Indian Institute of Management, Ahmedabad

Macroeconomics and Policy (MEP) PGP1

End-Term Examination: 2016-17

Instructions

1. Answer all the questions

2. It is a closed book/note examination
3. Use of scientific calculator is allowed. No other electronic devices are allowed during the
examination.
4. Maximum marks: 100
5. Questions are divided in two parts Part I: Multiple Choice Questions (40 marks-20
questions, 2 marks each) and Part II: Numerical Problems (60 marks-5 questions, 12 marks
each)
6. Maximum time allowed is 2.30 hours

Part I: Multiple Choice Questions

Q1. Assume many more stores agree to accept credit cards. Which of the following will be a
likely outcome?

a. The money multiplier will decrease

b. The money multiplier will increase
c. Money supply will decrease, given a fixed monetary base
d. The currency-deposit ratio will increase
e. The reserve ratio will decrease

Q2. Assume that the currency-deposit ratio is 32%, the required reserve ratio is 7%, the excess
reserve ratio is 1%, and total money supply is $1,320 billion. What is the amount of high-
powered money?

a. $132 billion
b. $165 billion
c. $330 billion
d. $400 billion
e. $800 billion
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Q3. Which are the three channels by which the RBI can reduce money supply?

a. Buy government securities, lower reserve requirements, and lower the discount rate
b. Buy government securities, raise reserve requirements, and raise the discount rate
c. Buy government securities, lower reserve requirements, and raise the discount rate
d. Sell government securities, raise reserve requirements, and raise the discount rate
e. Sell government securities, lower reserve requirements, and raise the discount rate

Q4. A country's balance of payments can be affected by changes in

a. Domestic income
b. Foreign income
c. The real exchange rate
d. The differential between domestic and foreign interest rates
e. All of the above

Q5. A real depreciation of the domestic currency will

a. Improve the trade balance and increase aggregate demand

b. Improve the trade balance and lower aggregate demand
c. Improve the trade balance but not affect aggregate demand
d. Lower the trade balance and aggregate demand
e. Lower the trade balance and increase aggregate demand

Q6. Assume that interest rates drop and GDP increases as a result of expansionary monetary
policy. What should happen to the demand for real money balances?

a. It should increase
b. It should decrease since interest rates will decrease
c. It will remain unaffected since income will go up but the interest rate will go down
d. It will remain unaffected since the income velocity of money does not change
e. We can't tell for sure since we do not know what will happen to the income velocity of money

Q7. If real GDP has grown at a rate of 3%, but nominal money supply and the price level have
both grown by 5%, then the income velocity of money must have

a. Stayed constant
b. Decreased by 2%
c. Decreased by 3%
d. Increased by 3%
e. Increased by 8%

Q8. Assume a production function with constant returns to scale. Labor's share of income is 0.7
and capital's share is 0.3. If labor grows at 4% and capital grows at 3%, how many years would it
take to double the current level of output if no technological advances are made?

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a. 7
b. 10
c. 19
d. 23
e. 33

Q9. If we assume a Cobb-Douglas production function, where the share of capital is 0.25 and the
share of labor is 0.75, then the marginal product of labor is equal to

a. Y/L
b. 3Y/4L
c. (3/4)L
d. 3K/4L
e. 3L/4Y

Q10. Assume that the rate of technological advance is 1.5% and both labor and capital grow at a
rate of 2%. What is the rate of output growth if labor's share of income is three times as high as
capital's share and there are constant returns to scale?

a. 1.5%
b. 2.0%
c. 3.0%
d. 3.5%
e. 5.5%

Q11. If interest rates are currently very high and you expect them to go down soon, you will
most likely

a. Sell your bonds now, while their yield is high and they are more marketable
b. Want to hold more money now to undertake more transactions since you expect economic
activity to increase
c. Hold more money now, so you can buy more bonds later as soon as interest rates have dropped
d. Hold on to your bonds for now but expect to sell some of them later once interest rates
have declined
e. Switch from holding long-term bonds to holding short-term bonds

Q12. Which of the following items are deficit items in the balance of payments for the United
States?

a. A German citizen buys a U.S. Treasury bill

b. A U.S. citizen buys a vacation home in Mexico
c. A U.S. citizen makes a deposit in a Swiss bank
d. All of the above
e. Only b and c

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Q13. Our country's net exports will increase if

a. There is an increase in domestic income

b. There is appreciation of the real exchange rate
c. There is an increase in domestic inflation
d. Many of our trade partners experience inflation
e. Domestic interest rates rise due to expansionary fiscal policy

Q14. According to the Baumol-Tobin transaction demand model, money demand for
transactions

a. Depends only on the level of income

b. Depends only on the cost of illiquidity
c. Varies inversely with both the interest rate and the level of income
d. Increases as the interest rate decreases or income increases
e. Decreases as the cost of illiquidity increases

