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Grade /100 ANSWERS Midterm Exam Fall 2016 Supervisor

Date: Monday, November14th 2016. signature
Course Title: Introduction to Macroeconomics
(BCOR 240)
Duration: 2 Hours
Groups: G1...G12
Number of pages: 6

INSTRUCTIONS
1. Books and notes are not permitted.
2. Calculators are allowed.
3. Cell phones are not allowed.

GENERAL QUESTIONS (10 points)

For the next Multiple Choice Questions, circle the right (only one) answer (1 point each).

Figure: Nominal GDP and Real GDP

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 1) According to the hypothetical economy of the Figure page 1, between 1960
and 1970 real GDP declined but nominal GDP continued to rise. The increase in
nominal GDP was due to

A. An increase in the price level greater than the decrease in output, causing the
nominal dollar value of output produced to increase.
B. An increase in the quantity of output produced.
C. A decrease in the price level.
D. An increase in the standard of living.

Answer: A
Nominal GDP can suggest the economy doing well, but it could be a distortion since the
growth may be due to an increase in the price level only.

2) In the Figure page 1, during the 1980-1990 time periods, real GDP was relatively
constant but nominal GDP increased. This can be explained by

A. Lower average price levels.

B. Inflation.
C. Higher levels of production.
D. A decrease in production per capita.

Answer: B
Real GDP can be constant and nominal GDP can be increasing. But this must be due to a
change in the price level and not actual production
3) Disposable income is equal to

A. Personal taxes + personal income.

B. Personal taxes - personal income.
C. Consumption - saving.
D. Consumption + saving.

Answer: D
The only two general uses of disposable income are saving and consumption.

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Consider the following data, the unit is billion $:

Expenditures for consumer goods and services $ 4,565

Exports $ 740
Government purchases of Goods and Services $ 1,465
Social security taxes $ 510
Net investment $ 225
Indirect business taxes $ 520
Imports $ 825
Gross investment $ 865
Corporate income taxes $ 185
Personal income taxes $ 750
Corporate retained earnings $ 45
Net foreign factor income $ 20
Government transfer payments to households $ 690
Net interest payments to households $0

4) On the basis of the Table above, net exports are

A. $740 billion.
B. $825 billion.
C. -$85 billion.
D. $85 billion.

Answer: C
Net exports are equal to exports minus imports ($740 - $825).

5) On the basis of the Table above, gross domestic product is

A. $6,980 billion.
B. $7,635 billion.
C. $6,810 billion.
D. $7,720 billion.

Answer: C
GDP can be obtained by adding C + I + G + (X - M) = $4,565 + $865 + $1,465 + ($740 - $825).

6) On the basis of the Table above, personal saving is

A. $1,215 billion.
B. $1,130 billion.
C. $305 billion.
D. $205 billion.

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Answer: C
Personal saving is equal to disposable income less consumption. Personal income equates to
the GDP ($4,565 + $865 + $1,465 + ($740 - $825)) minus depreciation (gross investment
minus net investment =$640) plus transfer payments and net foreign factor income and net
interest payments to households ($690 + $20 + $0). This result is subtracted by personal
income taxes, indirect business taxes and Social Security taxes, corporate income taxes and
corporate retained earnings ($750+$520 + $510 + $185 + $45).

7) If the price level is increasing at 4% and output is increasing at 5%, then

A. A Real GDP is increasing faster than nominal GDP.
B. Nominal GDP is increasing faster than real GDP.
C. Nominal GDP is increasing at 20%.
D. None of the choices are correct.

Answer: B
Since both price and output are increasing, both will increase nominal GDP. Since prices are
fixed when we measure real GDP, only increases in output affect real GDP.

8) When there is a mismatch between the skills required for a job and the skills of job
seekers, the unemployment that results is an example of

A. Frictional unemployment.
B. Structural unemployment.
C. Cyclical unemployment.
D. Seasonal unemployment.

Answer: B
Structural unemployment is a serious matter because the worker does not have skills that
employers are looking for.

9) After being fired from a job, some people find that it may take several months to
find a new job in the same type of work, even when the economy is not in a
recession. This is an example of which of the following types of unemployment?

A. Structural unemployment.
B. Frictional unemployment.
C. Cyclical unemployment.
D. Seasonal unemployment.

Answer: B
Frictional unemployment is normal in the economy and does not tend to last long because
the worker has skills that are in demand.

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 10) Structural unemployment occurs when

A. Workers do not have the skills required to fill the vacant positions in the job
market.
B. Firms fail in the normal course of business activity.
C. An industry experiences a seasonal downturn.
D. There is inadequate demand for labor.

Answer: A
Structural unemployment can persist for a long time because the skills possessed by the
unemployed are no longer in demand.

