Midterm Exam #2

General Instructions:

This exam is closed book and closed notes. The time limit is 90 minutes. Please read each question carefully before answering. If you are confused about a question please ask me to clarify it before answering. Be as specific as possible when answering questions. Total points = 90. Relax, don't stress and good luck!

I. Definitions (10 points total, 2.5 points each). Please define 4 of the following 8 terms and write your answers in the space provided below.

• AD curve
• open market operation
• money neutrality
• LM curve
• business cycle
• IS curve
• economic shock
• liquidity
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II. Historical Question (10 points total).

For each variable below, indicate whether the variable is procyclical, countercyclical or acyclical and coincident, leading or lagging over the business cycle (2 points each):

• nominal money stock (M1)
• real wages (W/P)
• real interest rate (r)
• unemployment rate (U)
• price level (P)
•  

III. IS/LM ( 30 points total, 3 points each). The following questions apply to the IS/LM diagrams ignoring the full employment restriction (ignore the FE line). Show what happens to the equilibrium interest rate (r) and the level of demand (Y) if the following variables increase:

• Government spending (G)
• The nominal money supply (M)
• The price level (P)
• Nominal interest rate on money assets (i_m)
• Expected future marginal product of capital (FMPK^e)
• Expected inflation (^e)
• Wealth (WL)
• Productivity (A)
• Expected future income (Fy^e)

IV. More on IS/LM (Circle the correct answer. 10 points total,5 points each)

1. Monetary policy (increases in M to increase demand) is more effective if

(a) The IS curve is flat

(b) The LM curve is flat

(c) The IS curve is steep

(d) The LM curve is steep

(Hint: draw IS/LM curves for each case)

2. Fiscal policy (increases in G or decreases in T to increase demand) is more effective if

(a) The IS curve is flat

(b) The LM curve is flat

(c) The IS curve is steep

(d) The LM curve is steep

(Hint: draw IS/LM curves for each)

V. The following questions are based on the classical IS/LM - AD/AS curves below (30 pts.)

A. Starting from an initial full employment equilibrium, suppose that firms become more optimistic about the future and decide to invest more (e.g. FMPK^e increases).

(15pts)

(a) Describe what happens to the equilibrium values of the following variables:

(i) output (Y)

(ii) employment (N)

(iii) expected real interest rate (r)

(iv) price level (P)

(v) real wages (W/P)

(vi) real balances (M/P)

(b) Do your predictions for the movements of the economic variables in part (a) agree with the basic business cycle facts?

B. Starting from an initial full employment equilibrium, suppose that OPEC falls apart and the price of oil fall dramatically (say by 50%). (15 pts)

(a) Describe what happens to the equilibrium values of the following variables:

(i) output (Y)

(ii) employment (N)

(iii) expected real interest rate (r)

(iv) price level (P)

(v) real wages (W/P)

(vi) real balances (M/P)

(b) Do your predictions for the movements of the economic variables in part (a) agree with the basic business cycle facts?