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Winter 2007 - Telyukova's Class - Practice Exam 2

# Winter 2007 - Telyukova's Class - Practice Exam 2 - ECON...

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ECON 110A Spring 2007 Professor Irina A. Telyukova PRACTICE Midterm 2 SOLUTIONS 1. (20 points, 2 each) Answer True or False, and provide a short explanation . Be brief but precise as to the reason for your answer and the underlying economic mechanisms of the phenomenon in question. (a) The unemployment rate tends to be low in recessions, high in expansions. False. The unemployment rate tends to be high in recessions and low in expansions. This is because during a recession, output falls, so firms typically need fewer workers and lay people off as a result. (b) Most workers are typically paid their reservation wage. False. A reservation wage makes a worker indifferent between working and being unemployed. So in order to make workers productive, it is in the interest of firms to pay above the reservation wage of workers. (c) The natural rate of unemployment is the equilibrium rate of unemployment that results whenever the wage chosen by the wage setters is consistent with the wage implied by the price-setting relation. False. The natural rate of unemployment is this equilibrium rate of unemployment under the necessary condition that prices are equal to price expectations, which is often not the case. (d) In the absence of changes in monetary or fiscal policy, the economy will always remain at the natural level of output. False. The economy can deviate from the natural level of output due to factors other than policy changes, such as changes in oil prices or changes in labor market conditions. (e) The aggregate supply relation states than when output goes up, prices go down. False. When output goes up, unemployment goes down, so wages go up, and prices go up as a result (production becomes too costly for firms). This can be seen either from an AS-AD graph, or from the AS relation directly ( P=P e (1+ μ)F(1-Y/L , z) ), or from the price- and wage-setting relations directly.

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(f) The Phillips curve - the negative relationship between unemployment rate and the inflation rate - has been stable over time in the U.S. False. The Phillips curve does capture exactly this negative relationship, but it has not been stable over time in the U.S.: after the 1960's- 1970's, the relationship fell apart, where it was quite apparent through the 1960's. (g) Okun's law gives the relationship between the rates of growth of output and the change of unempoyment rate from year to year. True. Okun's law states that there is a negative relationship between growth of the unemployment rate and growth of output. The formula is u t -u t-1 = - β(g yt - g_bar y ). (h) In an AS-AD model, a change in fiscal policy affects aggregate demand first, while a change in monetary policy affects aggregate supply first.
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