Exam 3:  Macroeconomic Theory and Policy
Take-home due December 4, 2002

In a blue book, answer the following questions.  Use both complete sentences and graphs.  Each is worth 10%.

1.  What is GDP, and what does it measure?  What are the three approaches to calculating GDP?  How do we adjust GDP for price inflation?  Why is GDP per capita not a perfect measure of economic welfare, even if we adjust for price inflation?

2.  Solve for the following macroeconomic equilibrium for the U.S. economy in 2000, assuming that prices, interest rates, and exchange rates are fixed.  Assume that C = 200 + 0.85*(Y-T), where Y is GDP and T = 0.2*Y, I = 1300, G = 1900, EX = 600, and IM = 0.1*(Y-T).  All amounts are in billions of dollars.
a) Solve for the equilibrium level of GDP.
b) Solve for the government budget surplus (deficit).
c) Solve for the balance of trade.
d) Solve for private savings as the difference between disposable income and consumption.
e) Show that savings equals investment.

3.  Beginning with your solution to #2 above, assume that in 2001 investment and exports each fell by 100 billion dollars, to 1200 and 500 respectively.  Show the net effect of this on Y using the Keynesian aggregate expenditures model, and explain how Keynes believed the adjustment to equilibrium would happen.  Solve for the new levels of Y, along with new level of private savings, the new government surplus or deficit, and the new balance of trade.

4.  Beginning with your solution to #3 above, assume that in 2002 government spending rose by 135 billion dollars (to 2035) as a result of the war on terrorism, while simultaneously taxes were cut by 100 billion dollars (so now T = 0.2*Y-100).  Solve for the new levels of Y, along with new level of private savings, the new government surplus or deficit, and the new balance of trade.

5.  What is fiscal policy?  Who is responsible for it, and how would this policy be carried out?  Why did Keynes advocate it, and why did he believe that it was particularly effective?  Why might it be less effective than originally thought?

6.  What is monetary policy?  Who is responsible for it, and how would this policy be carried out?  Assuming that banks hold 12.5% of their deposits in reserve, and that depositors prefer to put all increases in their money balances back into their bank, how much would a $10 billion purchase of government bonds by the monetary authority change the money supply?  Why might monetary policy be less effective in a recession?

7.  How does an increase in the money supply affect the interest rate in the short-run?  Assume there are only two financial assets available to households, money (either cash or deposits) which earns no interest and one-year discount bonds which pay the market interest rate.  Show how an increase in the money supply would affect both markets.   Would monetary policy be more effective if (a) money demand was elastic and investment demand was inelastic, or if (b) money demand was inelastic and investment demand was elastic?

8.  Using the full-employment model, show how equilibrium is determined in the product market, the labor market, and the capital market.  Draw and label your graphs carefully, and explain the source of supply and demand.  Give equations where appropriate.  Explain the important differences in this model between a closed economy and an open economy that allows for both international trade and savings flows, and for the latter show (and explain) what determines equilibrium in the foreign exchange market..

9.  Using the full-employment model for a closed economy, show the effects of an increase in the investment tax credit on interest rates, GDP, the price level, domestic savings, the real wage, and the long-run growth rate of the economy.

10.  Using the full-employment model for an open economy, show the effects of an increase in the money supply on interest rates, the real wage, GDP, the price level, domestic savings, foreign savings, the real wage, the real exchange rate, and the long-run growth rate of the economy.

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