# Economics 100b Practice Exam

### Part I: Identifications (one paragraph each; one hour; 100 points)

2. Gross Domestic Product.
3. Gross National Product.
4. Solow growth model.
5 Aggregate production function.
7. Monetary policy.
8. Circular flow of income and expenditure.
9. Mundell-Fleming model.
10. Productivity slowdown.
11. Alan Greenspan.
12. John Maynard Keynes.

### Part II: Problems (one hour; 50 points each)

1. Suppose that initial real GDP Y equals \$8,000 billion, that the multiplier equals 2, and that imports and exports are given by:

X = \$1,200 + 4 * (100 - e/p)

M = \$1,200 + 2 * (e/p - 100)

where e is the value of the dollar in yen, and p is the level of the consumer price index. Suppose that the initial value of the dollar e is 100 yen, and that the initial level of the consumer price index p is equal to 1.00.

Further, suppose that the rate of inflation is given by:

this year's inflation (in percent per year) equals the difference between last year's output and \$8,000, all divided by 100, or:

inflation (in percent per year) = (Yt-1 - \$8,000)/100

a. Determine the value of the trade balance as a function of the exchange rate.

b. Suppose that demand for exports rises because of improvements in the quality of American-made goods so that new export demand is:

X = \$1,320 + 4 * (100 - e/p)

Suppose the exchange rate is fixed at e = 100 yen. What is output in the first year of this shift in export demand?

c. Using the same shift in export demand as in part b, what is the inflation rate in the first year after this shift in export demand?

d. Eventually inflation will subside to zero. If the government continues to fix the exchange rate at e = 100 yen, what will be the price level when inflation subsides to and remains at zero.

e. Suppose that the government had, initially, allowed the exchange rate to appreciate in part b in order to avoid internal inflation in response to the increase in investment demand. How high would the exchange rate have had to go in order to restore balance between imports and exports without inflation?

2. Investment is a function of the real interst rate r, whereas money demand is a function of the nominal interest rate i. Suppose that your IS and LM curves in an economy are given by:

IS: r = 40 - 0.025 Y

LM: i = -50 + 0.05 Y

and recall that: r = i - E(p), where E(p) is the expected rate of inflation.

a. Assume that expected inflation E(p) equals zero, so that r = i. What is the equilibrium level of output? What is the equilibrium nominal interest rate? What is the equilibrium real interest rate?

b. Now suppose that deflation occurs, so that expected inflation E(p) = -7.5 percent per year. Is the previous equilibrium nominal interest rate still the equilibrium of the IS-LM system? How large is the gap between the level of output consistent with the LM curve at the previous interest rate and the level of output consistent with the IS curve?

c. What is the new equilibrium level of output given the expected rate of deflation?

d. Is output higher or lower than before? Is the nominal interest rate higher or lower than before? Is the real interest rate higher or lower than before? Why?

### Part III: Essay (one hour; 100 points)

Read the attached passage from Herbert Hoover's memoirs concerning his belief in the importance of balancing the federal budget as the country slid into the Great Depression.

Write an essay to President Hoover--using concepts and models developed in this course--arguing that he should abandon his concern with balancing the budget and embrace deficits in times like the Great Depression. Be sure to use models and concepts developed in this course to try to ease Hoover's fears of the adverse consequences of a large federal budget deficit:

National stability required that we balance the [federal] budget [during the Great Depression]. To do so we had to increase taxes on one hand and, on the other, to reduce government expenditures. In reduction of expenditures we had to limit ourselves to ordinary government activities... I opened up the fight in my messages to Congress [in] December, 1931, saying:

The first requirement of confidence and of economic recovery is financial stability of the United States government.... I must at this time call attention to the magnitude of the deficits which have developed and the resulting necessity for determined and courageous policies.... We must have insistent and determined reduction in government expenses. We must face a temporary increase in taxes... Our fist duty as a nation is to put our governmental house in order.... With the return of prosperity the government can undertake constructive projects both of social character and in public improvement. We cannot squander ourselves into prosperity...

On April 1 the House finally passed a wholly inadequate [tax] bill.... [O]n May 5 I sent a stiff message to Congress devoted solely to the necessity for balancing the budget as the next item on the recovery program....

The most essential factor to economic recovery today is the restoration of [business] confidence.... Fear and alarm prevail in the country because of events in Washington whichhave greatly disturbed the public mind.... Nothing is more necessary at this time than balancing the budget. Nothing will put more heart into the country than prompt and courageous and united action...

The Senate took on a burst of speed, and I was [finally] able to sign a tax [increase] bill on June 6th [1932].... The bill was intended to produce about \$1,250,000,000 additional revenue. But these addtions to our income came too late....[O]ur deficit looked worse than might otherwise have been the case.

Humor never dies in America... [Democratic] candidate for Vice President... Garner, on October 17, 1932, said of [my administration]: "Their failure to balance the budget of a family of 120,000,000 people is at the very bottom of the economic troubles from which we are suffering."

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# Econ 100b

Created 4/30/1996
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