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Unformatted text preview: Economics 100B
University of California, Santa Cruz Professor K. Kletzer
Fall 2008 Second Midterm – Sample Answers
The answers to part A are more complete and a bit more difficult than most students thought. The “answers” for
B and C are explanations of how you could answer the questions because you can order your answer and choose
to use words, graphs and equations to varying degrees.
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. You must provide an explanation to receive any credit.
A1) A higher saving rate lowers consumption in the medium run and in the long run.
An increase in the saving rate is a reduction in the propensity to consume out of disposable income.
C = C(Y-T) is lower for any given Y-T. In the medium run, Y = Yn so consumption, C(Yn -T), is lower. In the
long run, a rise in the saving rate leads to higher output per worker (if there is no technological progress, or
higher output per effective worker if there is technological progress). The long run level of output per worker is
found from K
= (δ + g N )
⎛ sf and an increase in s leads to an increase in K/N. You can use the diagram from the book and lectures to show
this. You can also do it with AN in the denominator in place of just N. Since K/N rises in the long run, so does
Y/N = f(K/N). Since K/N rises in the long run, consumption rises if the economy is below the Golden Rule in the
A2) An increase in the rate of technological progress raises the growth rate of output per effective worker in the
medium run but not in the long run.
An increase in the rate of technological progress is an increase in gA. The growth rate of output per
effective worker is always zero in the long run. The growth rate of output is g N + g A in the long run; the
growth of output per worker is gN; but the growth of output per effective worker is 0 in the long run.
In the long run, saving per effective worker equals depreciation per effective worker, K
= (δ + g N + g A )
⎛ sf which determines K/AN. An increase in gA lowers K/AN. You should draw a graph to show this by swinging up K
to show that the intersection with the line sf
⎛ the line (δ + g N + g A ) occurs at a lower K/AN. Therefore, K/AN is falling in the medium run as the economy adjusts to new long run. Because K/AN is falling,
output per effective worker is falling. If this is confusing, remember that output per worker can be rising because
gA is larger.
A3) In the medium run, higher inflation should lower the price of discount bonds but have no effect on the stock
In the medium run, inflation is higher but the real interest rate and output are at their natural levels, rn
and Yn. The price of a discount bond that pays $100 in one year is $P = $100
1+ i The nominal interest rate is i = rn + which rises with inflation. The price of the bond falls.
The value of the stock market depends on the present discounted value of real GDP. This is discounted
at the real rate of interest. Neither of these is affected by inflation in the medium run. Both parts of the question
are true. π A4) The growth rate of output equals the medium-run growth rate only if unemployment equals the natural rate.
This question is just testing whether you understand Okun’s law: u t − u t −1 = − β ( g y − g y ) .
The growth rate of output equals the medium run growth rate whenever ut = ut-1. This happens in the medium
run, but it also happens at the trough of a recession and the peak of a boom. Part B (30%) Answer each of the following 2 questions
B1) Write down Okun’s law, the Phillips curve and the AD relationship. Briefly interpret each.
To answer this, you should write down each of these relationships (the AD in terms of the growth rate of
output, growth rate of the money supply and inflation). Your interpretation of Okun’s law should explain that an
increase in the growth rate requires employment to rise faster than labor force growth, and conversely. For the
Phillips curve, explain why wage setting and price setting lead to a negative relationship between inflation and
unemployment and explain why expected inflation matters. I recommend using the accelerationist Phillips curve
with expected inflation equal to last year’s inflation. For the AD relationship, you simply need to explain that
output grows proportionally with real balances if fiscal policy is fixed. Real balances grow as the difference
between gM and . π B2) Use these to explain how unemployment, inflation and output growth adjust during the recovery from a
Your answer should begin with unemployment above the natural rate. An AD-AS diagram can be
helpful, but you should use the equations from B1. Start with the Phillips curve. It tells us that inflation is less
than expected inflation, so that inflation is falling. As inflation falls, real balance growth rises and output growth
rises (using the AD relationship). The rise in output growth leads to a decrease in unemployment by Okun’s law, u t − u t −1 = − β ( g y − g y ) .
As long as u is below un , inflation continues to fall by the Phillips curve so real balance growth continues to rise,
output growth continues to rise and unemployment continues to fall. Your answer can be a bit more elaborate by
using each equation along with the words.
Part C (25%) Answer each part of the following question. You should use both words and graphs in your
answer; equations can be helpful.
C) Suppose the economy is in recession. First, explain how the announcement of a fiscal expansion affects the
yield curve and the stock market. Explain how your answers are different if people expect an increase in the
growth rate of the money supply to accompany the fiscal expansion. Explain how the combined fiscal and
monetary expansions affect short-term nominal and real interest rates in the short run and medium run.
Begin in a recession with unemployment above the natural rate. First, explain how a future fiscal
expansion affects expected future interest rates. You can draw a IS-LM diagram to depict the future fiscal
expansion’s effect on future output and interest rates. You conclude that Y , i e and r all rise. Since expected nominal interest rates rise, the yield curve should steepen. You can write down a simple expression for the twoyear bond interest rate as i2t = ( 1
i1t + i1et +1
2 ) to illustrate your explanation. The two-year bond rate is higher than the one-year bond rate because the expected
future one-year bond rate will rise when the fiscal expansion takes place.
The value of the stock market is the expected discounted present value of real dividends using the real
interest rate. You should write down this formula for two years, Dte+1
1 + rt (1 + rt )(1 + rte 1 )
and explain that expected dividends depend on expected profits which rise with expected output. The equation
shows that a rise in r lowers Q but a rise in Y raises D which increases Q. The net effect of the future fiscal
expansion on the stock market is ambiguous.
If people expect a monetary expansion instead, then they expect future interest rates to fall while future
output rises. You can use an IS-LM diagram to show this. Use the same formulas to show that a decrease in
expected future nominal interest rates flattens and can invert the yield curve because two-year bonds have lower
yields than current one-year bonds in this case.
The expected monetary expansion raises expected output while it lowers expected future real interest
rates. Using the expected present value expression for the value of the stock market, the denominator falls and
the numerator rises so Q unambiguously increases. You might want to explain this a bit more, but it doesn’t take
For the combined policies, you want the future LM curve and future IS curve to shift out together to
keep the interest rate constant and reach the natural level of output. Your answer for the medium run change in
short-term interest rates, i and r, depends on this assumption you make. It is in the question to help you show the
effects on the short run. The effects on the short run come through the expected shift in the current (that is, now
before the fiscal and monetary expansions take place) in the IS curve. The current LM curve does not shift
because money demand depends only on the current short-term nominal interest rate. The IS curve shifts
because consumption and investment are forward looking.
Consumption rises because human wealth rises. Human wealth rises because future output rises and
expected future real interest rate stay constant. You can write down an expression for human wealth, but the
time limit of the test makes this unreasonable to expect. Investment rises because the expected return to
investment is the expected present value of the profits it creates. These depend on future output and future
interest rates. You might write down this expression also.
In a graph, all you show is that the current IS shifts outward while the LM stays fixed. Therefore, the
expected future fiscal and monetary expansions lead to a rise in current short-term real and nominal interest
It isn’t asked for, but the yield curve will invert and the stock market will rise. ...
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