Midterm_Exam_2010_Solutions - Economics W3213 Spring 2010...

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Economics W3213 Spring 2010 Bruce Preston Mid-term Examination Solutions Instructions: This is a 70 minute examination with 70 points. To get full credit you must give a clear, concise, and correct answer, including all necessary calculations and economic reasoning. Notes, books and calculators are not permitted. You must submit the exam with your blue books. Good luck! Short Answer Questions: 10 points each Indicate whether you think the following statements are true, false or uncertain. Support your answer by giving all necessary reasoning and calculations. Credit will not be given for a lucky guess. 1. In the expectations-augmented Phillips curve of Friedman and Phelps there is no long- run trade-o f between in f ation and unemployment. That is, a policy maker can not choose to have unemployment below the natural rate of unemployment by accepting a constant higher in f ation rate. Answer: True Thereisnolong-runtrade-o f under the Friedman-Phelps Phillips curve. Expectations will always adjust when there is some cyclical unemployment — i.e. when actual un- employment di f ers from the natural rate of unemployment. If unemployment is below the natural rate then in f ation will be higher. If this persists for some amount of time, agents’ expectations will adjust upwards. This leads to an upwards shift in the short-run Phillips curve. Because of this, in f ation will increase at any given unemployment rate. If policy makers insist on keeping unemployment low for an extended period of time, then the economy will experience ever high in f ation as expectations continue to adjust upwards. Identical arguments can be made for a policy that keeps unemployment high relative the natural rate of unemployment. In this case in f ation will continue to fall. The central insight is that the expectations-augmented Phillips curve does not present a menu of policy options in the long run . 2. The quantity theory of money implies that in the long run, the growth rate of in f ation should equal the growth rate of the money supply. Answer: Uncertain The quantity theory of money states that nominal income or nominal GDP is equal to the money supply times the velocity of money. Algebraically PY = MV. 1
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Written in terms of growth rates we have g P = g M + g V g Y . In class we argued that the velocity of money was, aside from some periods of improve- ment in transaction technology, constant. This gives g P = g M g Y so that in f ation, the rate of change of prices, is equal to the growth rate of the money supply less the growth rate of real output. In general then, in f ation does not equal the growth rate of money supply. However, in the special case that real output growth is
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Midterm_Exam_2010_Solutions - Economics W3213 Spring 2010...

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