 4

15. Consider an economy where all money is held in the form of checkable deposits and the required
reserve ratio is 10% and banks always lend out all the money they can. The central bank sells $75
million dollars in treasury bonds to banks. How does this action affect the economy’s monetary base
and money supply?
The monetary base ________________ and the money supply ________________.
a. decreases by $75 million; decreases by $75 million
b. decreases by $75 million; decreases by $750 million
c. decreases by $750 million; decreases by $75 million
d. decreases by $750 million; decreases by $750 million

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THIS PAGE INTENTIONALLY LEFT BLANK
(feel free to use it as scratch paper space)

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Name ___________________________ GSI name & section time _________________________
Short Answer, 30 points. Answer the question in the space given (and ONLY the (For admin
space given). Show your work, and label your graphs! Please circle or highlight purposes – please
all of your final answers. leave blank)
1. (10 points total) Consider the market for private loanable funds. The quantity Question Score
demanded (in dollars) is given by Id = 12 - r, where r is the interest rate (in 1
percent). The interest rate at which lenders are willing to provide a certain 2
quantity of funds to the private market, IS, is given by the equation 3
r = (IS - Sg)/2, where Sg is government savings (also measured in dollars).
a. (2 pts) Initially, the government has zero savings. Find the equilibrium interest rate and quantity
of private funds.

b. (3 pts) Government savings Sg is no longer zero. As a result of the change in Sg, the new
equilibrium interest rate decreases to r = 2. What is the numerical value of Sg? Is the government
running a deficit or a surplus?

c. (5 pts) In one graph, plot the situations from parts (a) and (b). Be sure to
i. label the equilibrium interest rates, quantities of funds,
ii. show how government savings are represented in this graph, and label this numerical value,
iii. show how the crowd-out effect is represented in this graph, and label this numerical value.

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2. (8 points total) Consider an economy in which A = (W/10) – P. In words: autonomous consumption
is equal to one tenth of wealth minus the price level. Planned investment in the economy is equal to
Ip. In this economy, the government spends money on goods and services, G, and the only taxes are
lump-sum taxes T. There are no transfers or international trade.
a. (1 pt) State the equation for aggregate planned expenditures in this economy.

b. (1 pt) As the economy improves, the value of financial assets and housing rises. How does this
affect AEp, and why?

c. (3 pts) In this economy, the government always has a balanced budget. State the equilibrium
condition in the income expenditure (Keynesian Cross) model, and use it to solve for equilibrium
rGDP as a function of W, P, Ip, G, and MPC only. (Hint: get rid of T by writing it as a very
simple function of government spending, G)

d. (1 pt) Given the equation from part (c), if the government spends $1 extra and has a balanced
budget, by how much does rGDP increase?

e. (2 pts) Given the equation from part (c), what is the slope of the AD curve of this economy?

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3. (12 points total) The US economy in 1979 can be characterized by the following equations:
SRAS: 𝜋𝑡 = 2(𝑔𝑡 − 4) + 𝜋𝑡𝑒
1
AD: 𝜋𝑡 = 10 − 2 𝑔𝑡
Here, 𝜋𝑡 is the inflation rate in year t and 𝑔𝑡 is the growth rate of the economy in year t. Inflation
expectations are given by 𝜋𝑡𝑒 , and in 1979, 𝜋𝑡𝑒 = 8. All variables are measured in percent (so that for
example 𝜋𝑡 = 2 means “2 percent”).
a. (2 pts) What is the equilibrium inflation rate and growth rate of the economy in 1979?

b. (1 pt) What is the long run growth rate, 𝑔𝐿𝐿 , in this economy?

c. (2 pts) An unexpected revolution in Iran cuts off the supply of oil to the US, causing a spike in
the cost of oil, an input in most industries. Immediately after the shock, SRAS jumps inwards so
that the new equation is 𝜋𝑡 = 2(𝑔𝑡 − 4) + 𝜋𝑡𝑒 + 5. What is the new equilibrium growth rate and
inflation rate?

d. (3 pts) President Jimmy Carter proposes a stimulus package to close the recessionary gap in
1979, before inflation expectations change. What is the inflation rate after the package is
implemented? In ONE graph (there is more room on the next page), plot the following, making
sure to label all equilibrium values:
i. The SRAS, AD and LRAS before the shock
ii. The effect of the oil price shock
iii. The effect of the stimulus package

continued 
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e. (4 pts) Carter realizes that the stimulus would cause higher inflation, so he instead allows the
economy to “naturally” adjust back to its long run level of output. It adjusts according to the rule
𝑒
i. if growth is at the long run level, then 𝜋𝑡𝑒 = 𝜋𝑡−1
𝑒
ii. if growth is below long run levels, then 𝜋𝑡𝑒 = 𝜋𝑡−1 −3
𝑒 𝑒
iii. if growth is above long run levels, then 𝜋𝑡 = 𝜋𝑡−1 + 1
One year after the cost shock due to the revolution, has the SRAS curve shifted back to its
original position? How many years does it take for SRAS to shift back to the long run growth
level? (hint: you don’t need to solve for equilibrium in each time period)

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