Econ 1120 – INTRO MACRO – Spring-2012 –April 18, 2012REGULAR-UP PRELIM #2 (Wednesday)PRINT YOUR NAME: ____________________________________ Your C.U. Netid: _____________

YOUR C.U. STUDENT NUMBER: ____________________________

Check YOUR TA’s NAME:

_____________TA = Xinli Wang (Monday sections)

_____________TA = Wei Quan (Tuesday sections)

_____________TA = Lingwen Zheng (Wednesday sections)

_____________TA = Minwook Kang (Wednesday sections)

_____________TA = Liyuan Cui (Thursday sections)

INSTRUCTIONS:

There are two sections in this exam Part I: 15 multiple choice questions @ 3 points each Part II: 3 short answer question (24 points) + 2 Newspaper Article questions (31 points) ANSWER ALL QUESTIONS. TOTAL POINTS = 100. TOTAL TIME = 90 minutes. Prelim2 score weights 30% of final grade. Please number each exam book from 1 to 6 and write your ID, name and section TA on the front page of

each book.

Please write down your answers in different exam books with following order.o Multiple choice questions in exam book1.o Short Essay 1 in exam book2o Short Essay 2 in exam book3o Long Essay 1 in exam book4o Long Essay 2 in exam book5

1

AGAIN, please….

PRINT YOUR NAME: ____________________________________ Your C.U. Netid: _____________

YOUR C.U. STUDENT NUMBER: ____________________________

_____________TA = Xinli Wang (Monday sections)

_____________TA = Wei Quan (Tuesday sections)

_____________TA = Lingwen Zheng (Wednesday sections)

_____________TA = Minwook Kang (Wednesday sections)

_____________TA = Liyuan Cui (Thursday sections)

GRADING----------------------------------------------------------------------------------------------------------

________/ 45 (mc)______/ 8 (short essay 1) ______/ 8 (short essay 2) ______/ 8 (long essay 2)________/ 16 (long essay 2)

TOTAL: ___________/100 --------------------------------------------------------------------------------------------------------------------------

2

Part I: Multiple Choice. 1. The Fed is said to accommodate an expansionary fiscal policy

a) when it decreases the money supply to avoid inflation caused by the fiscal policy.b) when it decreases the money supply to decrease interest rates to further stimulate the

economy.c) when it leaves the money supply fixed in order to let the fiscal policy work on its own.d) when it increases the money supply in order to keep interest rates from rising in

response to the fiscal expansion.e) when it increases the money supply so that interest rates also rise in an attempt to

further stimulate the economy.

2. Refer to the figure above. An increase in the tax rate will increase tax revenue if the economy is at point a) Ab) Bc) Cd) D

3. If financial crises cause incomes to decrease and consumption then decreases dramatically, our model can explain this if the _____ curve shifts _____ . An increase in the discount rate will cause the _____ curve to shift _____.a) aggregate demand; left; aggregate supply; rightb) aggregate supply; down; aggregate supply; not at allc) aggregate demand; left; aggregate demand; leftd) aggregate supply; up; aggregate demand; lefte) none of the above

3

4. If we assume money velocity is constant, and the following equation holds: Monetary Supply * Money Velocity = Price level * Output Which of the following is a correct conclusion?

a) If the economy always converges to long-run output very fast, increases in the money supply only induce increases of the price level.

b) Increases in the Money supply cause increases of output only.c) Increases in the Money supply have no effect on our economy.d) None of above

5. Assume that there is a significant decrease in the number of laborers covered by labor contracts that set wages for a lengthy predetermined period of time. That is to say, assume wages can now adjust more rapidly to changing economic conditions. Which of the following statements is true?a) This will decrease the effectiveness of both monetary and fiscal policy.b) This will increase the effectiveness of both monetary and fiscal policy.c) This will increase the effectiveness of fiscal policy, but decrease the effectiveness of monetary

policy.d) This will have no impact on the effectiveness of either monetary or fiscal policy.e) This will increase the effectiveness of monetary policy, but decrease the effectiveness of fiscal

policy.f) None of above

6. The crowding out effect associated with expansionary fiscal policy will be rather small whena) the money multiplier is very large.b) the demand function for money is very sensitive to changes in Y.c) the desired investment function is very insensitive to changes in r.d) the commercial banks hold zero excess reserves.e) the demand function for money is very insensitive to changes in r.

