June 1, 2011 FINAL EXAM ANSWER KEY:

1. The growth rate of real GDP in the 1 quarter of 2011 was:

st

1.8%

Year

Nominal (Current-dollar) GDP 100,000 105,000 110,000 115,000

2000 2001 2002 2003

Fixed-weight growth rate using year-2000 prices 1.2% 1.5% 2.5% 3.0%

Fixed-weight growth rate using year-2001 prices - 1.2% 1.0% 2.5% 3.6%

Chain-weighted growth rate

2.5% 3.3%

2. Which of the calculations below would you need to do, in order to compute the chain-weighted growth rate of real GDP in the year 2001?

Answer: (1.5 + 1.0)/2

The average of two fixed-weight growth rates for 2001 (one useing year-2000 prices as fixed weights, and the other using year-2001 prices) Other Choices: (1.5 + 1.2)/2 (Average of year-2000 growth rate and year-2001 growth rate), [(1.5 1.0)/1.0] x 100 (percentage difference in the fixed-weight year-2001 growth rate, using two different years prices as fixed weights), [(1.5 1.2)/1.2] x 100 (percentage difference in the year 2001 and year 2000 fixed-weight growth rates) 3. Which of the following calculations would you need to do, in order to compute year-2003 real GDP, in chained year2002 dollars? A. $115,000 x 1.033 B. $110,000 x 1.033 C. $115,000 x 1.025 D. $110,000 x 1.025

4. Examine the two fixed-weight growth rates for year-2000 real GDP. A likely reason for the discrepancy in these two numbers is: The answer to this one was supposed to be: There was a lot of inflation in 2001 in the slowest-growing sectors of the economy. However, there is a typo in the question: it should have asked you to examine the fixed-weight growth rates for year-2001 real GDP. As a result of the typo, which was not discovered during the exam, none of the answers to this question are correct. We handled this question by giving all students credit for it, regardless of their answers. 5. Which of the following is a method for calculating current dollar GDP:

Answer: The Income Approach

Other Choices: The Fixed-Weight Approach, The Hedonic Approach, and All of the above

6. Which of the following will cause measured GDP to understate the economys standard of living? Answer: All of the above.
Other Choices:

Since GDP includes only market transactions, it excludes production of goods and services that take place for the producers personal consumption. Measured GDP does not take account of the value of leisure. GDP does not count production that is unreported in order to avoid taxation and regulation.

Please examine the table below, which will be used to answer the next two questions. Current dollar GDP Inflation (%) GDP (chain-weighted (using the Implicit (billions of $) year-2000 dollars) GDP Deflator) 2000 $20,000 2001 $21,040 $20,400 2002 $21,987 $20,808 2.5 2003 $21,224 0.1

Implicit GDP Deflator 105.9

7. Which of the following calculations would you need to do, to calculate the 2002 GDP deflator:

Answer: (21,987 20,808) x 100

Other Choices: (21,987 20,000 ) x 100 The deflator compares nominal to real GDP. This answer compares nominal GDP in 2002 to nominal GDP in 2000. [(21,987 21,040) 21,040] x 100 This answer gives the growth rate of nominal GDP in 2002. (21,987 21,040) x 100. This answer compares nominal GDP in 2002 to nominal GDP in the previous year. 8. Which of the following cannot possibly be computed, using the information in the Table above? Answer: the growth rate of real GDP in 2000 youd have to know what real GDP was in 1999 in order to do this calculation. Other Choices: the chained growth rate of real GDP in 2003 (21,224-20,808)/20,808 x 100 chain-weighted real GDP in 2000 $20,000: its the base year! the chained growth rate of real GDP in 2002 (20,808-20,400)/20,400 x 100

9. Now lets turn to the topic of the CPI. Which of the following would it be unnecessary to know, in order to calculate the CPI for 2010? Answer: total output of all of the items that are included in the market basket. You only have to know the quantity consumed by a typical urban family of four. You dont have to know total output.
Other Choices: the prices of the goods in the market basket in 2010 the base-year prices of goods in the market basket none of the above: it is necessary to know all of these things in order to calculate the CPI. 10. Which of the following is an example of Substitution Bias in the CPI?

