EE 312: Intermediate Macroeconomics

Mid term examination

A Suggested Answer

February 1999

Circle the correct answer

1. If 1994 is the base year for GDP, then real GDP for 1990 will

1. Fall short of nominal (1990) GDP
2. Exceed nominal GDP
3. Reflect only the price differences between 1990 and 1994
4. Exceed Real GDP based on 1998 prices.

1. Of the following examples of government spending activities, the only one that should not be included in GDP is

1. The governments investigation of illegal activities in the Stock Market of Thailand
2. The inquiry into the allegation that an advisor to the interior ministry has received bribe made by Mr Wolfgang Ullrich to secure the latter his freedom.
3. The burning of seized drugs
4. The governments purchase of the stock of a commercial bank.

1. A terrible earthquake has struck Colombia recently and has reduced the country’s capital stock. In the savings-investment model, this will

1. Increase interest rates and reduce investment
2. Lead to a fall in the government budget deficit
3. Reduce interest rates and increase investment
4. Lead to a rise in the wage rate

1. A car company buys 4 tires from a tire company for 4,000 baht and a battery from a battery company for 1,000 baht. The company assembles these components into a car and sells it for 500,000 baht. The total amount that should be included in GDP is

1. 500,000 baht
2. The car company’s value added
3. 505,000 baht
4. 505,000 baht less the value-added of the three companies.

1. Japan has a very large holding of assets outside of the country, which earn interest for Japan every year. We should expect then that

1. Japanese GNP is greater than its GDP
2. Japanese GDP is greater than its GNP
3. Japanese GNP is approximately equal to its GNP
4. Japanese GDP growth exceeds its GNP growth

1. Assume that the marginal propensity to consume is unchanged, but that the intercept of the consumption function falls so that at any given income level people consume less and save more. This will

1. Lower equilibrium income by the decrease in the intercept times the multiplier
2. Lower equilibrium income by the decrease in the intercept
3. Increase savings, but leave equilibrium income and investment unchanged.
4. Increase savings and investment and hence equilibrium income.

1. In ISLM analysis, an exogenous increase in the demand for money will

1. Reduce equilibrium investment
2. Reduce the equilibrium interest rate
3. Raise equilibrium consumption.
4. Raise equilibrium income.

1. Other things being equal, a given change in government spending has a larger effect on output in the ISLM model the:

1. Flatter the LM curve
2. Steeper the LM curve
3. Smaller the interest sensitivity of money demand
4. Larger the income sensitivity of money demand

1. Other things being equal, a given change in the money supply has a larger effect on output in the ISLM model the:

1. Steeper the IS curve
2. Flatter the IS curve
3. Smaller the interest sensitivity of money demand
4. Smaller the income sensitivity of money demand

1. The effect of a tax increase is to

1. Increase savings.
2. Shift speculative demand for money function to the right.
3. Increase interest rates.
4. None of the above.

Part 2 80 percent

1. Suppose that the demand for money was described by the following equation:

M^d = 70 + 4y - 0.125r

where

M^d = demand for money in real term

y = real national income

r = interest rate

What is this equation telling us? Explain also what is meant by demand for money in real term 20 percent

It says demand to hold money whose purchasing power is held constant depends positively on income and inversely on interest rate.

Should there be an increase of a unit of income, the demand for money is expected to increase by 4 units, other things being constant.

If, however, interest rate increases by 1 unit, money demand is expected to decrease by 0.125 unit, other things are the same.

On the other hand, if both income and interest rate are zero, demand to hold money amounts to 70 units.

2. Given two IS curves, where the government expenditure associated with IS₁ is less than that associated with IS₂, explain in words (without using mathematics) why IS₂ must lie on the right of IS₁. Be concise. 20 percent

Each point on an IS curve is the combination of interest rate an income which equilibrates the product market.

Thus, for a given rate of interest, there will be only one level of income or spending that would give rise to the equilibrium in the market. Therefore, IS₂, which represents a greater spending and income in the economy than that of IS₁, must be to the right of IS₁, for that rate of interest.

3. You have been asked to make stabilization policy recommendation to deal with a sluggish economy but not to alter the mix between private investment and government spending. What would be your recommendation within the ISLM analysis? 20 percent

Use either

1. A policy mix of a tax reduction and expansionary monetary policy such that interest rate is kept constant. Both tax reduction and expansionary monetary policy with proper dose would stimulate the economy. The reduction in tax, while, by itself, having no effect on government spending, may lead to an increase in the rate of interest and a decrease in investment. However, the expansionary monetary policy reduces the interest rate and thereby stimulates investment. If the application of monetary policy is maintained so that the interest rate is held at the same level before the policy mix, there should be no change in the level of investment. Hence, the mix between private investment and government spending is unaffected.

2. A policy mix of an increase in government spending and an expansionary monetary policy such that the rate of interest is lowered than before. Both would stimulate the economy. While the increase in government spending increases interest rate, the monetary policy reduces it. As the mix between private investment and government spending is not to be altered, it is necessary to apply the monetary policy so that interest rate is somewhat lowered than before. This is to invigorate investment spending further so as to match the increase in government expenditure.

4. In an attempt to counter the criticism made against New Aspiration Party (NAP) led government that it had caused inflation during its administration, an advisor to NAP said during those years budget had been kept in balance. “An increase in government expenditure that is fully financed by a rise in taxes will not generate inflationary pressure in the economy.” Do you agree with him or not. Explain. 20 percent

Can’t possibly be in agreement with him. This is because the increase in spending, although fully financed by a tax increase, still has a positive income effect and must therefore generate inflationary pressure in the economy.