Economics 212

Intermediate Macroeconomics

Professor Rafferty
Fall 2012

Exam #1
Answer all 25 multiple choice questions (2 points each)
1. If the quality of the labor force increased then
a. the long-run aggregate supply curve would shift to the right.
b. the long-run aggregate supply curve would shift to the left.
c. the aggregate demand curve would shift to the right.
d. the aggregate demand curve would shift to the left.
2. If the U.S. government cuts spending across the board as expected on January 1, 2013 then this
will cause
a. a shift to the right of the aggregate demand curve.
b. a shift to the left of the aggregate demand curve.
c. a shift to the right of the aggregate supply curve.
d. a shift to the left of the aggregate supply curve.
3. If the Fed decided to double the money supply then this would
a. shift the aggregate demand curve to the right and decrease the price level, but increase output.
b. shift the aggregate demand curve to the right and increase the price level, but decrease output.
c. shift the aggregate demand curve to the right and increase both the price level and output.
d. shift the aggregate demand curve to the right and decrease both the price level and output.
4. If the price of oil fell to $50 a barrel tomorrow and stayed at that level then
a. the long-run aggregate supply curve would shift to the right.
b. the long-run aggregate supply curve would shift to the left.
c. the short-run aggregate supply curve would shift to the right.
c. the short-run aggregate supply curve would shift to the left.
5. In the circular-flow diagram, the total value of ____ equals the total value of _____.
a. exports; imports.
b. GDP; GNP.
c. spending on goods and services; income.
d. capital; labor.
6. Suppose that the term premium is 0.5 percent and the default-risk premium is 2.0 percent.
Now suppose that the interest rate on a one-year Treasury security is 5 percent and the expected
interest rate on a one-year Treasury security next year is 7 percent. What is the interest rate for
the a two-year corporate security?
a. 8.5%
b. 8.0%
c. 6.5%
d. 9.0%

7. All of the following are examples of investment spending except

a. the purchase of a new apartment building by a property management company.
b. the purchase of a new home by the MacGregor family.
c. Sandra purchases her childhood home from her parents.
d. Ford builds a new factory in Alabama.
8. On September 21, 2012, the nominal interest rate on a 10-year U.S. Treasury security was
1.8% and the interest rate on a 10-year U.S. Treasury inflation protected security (a measure of
the real interest rate) was -0.7%. The expected inflation rate was
a. 2.5%
b. 1.1%
c. 2.6%
d. 1.3%
9. The profits from a U.S. owned Burger King in France are included in U.S. _____ and French
______.
a. GDP; GDP.
b. GDP; GNP.
c. GNP; GDP.
d. GNP; GNP.
10. If the inflation rate is less than the expected inflation rate, the real interest rate will be ____
than the expected real interest rate. When this happens, _____ will lose and ____ will gain.
a. greater; borrowers; lenders.
b. less; lenders; borrowers.
c. greater; lenders; borrowers.
d. less; borrowers; lenders.
11. Which of the following would cause the unemployment rate as measured by the Bureau of
Labor Statistics to understate the true degree of joblessness in the economy?
a. unemployed persons who falsely report themselves as actively looking for a job.
b. people with part-time jobs who would prefer to be working full time.
c. retired people who have no intention of returning to work.
d. people employed in the underground economy.
12. By acting as a lender of last resort during a banking panic, a central bank allows commercial
banks to
a. satisfy customer withdrawal needs and eventually restore the publics faith in the banking
system.
b. make additional loans to increase the assets on their balance sheets.
c. encourage the public to borrow directly from the central bank, taking pressure off the banking
system.
d. call in their loans to their customers and eventually restore the publics faith in the banking
system.
13. A situation in which the price of an asset rises significantly above the assets fundamental
value is referred to as
a. magnification.
b. asset liquidity.
c. dissipation.
d. a bubble.

14. In a small open economy an increase in tax revenues will _____ the real interest rate, ____ the
level of savings, _____ the level of investment so net exports will ______.
a. decrease; increase; increase; decrease.
b. not change; increase; not change; increase.
c. decrease; increase; decrease; increase.
d. not change; decrease; not change; increase.
15. Moral hazard occurs when:
a. One party to a financial transaction takes advantage of knowing more than the other party.
b. actions people take after they have entered into a transaction that make the other party to the
transaction worse off.
c. agents pursue their own interests rather than the interests of the principals.
d. none of the above.
16. If a borrower does not have the resources to make a down payment or the ability to post
collateral, and is therefore unable to obtain a loan even when she is willing to pay the current
interest rate, the borrower is being subject to
a. financial asymmetry.
b. bank hegemony.
c. unfair lending practices.
d. credit rationing.
17. In the United States, the growth rate of expenditures has been most volatile for
a. services.
b. durable goods.
c. non-durable goods.
d. the volatility has been roughly equal for all three categories of consumption.
18. Which of the following is not one of the three key services provided by the financial system
to savers and borrowers?
a. information
b. liquidity
c. risk sharing
d. credit counseling
19. Suppose that the government cuts government spending. In a closed economy the level of
private investment will ______, in a small open economy the level of private investment would
_____ and in a large open economy the level of private investment would ______.
a. increase; increase; increase.
b. increase; decrease; decrease.
c. increase; not change; decrease.
d. increase; not change; increase.
20. Dan expects to work for another 30 years and to live for another 10 years after he retires. If
Dan completely smoothes consumption over his lifetime and the value of his stock portfolio
decreases by $100,000 then consumption will decrease by
a. $75,000
b. $25,000
c. $100,000
d. $2,500

