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Spring 2021 Econ 2123 (L6) Midterm Exam

Prof. Zhigang Ge

March 17, 2021

1. (40pts, 4pts for each subquestion) In the book chapters we covered so far,
the economy is assumed to be closed. In other words, there are no imports
and exports. Now we consider a simple extension in which exports (X) are
fixed and imports (M) positively depend on income:

X = X̄,
M = m0 + m1 Y,

where m0 and m1 are positive constants. All other parts are similar as in our
basic IS-LM model:

C = c 0 + c 1 (Y T ),
I = b0 + b1 Y b2 i,
i = ī.

Government spending is given by G.

(a) Which variables are endogenous? Which variables are exogenous?

(b) In an open economy, the aggregate demand is given by

Z = C + I + G + NX,

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where NX is net exports. Write down the equation for aggregate de-
mand (Z). (Hint: You want have an equation with Z on the left side and
other endogenous and exogenous variables on the right.)
(c) What is the slope of the aggregate demand curve? What assumption
is needed for the aggregate demand curve to cross with the 45 degree
line? Write down the assumption and explain it in words.
(d) Suppose the assumption is satisfied, derive the IS relation. (Hint: You
want an equation with Y on the left side and everything else on the
right.)
(e) What is the multiplier of government spending? Compare it with the
multiplier in the economy without imports or exports.
(f) Now we turn to financial markets. Suppose money supply (Ms ) and
money demand (Md ) are given by

Ms = M,
Md = P̄(d0 d1 i ),

where P̄ is the fixed price level, and d0 , d1 are positive constants.

Write down the equilibrium condition for the money market. In order
to have the interest-rate target ī, how much money should be supplied?
(Hint: You want an equation with M on the left side and everything else
on the right.)
(g) From (f), we know that the central bank can set interest rate (i) by choos-
ing money supply (M). Write down the LM relation, then solve the
equilibrium output (Y).
(h) Based on your result in (g), solve the equilibrium consumption (C) and
investment (I).
(i) For some reason, people in this economy start to favor foreign goods
more than before. This taste change is summarized by an increase in

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m0 . How does the taste change affect equilibrium output (Y)? Use the
IS-LM diagram to illustrate, then explain in words.
(j) What fiscal or monetary money should the government and central
bank take to bring the output (Y) back to its initial level? Use the IS-
LM diagram to illustrate, then explain in words.

2. (20pts, 5pts for each subquestion) Firms set the price of goods to be marginal
cost of production multiplied by a markup:

P = (1 + m)W.

When deriving this price-setting relation, we considered the production func-

tion, Y = N, where Y is the quantity of production and N is the quantity of
labor inputs (or employment). Now we consider the production function
with labor productivity A (A 6= 1):

Y = AN.

All other things are same as in the textbook, and the nominal wage is deter-
mined by
W = Pe (1 au + z),

where u is unemployment rate and z is a catch-for-all variable.

(a) Write down the price-setting relation.

(b) Solve the natural rate of unemployment un . (Hint: You want an equa-
tion with un on the left side and everything else on the right.)
(c) Draw the price-setting and wage-setting relation in a diagram, then la-
bel the equilibrium of labor market by B and the natural rate of unem-
ployment by un in the diagram.
(d) Suppose there is a progress in technology that improves labor produc-
tivity. How does it affect the natural rate of unemployment? Illustrate

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your answer using graph, then explain in words. (Label the new equi-
librium by B0 and the new natural rate of unemployment by u0n ).