ANSWER KEY MIDTERM 2012

Section I
QUESTION 1
1. For each of the following state whether it is a stock or a flow and say why:
(a) depreciation (b) government debt (c) wealth (d) net exports (e) national saving.
ANSWER 1
1. (a) flow (b) stock (c)stock (d) flow (e) flow
FYI box in Chapter 2.

2.
(a)
(b)
(c)
(d)
(e)

QUESTION 2
State whether each of the following is True or False, explaining your choice
concisely.
Nominal GDP = Real GDP/ GDP deflator
Production for inventory contributes to GDP.
LM curve is upward sloping because an increase in r is needed to raise Y.
If neither C nor I responds to changes in r, then monetary policy cannot affect Y in
the ISLM model.
In the Keynesian cross model (Simple Keynesian model) production is increased if
actual expenditure falls short of planned expenditure.

ANSWER 2
2. (a) F. The correct relation to be stated. [Real GDP = Nominal GDP/ GDP deflator]
(b)T. Part of current productive activity.
(c) F. Money demand should be kept unchanged along LM since real money supply is fixed.
An increase in Y raises money demand, which must be neutralized by an increase in r.
(d) T. Change in M causes r to change which affects Y by changing either/both of the two
components of demand, C and I.
(e) T. Y rises if planned expenditure E > Y.

Section II
QUESTION 3
3. An economy is described by the following equations:
C = a + b ( Y-T); a and b are constants
I = c + dY; c and d are constant
G = constant
(M/P)s = constant
(M/P)d = 1/r
(a) Derive the expression for the equilibrium output.
(b) Derive the government expenditure multiplier for this economy and compare it with
the government expenditure multiplier in the Keynesian cross model.
(c) Derive the equation for the IS curve for this economy and draw a picture of the IS
curve.
(d) Draw a picture the AD curve for this economy.
1+2+3+3= (9)

ANSWER 3
(a) Y = C + I + G = a + bY bT + c + dY + G = (a + c + G bT)/(1-b-d)
(b) From (a) it follows that the government expenditure multiplier (Y/G) = 1/(1 b d) in
this model. In the Keynesian cross model I is treated as wholly given: that corresponds
to the case d = 0 since in that case I = c, a constant. Thus the government multiplier is
larger in this case relative to the Keynesian Cross model: 1 b d < 1 b for d > 0.
(c) Y = (a + c + G bT)/(1 b d) is the equation for the IS curve. Since I is independent of r,
changes in r have no effect on the equilibrium Y. Thus the IS curve is a vertical line:
r

IS

(d) A change in P, while it changes r in the same proportion, has no effect on Y since the change in
r does not affect Y as IS is vertical. Hence the AD curve is a vertical line.
P

QUESTION 4
4. In your answer book write the correct answer for each numbered cell following the
example in the first row:
12x0.5= (6)

Effects of Monetary and Fiscal Policies in ISLM

Shift of
IS

Shift of LM Shift of AD Change in r

Increase in Right
G

None

Right

Up

Increase in 2.1
T

2.2

2.3

2.4

Increase in 3.1
M

3.2

3.3

3.4

Increase in 4.1
P

4.2

4.3

4.4

ANSWER 4
2.1
Left

2.2

None

2.3

Left

2.4

Down

3.1

3.2

Right

3.3

Right

3.4

Down

None

4.1
None
4.2
Left
4.3
None
4.4
Up
________________________________________________________________________

QUESTION 5
5. The following equations summarize the structure of an economy.
C = 260 10r + 0.8 (Y-T)
T = 200 + 0.2Y
I = 1900-40r
G = 1800
NX = 700 -0.14Y
(M/P)d = 0.25Y -25r
(M/P)s = 2000
(a) Calculate the equilibrium values of Y and r
(b) If a drop in confidence reduces autonomous consumption by 40 and autonomous
investment by 60, find the new equilibrium values of Y and r.
(c) Suppose your answer to part (a) represents Y = Yn, the natural rate of output.
In trying to restore Y to Yn , policy makers also wish to make investment (I) as high as
possible. Consider the six options given below:
(i)
Government (reduces/raises) G
(ii)
Government ( reduces/raises) T
(iii)
The central bank (reduces/raises) M