21. Hectors wealth is $100,000, he expects to work for another 45 years at an average salary of
$80,000 and leave for 5 years after he retires. If yearly taxes are $20,000 and Hector completely
smoothes consumption over his lifetime, his annual consumption is:
a. $56,000
b. $54,000
c. $74,000
d. $72,000
22. A bank run occurs when:
a. the central bank acts as a lender of last resort.
b. a large number of depositors lose confidence in a bank and simultaneously withdraw their
funds.
c. a large number of banks make loans to a particular financial institution at the same time.
d. none of the above.
23. In 2010 nominal GDP in Spain was $1,395.0 billion and the GDP deflator was 156.7. What
was real GDP?
a. $8.9 billion.
b. $890.2 billion.
c. $0.1 billion.
d. $11.2 billion.
24. In January 2011, the U.S. labor force was 153,250,000 and 139,330,000 people were
employed. What was the unemployment rate?
a. 90.1%
b. 9.1%
c. 10.0%
d. Not enough information to tell.
25. An increase in uncertainty about the future will tend to _____ precautionary saving and _____
the desired level of wealth for households.
a. increase; decrease.
b. increase; increase.
c. decrease; increase.
d. decrease; decrease.

Choose 1 of the following (50 points)

1. On January 1, 2013 a number of temporary tax cuts are set to expire. This is part of the fiscal
cliff that has been discussed in the news since this past summer. Many commentators have
argued that the fiscal cliff is causing households to cut back on consumption now and real GDP
growth to decrease. For example, the growth rate of real GDP has fallen from 4.1% during the
fourth quarter of 2011 to 1.3% during the second quarter of 2012. The personal savings rate has
increased from 3.2% in November 2011 to 4.2% during July 2012.
a. Would the Keynesian theory of consumption predict that the fiscal cliff should reduce
consumption spending now? Explain. (10 points)
b. Would the Permanent Income Hypothesis or the Life-Cycle Model predict that the fiscal cliff
would reduce consumption spending now? Explain. (10 points)
c. Which theory is the data on the personal savings rate consistent with? Explain.
d. Suppose the tax cuts expire and either the Permanent Income Hypothesis or the Life-Cycle
Model is true. Do you expect a large decrease in consumption spending after January 1, 2013 or
not? Explain. (10 points)
e. Suppose that there is a large degree of credit rationing. Would this change your answer to part
d? Explain (10 points)
2. The Congressional Budget Office forecasts that the fiscal cliff will cause a recession because
consumption and investment spending will decline.
a. Explain how expectations about the fiscal cliff might be depressing investment spending now.
(10 points)
b. Explain in great detail how the Federal Reserve can offset the effect of the fiscal cliff on
investment spending. Start with open market operations and go all the way through to the model
of investment spending. In other words, explain the interest rate channel for monetary policy. (20
points)
c. The effective federal funds rate was already 0.15% on September 21, 2012. Some
commentators argue that this means the Fed cannot offset the effect of the fiscal cliff. Explain
this argument. (10 points)
d. On September 13, 2012 the Federal Open Market Committee issued a statement that read in
part that exceptionally low levels for the federal funds rate are likely to be warranted at least
through mid-2015. How might this get around the argument you described in part c? (10
points)

Answers to Multiple Choice Questions

1. A

6. A

11. B

16. D

21. A

2. B

7. C

12. A

17. B

22. B

3. C

8. A

13. D

18. D

23. B

4. A

9. C

14. B

19. D

24. B

5. C

10. A

15. B

20. D

25. B

1.
a. The Keynesian consumption function is:
D
Ct =C t +mpc Y t .

