2103mt2sl - Economics 2103E Intermediate Macroeconomics II...

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Economics 2103E Intermediate Macroeconomics II 2nd Midterm Solutions TEST A SECTION A 1. TRUE - In the IS-LM model a fiscal expansion initially causes income to rise. With higher incomes household’s demand more money. However, in the absence of a monetary expansion the interest rate has to rise in order to eliminate this excess money demand. The rise in the interest rate causes a crowding out of consumption and investment which offsets the initial increase in income. The more sensitive is money demand to the interest rate, the less the interest rate has to rise to eliminate the excess money demand and therefore the less consumption and investment fall. 2. FALSE - While changes to the unemployment insurance benefit scheme made benefits more generous and accessible therefore likely raising the natural rate of unemployment they were not the only change. Increased participation rates for young and female workers who had higher average unemployment rates were also a factor, as were structural changes that led to the decline of some regions and industries. 3. TRUE - If π > π e then the ex post real interest rate is lower than the ex ante real interest rate. This means that the cost of borrowing is lower than anticipated meaning that borrowers are better off. Similarly the return to lending has fallen, meaning lenders are worse off. Therefore the unanticipated increase in inflation redistributes from lenders to borrowers. SECTION B 1. . (a) The IS curve satisfies Y = C + I + G and so is given by Y = 100+0 . 75 Y - 300 r +200 - 200 r which simplifies to Y = 1200 - 2000 r . The LM curve satisfies M = M d and so is given by 900 /P = 0 . 5 Y - 500 r . (b) In the long-run Y = Y and so the IS curve gives 1000 = 1200 - 2000 r and r = 0 . 1. This implies I = 180 and C = 820. Using the LM curve gives 900 /P = 0 . 5 × 1000 - 500 × 0 . 1 and so P = 2. (c) In the short-run P is fixed and so P = 2. The change in investment causes the IS curve to shift inwards to Y = 1080 - 2000 r . With P = 2 the LM curve becomes 900 / 2 = 0 . 5 Y - 500 r which can be written as Y = 900 + 1000 r . Setting the two equal
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