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Econ 40700 Midterm Exam Fall 2018

The document is a midterm exam for Econ 40700, administered by Professor Robert Johnson, consisting of multiple-choice questions and written responses regarding economic concepts such as the IS-LM model, fiscal shocks, and monetary policy in the eurozone. It includes instructions for completing the exam under the Notre Dame Academic Code of Honor and outlines the point distribution across various sections. The exam covers topics like the effects of government spending, trade dynamics, and the implications of capital controls on exchange rates.

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18 views12 pages

Econ 40700 Midterm Exam Fall 2018

The document is a midterm exam for Econ 40700, administered by Professor Robert Johnson, consisting of multiple-choice questions and written responses regarding economic concepts such as the IS-LM model, fiscal shocks, and monetary policy in the eurozone. It includes instructions for completing the exam under the Notre Dame Academic Code of Honor and outlines the point distribution across various sections. The exam covers topics like the effects of government spending, trade dynamics, and the implications of capital controls on exchange rates.

Uploaded by

bobbleheads56
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Econ 40700

Fall 2018
Professor Robert Johnson

Midterm Two
November 5, 2018

Name (print): __________________________________________________________________

Instructions: Please answer all questions and show your work on the test itself. If you need more space, there
is an extra blank page attached. There are a total of 75 points (one per minute). You have the full class period
to complete the exam.

Do not look at any books, notes, or classmates’ answers. This exam is being administered under Notre Dame’s
Academic Code of Honor. Abuse of the Code will be prosecuted using ND protocol for such violations.

Signature: _____________________________________________________________________
(Signing indicates that you have understood the instructions and adhered to the Honor Code)

Section Points
Multiple Choice (18 points)

Question #1 (19 points)

Question #2 (6 points)

Question #3 (20 points)

Question #4 (12 points)

Total (75 points)

Page 1 of 12
Multiple Choice

Choose the single best response among the alternatives. Each question is worth 2 points.

1. Which of the following shocks leads to an exchange rate depreciation in the IS-LM model?

A. Foreign disposable income falls.


B. Investment demand increases.
C. Demand for exports increases.
D. Demand for imports decreases.
E. None of the above.

2. In the IS-LM model, there is no tradeoff between stabilizing output and keeping the exchange rate fixed
after which of the following shocks?

A. Government spending decreases.


B. Consumption increases (consumption rises for a given level of disposable income).
C. Investment demand decreases.
D. Demand for liquidity increases.
E. None of the above.

3. The benefits of a fixed exchange rate are likely to be greater than the costs when:

A. The home and foreign countries experience asymmetric economic shocks.


B. The home and foreign countries do not trade much with one another.
C. The home country has a larger fiscal multiplier than the foreign country.
D. The home and foreign countries have high interest rates prior to joining the currency peg.
E. None of the above.

4. The following statement about the IS-LM model is false:

A. The trade balance is equal to the current account in the IS-LM model.
B. The LM curve represents interest rates and output levels that are equilibria in the goods market.
C. The marginal propensity to consume home goods is less than the marginal propensity to consume:
.
D. The FR curve shifts up when foreign interest rates rise.
E. None of the above.

5. Which of the following statements about the macro-policy trilemma is false:

A. Under the post-WWII Bretton Woods system, capital controls allowed countries to have both monetary
autonomy and fixed exchange rates simultaneously.
B. Because China accepts free capital mobility across its borders, it sacrifices monetary autonomy in order
to peg the yuan to the dollar.
C. The United States has a floating exchange rate, and thus can allow capital mobility while preserving
monetary policy autonomy.
D. All of the above.
E. None of the above.

Page 2 of 12
6. According to the macro-policy trilemma, the correlation between home and foreign interest rates should be
highest for a country with:

A. a fixed exchange rate and capital controls.


B. a floating exchange rate and capital controls.
C. a fixed exchange rate and free capital mobility.
D. a floating exchange rate and free capital mobility.
E. None of the above.

7. Suppose that the economy of Zooropa is described by the following consumption, export, and import
equations: 0.7 , 0.1 0.2 ∗ ∗
, and 0.1 0.2 ,
where , , and are constants. Holding the interest rate constant, how much does Y rise when
government spending increases by $1?

