Final Exam

Question 1

Product approach:

Answer 1

the amount of output produced

Question 2

Income approach:

Answer 2

the incomes generated by production

Question 3

Expenditure approach

Answer 3

the amount of spending by purchasers

Question 4

NFP

Answer 4

payments to domestically owned factors located abroad minus payments
to foreign factors located domestically

Question 5

Consumption

Answer 5

spending by domestic households on final goods and services

including those produced abroad

Question 6

Effect of changes in current income

Answer 6

 Increase in current income: both consumption and saving increase (vice versa for
decrease in current income)

Question 7

2. Effect of changes in expected future income

Answer 7

 Higher expected future income leads to more consumption today, so savings fall

Question 8

3. Effect of changes in wealth

Answer 8

 Increase in wealth leads to more consumption today, so savings fall

Question 9

4. Effect of changes in real interest rate

Answer 9

4. Effect of changes in real interest rate
   Increased real interest rate has two opposing effects:
    Substitution effect: Positive effect on saving, since rate of return is higher; greater
   reward for saving elicits more saving
    Income effect
    For a saver: Negative effect on saving, since it takes less saving to obtain a given
   amount in the future (target saving)
    For a borrower: Positive effect on saving, since the higher real interest rate
   means a loss of wealth. Borrowing falls, or savings rise.1

Question 10

 The desired capital stock

Answer 10

Desired capital stock is the amount of capital that allows firms to earn the largest
expected profit
 Desired capital stock depends on costs and benefits of additional capital

Question 11

User cost of capital

Answer 11

The user cost of the desired capital stock includes the real interest cost + depreciation
cost i.e.,

Question 12

 Changes in the desired capital stock

Answer 12

1. Increase in future MPKf Increases MPK, and increases desired
capital stock
2. Increase in real rate of interest,
depreciation or taxes
Increases the user cost of capital, and
decreases the desired capital stock

Question 13

What shifts when:

1. A rise in current output /income
2. A fall in expected future output/income
3. A fall in wealth
4. A fall in government purchases

Answer 13

Savings curve shifts right

Question 14

What shifts when:

1. A fall in current output/income
2. A rise in expected future output/income
3. A rise in wealth
4. A rise in government purchases

Answer 14

Savings curve shift to the left

Question 15

What shifts when:
1. A rise in expected future marginal product of
capital increases desired capital stock
2. A fall in tax rate or depreciation reduces user
cost of capital, and increases desired capital
stock

Answer 15

Investment curve shifts to the

right

Question 16

What shifts when
1. A fall in expected future marginal product of
capital reduces desired capital stock
2. A rise in tax rate or depreciation increases
user cost of capital, and reduces desired
capital stock

Answer 16

Investment curve shifts left

Question 17

The saving rate (solow growth)

Answer 17

 Higher saving rate means higher capital-labor ratio, higher output per worker, and
higher consumption per worker

Question 18

Population growth (solow growth)

Answer 18

Higher population growth means a lower capital-labor ratio, lower output per worker,
and lower consumption per worker

Question 19

Productivity growth (solow growth)

Answer 19

In equilibrium, productivity improvement increases the capital-labor ratio, output per
worker, and consumption per worker

Question 20

Dominant factor effecting the solow growth model

Answer 20

Productivity growth

Question 21

Policies to affect the saving rate

Answer 21

If the private market is efficient, the government shouldn’t try to change the saving rate
 The private market’s saving rate represents its trade-off of present for future consumption
 But if tax laws or myopia cause an inefficiently low level of saving, government policy to
raise the saving rate may be justified
 How can saving be increased?
 Raise real interest rate
 The government could reduce the deficit or run a surplus

Question 22

Policies to raise the rate of productivity growth

Answer 22

Improving infrastructure
 Infrastructure: highways, bridges, utilities, dams, and airports
 Empirical studies suggest a link between infrastructure and productivity
 Building human capital
 There’s a strong connection between productivity and human capital
 Government can encourage human capital formation through educational policies,
worker training and relocation programs, and health programs
 Another form of human capital is entrepreneurial skill. The government should
support the growth of SME’s (small and medium scale enterprises)
 Encouraging research and development
 Support scientific research
 Fund government research facilities
 Provide grants to researchers
 Contract for particular projects
 Give tax incentives
 Provide support for science education

Question 23

 How does the central bank of a country increase the money supply?