Since taxes will increase in the future, Y Dt has not yet changed so expectations of
higher taxes in the future do not affect Ct .
b. In contrast, the permanent-income hypothesis and the life-cycle hypothesis suggest
that future taxes will affect consumption today. The intertemporal budget constraint for
the two-period model is:
D

C
Y
C1 + 2 =Y D1 + 2
( 1+r )
( 1+r )
which says that the present value of consumption equals the present value of disposable
income.
If taxes increase in the future then Y D2 decreases which reduces the present value of
disposable income. As a result, consumption will decrease today.
c. The permanent-income hypothesis and the life-cycle hypothesis are consistent with the
increase in the personal savings rate from November 2011 to July 2012. Note that
disposable income is defined as follows:
D

Y t =Y t +TRtT t
and there are two uses of disposable income:
D

Household

Y t =C t +St

Since taxes do not increase until the future, disposable income is constant. That means if
consumption decreases today then household savings must increase. As a result, the
personal savings rate should increase which is what we saw in the data.

d. At the time that the tax cuts were passed they were announced as temporary tax cuts.
If people expected the tax cuts to be temporary then the tax cuts increased transitory
income. The permanent-income hypothesis says that the marginal propensity to consume
out of transitory income is low so temporary tax cuts should not increase consumption
spending much. Therefore, when the temporary tax cuts expire as expected, consumption
should not decrease much if at all. Why? Households smooth their consumption
spending over time so unless the present value of lifetime disposable income decreases
by a large amount, consumption spending will not decrease by a large amount. So the tax
increases are expected, the present value of life-time disposable income should not
change at all. That means consumption should not change.
e. The claim that households smooth consumption so that temporary tax cuts which have
a small effect on the present value of lifetime income should have little effect on the
consumption today assumes that households can borrow as much or as little as they want
at the going real interest rate. However, this may not be the case. Financial institutions
cannot easily observe all the relevant characteristics of potential borrowers so financial
institutions cannot know with certainty who the high and low risk borrowers are. As a
result, financial institutions may not make loans to households with high future income,
but which have low credit scores now etc. Therefore, there are likely some households
that would like to borrow to smooth consumption, but cannot since they cannot obtain
loans. Therefore, when taxes increase these households may be forced to decrease
consumption substantially. If there are enough of these households in the economy then
aggregate consumption may decrease substantially.
2.
a. The Congressional Budget Office predicts that if taxes increase and spending decreases
on January 1, 2013 then the U.S. economy will enter a recession. In other words, future
output will decrease so the expected marginal product of capital will decrease and the
MPK curve will shift left causing the desired capital stock to decrease.

uc

(r + d)pk

MPK2

MPK1

K 1

Investment is a function of the desired capital stock, so investment spending also

decreases:

I t =z ( K t K t1 ) + d K t 1 .
The decrease in the desired capital stock means that firms will now invest less than they
otherwise would have so investment spending falls now.
b. If the Fed purchases financial securities then this will increase bank reserves so the
money supply curve will shift to the right and reduce the short-term nominal interest rate.
M S1

M2

iFF,1

iFF,2

The Feds influence on long-term real interest rates is indirect. The Fed influences longterm nominal interest rates through the term-structure of interest rates. The interest rate
on a long-period bond (assuming that financial markets are efficient) equals the average
of the expected interest rates on short-period bonds plus a term-premium to compensate
for interest rate risk. The general equation is:

in ,t

i1,t i1e,t 1 i1e,t 2 i1e,t ( n1)

n

TPn ,t

TP
where is the time to maturity for the long-period bond and n ,t is the term premium, in,t
is the interest rate on the long-term government bond and iFF,t is the interest rate on the
federal funds rate today. The interest rates that households and firms pay also incorporate
a default-risk premium, DPt,
in ,t

e
e
e
iFF ,t iFF
,t 1 iFF ,t 2 iFF ,t ( n 1)

TPn ,t DPt

To go from nominal to real interest rates we must include the expected inflation rate:
r n ,t =i n ,t et .
Therefore, changes in the nominal federal funds rate will change the nominal long-term
interest rate assuming that the term premium and default-risk premium are constant. If
we further assume that expected inflation is constant then the real interest rate also
changes.

The decrease in the real interest rate causes the user cost of capital curve to shift down so
the desired capital stock rises back to its initial value. As a result, investment rises.

MPK2

uc1

MPK1

uc2

K 2

(r1 + d)pk

(r2 + d)pk

K 1=K 3

c. The interest rate channel for monetary policy works by reducing the federal funds rate
today, i FF , t , which then causes the long-term nominal interest rate to decrease
assuming the term premium and default-risk premium are constant. Assuming the
expected inflation rate is constant, the long-term real interest rate decreases as well.
However, if the federal funds rate is already 0% then the Fed cannot reduce it further so
the textbook interest rate channel can no longer operate.
d. By signaling that the federal funds rate will remain exceptionally low (which
essentially means 0%) until mid-2015 the Fed is trying to reduce expectations of future
federal funds rate. If the Fed can reduce the expected federal funds rate in the future then
i eFF , t +1 etc. decrease. Assuming the term premium, the default-risk premium, and the
expected inflation rate are constant, the long-term real interest rate should decrease even
if the current federal funds rate equals 0%.

10