A. $1.42 (i.e., $1/0.7)


B. $3.33 (i.e., $1/0.3)
C. $1
D. $5 (i.e, $1/0.2)
E. $2 (i.e., ($1/0.5)
F. $1.25 (i.e., $1/0.8)

8. In the trade with endowments model, the following statement about demand is true:

A. Relative demand for good X falls when the Cobb-Douglas share of good X ( ) rises.
B. Relative demand for good X falls when the price of good X falls relative to the price of good Y.
C. Foreign import demand for good X rises when the Cobb-Douglas share of good X ( ) rises.
D. Home export supply of good X rises when the Cobb-Douglas share of good X ( ) rises.

9. A common monetary policy tends to be more attractive for members of a monetary union when:

A. The monetary union has strong fiscal rules that ban fiscal transfers between countries.
B. Labor mobility is high, so workers move from areas with high unemployment to areas with low
unemployment.
C. Economic shocks are asymmetric across countries within the monetary union.

Page 3 of 12
Question #1

In 2018, Congress and the Trump administration enacted tax cuts and an increase in government spending. This
question asks you to evaluate some consequences of these actions. This question is worth 19 points.

(a) Illustrate the effects of these shocks on US output, interest rates, and the exchange rate using the IS-LM-FX
model. Explain what curves shift and why, and how the economy adjusts to the new equilibrium. Label the
pre-shock equilibrium A and the post-shock equilibrium B. [6 points]

(b) Briefly explain how and why consumption, investment, and the trade balance change following the fiscal
shocks in part (a). [4 points]

Page 4 of 12
(c) The United States is relatively closed with respect to world trade – i.e., imports are a small share of total
consumption, as compared to other major countries. Would the change in output in part (a) be larger or
smaller if the US economy were more open to international trade? Explain briefly. [4 points]

(d) The unemployment rate is currently at 3.7%, the lowest level since 1969. Thus, the US economy is
operating at or above its “full employment” level. Given this, how might the Federal Reserve respond to the
fiscal shocks in part (a)? How would this reaction by the Fed change the impact of the fiscal shock on
output and the trade balance? Explain. (Hint: you do not need to draw diagrams here.) [5 points]

Page 5 of 12
Question #2

"When members of a monetary union are experiencing different macroeconomic conditions, a single policy rate
is unlikely to fit circumstances in all countries...economic differences between peripheral and core euro-area
countries are sharp." (Fernanda Nechio, FRBSF Economic Letter, June 13, 2011).

Using the concept of the Taylor Rule, explain how the common monetary policy in the eurozone led to
problems for peripheral countries (i.e., the GIIPS group) before and after the eurozone crisis. This question is
worth 6 points.

Page 6 of 12
Question #3

Growth and Trade, Revisited. Over the past two decades, emerging market economies have grown larger
relative to the United States. We want to analyze some of these implications using the endowment trade model.

Suppose that the United States (the Home country) initially is abundant in manufactured goods (good X)
relative to agricultural goods (good Y), while emerging markets (the Foreign country) are initially scarce in
manufactured relative to agricultural goods. And assume that the US and emerging markets can trade freely.
This question is worth 20 points.

(a) Suppose that emerging markets (Foreign) grow relative to the US (Home), and suppose that this growth
occurs entirely due to an increase in manufacturing production. That is, suppose that growth raises the
Foreign endowment of manufacturing good X. Does this growth raise or lower the price of good X relative
to good Y? Use the relative supply-demand diagram to explain your answer. [6 points]

(b) Now, repeat your analysis of world prices using the Export Supply and Import Demand diagram. Explain
how the Home Export Supply and Foreign Import Demand curves shift and why, and what happens to the
relative price of good X as a result. [4 points]

Page 7 of 12
(c) Using the budget constraint diagram, illustrate US consumption choices before and after the growth in the
Foreign endowment of good X. Label the endowment point, draw the budget constraint before and after
Foreign growth, and label consumption choices before and after. Explain how/why consumption changes.
[8 points]

(d) How do Home exports and imports change as a result of Foreign manufacturing growth? [2 points]

Page 8 of 12
Question #4

In the standard IS-LM-FX model, we assume that capital is mobile across countries. Now, let us suppose
instead that there are extensive capital controls, so that the economy is in financial autarky (agents cannot
borrow or lend abroad). Given this alternative assumption, trade must be balanced at all times: ,
, ∗ ∗
0, with ∗
/ as usual.

