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Economics 212
Intermediate Macroeconomics
Professor Rafferty
Fall 2011
Exam #2
Answer all 25 multiple choice questions (2 points each)
1. Assume that the goal of fiscal policy is to keep real GDP close to potential GDP. An
appropriate fiscal policy for an economy in a recession would be to:
a. increase income taxes.
b. increase corporate taxes.
c. increase sales taxes.
d. increase government spending on goods and services.
2. If the Fed decreased the money supply then in the short-run:
a. the price level would decrease and output would increase.
b. the price level would decrease and output would decrease.
c. the price level would increase and output would increase.
d. the price level would increase and output would decrease.
3. In the short run, an unexpected surge in oil prices would:
a. shift the short-run aggregate supply to curve to the left, increasing the price level, and
decreasing output.
b. shift the short-run aggregate supply curve to the left, increasing the price level, and increasing
output.
c. shift the short-run aggregate supply to curve to the right, decreasing the price level, and
decreasing output.
d. shift the short-run aggregate supply curve to the right, decreasing the price level, and
increasing output.
4. If the government devoted more resources to research and development so new ideas were
discovered more quickly:
a. the long-run aggregate supply curve would shift to the right.
b. the long-run aggregate supply curve would shift to the left.
c. the long-run aggregate supply curve would not shift.
d. none of the above.
5. Dollar bills serve as money because
a. they are backed by gold.
b. people have confidence that others will accept them as money.
c. they can be redeemed for gold by the Federal Reserve.
d. they have a value as a commodity independent of their use as money.
6. The sale of Treasury securities by the Federal Reserve will, in general,
a. increase the quantity of reserves held by banks.
b. decrease the quantity of reserves held by banks.
c. not change the money supply.
d. not change the quantity of reserves held by banks.
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7. A firm that wishes to maximize profits will continue to hire labor until the
a. the nominal wage equals the real wage.
b. the nominal wage equals the marginal product of labor.
c. the nominal wage equals the price level.
d. the real wage equals the marginal product of labor.
8. According to the quantity theory of money, if the money supply grows at 25% and the inflation
rate is 20% then the growth rate of real GDP is
a. 0.8%.
b. 1.25%
c. 5%
d. 45%
9. The German hyperinflation of the early-1920s was caused by
a. an overly aggressive money policy implemented to combat a severe recession.
b. the German government raising funds to finance its expenditures by printing money.
c. rising oil prices following World War I and the resulting severe stagflation.
d. large surpluses resulting from the high levels of wartime production and low level of taxes.
10. Prices and wages are considered ‘sticky’ if
a. they do not fully adjust to changes in demand and supply.
d. their rates of increases and decrease are identical.
c. as prices increase, wages increase by the same percentage.
d. their rates of change are directly connected to rate of change in unemployment.
11. Assume that for the third quarter of 2011, actual real GDP was $176.1 billion and potential
real GDP was $163.9 billion. According to Okun’s law, the cyclical unemployment rate during
the third quarter of 2011 was
a. -6.1%
b. -3.7%.
c. 3.7%
d. 6.1%
12. If two countries have the same level of capital’s share of income, but total factor productivity
varies in these countries, rates of return to capital _______, and GDP per worker _____.