EXERCICE (20 points) (Answers: Check your tutorial for the answers to this exercise
Chapter3homework.pdf problem 1)

Consider the following Cobb-Douglas production function

Y = 60K1/3L2/3,
where Y refers to output, K is capital and L is labor.

a. Does the Cobb-Douglas production function verifies the property of constant returns to scale?
Interpret your answer. (8 points)
b. Derive the algebraic expression for the marginal product of labor (MPL). (4 points)
c. Does MPL increase as more labor is added? Explain the property of diminishing product of labor
for the production of a specific good of your choice. (8 points)

PROBLEM I (35 points)

Consider an economy described by the following equations:
Y = C + I + G (1)
Y = 5000 (2)
G = 1000 (3)
T = 1000 (4)
C = 200 + 0.75 (Y -T ) (5)
I = 1300 - 50r (6)
a) In this economy, compute private saving, public saving, investment, and the equilibrium interest
rate.(8 points)

Answer:
Private Saving (SPr) = Y-T-C = 5000 - 1000 - (200 + 0.75 (5000-1000)) = 800
Public Saving (SPu)= T-G= 1000-1000 = 0
I = SPr + SPu = 800
I =800 and I= 1300 - 50r, hence r=10

b) Now suppose firms become very pessimistic about the future, and as a result, equation (6)
changes into

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 I = 1000 - 50r (7)
find the new equilibrium interest rate and investment. Does the amount of investment
differ from what you get in (a)? Why or why not?(8 points)

Answer:
SPr + SPu = I = 1000-50r
Note that there are no changes in the amount of private saving and public saving, as a result,
800 = 1000 - 50r
r= 4
The amount of investment is the same as what one gets in (a),because there are no changes
in national saving despite in the investment equation

c) Now consider a more sophisticated consumption function than equation (5) :

C = 200 + 0.75 (Y - T) - 50r (8)

what is the rationale here behind the assumption that consumption depends
negatively on the real interest rate? Now we have a new economy described by
equations (1);(2);(3);(4);(6) and (8); compute the consumption and investment in this
new economy.(10 points)

Answer:
Because the interest rate is the return to saving (as well as the cost of borrowing), a higher
interest rate might reduce consumption and increase saving. If so, the saving schedule would
be upward sloping.
To compute the consumption and investment in the new economy, first we need to derive
the function for the national saving S :
S =Y - C - G = 5000 - [200 +0.75(Y - T) - 50r] - 1000 = 800 + 50r
In equilibrium, we have investment equal to national saving, and as a result:
S = I then 800 + 50r = 1300 - 50r
hence r = 5
Substitute the equilibrium interest rate into consumption and investment functions
respectively, we have
C = 200 +0.75(Y - T) - 50r = 200 +0.75(5000 - 1000) - 50*5 = 2950
I = 1300 - 50r = 1050

d) Now consider another economy described by equations(1);(2);(3);(4);(7) and (8); compute

the equilibrium interest rate and investment in this case. Does the amount of investment
differ from what you get in (c), why or why not?(9 points)

Answer:
I=Y-C-G
1000 - 50r = 5000 - [200+0.75(Y - T )- 50r] - 1000
r=2
then

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 I = 1000 - 50*2 = 900
The amount of investment differs from what one obtains in (c).The reason is that we now
have an upward sloping saving function. As the equilibrium interest rate decreases as a
result of the downward shift in the investment function, both investment and savings
decrease.

PROBLEM II (35 points)

Read the following text (from http://www.bct.gov.tn/ ) and answer the questions a), b) and
c) using what you’ve learned in this course.

MONETARY POLICY
In compliance with article 33 (new) of law n°2006-26 of 15 May 2006 modifying law n°58-
90 of 19 September 1958 providing for creation and organization of the Central Bank of
Tunisia (BCT), the main assignment of the monetary policy consists in preserving price
stability.

In fact, the sound control of inflation as reflected through the trend in consumer price
index, helps ensure a non-inflationary growth that contributes to job creation and
improvement of social welfare while preserving the purchasing power.

To this end, through the instruments put at its disposal, the BCT influences the money
market interest rate considered as the main instrument for conducting the monetary policy
to achieve the final target of price stability.

Given the importance of inflation forecasts for this monetary policy framework, major
efforts are being implemented within the BCT to set up a device for analysis and forecast
of inflation on the short term. This will help as a reference for decision making with respect
to monetary policy and as a means of communication with the public.

a) Why the Central Bank of Tunisia targets to achieve price stability? (5 points)

Answer: to avoid inflation which is bad for society: inflation tax and social costs. All
the nominal variables in the economy (price, interest rate, exchange rate, wage…) are
corrected for inflation o be interpreted in real terms.

b) What costs does inflation or price instability impose on the Tunisian society? Please list and
briefly define 3 costs. (5 points)

Answer: section 5.5 of your reference book page 116 (Shoeleather cost, menu cost,
arbitrary redistribution of wealth…)

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c) Why the Central Bank of Tunisia considers “inflation forecast” important? Please note that
“inflation forecast” refers to expected inflation πe. (2 points)

Answer: since contracts involving interest rate in the future depend on future inflation
and not present inflation

Assume the BCT supplies a quantity of money denoted by M.

d)Use the Quantity Equation to state the demand for money, define all the macro variables that
you introduce.(8 points)

Answer: M x V = Px Y
M is the quantity of Money in the economy
V is Velocity which measures the rate at which money circulates/ changes hands
P is Price of Output
Y is quantity of Output
e)Assume Velocity is constant, if the money growth of M decided by the BCT is 7% and growth
of real GDP is 1.5% what would be the inflation rate according to the quantity theory of money?(5
points)

Answer: 5.5%

f)Using the Fisher Effect and your result from question e), compute the real interest rate if the
nominal interest rate is 6.5%. In general, does the Fisher Equation prevent the real interest rate
from being negative? Explain briefly.(7 points)

Answer: real interest rate 1%. Real interest rate is negative if nominal interest rate
lower than inflation

g)Should the nominal interest rate be a determinant of the demand for money? If only expected
inflation increases in the future, does today’s level of prices change to re-establish equilibrium?
Explain your answers.(3 points)

Answer: yes nominal interest rate is a determinant for the demand for money. P
increases in the present (see section 5.4 page 114 of your reference book)