You will have 120 minutes to complete this exam. It is divided into 170 points.
Please write the multiple choice answers in your blue-book. Good luck.

Multiple Choice: (50 points total, 5 points each) Choose the best answer for each.

1) All of the following actions are included in GDP as investment expenditure except:
a) IBM builds a new factory
b) the corner candy store builds up inventory in preparation for the Holiday rush
c) John smith buys a new home
d) Sandra Santiago buys 100 shares of IBM stock

2) A difference between the long run and the short run in our macroeconomic analysis is:
a) the classical dichotomy holds in the short run but not the long run.
b) monetary and fiscal policy affect output only in the long run.
c) demand can affect output and employment in the short run, while supply is the ruling
force in the long run.
d) prices are sticky in the long run only.

3) The consumer price index (CPI):
a) is computed as an average of prices of all goods and services.
b) is the price of a fixed basket of goods and services, relative to the price of the same
basket in a base year.
c) tends to understate the true value of inflation
d) is computed as nominal GDP relative to real GDP

4) When there is wait unemployment, the real wage is:
a) rigid at a level below the market-clearing level
b) rigid at the market-clearing level.
c) rigid at a level above the market-clearing level.
d) flexible.

5) All four models of aggregate supply (such as the worker misperception model, for example) suggest if the price level is lower than expected, output:
a) will fall below the natural level of output in the short run
b) will exceed the natural level of output in the long run
c) will equal the natural level of output in the short run
d) will exceed the natural level of output in the short run

6) Which of the following is not an implication of the Permanent Income Hypothesis:
a) the average propensity to consume is unaffected by permanent changes in income
b) consumption is not affected by transitory changes in income
c) the individual plans for the future over an infinite horizon
d) individuals consume a constant fraction of their transitory income

7) All of the following are arguments against Ricardian equivalence except:
a) consumers make decisions myopically.
b) consumers are rational and forward-looking in choosing their consumption level.
c) consumers are borrowing constrained
d) consumers do not expect future taxes to fall on them.

8) According to the neoclassical model of investment, the immediate impact of a rise in the real interest rate will be to:
a) increase the cost of capital, the rental price of capital, and the investment level.
b) increase the cost of capital and the rental price of capital, but lower the investment level
c) increase the rental price of capital and investment level, but not affect the cost of capital.
d) increase the cost of capital and lower investment level, but not affect rental price of capital.

9) In the two-period Fisher model, if the consumer is initially saving in period one and the real interest rate falls, second-period consumption will:
a) certainly fall
b) certainly rise
c) remain constant
d) either rise or fall

10) Which of the following makes monetary policy effective in increasing the level of output?
a) the IS curve is steep
b) money demand is highly responsive to the interest rate
c) investment is a positive function of income, as well as a negative function of the interest rate.
d) none of the above

Problem 1: IS-LM (30 points total, 10 points each part)

Suppose Congress and the President work out a compromise and agree to permanently cut government spending.

a) Graphically illustrate the short-run effects of this policy in two graphs: the IS-LM graph and the AD-AS graph (where the SRAS curve is horizontal). Be sure to label the axes, the curves, and arrows showing the direction the curves shift. Also mark the initial equilibrium as point '1', and the short-run equilibrium as point '2'. Describe briefly in words what is happening.

b) For each of the following variables, state if it rises, falls or doesn't change in the short run as a result of the policy:

Output, interest rate, investment, consumption, and price level. (Assume the usual consumption and investment functions, in which consumption is just a function of current income, and investment is just a function of the interest rate.)

c) Which of the five variables above return in the long run to their original levels?

Problem 2: (30 points total)

Suppose the demand side of the economy is characterized by the following equations:
(use these equations throughout the problem).
     G = 100 T = 100
     C = 50 + .75(Y-T) I = 150 - 1000r
     M^s = 40 M^d /P= .01Y - 10r

a) (15 points) Suppose a Classical specification of the supply side of the economy, in which the amount of output is determined by the factors of production available, and price level is perfectly flexible. In particular, assume the supply side of the economy is characterized by:
     Y = 5 K^1/2 L^1/2                K = 100, L = 100
Compute the equilibrium level of the following variables: income, real interest rate, investment, real wage, and price level.

b) (6 points) Given the Classical specification of the supply side in part (a), consider a rise in nominal money supply to 60. Compute the equilibrium values of the following: investment and price level. Does the "classical dichotomy" hold here?

c) (9 points) Now suppose instead a Keynesian specification of the supply side of the economy, in which price is fixed in the short run. In particular assume the supply side of the economy is characterized in the short run here by:
     P = 10.
Now consider the short-run effect of a rise in nominal money supply to 60. In particular, compute the short-run equilibrium values of the interest rate, investment, and income.

Problem 3: Phillips Curve & Time Inconsistency (30 points total)

Suppose the Phillips curve for the U.S. is estimated to be: pi=pi ^e - 2(u - uⁿ), and the natural rate of unemployment is estimated to be 6% (0.06). The Federal Reserve was dissatisfied with last year's inflation rate at 2 percent (0.02), and the Fed wants to achieve zero percent inflation this year.

a) (10 pts) First, suppose expectations are adaptive. How high must the Fed allow unemployment to be if it wants to achieve its inflation objective?

b) (5 pts) Suppose instead that expectations are adaptive, and everyone believes the Fed when it announces its policy to make inflation zero this year. Now, how high must the Fed allow unemployment to be if it wants to achieve its inflation objective?

c) (10 pts) Suppose now that expectations are rational, but everyone knows the Federal Reserve also dislikes unemployment as well as inflation, as summarized in its loss function:
     L(u,p ) = u + 5p². Despite the Fed's announcement, what level of inflation will people expect?

d) (5 pts) The new Labor Party government in the United Kingdom is making the British central bank more independent of government control. Usually we think that liberal governments dislike unemployment more than inflation, and that they do not trust conservative central bankers, who tend to dislike inflation more. Discuss briefly why this decision by the Labor Party nevertheless might make sense.

Problem 4: Growth and Investment (30 points total, 10 points each part)

Suppose the following about the United States economy, which is currently in steady state:

• the depreciation rate is 5 percent per year (0.05), and there is no population growth or technological progress.
• the capital-output ratio at the current steady state is 3.
• the "capital share" of output is 30 percent (0.30), and since the production function is Cobb-Douglas with constant returns to scale, this capital share is constant.

b) In this initial steady state, compute what the real rental price of capital must be, according the neoclassical theory of investment.

c) What saving rate is necessary to achieve the "Golden Rule" level of capital stock?