Answer 23

Use newly printed money to buy financial assets from the public—an open-market
purchase
 To reduce the money supply, sell financial assets to the public to remove money from
circulation—an open-market sale
 Open-market purchases and sales are called open-market operations

Question 24

What happens to money demand when:

. Increase in real income

Answer 24

Real money demand increases, inorder to

conduct a larger volume of transactions

Question 25

What happens to money demand when:
Increase in real interest rate on
nonmonetary assets

Answer 25

Real Money demand falls. Higher real interest
rate on nonmonetary assets means a higher
return on alternative assets and a switch away
from money

Question 26

What happens to money demand when:

. Increase in expected inflation

Answer 26

Real Money demand falls. The value of
money falls, and leads to a switch away from
money

Question 27

What happens to money demand when:

Increase in wealth

Answer 27

Real money demand increases. Part of the

wealth may be held as money

Question 28

What happens to money demand when:

Increase in riskiness in the economy

Answer 28

Real money demand increases. Higher risk of
holding alternative assets makes money more
attractive.

Question 29

Economic variables show comovement

Answer 29

they have regular and predictable patterns of behavior

over the course of the business cycle

Question 30

1. What direction does a variable move relative to aggregate economic activity?

Answer 30

a. Procyclical: in the same direction

b. Countercyclical: in the opposite direction

Question 31

2. What is the timing of a variable’s movements relative to aggregate economic activity?

Answer 31

a. Leading: in advance
b. Coincident: at the same time
c. Lagging: after

Question 32

Procyclical Variables

Answer 32

a. Coincident: industrial production, consumption, business fixed investment, and
employment
b. Leading: residential investment, inventory investment, yield curve, consumer confidence,
business sentiment
c. Lagging: inflation, nominal interest rates

Question 33

Countercyclical

Answer 33

unemployment

Question 34

Why is the savings curve upward sloping

Answer 34

because a higher real interest rate increases saving

Question 35

Why is the investment curve downward sloping

Answer 35

because a higher real interest rate reduces the

desired capital stock, thus reducing investment

Question 36

What does the IS curve show

Answer 36

the relationship between the real interest rate and output for which
investment equals saving

Question 37

 Real exchange rates

Answer 37

The real exchange rate tells you how much of a foreign good you can get in exchange for
one unit of a domestic good

Question 38

 The real exchange rate and net exports

Answer 38

 The real exchange rate affects net exports through its effect on the demand for goods
 A low real exchange rate makes domestic goods cheap relative to foreign goods, so there’s
a high demand for US goods (in both countries)
 With demand for domestic goods being high, net exports rise
 Thus the lower the real exchange rate, the higher a country’s net exports

Question 39

 What causes changes in the exchange rate?

Answer 39

Holding prices fixed means that changes in the real exchange rate are matched by
changes in the nominal exchange rate
 The nominal exchange rate is determined in the foreign exchange market by supply and
demand for the currency
 Demand and supply are plotted against the nominal exchange rate, just like demand and
supply for any good

Question 40

 Effects of changes in output/income (domestic and foreign)

Answer 40

If domestic output (income) rises (Graph A (1) below)
Imports rise (supply of dollars rise)
The exchange rate depreciates
 The opposite occurs if foreign output (income) rises (Graph A (2) below)
Exports rise (demand for dollars rise)
The exchange rate appreciates

Question 41

 Effects of changes in real interest rates (domestic and foreign)

Answer 41

 If domestic real interest rate rises (Graph B (1) below)
Demand for domestic assets (dollar) increase
Capital inflow
The exchange rate appreciates
 If domestic real interest rate falls (Graph B (2) below)
Demand for foreign assets (foreign currency) go up
Supply of dollars rise
Capital outflow
The exchange rate depreciates

Question 42

How do fiscal and monetary policies affect the home country’s real exchange
rate and net exports in the short run?

Answer 42

A fiscal expansion reduces net exports, but the effect on exchange rate is ambiguous.

A monetary expansion leads to an exchange rate depreciation, but the impact on net
exports is ambiguous.

Question 43

 There are two major benefits of fixed exchange rates

Answer 43

 Stable exchange rates make international trades easier and less costly
 Fixed exchange rates help discipline monetary policy, making it impossible for a country
to engage in expansionary policy; the result may be lower inflation in the long run

Question 44

 But there are some disadvantages to fixed exchange rates

Answer 44

They take away a country’s ability to use expansionary monetary policy to combat
recessions
 Disagreement among countries about the conduct of monetary policy may lead to the
breakdown of the system

Question 45

Multiplier Effect:

Answer 45

The additional shifts in aggregate demand
that results when expansionary fiscal policy increases income and thereby increases
consumer spending

Question 46

Crowding Out Effect:

Answer 46

An expansionary fiscal policy may increase the interest rate and
reduce investment (crowd out investment), thereby weakening or cancelling the stimulus
of the expansionary policy. The reduction in aggregate demand that results when a fiscal
expansion raises the interest rate is called crowding-out-effect.