a. do converge to the same values; does not converge to the same level.
b. do not converge to the same values; does not converge to the same level.
c. do not converge to the same values; does converge to the same level.
d. do converge to the same values; does converge to the same level.
13. Suppose that the money supply is set to grow at 7%, real GDP grows at 5%, and the expected
real interest rate on Aaa bonds averages 6%. Using the quantity theory of money and the Fisher
equation, the nominal interest rate on Aaa corporate bnds should be
a. -2%
b. 2%
c. 6%
d. 8%
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14. Multiplier effects occur when there is a change in spending which does not depend on
income. Spending which does not depend on income is referred to as
a. induced expenditures.
b. autonomous expenditures.
c. coincident spending.
d. nominal spending.
15. Suppose that the production function for the economy is  =  0.2 0.8 . If the growth rate of
the capital stock is 4.25%, the growth rate of labor is 2.5%, and the growth rate of total factor
productivity is 1.25%, the growth rate of real GDP is
a. 1.25%
b. 4.10%
c. 4.67%
d. 5.84%
16. Suppose that the production function for the economy is  =  0.4 0.6 . If the growth rate of
real GDP is 3.92%, the growth rate of the capital stock is 3.4%, the growth rate of labor is 2.1%,
and the growth rate of total factor productivity is 1.3%, the relative share of total factor
productivity growth to the growth rate of real GDP is
a. 9.3%
b. 28.3%
c. 30.2%
d. 33.2%
17. The most widely available measure of the standard of living is
a. the labor force growth rate.
b. total factor productivity
c. real GDP per capita
d. labor productivity
18. Labor productivity in the United States was 5.4 times higher in the United States than in
China in 2010. A key reason that labor productivity is higher in the United States is because the
United States
a. devotes more resources than China to developing export markets to boost its real GDP and
income.
b. has a higher growth rate, based on GDP per capita, than China.
c. devotes more resources than China to developing new technology and accumulating human
capital.
d. has a higher life expectancy and higher birth rate than China.
19. If Jennifer withdraws $750 from her savings account and deposits it in her checking account,
then M1 will _______ and M2 will ________.
a. increase; not change.
b. not change; decrease.
c. increase; decrease.
d. increase; increase.
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20. Suppose for every dollar change in household wealth, consumption expenditures change by
$0.05. If real household wealth declines by $45 billion, potential GDP is $120 billion, and the
multiplier effect for the first year after an expenditure shock is 1.4, what is the total change in
output relative to potential for the first year?
a. -1.63%
b. -2.63%
c. -2.8%
d. -7.0%
21. The increase in real GDP per capita in the United States from 1949 to 2010
a. is equally due to both increase labor productivity and increase in hours worked per person.
b. was due to increased labor productivity.
c. was due to an increase in the hours worked per person.
d. was due to mostly increases in hours worked per person with a minor role played by labor
productivity growth.
22. Reserves are a bank _____ consisting of ______.
a. liability; checking account deposits and savings account balances
b. liability; vault cash plus bank deposits with the Federal Reserve
c. asset; checking account deposits and savings account balances
d. asset; vault cash plus bank deposits with the Federal Reserve
23. If the money supply grows at 5% and real GDP grows at 6%, the quantity theory predicts the
inflation rate will be
a. -1%
b. 1%
c. 1.2%
d. 11%
24. If the excess reserves-to-deposit ratio decreases and the monetary base is unchanged, the
