Directions: do all work on the exam itself, answering the question in the space provided.  If you require extra space, use the back of the exam, indicating that you have done so.

Name:

 

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First Part (10 point questions)

For each of the following statements, indicate whether they are TRUE or FALSE and explain why.

1                  There are times when GDP declines for a year or so.  The most prominent example is 1929-1933, the Great Depression.  Perhaps there is nothing the government can do about these declines, but it is vital that it keeps national income up during these declines. 

 

2                  All this talk about real interest rates is nonsense.  If a bank promises me 5% on my deposit, that is what I really earn, and nothing else matters.

3                  If we cut taxes, people will work harder and the government will collect more revenue.

 

4.                If the Federal Reserve System wanted to increase the money supply this month, May 2000, it could do so by simply cutting its reserve requirements.  There is no need for open market operations.

5.                A short run Phillips Curve gives the relation between inflation and unemployment.

 

6.                If the government increases spending by $10 for one year and pays for the increased spending with taxes, there will be more of an increase in aggregate demand than if the spending and tax increases were permanent.

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Second Part (10 Point Questions)

1.              Explain the economic theory that is the basis for purchasing power parity.  What assumptions are necessary for the theory to hold up in reality?

2.              The United States has had a relatively constant rate of growth of real GDP since the end of World War II. European countries initially had high growth rates, but they have recently declined. In other countries, such as Malaysia, growth rates are very high and continue to be high.

(a)               Make Sense of this pattern.

(b)               What growth rate do you expect for Malaysia in the next few years?  What growth rate do you expect 50 years from now? Why?

(c)                Still other countries have had very low or negative growth rates? Why has this occurred?

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3.              Explain what is meant by the majority and minority views.  Give an example of a policy measure where it makes a difference.

4.              Explain what is meant by the Natural Rate of Unemployment.  Explain why it might be higher in one country than another.

 

5.              In 1981, Paul Volker, then Chairman of the Federal Reserve System, cut the rate of growth of the money supply, bringing inflation under control but also triggering a major recession.  Explain why cutting the rate of growth of the money supply will cut the inflation rate and why the recession could have been avoided if people had believed Volker was serious.

 

6.              Explain how an open market operation works.  Give an example of how the Federal Reserve System might use open market operations if it wanted to push the aggregate demand curve to the right.  Show why the open market operation you suggest would have the effect on aggregate demand.

Third Part (20 Point Questions)

1.             In answering these questions, be sure to show your work.

 

a.                  If the M2 multiplier is 70, M2 is $14,000, the price level is 1.4, real GDP is $5000, and M1 velocity is 5, what is the M1 multiplier?

 

 

 

 

 

 

 

 

b.                  If real GDP rises from $5,000 to $6,000 and M and the price level are unchanged, how much (in percent) must velocity change?

 

 

 

 

 

 

 

c.                   The kingdom of Bratwurst expects that factor productivity will grow by 2% next year.  Both population and the labor force are expected to grow by 1%, and the capital stock is expected to grow by 4%.  What will be the rate of growth of total output?

 

 

d.                  If  M2 is growing at 5% a year, and real GDP is growing at 6%,  and prices are stable, then what can you say about the rate of growth of velocity?

2.             Suppose that, when you go home after this exam, you get some news. For each of these events, predict what effect it will have on the quantity of loans demanded.  Note: assume that these stories are true. Don't worry about whether the check is good, whether the newspaper stories are accurate, or that you might change your major, etc. Further, show what effect it will have on the real interest rate and the level of investment.  Show the logic by which you arrive at your answer. I expect clear well-labeled graphs in these answers.  Hint:  there is a minor trick.  The question talks about the quantity of loans demanded.  The demand for loans may not shift, but if the supply of loans shifts, the quantity demanded may change.

·        Your Uncle Frank has written, surprisingly enclosing a check for $500.

 

·        You read a newspaper story that salaries for persons with your major are expected to rise.

 

 

·        You read of a new law requiring an additional year of study for persons in your major.

 

 

 

 

 

 

 

3.             Suppose that medical research reveals that next year, a new virus will hit the United States, making all workers lethargic.  There will be no cure, though thankfully, the population will acquire immunity to this new disease within a year.  Trace the impact of this disease this year on employment and the price level.  If effects are ambiguous, indicate that.

 

Remember: this problem asks for effects this year, not next year.  This year the US is disease free, but all know what is about to come.

 

4.             South Freestone, an idyllic Caribbean island, has a recently developed and thriving tourism industry. About half the tourists come from the United States, while the other half come from Germany. While the native tongue is English, the German influx is so pronounced that signs "Wir Spreche Deutsch" can be found throughout the island. Freestone's currency is the Peach (P). The nation has a flexible exchange rate, so that the rate between the Peach and the Dollar and the Deutsche Mark (DM) fluctuates daily. Right now the Peach is going at 1P = $1, though that rate may change tomorrow. Professor Emeritus of Economics Nathan Reingold, who retired to the island a few years ago has noticed that whenever the DM appreciates against the dollar, the Peach tends to appreciate, and whenever the DM depreciates against the dollar, the Peach tends to depreciate.

There are proposals from time to time to establish a currency board for Freestone and peg the peach to the dollar at 1P = $1. To help the island's minister of finance evaluate the proposal, please analyze the following scenarios. As you read these scenarios, you may think that your analysis is complicated by the European Monetary Union.  You are probably right, but, for the purposes of this exam, you need not worry about it.

·        Suppose that Freestone continues on a flexible exchange rate and that, the next winter is a brutal one for the United States. There is an increase in the demand for vacation trips from the US to Freestone. You may assume no change in European weather conditions and that the Freestone Central Bank (which controls their money supply) makes no change in the supply of Peaches. Under those conditions, what would happen to the Peach-Dollar Exchange rate? The domestic price level in Freestone? The number of German tourists? Describe carefully the mechanism by which these changes would come about.

·        Suppose that Freestone switches to a currency board.  The supply of Peaches is backed by dollars at 1:1.  The next winter is a brutal one for the US, and there is an increase in the demand for vacation trips from the US to Freestone.  You may assume no change in European weather conditions.  Under those conditions, what would happen to the Peach-Dollar Exchange rate? The domestic price level in Freestone?  The number of German Tourists?  Describe carefully the mechanism by which these changes would come about.