The IS-LM macroeconomic equilibrium with capital controls then requires that (1) the goods market is in
equilibrium, (2) the money market is in equilibrium, and (3) trade is balanced. [Note: we drop the UIP
condition.] This question asks you to analyze the behavior of the exchange rate in this modified model. This
question is worth 12 points.

(a) Under financial autarky, the nominal exchange rate is pinned down (determined in equilibrium) by the trade
balance condition (i.e., TB=0). Given this, does the exchange rate rise or fall when home disposable income
rises? What about when foreign disposable income rises? Explain your answer carefully. [4 points]

Page 9 of 12
(b) Suppose that there is an increase in government spending (G) in this IS-LM model with capital controls.
How do output and the exchange rate respond to an increase in government spending? Explain your answer.
[5 points]

(c) How does the result in part (b) compare to the standard IS-LM-FX model? Explain similarities or
differences briefly. [3 points]

Page 10 of 12
This page is intentionally blank. Use it for scratch work or extra space for answers.

Page 11 of 12
This page is intentionally blank. Use it for scratch work or extra space for answers.

Page 12 of 12

Common questions

Powered by AI

In the endowment trade model, if emerging markets experience increased manufacturing production, the relative supply of manufactured goods (good X) rises. This increase in supply reduces the relative price of manufactured goods compared to agricultural goods (good Y) as per supply and demand dynamics .

At full employment, fiscal shocks like increased government spending may lead to inflationary pressures. The Federal Reserve might respond by raising interest rates to cool down the economy, which could lead to an appreciation of the currency and an adverse effect on the trade balance due to less competitive exports .

The correlation between home and foreign interest rates is highest for a country with a fixed exchange rate and free capital mobility, as the country's monetary policy must align with foreign rates to maintain the exchange rate peg, thereby reducing autonomy over interest rates .

An increase in investment demand raises domestic output, leading to higher interest rates. Higher interest rates attract foreign capital, causing an appreciation of the exchange rate as demand for the home currency increases .

High labor mobility within a monetary union can mitigate the impact of asymmetric economic shocks by allowing workers to move from high-unemployment areas to low-unemployment areas, thus balancing demand and stabilizing the economy. This ability makes a common monetary policy more attractive as it reduces the need for localized monetary interventions .

In an open economy, increased government spending can lead to a smaller change in output compared to a closed economy. The openness allows for greater importation, which can offset the increase in domestic output stimulated by the spending. Thus, the multiplier effect on output is reduced as a portion of demand leaks abroad .

Under financial autarky, an increase in government spending leads to a more straightforward increase in output, as the trade balance condition ensures TB=0. The exchange rate adjustments directly influence domestic demand, compared to standard IS-LM-FX models where capital flows play a significant role. The absence of capital flows means exchange rates are dictated more directly by trade balance changes .

According to the macro-policy trilemma, a country with fixed exchange rates and free capital mobility cannot maintain monetary policy autonomy. This implies that the country's interest rate policy will align with the foreign rates to maintain the exchange rate peg .

The Taylor Rule suggests setting interest rates based on inflation and output gaps. Before and after the eurozone crisis, applying a single monetary policy rate across diverse economies led to inappropriate interest rates for peripheral countries. These rates often failed to align with the economic conditions of these countries, exacerbating fiscal imbalances and leading to economic divergence within the eurozone .

In a modified IS-LM model with financial autarky, the nominal exchange rate is determined by the trade balance condition, which requires TB=0. An increase in foreign disposable income typically improves trade balance by increasing foreign demand for home goods, leading to an appreciation of the nominal exchange rate .

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