7. Which of the following is not an event shifting long run aggregate supply to right? a) A creation of new technology that will decrease production cost.b) A quality improvement in education making people more productive.c) A more friendly immigration law allowing professional workers to immigrate into the

country.d) Fed takes expansionary monetary policy.e) Fed takes contractionary monetary policyf) (d) and (e)g) (b) and (c)h) None of the above

4

8. Refer to the figure above that illustrates short run and long run Phillips Curves. Assume that Uo is the natural unemployment rate. Which combination of events could move the economy from Point A to Point E, and then from Point E to Point C?a) A contractionary monetary policy followed by a leftward shift in the SR-AS curve.b) A contractionary monetary policy followed by a rightward shift in the SR-AS curve.c) An expansionary fiscal policy followed by a leftward shift in the SR-AS curve.d) An expansionary fiscal policy followed by a rightward shift in the SR-AS curve.e) A contractionary monetary policy followed by a contractionary fiscal policy.

9. Assume the economy currently has high unemployment (above the natural rate of unemployment) and the factories have reached full capacity. If the Fed increases the money supply, then in the short run we can expect to seea) a small increase in real GDP and a large increase in the overall price levelb) a large increase in real GDP and a large increase in the overall price levelc) a small increase in real GDP and a small decrease in the overall price leveld) a small decrease in real GDP and a small increase in the overall price levele) None of above

10. Which set of answers is correct for the following statements? As aggregate income changes the transaction motive for holding cash balances ___________ money demand curve. The interest rate change ____________ money demand curve.a) shifts the; shifts theb) shifts the; causes movements along the samec) causes movements along the same; shifts the

SRPC2

SRPC1

SRPC3

D

EC

B

A

Inflation rate, %

Unemployment Rate, %

5

LRPC

4

3

Uo

5

d) causes movements along the same, causes movements along the samee) causes movements along the same, has no impact on the

11. Refer to the figure above. If the economy is currently at Point B then a) if the government doesn’t do anything, aggregate demand will shift left, and the

economy ends up at the original Point Cb) the economy is operating above full employment, and the unemployment rate is below

the natural unemployment ratec) we expect the price level to decrease further.d) (a) and (c)e) None of the above

12. Which of the following statements about social security is correct?I. Pay-as-you-go systemII. Defined-benefit pensionIII. Its funding source is from taxesIV. The social security trust funds are within the federal accounting and budget

system.

a) I and IIb) II,IV c) I,IIId) All of above

6

13. During the Great Recession of 2008-2009, the time it took for the Obama administration to put the stimulus package into legislation is called _____________ and the time it took for the stimulus package to have an effect on the economy is called_____________1. Recognition lag; Implementation lag2. Recognition lag; Response lag3. Implementation lag; Response lag 4. Response lag; Implementation lag

14. Suppose that in the economy of Wonderland, a nationwide earthquake occurs. In response to this disaster, the president has accepted the Economic Advisory Committee’s proposal which aims to boost the economy by cutting taxes. Then in equilibrium, we would expect:a) The price level to increase and the effect on aggregate output to be uncertainb) The price effect to be uncertain and aggregate output to decreasec) The price level to increase and aggregate output to increased) The price level to decrease and aggregate output to decrease

15. If the wage increases and we observe that labor supply decreases, we can conclude___________; If one wins a 2 million dollar lottery and we observe labor supply decreases, we can conclude__________a) Income effect dominates substitution effect; there is only pure income effectb) Substitution effect dominates income effect; Substitution effect dominates income effectc) Income effect dominates substitution effect; Substitution effect dominates income effect d) Substitution effect dominates income effect; there is only pure income effect, no

substitution effect

7

Part II: Short Essays (24 points)1. Classical school of economic thought (12 points)

a) Please compare Classical and Keynesian economists’ views in the following areas. (1) Labor market (3 points)(2) Short run aggregate supply and long run aggregate supply (3 point)(3) When a supply side shock happens, what policy should the government apply? (3 point)

b) According to the rational expectations theory, if people can perfectly predict the result of the policies, will you agree more with the claims of the classical school of thought or more the Keynesian? Why? (3 point)