Answer: When the price of chocolate rises, George switches from buying Hershey bars to buying gummy bears, because the price per ounce of gummy bears is much lower than the price per ounce of chocolate. George switches to a cheaper candy.

Other Choices: When the price of chocolate rises, Fred switches from buying Hershey bars to buying even-more-expensive Belgian artisanal chocolates, because I want to make sure I am getting my moneys worth! When the price of chocolate rises, Bill decides to postpone his chocolate purchases, to see if the price will fall. When the price of chocolate falls, Charlie hoards chocolate, expecting to make a huge profit by selling it after the price rises again. 11. Now for some questions about employment and unemployment. First, what was the U.S. unemployment rate in April 2011? 9.0%

12. Which of the following could cause the US unemployment rate to rise, even if the US economy was in an economic recovery with a high growth rate of real GDP? Answer: many people re-enter the labor force to begin to look for jobs Until they find jobs, these people will be
counted as unemployed: previously, they were out of the labor force. Other Choices: an increase in employment a discrepancy between CPS employment and CES employment an increase in the number of discouraged workers. Opposite result: these unemployed individuals will no longer be counted as unemployed! The unemployment rate could fall, as a result. 13. Payroll employment is a statistic that comes from the

Answer: Current Employment Statistics

Other Choices: Current Population Survey, Consumer Employment Survey, Consumer Price Statistics 14. Employment, as measured by the CPS, is always larger than the employment estimate from the CES. This is because ______________.

Answer:

The CPS covers more categories of employment.

Other Choices: The CPS is a monthly survey while the CES is an annual one. Substitution Bias only affects the CPS. The CPS counts individuals, not jobs This answer is a correct statement about the CPS, but it does not help to explain why CPS employment is larger than CES employment. Part II: Questions about the Spending Allocation Model, the Deficit, Growth, and Money 15. Suppose that US government securities are downgraded by the ratings agency Standard & Poors, reflecting a general belief that the US Government may not be able to pay back all that it has borrowed. Savers around the world decide to buy securities from China instead. According to economic theory, this will change the long-run equilibrium in the US and in China. In the new equilibrium,

Answer: C/Y will be higher in China than it was before. Demand for Chinas currency will rise (and edmand for
dollars will fall). The exchange rate in China will rise, leading to a fall in Net Exports and therefore, a fall in R*. This will lead to equilbirium increases in C/Y, I/Y, and X/Y.

Other Choices: G/Y will be higher in China than it was before, I/Y will be lower in China than it was before, all of the above will occur.

16. According to economic theory, which of the following will lead to a decline in the long-run equilibrium US
trade deficit, as a percentage of GDP (note that a decline in the trade deficit is the same thing as an increase in X): Choices were: Congress enacts tax cuts for New Investment. I/Y rises, and so does NG/Y. The rise in R* then causes X/Y to fall. The Government decides to reduce its share of GDP. 1-G/Y rises, so that R* falls and X/Y rises. US government securities are downgraded by Standard & Poors, and world demand for these securities falls. The price of dollars on the foreign exchange market falls, causing X/Y to rise. All of the above. Another flawed question. As you can see, there are two possible answers. Since some students may have selected all of the above after noticing this, we decided to eliminate this question from the curve by giving everyone credit for it.

17. The name of the economic theory that you needed to use in order to answer the previous question is (dont overthink this) Answer: the Spending Allocation Model
Other Choices: the Spending Balance Model, the Economic Fluctuations Model, the Simple Solow Growth Model 18. Suppose that Private Saving is 10% of GDP, the Governments Budget Deficit equals 5% of GDP, Investment equals 12% of GDP, and there is a trade deficit equal to 8% of GDP. In this situation, Economic theory predicts that National Saving equals (10% - 5%) of GDP. I/Y + X/Y = 12% - 8% = 4%. Therefore National Saving is larger than I/Y + X/Y, so the answer is The long-run real interest rate, R*, will have to fall. Other Choices: The long-run real interest rate, R*, will have to rise, The ratio of Private Saving to GDP will be a negative number, NG/Y > 1 C/Y I/Y X/Y The last of these is a nonsense choice. Hope it did not throw you off. 19. Since much of the US government debt has a short maturity, a rise in US short-term interest rates will dramatically

