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**Unformatted text preview: **Economics 121 Pamela Labadie George Washington University Fall 2010 Answers - Exam 1 Provide a brief and concise answer to each question. Clearly label each answer. There are 75 points on the exam. The point allocation is indicated next to the question and corresponds approximately to how much time you should allocate to that question. 1. Short Answers (a) (3 pts) Evaluate whether the following statement is true or false and explain your answer (most points are awarded for your explanation): Business cycles have fixed amplitude and duration . Answer: This statement is false. The amplitude of a cycle (the vertical deviation from the trend line) has varied greatly over history and measures the severity of a cycle. The duration of a cycle, which equals the number of months from peak-to-peak or else trough-to-trough, is also highly variable in economic history. We have had long recessions (The Great Depression) and long expansions (the Reagan years or the Clinton years). (b) (4 pts) Inflation turns out to be much lower than expected: π < π e . Describe whether borrowers or savers benefit from unanticipated inflation. Answer: From the Fisher equation, i t = r e t + π e t = r t +1 + π t +1 Rewriting, we have r e t- r t +1 = π t +1- π e t Hence if the right side is negative, then so is the left side r t +1 > r e t . In this case, savers (lenders) are better off because they have received a higher real return than they were expecting. Borrowers are worse off. 2. (5 pts) Describe the long-run relationship between money growth and inflation. Does the long run growth of income affect this relationship? Answer The long run relationship is summarized by π = g m- ηg y 1 Inflation π Money growth g m η g y π = g m- η g y Figure 1: Long run inflation and money growth where g m is the growth rate of money, g y is the growth rate of income (or output), and η is the elasticity of real balance demand with respect to income (small and positive). There is a direct positive relationship between money growth and inflation. Income growth impacts the point where the line intersects the x-axis in figure (1). An increase in income growth will shift the line out to the right. Income growth determines the level of money growth at which there is zero inflation. 3. (6 pts) It is cheaper and less restrictive to use direct finance, yet most borrowing occurs through indirect finance. Explain the differences between direct and indirect finance. Explain why indirect finance is more prevalent, using the concept of asymmetric information in your answer. Answer: If all participants (borrowers and lenders) have identical information about the quality of a firm and the quality of an investment project, then firms can borrow directly from households by way of organized exchanges and OTC dealers. This is direct finance, which takes the form of 2 marketable debt and equities. When market participants have different information, in particular when the firm has better information (so information is asymmetric), then households are not able...

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