ANSWER 5
5. C = 260 10r + 0.8(Y T)
T = 200 + 0.2Y
I = 1900 40r
G = 1800
NX = 700 0.14Y
(M/P)d = 0.25Y 25r
(M/P)s = 2000
(a) IS: Y = C + I + G + NX
Y = 260 -10r +0.8Y 0.8(200 + 0.2Y) + 1900 40r + 1800 + 700 0.14Y
Y 0.8Y + 0.16Y + 0.14Y = 4500 50r

0.5Y = 4500 50r

0.5Y + 50r = 4500 ..(i)
LM: Demand for real balances = supply of real balances
0.25Y 25r = 2000 ..(ii)
Or Y = (2000 + 25r)/0.25
Or Y = 8000 + 100r
Substituting Y in (i)
4000 + 50r +50r = 4500
Or r = 5
And Y = 8000 + 100.5 = 8500
(b) If autonomous spending falls by 60 plus 40 = 100 then (i) becomes 0.5Y =4400 50r
Y = 8000 +100r from the LM equation
So 4000 + 50r + 50r = 4400
Or 100r = 400
Or r = 4
And Y = 8400
New values are Y = 8400 and r = 4
(c) Moving Y to Yn and increasing investment means that r has to be reduced. This can be done by
the central bank by reducing r through an increase in money supply. LM shifts to the right hand
side or LM comes down.

r
LM
M

IS
Y

QUESTION 6 (1)
6(1) Consider the AD-AS model.
(a) Draw a long run equilibrium diagram with AD, SRAS, LRAS curves. Mark the
equilibrium as 1.
(b) An adverse supply shock reduces Yn and also opens up short run unemployment.
Show this new equilibrium in the same diagram and mark it as 2.
(c) Show the long run equilibrium if the government does not intervene in the same
diagram and mark it as 3.
(d) Suppose the government decides to intervene and stimulates aggregate demand to
restore equilibrium at the new lower Yn after the shock. Mark this new equilibrium
as 4 in the same diagram.
(e) Comment on the two alternative outcomes. (Not more than 2 sentences).
ANSWER 6 (1)

New AD
pushes
economy
to 4

6(1) (a) (b) (c) (d)

New
LRAS

LRAS

New
SRAS

4
2

SRAS
1
3
AD

New SRAS
When economy
settles back without
intervention at 3

New Yn after
supply shock

Yn

(e) Between outcomes 3 and 4 the demand management intervention has led to full employment
at 4 albeit at a higher price level, while no intervention has allowed market forces to move the

economy to the full employment point 3 with a lower price level. However, in practical contexts,
the time required for the two alternative outcomes to be attained may be quite different with
intervention likely to be a faster path to full employment (natural rate of output).

QUESTION AND ANSWER 6(2)

6(2). (a) Suppose that the nominal wage rate W is fixed. Then an increase in P increases
Y if (i) the demand for labour (DL) depends on _____; and (ii) employment is determined
by _____. Fill in the blanks with an appropriate word, an expression using standard
notation, or a phrase involving some economic concept.
Ans (a) (i) W/P, the real wage rate (ii) DL
(b)Write an equation relating W to the target real wage in the Sticky Wage Model.
Ans (b) W = Pex, where Pe = expected price level, and = the target real wage
(c) Why is the long run aggregate supply curve (LRAS) vertical? Explain in one sentence.
Ans (c) In the long-run, the amounts used of K and L are determined by factor market
equilibrium and since these demands and supplies depend on (R/P) and (W/P) and not
on P, Y = F(K, L) is not affected by changes in P
(d) Apart from market clearing what other condition is fulfilled in long run equilibrium?
Ans (d) Fulfilment of expectations; in particular P = Pe
2x3+3= (9)

QUESTION AND ANSWER 7

7. Consider the modified ISLM model. In addition to disposable income (Y-T),
consumption (C) also depends on (M/P).
(a) What happens to C if P increases, given (Y-T) and M?
(b) How would the IS curve shift in this case? Draw a diagram to depict your answer.
2+3= (5)
Ans (a) C would be positively associated with (M/P). Hence an increase in P, with (Y
T) and M fixed, should reduce C.

(b) If C goes down with (Y T) fixed then the IS curve should be shifted to the left: for
the same r and hence I there is now a fall in demand (C + I + G). Equivalently the
fall in C will raise S and so Y has to fall to bring it back into equality with I, which has
not changed for the same r.