value of the money multiplier will _______ and the value of the money supply will _______.
a. decrease; increase
b. decrease; decrease
c. increase; decrease
d. increase; increase
25. If actual inflation is lower than expected inflation,
a. there is a redistribution of wealth from lenders to borrowers.
b. there is no redistribution of wealth, but the total wealth in the economy increases.
c. there is a redistribution of wealth from borrows to lenders.
d. there is no redistribution of wealth, but the total wealth in the economy decreases.
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Answer 2 out of 3 long answer questions (25 points each)
1.
a. What is the relationship between real GDP and income? What is the intuition for
using real GDP per capita as a measure of the standard of living? (5 points)
b. From the end of World War II until about 1990, countries with initially low levels of
real GDP per capita such as Germany and Japan grew more quickly than countries with
initially high levels of real GDP per capita such as the United States. Economists call
this “convergence.” Use the appropriate model to explain this “convergence.” (10 points)
c. However, not all countries converge to the same level of real GDP per capita. Many
sub-Saharan African nations such as Chad and Niger had low levels of real GDP per
capita in 1960, but have not experienced substantial economic growth since then.
Explain at least two reasons why some countries do not experience “convergence.” Use
the appropriate model to explain. (10 points)
2.
a. How does the Fed influence the long-term real interest rates that are important
for consumption and investment decisions? Explain in great detail using the
appropriate models. (10 points)
b. The federal funds rate is very close to 0%. Does this mean that the Fed is no
longer able to affect consumption and investment decisions? Explain in great
detail using the appropriate models. (10 points)
c. Many people believe that since the federal funds rate is close to 0% that
monetary policy is stimulating the economy. Is this view necessarily correct?
Explain. (5 points)
3.
a. Explain why nominal wage and nominal price stickiness are important for causing
business cycles. (10 points)
b. What is the multiplier effect? Explain the intuition behind the multiplier effect. (5
points)
c. Suppose that the supply of capital and labor are perfectly inelastic. Now suppose that
the government increases spending on roads and bridges by $500 billion. Does real GDP
change by $500 billion, less than $500 billion or more than $500 billion? Explain. (10
points)
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Answers to Multiple Choice Questions
1. D
6. B
11. B
16. D
21. B
2. B
7. D
12. A
17. C
22. D
3. A
8. C
13. D
18. C
23. A
4. A
9. B
14. B
19. A
24. D
5. B
10. A
15. B
20. B
25. C
Answers to Long Answer Questions
1.
a. Real GDP measures income (think about the circular flow diagram) so real GDP per
capita measures the income that the average individual in a country has to spend on
goods and services. Assuming individuals know their own self interests, the greater the
income the better off individuals will be. If they are hungry then they will buy food, if
their children are sick then they will buy health care etc.
b. According to the aggregate production function countries with low levels of income
per person should grow more quickly than countries with high levels of income per
person. As a result, countries with initially low levels of real GDP per capita will
eventually converge to the level of real GDP per capita in the rich countries. This
argument assumes that capital’s share of income and the level of Total Factor
Productivity is the same in both the rich and the poor countries.
A
Y 
 
