OF QUEENUNIVERSITY
DEPARTMENT ECONOMICS
ECON320: MACROECONOMIC THEORY II
Instructor: Khazri Afifa
Final examination
Section A (30percent): Read the following statements and indicate whether they are
True, False or Uncertain. Briefly explain your answer. All questions have equal value.
NO MARKS WILL BE GIVEN FOR UNSUPPORTED ANSWERS.
A1. Reel business cycle models do not account well for the relative volatility of
employment.
True In the data for the US, Canada employment is almost as volatile as output over
time. The basic RBC model adopts the classical assumption that fluctuations in
unemployment reflect individual labour supply curves. In order to get the same degree of
volatility as in the data, in response to productivity shocks, a very high elasticity of
labour supply is needed. However, micro estimates of the labour supply elasticities are
typically very small, so that RBC models have a hard time replicating the relative
volatility of unemployment.
A2. The neutrality of money only holds if markets are competitive.
False- If all prices are flexible and price information is perfect, then money will be
neutral, will not affect real variables even if markets are imperfectly competitive
(monopoly)
Section B (20 percent): Multiple choice- CIRCLES the one correct answer
1. An increase in expected future output while holding todays output constant
would
a. increase todays desired consumption and increase desired national saving.
b. increase todays desired consumption and decrease desired national saving.
c. decrease todays desired consumption and increase desired national saving.
d. decrease todays desired consumption and decrease desired national saving.
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2. According to the permanent income theory, temporary increases in income will
mostly be ____, and permanent increases in income will mostly be____.
a. Spent; saved
b. Saved; spent
c. Spent; spent
d. Saved; saved
3. which of the following machines has the lowest user cost? Machine A costs
$15,000 and depreciates at 25% rate, machine B costs $10,000 and depreciates at
a 20% rate, machine C costs $20,000 and depreciates at 10% rate, and machine D
costs $17,000 and depreciates at an 11% rate. The expected real interest rate is
15%.
a. machine A
b. machine B
c. machine C
d. machine D
4. Suppose your company is in equilibrium, with its capital stock at its desired level.
A permanent decline in the expected real interest rate now has what effect on your
desired capital stock?
a. raises it, because the future marginal productivity of capital is higher
b. lowers it, because the future marginal productivity of capital is lower
c. raises it, because the user cost of capital is now lower
d. lowers it, because the user cost of capital is now higher
5. Total factor productivity growth is that part of economic growth due to
a. capital growth plus labour growth
b. capital growth less labour growth
c. capital growth times labour growth
d. neither capital growth nor labour growth.
6. Over the past year, output grew 6%, capital grew 2%, and labour grew 4%. If the
elasticities of output with respect to capital and labour are 0.3 and 0.7,
respectively, how much did productivity grow?
a. 2.0%
b. 2.6%
c. 3.0%
d. 3.3%
7. In the long run, an increase in the saving rate in a steady-state economy will cause
a. an increase in the capital-labour ratio and an increase in consumption
per worker
b. an increase in the capital-labour ratio and a decrease in consumption per
worker
c. a decrease in the capital-labour ratio and a decrease in consumption per
worker
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d. a decrease in the capital-labour ratio and an increase in consumption per
worker
8. Unconditional convergence means that in the long run,
a. living standards converge only within groups of countries having similar
characteristics
b. living standards converge only for countries that have the same initial
capital-labour ratio
c. living standards around the world become the same
d. differences persist in living standards around the world.
9. The fact that business cycles are periodic but not recurrent means that
a. business cycles occur at predictable intervals, but do not last a
predetermined length of time
b. the business cycles standard contraction-trough-expansion-peak
pattern has been observed to recur over and over again, but not at
predictable intervals
c. business cycles occur at predictable intervals, but do not all follow a
standard contraction-trough-expansion-peak pattern
d. business cycles last a predetermined length of time, but do not all follow a
standard contraction-trough-expansion-peak pattern.
10. Which of the following macroeconomic variables is countercyclical?
a. real interest rate
b. unemployment
c. the money supply
d. consumption
11. What do RBC economists mean by the term calibration?
a. modifying the structure of an economic theory to strengthen its logic
b. changing a theory as the economy changes
c. working out a detailed numerical example of a more general theory
d. writing out the implications of a theory for all the main economic
variables.