2. Philips Curve (12 points)a) Draw the Short-Run Phillips curve and Label each axis. (4 points)b) Please use an AD-AS diagram to explain why we can observe conventional shape Phillips curve before 1980s when the AS curve is more stable (fixed). (4 points)b) Please use AD-AS curve to illustrate an example when the relationship of the conventional Phillips curve breaks down. (4 points)

8

Part III: Long Essay (31 points)1.Fiscal policy and Monetary Policy (16 points)The following paragraphs are selected from The Wall Street Journal, “Euro-Zone's Recession Fears Grow” by ILONA BILLINGTON on April 13, 2012. Please read them carefully, and use what we have learned to answer the following questions.

LONDON—Industrial production in the euro zone slumped in February by the largest amount in more than two years, Eurostat reported Thursday, adding to evidence that the common-currency bloc is in an economic recession.Other data released Thursday, including Greek unemployment, added to the bleak outlook for the region.………Industrial production accounts for almost a fifth of the euro-zone economy, which analysts say may already be in a technical recession, or two consecutive quarters of economic contraction, after shrinking 0.3% in the final three months of 2011. Euro-zone industrial output in the first quarter of 2012 is likely to contract 0.5%, shaving around 0.1 percentage point off gross domestic production, according to Martin van Vliet, an economist at ING Bank NV.………..Greek unemployment rose to a fresh record-high rate of 21.8% in January from 20.9% in December, Elstat, the country's statistics agency said. Records began in 2004. The increase highlights the widening divergence between the larger and stronger euro-zone economies such as Germany, where unemployment is falling, and the weaker regions struggling with fiscal imbalances and a weak economy.Greece is now in the fifth year of a recession that has led to soaring unemployment and rising business bankruptcies, made worse by tough austerity measures aimed at narrowing the government budget gap."The contraction of the Greek economy in 2012 will be much higher than the 5% expected, maybe around 6.5% or even 7%," said Panagiotis Petrakis, professor of economics at the University of Athens. "Unemployment figures are a signal of the recession that already exists in the economy and has not yet been seen in the economic indicators."And, other data out Thursday showed inflation across the region accelerated. An increase in fuel costs saw Irish consumer price inflation rise 1% on a monthly basis in March—the largest rise since February 2008 and by 2.2% from the year earlier

………

9

(a) Please use 3 panel diagrams as well as AD-AS curve diagrams to illustrate how

austerity policy worsens the Greek recession. What price level change would you

expect given austerity policy? (6 points)

(b) We also find that minor inflation happens. Please use an AD-AS curve diagram to

depict a possible reason. (4 points)

(c) A lot of economists consider leaving the common-currency zone to be a good option for

Greece to improve the current recessionary situation. Again, please use the 3 panel diagram

together with AD-AS analysis to explain what government can do if Greece leaves the Euro

Zone? What the price level change would you expect given your analysis? (6 points)

2. Labor Market (15 points)The following paragraphs are selected from The Wall Street Journal, “AT&T Inc. Staves Off a Walkout; Talks Go On” by GREG BENSINGER on April 8, 2012. Please read them carefully, and use what we have learned to answer the following questions.

10

NEW YORK—AT&T Inc. agreed to extend talks with union officials representing about 40,000 workers after the two sides failed to come to terms on a new contract before a deadline early Sunday.

AT&T avoided a walkout by Communications Workers of America employees in the Northeast, Midwest and West, who last week authorized union leadership to call a strike if an accord couldn't be reached. While talks continue, union employees will continue to report to work under the terms of their previous contract, the CWA said. "Both sides are still far apart," the CWA told members Saturday in a posting on a union website. "The pace of progress is slow and frustrating." AT&T is seeking concessions from its workers including cuts to their pensions and increased health-care premiums and co-pays to help offset revenue declines in the wireline division, which includes traditional home and business telephones and the U-verse television service. "We are committed to continuing to work together with the union to bargain a contact," a spokesman for AT&T said Sunday. AT&T rival Verizon Communications Inc. also is trying to negotiate a new, less-generous contract with its wireline union workers.………..Those talks saw union officials call a two-week strike last August for about 45,000 Verizon workers. The negotiations continue without a settlement. Carriers' traditional wireline businesses are contracting as users switch off their home phones in favor of smartphones and other mobile devices. …..