Answer: increase the governments budget deficit, but have no effect on the Primary Deficit. I thought that this
was a challenging question. We know that if short-term interest rates rise, then the interest cost of refinancing the National Debt will go up. This will increase the deficit. It will also increase teh Structural Deficit, since the rise in interest cost has nothing to do with whetherthe economy is at potential GDP or not. The Primary Deficit, however, will not be affected, since it excludes interest payments. Other Choices: increase the Primary Deficit, but have no effect on the overall government budget deficit. increase the Primary Deficit and the Structural Deficit increase the Primary Deficit, the Structural Deficit, and the overall budget deficit.

20. Please examine the graphs below. In these graphs, the economy starts out at a long run equilibrium, and then the equilibrium is disturbed. The original curves are drawn with thin lines: the curves that have shifted are the darker ones. Which set of graphs is inconsistent?

A.

B.

S/Y, I/Y+X/Y R R

NG/Y, 1-G/Y R

S/Y, I/Y+X/Y R

NG/Y, 1-G/Y

C.

D.

S/Y, I/Y+X/Y

NG/Y, 1-G/Y

S/Y, I/Y+X/Y

NG/Y, 1-G/Y

In the set of graphs labeled D, the equilibrium interest rate is not the same. This is similar to a homework question from way back. 21. Which of the following is a prediction of the Solow Model of economic growth:

Answer: Other things equal, countries with higher savings rates will tend to have higher-long-run standards of living
Other Choices: Other things equal, countries with higher population growth rates will have higher long-run standards of living. Other things equal, countries with more capital will tend to have higher growth rates. Other things equal, the richest countries will have the highest growth rates. 22. The countries of Hoya and Saxa are alike in every way, except that Hoya has a larger capital stock and a larger savings rate than Saxa. Both countries are growing. According to the simple Solow Growth Model,

Answer: It is impossible to tell which country has the higher growth rate for average labor productivity.
The larger capital stock will tend to give Hoya the smaller growth rate (due to diminishingreturns), but the higher savings rate will tend to give Hoya a higher growth rate (due to greater Gross Investment). This question resembles one that many students got wrong on the second mid-term exam. Other Choices: The growth rate of average labor productivity is higher in Hoya than in Saxa, The growth rate of average labor productivity is lower in Hoya than in Saxa, The growth rate of average labor productivity is the same in Hoya and in Saxa. 23. Suppose that in 2001 in the country of Solovia, GDP is equal to $1,000, the National Savings Rate equals 25%, the depreciation rate is 10%, and the capital stock equals $3,000. The other assumptions of the simple Solow Model are also true. In Solovia,

Answer: average labor productivity is shrinking Saving (i.e., Gross Investment) equals 0.25 x 1000 = 250.
Depreciation = 0.10 x 3000 = 300. Net Investment = 250 300 = -50, so Capital, GDP, and Productivity are shrinking.

Other Choices: average labor productivity is growing, average labor productivity is constant, average labor productivity is negative. 24. In an economy in which the reserve ratio equals 10%, Total Bank Reserves = $200, Currency in Circulation = $800, and M1 = $2500, the money multiplier equals

Answer: 2500/1000 = 2.5 Similar to a mid-term 2 question. Since there is currency, you cannot use the simple
money multiplier formula 1/reserve ratio. You have to remember that M1 = Base x multiplier, and compute the multiplier as M1/Base. You also have to recall that Base = Reserves + Currency. Other Choices: 1/0.10 = 10, 2500/200 = 12.5, 1000 x 0.10 = 100 25. Which of the following is the best characterization of Fed monetary policy, prior to the 2007 recession:

Answer: the FOMC selects a target Fed Funds Rate and conducts an Open-Market operation calculated to make the effective Fed Funds Rate equal the target. Other Choices:
The FOMC purchases bonds and other securities to inject liquidity into the financial market and increase lending. The FOMC selects a target money supply, then conducts an open-market operation calculated to achieve this target. The FOMC selects a target level of bank reserves, then adjusts the reserve ratio and the primary credit rate (aka the discount rate), to keep member bank reserves at this target. 26. Suppose that there are no leakages into currency, banks hold no excess reserves, and the required reserve ratio is 10%. The Fed conducts an OMO with BANK 1, which leads, in chronological order, to changes in assets and liabilities at BANK 2, BANK 3, etc. As part of this financial activity, BANK 2s reserves rise by $10 million. This OMO was a __________________ (purchase, sale) of ______________ worth of securities.

Answer: purchase, $100 million If Bank 2s reserves rose by $10 and the required reserve ratio was 10%, then Bank
2s deposits must have risen by $100. This would happen if the Fed conducted an Open market purchase of $100 from Bank 1. Other Choices: purchase, $10 million. sale, $10 million. sale, $100 million. Part III. Questions about Economic Fluctuations 27. The National Bureau of Economic Research defines a recession (aka contraction) as

Answer: a period of significant decline in aggregate economic activity spread across the economy. Tutorial.
Other Choices: two consecutive quarters of declining nominal GDP, two consecutive quarters of declining real GDP, any period of time during which GDP is smaller than potential GDP. 28. According to the NBER chronology, post-WWII recessions have averaged half as many months in length as pre-WWII recessions. Some economists have suggested that the NBER chronology exaggerates the improvement in business cycles, since

Answer: most of the pre-war GDP data were extrapolated from Manufacturing output data, which are known to be more volatile than GDP.
Other Choices: the pre-1930s data were extrapolated from the post-1930s data. the NBER exaggerates just about everything. recent data suggest that post-WWII recessions were actually twice as long as the pre-war recessions. 29. A Monetary Rule is an equation that shows

Answer: which factors cause the FOMC to change the target Fed Funds Rate
Other Choices: how changes in the Fed Funds Rate cause the inflation rate to change how banks decide what interest rate to charge on the interbank market how big the change in the money supply will be for a given change in the monetary base. 30. Which of the following is an accurate statement of Taylors Rule? (symbols in this equation are not defined, but you are supposed to know what they represent)

Answer: R = R* + 0.5 x GAP - 0.5 x * + 0.5 x

Other Choices: R = R* + 0.5 x GAP + 0.5 x * - 0.5 x , F = R* - 0.5 x GAP + 0.5 x * + 0.5 x , F R = R* + 0.5 x GAP + 0.5 x * + 0.5 x 31. Please assume that the Feds monetary rule is Taylors Rule. Which of the following things will not cause the Monetary Rule curve to shift upwards?

Answer: a rise in the current inflation rate. This will lead to a movement along the Monetary Rule Curve (but just like
with an upward shift, R will rise) Other Choices: a fall in the central banks target inflation rate, a rise in the long-run real interest rate, an increase in the size of the GDP gap. 32. A GDP gap term in the central banks Monetary Rule will help the central bank to

Answer: keep inflation from rising when GDP is above potential, and keep inflation from falling when GDP is below potential. If GDP > potential, then the Feds Gap term reduces AD, to make GDP = potential without any
inflationary pressure. If GDP < potential, then Fed policy raises AD. This prevents inflation from falling, but also gets rid of the GAP. Other Choices: keep inflation from rising when output is above or below potential. keep the inflation rate lower than it would be if the central bank ignored the GDP Gap. estimate the deviation of GDP from its long-run value.
F 8 6 4 R 4 2 3 Please use this scenario to answer the following two questions. Examine the table at the left to see what the Fed Funds Rate (F) and the short-term real interest rate (R) were, in the months of May through July:

May June July

33. What was the inflation rate in July? (Hint: use the definition of the real interest rate to figure this out)

Answer: 1% Use the hint! Inflation = Nominal Interest Rate Real iNterest Rate. Here, thats F R. In July, F R =
4 3 = 1. This is why I urged you to highlight this definition on your note pages.
Other Choices: 4%, 3%, 2%

