International College of Economics and Finance

International College of Economics and Finance

Macroeconomics

Mock-Exam # 2 December 24, 2012

SECTION II

Free-Response Questions

Planning time—10 minutes

Writing time—60 minutes

Directions: At the conclusion of the planning time, you have 60 minutes to respond to the following three questions. In answering the questions, you should emphasize the line of reasoning that generated your results; it is not enough to list the results of your analysis. Include correctly labeled diagrams, if useful or required, in explaining your answers. A correctly labeled diagram must have all axes and curves clearly labeled and must show directional changes. Use a pen with black or dark blue ink. When you use graphs on the free-response questions, label the axes and make direct references to any symbols, e.g., P, M, Y on the graphs when you respond to questions. Good luck!

1. (13,5 points + 1 point bonus) Assume the economy is operating in a long-run equilibrium.

a. Draw a correctly labeled aggregate demand and aggregate supply graph that represents this scenario (1 point).

b. Suppose the economy experiences a change in consumer spending due to a sharp increase in stock market indices and that this has increased the wealth of the nation (1 point for explanation).

i. Redraw the graph from part (a) and show the results of this change (0,5 point).

i. Show the new equilibrium output and price level on your graph.

i. What type of gap exists in this economy? (0,5 point)

c) To move the economy back to full-employment output government decides to use fiscal policy (0,5 point for explanation of the type of policy). One policy analyst advocates the tax policy, while another advocates government spending policy. Which of these policies will have the greatest impact on real domestic output? Explain how you know. (1 point with explanation / 0,5 without explanation)

d) If you can choose only one of the policies, proposed in part (c), explain and show on the appropriate correctly labeled graphs (of the loanable funds market (0,5 point), money market (0,5 point), investment demand curve (0,5 point), Keynesian cross model (1 point including crowding out effect or 0,5 without it), AD-AS model (0,5 point)), how this policy impacts each of the following in the short run:

(i) Interest rate (1 point with explanation / 0,5 without explanation) + bonus (1 point for explanation through the bonds market + graph)

(ii) Investment (1 point with explanation / 0,5 without explanation)

(iii) Aggregate demand (1 point with explanation / 0,5 without explanation)

(iv) Real GDP (1 point with explanation / 0,5 without explanation)

(v) The price level (1 point with explanation / 0,5 without explanation)

e) List and briefly explain the factors that can lessen the effectiveness of fiscal policy. (1,5 points with explanation/0,5 without explanation)

2. (13,5 points + 1 point bonus) Suppose the economy is experiencing a recession and the public budget is currently balanced. Draw this situation on the correctly labeled aggregate demand and aggregate supply graph and show the current level of output and the current price level. (1 point)

a) Suppose the central bank decides to intervene by carrying out the open market operation (0,5 point) in order to move the economy to the full employment level. Define the type of this operation. (0,25 point) Explain the effect of this operation on the commercial banks’ reserves (0,5 point), bond prices (0,5 point), monetary base (0,5 point), money multiplier (0,25 point) and money supply (0,5 point). (or 0,25 point for identifying the change in each variable without explanation)|.

b) Using a correctly labeled money market graph, show the impact of the central bank’s operation, you identified in point (a) (0,5 point), on the interest rate. Explain this change. (0,5 point) + bonus 1 point for explanation through bonds market + graph

c) Explain and show on the appropriate graphs (of investment demand (0,5 point), Keynesian cross model (0,5 point) and AD-AS model (0,5 point)), how the open market operation, you identified in point (a), affects each of the following in the short run:

(i) Investment (1 point with explanation / 0,5 without explanation)

(ii) Aggregate demand (1 point with explanation / 0,5 without explanation)

(iii) Real output (0,5 point)

(iv) The price level (0,5 point)

(v) Government budget (1 point with explanation / 0,5 without explanation)

d) How will your answers to point (c) change, if banks decide to hold reserves over and above the required amount? (Hint: give the intuition only, graphs are not needed). (1,5 point with explanation)

e) Suppose a large corporation makes the open market operation of the same amount. Explain how the money supply will be affected in this case. (1,5 point with explanation)

3. (6,5 points)

a) Identify the impact of the events, listed below, on the situation in the loanable funds market in the short run. In each case define whether there will be the change in the demand for loanable funds or in the supply of loanable funds. Explain your reasoning for each case and show the changes on the loanable funds market graph.

b) In each case define how the interest rate will be affected. Explain how these changes in the interest rate can influence the long-run economic growth.

(i) a sharp decrease in the consumers’ wealth;

(ii) a simultaneous equal increase in government spending and lump-sum taxes;

(iii) a decrease in business confidence due to expectations of the second wave of

the world economic crises;

(iv) an increase in the public’s optimism;

(v) an increase in deficit financing by the government;

(vi) an implementation of a tax credit on spending for machinery for businesses;

(vii) a reduction of the tax rate on interest income from household savings with

no change in government budget deficit.

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