In reports to members on Friday, the CWA said AT&T wasn't holding "serious" talks with union officials. "AT&T continues to pass unrealistic proposals, and we continue to wonder when they will get serious," the union said in a report on the website of Local 1298, based in Hamden, Conn. "As they see their employees struggling to make ends meet, they continue to hold fast to their unrealistic request."The spokesman for AT&T said Sunday that the company is trying to protect middle-class jobs. According to AT&T, employees' medical costs rose 54% from 2004 to 2010 and 8% in 2010 alone. The company said on its website that it is seeking a new accord to "enable a competitive cost structure reflecting current market realities."

a) Please draw labor supply and labor demand to illustrate the traditional wireline labor market

today. (Please indicate the result if the contract (salary and benefit package) remains at the

same level as it was before.) (6 points)

11

b) According to the rational expectations theory, will the union agree to lower the salary

package? ( 3 points)

c) Please list at least 3 other reasons that makes sticky wages happen. (6 points)

Answer Key:

Classical school of economic thought (12 points)a) Please compare Classical and Keynesian economists’ views in the following areas. (1) Labor market (3 points)(2) Short run aggregate supply and long run aggregate supply (3 point)(3) When a supply side shock happens, what policy should the government apply? (3 point)

12

b) According to the rational expectations theory, if people can perfectly predict the result of the policies, will you agree more with the claims of the classical school of thought or more the Keynesian? Why? (3 point)

(a)(1) Classical economists think that labor market is very efficient and there is no sticky wage

problem leading to excessive supply or shortage. Therefore, the real wage will clear the

market, equaling labor supply to labor demand. People who don’t work are all

voluntarily. However, Keynesian economists believe the fact of sticky wage such that

wage is not determined totally by labor demand and supply. It takes a while to remove

wage rigidity away; hence, excessive labor supply or demand can happen.

(2) Believing market is efficient, classical economics school believe no lag between price level

and input cost; e.g., wage and thus the market is always at full employment. The

aggregate supply curve is vertical at level corresponding to full employment level.

However, considering labor market is inefficient, the Keynesian think there is a lag

between price level and cost of input, thus making short run aggregate supply curve

upward sloping.

(3) Given that classical economists’ vertical aggregate supply assumption, fiscal policy or

monetary policy only results in the change of the price level instead of output. Therefore,

they would ask government to do nothing. On the other hand, Keynesian would ask

government to apply fiscal policy, shifting aggregate demand curve to the right and

increase the output.

(b) If people can perfectly predict the result of the policy, people can totally understand the price level change and thus adjust wage. Given this argument, aggregate output is vertical, and thus rational expectation theorist would agree views of classical economists.

2. Philips Curve (12 points)a) Draw the Short-Run Phillips curve and Label each axis. (4 points)

13

b) Please use an AD-AS diagram to explain why we can observe conventional shape Phillips curve before 1980s when the AS curve is more stable (fixed). (4 points)b) Please use AD-AS curve to illustrate an example when the relationship of the conventional Phillips curve breaks down. (4 points)

(a)

(b) Because before 1980s we do not often have supply side shock, for example oil crises, the AS curve is quite stable (fixed). (or it could be other reasons; e.g., media is less active and information spreads at speed much slower, so input cost can adjust to price level more quickly. Aggregated supply curve tends to be vertical.) Therefore, government’s fiscal and monetary policy only shifts AD, making observed output always has negative relationship with price level. As depicted below, Y0 moves to Y1(Y2), while price level P0 shifts to P1(P2). (Y1,P1) corresponds to (UI,I1), and (Y2,P2) corresponds to (U2,I2).

Inflation rate

Unemployment Rate

Natural Rate of Unemployment

L.R.P.CS.R.P.C

14

(c) If AS curve is not stable, the negative relationship between unemployment and inflation breaks down. For example, if economy suffers oil crises at the same time, the final output falls from original output Y0 to Y1’ or to Y2’. Those observations correspond to higher inflation with higher unemployment; hence we can’t observe negative slope Phillips curve.