34. What could have caused the change that occurred from May to June?

Answer: a fall in the long run real interest rate

Other Choices: a fall in the current inflation rate, a fall in the Feds implicit inflation target, a rise in the size of the GDP gap. This is another difficult question. It is clear that R fell (from 4% to 2%). Two of the four possible answer choices would have led to a fall in R: a fall in the long-run real interest rate, and a fall in the current inflation rate (the other answers would have led to a rise in R). There is enough information in the Table to rule out a fall in the current inflation rate. All that you have to do is to compute the inflation rate in May and in June. In May, it was 8 4 = 4%. In June, 6 2 = 4%. Current inflation did not change. So the only possible answer is a fall in the long run real interest rate. 35. If the Fed Funds rate is consistently lower than the Taylors rule rate, which of the following could be the explanation?

Answer: The FOMC is not using Taylors Rule as a guideline for setting the target Fed Funds Rate.
Other Choices: The FOMCs implicit inflation target is lower than the Taylors Rule inflation target. The FOMC thinks that the long-run real interest rate is higher than the one that is assumed in Taylors Rule. The current inflation rate is falling. 36. The Fed Funds Rate was generally higher than the Taylors Rule guideline during which Fed Chairs tenure?

Answer: Paul Volcker.

Other Choices: Arthur Burns, Alan Greenspan, Ben Bernanke The Fed appears to have had a lower tolerance for inflation during the Volcker years. The Taylor Rule assumes a higher implicit inflation target (hence a lower guideline for the Fed Funds rate). 37. Which of the following equations represents the Keynesian Model of Consumption?

Answer: C = A + bY
Other Choices: C = I + G + X, C = A bR, C = Y S

38. One shortcoming of the Keynesian Model of Consumption is that it Answer: predicts that temporary tax cuts have the same effects on consumer spending as permanent tax cuts.
Other Choices: These answers are not true. assumes that only changes in Y, and no other factors, can affect real consumer expenditure. is only a theory of Nominal Consumption, which does not apply to Real Consumption. has been shown to have been accurate only during the 1940s. 39. The purpose of the 45-degree line in the Keynesian Cross diagram is to show

Answer: points where Y equals desired expenditure

Other Choices: the level of the real interest rate, the size of the GDP gap, none of the above

40. At which point shown in the graph below is desired expenditure larger than GDP?

Spending

C A
Desired Exp.

Y GDP
41. Please examine the four sets of expenditure curves shown below. In each set, the thin curve is the original expenditure curve: the bold curve indicates a shift. Which of these is consistent with a movement down and to the right along the economys Aggregate Demand curve?
Spending Spending Spending Spending

42. which of the following events will lead to a rightward shift in the economys aggregate demand curve?

Answer: a rise in the central banks target inflation rate.

Other Choices: a fall in the current inflation rate. a fall in the central banks target inflation rate. a rise in the current inflation rate.

AD shifts to the right if the Fed reduces R but the current inflation rate has not changed (if the Fed reduces R in response to a change in the current inflation rate, this will be a movement along the AD curve, not a shift). Thus, a change in current inflation does not shift AD. A fall in the target inflation rate will lead the Fed to raise R (to reduce AD). Only a rise in the target inflation rate will lead the Fed to reduce R, with teh goal of shifting AD to the right.
43. Which of the following will cause the economys inflation adjustment line to shift downwards?

Answer: GDP below potential GDP

Other Choices: unanchored expectations of rising inflation. IA shifts upwards.

a GAP term in the central banks Monetary Rule. GAP terms tend to prevent inflation adjustment all of the above.