12. When RBC economists compare the correlations in their models to the data, what
are they looking at?
a. The degree to which variables lead output over the business cycle
b. The strength of procyclicality of different variables
c. The amount of random variation in economic variables
d. The degree to which different economic variables move together.
13. According to the misperceptions theory, when the aggregate price level is higher
than expected,
a. the aggregate quantity of output supplied rises above the full
employment level
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b. the aggregate quantity of output supplied falls below the full employment
level
c. the aggregate quantity of output demanded falls below the full
employment level
d. the aggregate quantity of output demanded rises above the full
employment level.
14. Which of the following statements is true about the misperceptions theory?
a. Both anticipated and unanticipated changes in the nominal money supply
have real effects on the economy
b. Neither anticipated nor unanticipated changes in the nominal money
supply has real effects on the economy
c. Unanticipated changes in the nominal money supply have real effects,
but anticipated changes are neutral.
d. Anticipated changes in the nominal money supply have real effects, but
unanticipated changes are neutral.
15. The theory of rational expectations suggests that
a. people never make forecast errors
b. people make intelligent use of available information
c. people make systematic forecast errors
d. people are slow to incorporate new information into their forecasts.
16. Hysteresis in unemployment means
a. many people counted as employed are really underemployed
b. the natural rate of unemployment changes in response to the actual
rate of unemployment
c. there is no natural rate of unemployment; there is a natural rate of inflation
instead.
d. The actual unemployment rises when the natural rate of unemployment
rises.
17. The main determinant of how quickly expected inflation adjusts to changes in
monetary policy is
a. the slope of the Phillips curve
b. the slope of the short-run aggregate supply curve
c. the credibility of the Central Bank
d. the degree of indexation in the economy.
18. The that argument when policy changes, peoples behaviour changes so that
historical relationships between macroeconomic variables will no longer hold is
known as
a. the Phillips curve
b. the policy irrelevance hypothesis
c. hysteresis
d. the Lucas critique
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19. Historically, Brazil has suffered higher and more variable rates of inflation than
Venezuela. You would expect the short-run aggregate supply curve of Brazil to be
_______ than that of Venezuela, and the Phillips curve of Brazil to be _____ than
that of Venezuela
a. flatter; flatter
b. flatter; steeper
c. steeper; steeper
d. steeper; flatter
20. Both classicals and Keynesians agree that policymakers
a. Can exploit the Phillips curve in the short run.
b. Cannot exploit the Phillips curve in the short run
c. Can keep the unemployment rate permanently below the natural rate by
permanently running a high rate of inflation
d. Cannot keep the unemployment rate permanently below the natural
rate by permanently running a high rate of inflation
Section C (50 percent): Answer the two following Long question:
C1. Consider the following economy
IS curve
r = 2.47 0.0004Y
Real money demand
L = 0.5Y 500(r + e )
Short run aggrgate supply Y = Y + 100( P P e )
Here, r is the real interest rate, Y is output, and P is the price level. Assume that the
expected inflation is zero, nominal money supply M = 88,950, and full-employment
output Y = 6000.
a) What is the equation of the aggregate demand curve?
IS : r = 2.47 0.0004Y
M
= 0.5Y 500r
P
M
AD :
= 0.5Y 500(2.47 0.0004Y )
P
M
= 0.7Y 1235
P
127071.42
Y =
+ 1764.28
P
LM :
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b) Suppose the expected price level P e = 29.15. What are the
short-run and the long-run equilibrium values of the price
level P and output Y?
AS : Y = 3085 + 100 P
127071.42
AD : Y =
+ 1764.28
P
127071.42
3085 + 100 P =
+ 1764.28
P
13.20 + P 2 1270.71 = 0
b b 2 4ac
2a
P = 29.65
P=
Y = 6050
c) An unanticipated increase raises the money supply to M =
100000. What are the equilibrium values of the price level P
and output Y?
P e = 29.15
AS : Y = 3085 + 100 P
142857.14
+ 1764.28
AD : Y =
P
142857.14
3085 + 100 P =
+ 1764.28
P
13.20 + P 2 1428.57 = 0
b b 2 4ac
2a
P = 31.76
Y = 6261.83
P=
d) The Bank of Canada announces that the money supply will
be increased to M = 100000, which the public believes. Now
what are the equilibrium values of the price level P, the
expected price level P e , and the output Y?