 L  Rich
Y 
 
 L  Poor
PF
B
K 


 L  Poor
K 
 
 L  Rich
Real GDP per capita just equals labor productivity times labor input.
Due to the principle of diminishing marginal returns, the marginal product of capital is
greater at point B than at point A. Therefore, firms earn a higher rate of return if they
invest in countries with lower real GDP per capita. Hence, firms will invest in countries
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with lower real GDP per capita causing the capital-labor ratio and labor productivity in
poor countries to converge to the levels in rich countries. The convergence stops when
the poor countries reach point A and the marginal product of capital is the same in the
previously poor countries and the rich countries. Assuming roughly equal labor inputs,
real GDP per capita is now equal and convergence has occurred.
c. The answer in part b assumes that the overall level of efficiency is the same in all
countries. However, this is not necessarily a good assumption. For example, some
countries might experience wars and revolutions which make investing in those countries
riskier. The quality of the labor force may be lower in the poor countries if workers are
poorly nourished and/or poorly educated. As a result, capital in these countries may not
be as productive. In addition, government corruption and poorly enforced property rights
may make investing in poor countries riskier. If any of these things is true then the
production functions for the rich and poor countries would be different. The situation
may look like:
A
Y 
 
 L  Rich
PFPoor
B
Y 
 
 L  Poor
K 


 L  Poor
PFRich
K 
 
 L  Rich
In the above figure, the marginal products are equal when poor countries are at point B
and rich countries are at point A. Therefore, there is no more incentive for capital to flow
to poor countries. However, labor productivity is still lower in the poor countries because
Total Factor Productivity is lower so capital is less productive. Assuming equal labor
inputs, real GDP per capita is lower in poor countries and will never converge to the level
in rich countries.
2.
a. The Fed’s influence on long-term real interest rates is indirect. The Fed influences
long-term nominal interest rates through the term-structure of interest rates. The interest
rate on a long-period bond (assuming that financial markets are efficient) equals the
average of the expected interest rates on short-period bonds plus a term-premium to
compensate for interest rate risk. The general equation is:
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i1,t  i1,t 1  i1,t  2    i1,t  ( n 1 )
e
i n ,t 
e
e
n
 TP n ,t
where is the time to maturity for the long-period bond and TP n ,t is the term premium, in,t
is the interest rate on the long-term government bond and iFF,t is the interest rate on the
federal funds rate today. The interest rates that households and firms pay also
incorporate a default-risk premium, DPt,
i FF ,t  i FF ,t 1  i FF ,t  2    i FF ,t  ( n 1 )
e
i n ,t 
e
e
n
 TP n ,t  DP t .
To go from nominal to real interest rates we must include the expected inflation rate:
, = , −  .
Therefore, changes in the nominal federal funds rate will change the nominal long-term
interest rate assuming that the term premium and default-risk premium are constant. If
we further assume that expected inflation is constant then the real interest rate also
changes.
b. Even if iFF,t is currently 0%, the Fed can still affect long-term real interest rates. First,

the Fed can affect ,+1
by promising to keep the federal funds rate low out into the
future. This will reduce long-term real interest rates and increase consumption and
investment. Second, the Fed can try to affect  by changing its inflation target. If the
Fed increases the inflation target and the long-term nominal interest rate remains constant
then the long-term real interest rate will decrease and may lead to greater consumption
and investment expenditure. In addition, the Fed can engage in quantitative easing by
purchasing securities through open market operations. This will increase bank reserves
which banks may then decide to lend out so consumption and investment expenditures
will increase.
c. Even if the federal funds rate is at 0% monetary policy might be tight. What matters
for consumption and investment decisions is real interest rates. As we saw above, real
interest rates equal the nominal interest rate minus the expected inflation rate. If markets
expect deflation then the real interest rate might be high even though the nominal federal
funds rate is zero. Alternatively, real interest rates could be low as well, but this may
indicate a lack of demand for loanable funds due to pessimism about the economy. This
would again indicate that monetary policy may not be accommodative.
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3.
a.
S1
S2
B
A
P1= P2
C
P3
P4
D
D2
Q2
Q3
D1
Q1= Q4
1. Start at Point A. Think of Q1 as ‘normal’ or ‘potential’ output.
2. Shock shifts the D curve left from D1 to D2. Initially nominal wages and prices
are fixed so the market moves to point B. Note the large decrease in output from
Q1 to Q2. Firms layoff workers so unemployment increases in this industry.
3. As nominal prices adjust the price decreases from P2 to P3 so output increases
from Q2 to Q3.
4. Eventually, workers are willing to accept lower nominal wages so nominal wages
decrease causing the S curve to shift to the right from S1 to S2. Output increases
from Q3 to Q4 so output is back at ‘potential.’
b. The multiplier effect is a series of induced changes in consumption caused by an initial
change in autonomous expenditure. For example, if the multiplier is 1.5 then a $500
billion increase in government spending will increase real GDP by $750 billion. When
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the government spends money this provides $500 billion in revenue for firms who will
then purchase $500 billion of land, labor, and capital. This provides $500 billion of
income for some households out in the economy who will then used part of the increased
income to purchase goods and services. This provides further revenue for firms which
then hire more land, labor, and capital. Income increases again which leads households
to consume even more.
c. The above explanation of the multiplier assumes that there are spare labor and capital
for firms to hire so that the firms can increase output. Now suppose that the supply curve
is perfectly inelastic so that all resources are already fully employed. If the government
spends $500 billion on roads and bridges and all labor and capital is already fully
employed then to build the roads and bridges firms have to hire labor and capital away
from firms producing goods and services for the private sector. Production of roads and
bridges increases but production of private goods and services decreases. As a result, real
GDP increases by less than $500 billion. In the extreme case, real GDP does not increase
at all and the multiplier is 0.
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