44. The shape of the inflation adjustment line implies that in the short run, Answer: many different levels of GDP are consistent with the inflation rate.
Other Choices: GDP cannot be lower than potential GDP. many different inflation rates are consistent with the equilibrium level of GDP. This would imply a vertical IA line inflation is positively related to deviations of GDP from potential GDP. 45. Please assume that there is no GDP gap term in the Fed's monetary rule. Suppose that government expenditure rises, while at the same time, by coincidence, an influx of funds into the financial market reduces the long-run real interest rate, R*. As a combined result of these two events, the AD curve will

Answer: shift to the right Both of these events cause desired expenditures to rise.
Other Choices: shift to the left, not shift at all, AND any of the answers could be correct, depending on how big the changes in G and in R* are. This scenario applies to the next two questions. The economy is operating at a long-run equilibrium, when commercial banks begin to realize that they may be holding large amounts of worthless financial assets. Banks decide to reduce lending, so as to be able to repay depositors. As a result, Investment spending declines. Please assume that there is no GDP gap term in the Feds monetary rule. 46. Other things equal, what effect will these events have on the economys Aggregate Demand (AD) curve?

Answer: AD will shift to the left.

Other Choices: There will be a movement up and to the left along the AD curve, AD will shift to the right, There will be a movement down and to the right along the AD curve. 47. After the new short-run equilibrium occurs, which of the following events will occur, as the economy adjusts to the new long-run equilibrium:

Answer: There will be a movement down and to the right along the AD curve.
Other Choices: The expenditure curve will shift downwards, The AD curve will shift to the left, There will be a movement up and to the right along the monetary rule curve.

48. Which of the following will lead to the smallest increase in the inflation rate? Incorrect Choices: Expectation that the inflation rate will rise by 2%, if there is a GAP term in the Monetary Rule. A price shock that raises inflation by 2%, if there is a GAP term in the Monetary Rule. A price shock that raises inflation by 2%, if there is NO GAP term in the Monetary Rule.

Answer: Expectation that the inflation rate will rise by 2%, if there is NO GAP term in the Monetary Rule. A difficult question. Expectation that inflation will rise by 2% will shift up the IA line by two percentage points. If there is no
GAP term in the Monetary Rule, then the rise in inflation will lead the Fed to raise R (a movement along the Monetary Rule curve). This, in turn, will lead to a negative GDP gap, as desired expenditures fall and the economy moves up and to the right along its AD curve. Over the long run, the negative gap will make the inflation rate fall.

If there is a GAP term in the Rule, then the Fed will respond to the negative GDP gap by shifting the Monetary Rule curve upwards. AD will shift to the right, and the inflation rate will not fall in teh long run. If a price shock raises the inflation rate by 2%, then regardless of whether there is a GAP term in the Rule or not, the economy will wind up with lower GDP and inflation that is 2 percentage points higher than before. Check your notes to Example 4: Price Shock. 49. Assume that there is a GDP gap term in the Fed's monetary rule, and that the Fed knows the exact size of this gap. Now suppose that actual GDP is smaller than potential GDP. Which of the following will NOT occur as part of the economy's adjustment to a long-run equilibrium:

Answer: The Inflation Adjustment (IA) line will shift downward. If GDP < potential GDP, the Fed will react by taking
action to increase AD. The Fed will reduce R (shifting the Monetary Rule Curve downwards). This will raise desired Expenditures (shifting the Expenditure Curve upwards), and shift AD to the right. With no Fed action, the inflation rate would fall over the long run. If the Fed shifts AD, however, then the economy will reach potential GDP without any downward pressure on the inflation rate. Other Choices: The Expenditure Curve (Spending Balance Model) will shift upwards. There will be a shift downwards of the Monetary Rule Curve. The AD curve will shift to the right 50. Assume that there is a GDP gap term in the Feds monetary rule. Due to exceptionally poor estimates, the Fed believes that the gap is equal to (positive) 4%, but actually, the gap is equal to 0%. Which of the following will occur?

Answer: Fed policies will shift the AD curve to the left. If the Fed believes that the gap is 4%, then the Fed believes
that inflation is about to rise. As a result, the Fed will take action to reduce AD, by raising R (an upward shift in the monetary rule curve, which will reduce desired expenditures (C + I + G + X), and AD will shift to the left. The inflation rate will FALL in the long run (because the Fed was wrong about the 4%, so shifting AD to the left will create a negative GDP gap). Other Choices: the inflation rate will rise. Fed policies will make the gap rise until it equals 4%. the Monetary rule curve will shift downwards.