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Pe = P
AS : Y = 6000
100000 1235
+
0 .7 P
0 .7
100000 1235
6000 =
+
0 .7 P
0 .7
P = 33.72
AD : Y =
Y = 6000
C2. Suppose that the economy has the Phillips curve
= 1 0.5(u u n )
The natural rate of unemployment is: u n = 0.06
a. What is the natural rate of unemployment?
The natural rate of unemployment is the rate at which the inflation rate does not
deviate from expected inflation rate. Here, the expected inflation rate is just last
periods actual inflation rate.
b. How much cyclical unemployment is necessary to reduce inflation by 1percentage points? Using Okuns law, compute the sacrifice ratio.
To reduce inflation, the Phillips curve tells us that unemployment must be above the
natural rate of 6 percent for some period of time. We can write the PC in the form
1 = 0.5(u 0.06)
0.01 = 0.5u + 0.03
u = 0.08
Hence, we need 2 percentage point years of cyclical unemployment above the natural
rate of 6 percent.
Okuns law says that a change of 1 percentage point in unemployment translates into
2 percentage points in GDP. Hence, an increase in unemployment of 2 percentage
points corresponds to a fall in output of 4 percentage points. The sacrifice ratio is the
percentage of a years GDP that must be forgone to reduce inflation by 1 percentage
point. The sacrifice ratio is 4
c. Inflation is running at 3 percent. The bank of Canada wants to reduce it to 1
percent. Give two scenarios that will achieve that goal.
One scenario is to have very high unemployment for a short period of time. For
example, we could have 12 percent unemployment for a single year. Alternatively,
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we could have a small amount of cyclical unemployment spread out over a long
period of time. For example, we could have 4 percent unemployment for three years.
Both of these plans would bring the inflation rate down from 3 percent to one percent,
although at different speeds.
Suppose now that the natural rate of unemployment is given by an average of
the past two years unemployment:
u n = 0.5(u 1 + u 2 )
d. Why might the natural rate of unemployment depend on recent
unemployment (as is assumed in the preceding equation)?
The natural rate of unemployment might depend on recent unemployment for at least
two reasons, suggested by theories of hysteresis. First, recent unemployment rates
might affect the level of frictional unemployment. Unemployed workers lose job
skills and find it harder to get jobs; also, unemployed workers might lose some of
their desire to work, and hence search less hard for a job. Second, recent
unemployment rates might affect the level of wait unemployment. If labour
negotiations give a greater voice to insiders than outsiders, then the insiders
might push for high wages at the expense of jobs. This will be especially true in
industries in which negotiations take place between firms and unions.
e. Suppose that the bank of Canada follows a policy to reduce permanently the
inflation rate by 1 percentage point. What effects will that policy have on the
unemployment rate over time? [Hint: demonstrate that the unemployment
until period 4, remains at least 1 percent above its original natural rate].
If the central bank seeks to reduce inflation permanently by 1 percentage point, then
the PC tells us that the first period we require
1 0 = 1 = 0.5(u1 u1n )
u1 u1n = 2
That is, we require an unemployment rate 2 percentage points above the original
natural rate u1n . Next period, however, the natural rate will rise as a result of the
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cyclical unemployment. The new natural rate u 2 will be
n
u 2 = 0.5(u1 + u 0 ) = 0.5[(u1n + 2) + u1n ] = u1n + 1
Hence the natural rate of unemployment rises by 1 percentage point. If the bank of
Canada wants to keep inflation at its new level, then unemployment in period 2 must
n
equal the new natural rate u 2 . Hence, u 2 = u1n + 1
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In every subsequent period, it remains true that the unemployment rate must equal the
natural rate. This natural rate never returns to its original level: we can show this by
deriving the sequence of unemployment rates:
u 3 = 0.5u 2 + 0.5u1 = u1n + 1 1 2
u 4 = 0.5u 3 + 0.5u 2 = u1n + 1 1 4
u 5 = 0.5u 4 + 0.5u 3 = u1n + 1 3 8
Unemployment always remains above its original natural rate. Thus to reduce
inflation by 1 percentage point, unemployment rises above its original level by 2
percentage points in the first year, and by 1 or more percentage points in every year
after that.
f. What do these equations imply about the short-run and long run tradeoffs
between inflation and unemployment.
Without hysteresis, we found that there was a short run trade-off but no long-run
trade-off between inflation and unemployment. With hysteresis, we find that there is a
long-run tradeoff between inflation and unemployment: to reduce inflation,
unemployment must rise permanently.
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