AD

ASP

Y

P0

Y0Y1 Y2P1P2

AD2AD1

Inflation rate

Unemployment RateNatural Rate of Unemployment

L.R.P.CS.R.P.C

U0U2 U1I2

I1

AD

ASP

Y

P0

Y0Y1 Y2

P1

P2

AD2AD1

AS1

Y2’Y1’

P1’

P2’

15

Long question(a) Please use 3 panel diagrams as well as AD-AS curve diagrams to illustrate how austerity

policy worsens the Greek recession. What price level change would you expect given

austerity policy? (6 points)

The article doesn’t give the clue about why Greece has been in recession for 5 years. So originally it can be either left shift of the AD or AS curve. We first assume it is the case in which supply side shock caused the recession. Thus output Y0 is less than full employment output, Yu. Moreover, in following analysis, because first round effect generally dominants second round feedback effect, we limit our analysis to the first round. At first round, government implement austerity policy so government spending decrease, shifting down AE curve. The original equilibrium Y0 shifts to Y1. Regarding to AS-AD diagram, implementation of austerity policy shift AD curve to the left and worsens the out Y0 to Y1. We expect price level decreases.

Y0

AE=C0+I0+G0AE

Y

Ms0

r0 r0

r

I0 I

r

AE=C0+I0+G1

Y1

Md0

AD

ASP

Y Yu

LRAS

Y0

P0

Y1

P1

Y1’

16

(d) We also find that minor inflation happens. Please use an AD-AS curve diagram to

depict a possible reason. (4 points)

It is possible that AS curve also shift to the left at the same time because of increase

of production cost. Therefore, price level increase to P1’while output decreases

further Y1’.

(e) A lot of economists consider leaving the common-currency zone to be a good option for

Greece to improve the current recessionary situation. Again, please use the 3 panel diagram

together with AD-AS analysis to explain what government can do if Greece leaves the Euro

Zone? What the price level change would you expect given your analysis? (6 points)

Greece government will have another tool to help economy recover. This tool is monetary policy. Monetary policy accommodates the contractionary fiscal policy, and thus output doesn’t fall as much as if only contractionary policy is adopted. Here we follow the graph in question (A). After monetary policy is implemented, money

AD

ASP

Y Yu

LRAS

Y0

P0

Y1

P1P1’

Y1’

17

supply increase and interest rate decreases, inducing investment and shifting AE up. Thus monetary policy offset the adverse effect form austerity fiscal policy. However, in the short run the integrated effect on price is unclear. In the long run, once output moves to long run, the price level would increase.

Long essay 2a)Please draw labor supply and labor demand to illustrate the traditional wireline labor market today. (Please indicate the result if the contract (salary and benefit package) remains at the same level as it was before.) (6 points)

The following illustrate the labor market of the wireline workers. Because the business is

shrinking, labor demand shifts form LD to LD’. Original equilibrium is W0 and L0. If new

equilibrium is determined by market, new equilibrium level should be W1 and L1 after shift

of labor demand. There is no involuntarily unemployment. However, If wage contact

remains at same level, we will find excessive labor supply (L0-L1’).

Y0

AE=C0+I0+G0AE

Y

Ms0

r0 r0

r

I0 I

r

AE=C0+I0+G1

Y1

Md0

AD

ASP

Y Yu

LRAS

Y0

P0

Y1

P1

Ms1

r1 r1

I1

AE=C0+I1+G1

18

(b)According to the rational expectations theory, will the union agree to lower the salary package? ( 3 points)

Rational expectation economists would think that if the union is rational, it will lower the

salary package such that the company can keep running the wireline business. If the unit

insist original wage, the wireline business unit in AT&T would suffer loss and even loss the

wireline market because competitor who successfully reduce the labor cost can take over

total market shares by cheaper service.

(c) Please list at least 3 other reasons that makes sticky wages happen. (6 points)1. imperfect information

2. The existence of the union

3. Firms tend to pay wage higher than market equilibrium to recrite

productive workers.

4. Maximum wage is binds.

L

W

LD

LS

L0L1L1’

W0W1

LD’

19