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Unformatted text preview: Economics 100B Professor K. Kletzer UCSC Fall 2008 Sample Answers for First Midterm Exam: October 27, 2008 This Answer Key explains the answers to each question. These tend to be more elaborate than good answers but do not include graphs. As appropriate the answer key explains what a graph or graphs should show. As you read through, you can draw the graphs as described. Exam Instructions: Do all three parts. Graphs are useful for illustrating and explaining your answer, but you must use words to fully explain what you are showing in a graph. A graph by itself is not an answer. Part A (45%) Choose any 3 of the following 4 statements. For each one you choose, state whether it is true, false or ambiguous and explain why. Your score will be based on your explanation. A1) A monetary expansion increases consumption, investment and GDP in the short run but has no effect in the medium run. ANSWER: Both parts are true. An increase in the money supply raises real balances, M/P, in the short run. In financial market equilibrium, money demand equals money supply, M/P = L(Y, i), and money demand increases with GDP, Y, and decreases with the interest rate, i. An increase in M/P shifts the LM curve out because for any level of GDP, the interest rate must fall for money demand to increase with money supply. Because investment demand rises as the interest rate falls or GDP rises, the decrease in i raises investment leading to an increase in aggregate demand and equilibrium GDP. In the short run, investment increases because i falls and Y rises. Consumption rises in the short run because disposable income rises. In the medium run, the price level rises and real balances decline until GDP equals the natural level, Y n . The LM curve crosses the IS curve at Y n and the interest rate is determined by the IS curve (that is, in the goods market). The medium run interest rate and GDP are unchanged because real balances do not change in the medium run. A correct graph should show the LM curve shifting out for the short run and shifting back to where it started for the medium run. A2) A decrease in the government deficit reduces investment and GDP in the short run and in the medium run. ANSWER: A decrease in the deficit reduces GDP but has an ambiguous effect on investment in the short run. In the medium run, deficit reduction has no effect on GDP and raises investment. A decrease in the government deficit reduces aggregate demand either by reducing expenditures or raising taxes. A reduction in aggregate demand leads to a decrease in GDP for any given level of the interest rate to maintain equilibrium in the goods market. The IS curve shifts to the left. For a constant money supply, the interest rate must fall as GDP falls to maintain financial market equilibrium. The short-run effect on investment is ambiguous because a fall in GDP tends to reduce investment while a fall in the interest rate tends to increase investment (I(Y, i) is increasing in Y and decreasing in i). investment (I(Y, i) is increasing in Y and decreasing in i)....
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