Q15. If income taxes are lowered, we can expect that the income velocity of money will

a. Increase due to an increase in income and the interest rate

b. Decrease due to an increase in saving and money supply
c. Decrease since people will save more
d. Remain fairly stable since both income and prices will increase
e. Decrease since money supply will increase

Q16. If the RBI imposed a 100% reserve requirement, it would imply that

a. the RBI had no control over money supply

b. the RBI would no longer be able to conduct any open market operations
c. the money multiplier would be equal to one
d. The money multiplier would be equal to zero
e. Banks would become completely obsolete

Q17. If real GDP is $9,600 billion and nominal money supply is $1,200 billion, then

a. The income velocity of money is 8.0

b. The price level is 8.0
c. The income velocity of money is 1.25
d. The price level is 1.25
e. None of the above

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Q18. Which of the following is FALSE?

a. A rise in foreign income always improves a country's trade balance and leads to an increase in
aggregate demand
b. A rise in domestic interest rates improves a country's trade balance since it decreases
imports
c. An exchange rate depreciation improves a country's trade balance and thus increases aggregate
demand
d. An increase in domestic income worsens a country's trade balance since it increases spending
on imports
e. A decrease in exports leads to lower interest rates and a currency depreciation

Q19. If the RBI undertakes open market sales, then

a. The LM-curve will shift to the right

b. The LM-curve will shift to the left
c. Interest rates will decrease and income will increase
d. Bond prices will increase
e. Both A and C

Q20. If real GDP increased by 3% over the next year, we should expect

a. A decrease in demand for M1 by 3%

b. An increase in demand for M1 by 3%
c. An increase in demand for M1 by more than 3%
d. An increase in demand for M1 by less than 3%
e. No change in demand for M1

Part II Numerical Problems

Q21. Consider the Solow growth model without population growth or technological change. The
parameters of the model are given by s = 0.2 (savings rate) and = 0.05 (depreciation rate). Let k
denote capital per worker; y output per worker; c consumption per worker; i investment per
worker.
1 2
a) Rewrite production function = 3 3 in per-worker terms.

b) Find the steady-state level of capital stock, .

c) What is the golden rule level of k for this economy? Recall that the golden rule level of
capital stock maximizes consumption per worker in steady-state. Report your answer
in two decimal places.

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d) Let's say that a benevolent social planner wishes to obtain = in steady-state. What
is the associated savings rate that must be imposed by the social planner to support
?

e) Compare your result in the previous part with the assumed savings rate s. To obtain ,
do citizens need to save more or less?

f) Plot the following on a single graph: = (), , (), and (). Does the savings
curve pivot up or down, relative to its initial position, when the planner's is
implemented?

g) Discuss two to three economic policies that could help the social planner implement
in a real-world situation. (1+1+2+2+2+2+2)

Q22. Suppose that the real money demand function is L(Y, r + e) = (0.01 Y) / (r + e) where Y
is real output, r is the real interest rate, and e is the expected rate of inflation. Real output is
constant over time at Y = 150. The real interest is fixed in the goods market at r = 0.05 per year.

a) Suppose that the nominal money supply is growing at the rate of 10% per year and that
this growth rate is expected to persist forever. Currently, the nominal money supply is M
= 300. What are the values of the real money supply and the current price level?

Given Y=150; r=0.05

e = M/M = 10%
i = r + e = (5+10)%=15%
M/P = L = 0.01 x 150 / 0.15 = 10
P = 300 / 10 = 30

b) Suppose that the nominal money supply is M = 300. The central bank announces that
from now on the nominal money supply will grow at the rate of 5% per year. If everyone
believes this announcement, and if all markets are in equilibrium, what are the values of
the real money supply and the current price level?

e = M/M = 5%
i = r + e = 10%
M/P = L = 0.01 x 150 / 0.10 = 15
P = 300 / 15 = 20

c) Explain the effects on the real money supply and the current price level of a slowdown in
the rate of money growth. (4+4+4)

The slowdown in money growth reduces expected inflation, increasing real money
demand, thus lowering the price level.

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Q23. Consider an economy described by the following equations:

Y = C + I + G + NX,
Y = 5,000,
G = 1,000,
T = 1,000,
C = 250 + 0.75(Y - T),
I = 1,000 - 50r,
NX = 500 - 500,
r (domestic interest rate)= r*(foreign interest rate) = 5.

a) In this economy, solve for national saving, investment, the trade balance, and the
equilibrium exchange rate.

National saving S = Y C- G = 5000 [250+0.75(5000-1000)]-1000

=4000-[250+3000]=750

Case 1: Assuming r=r*=5

Investments = 1000 -50*5=750
Trade balance= NX=S-I=750-750=0
NX=500-500 => = 1

Case 2: Assuming r=r*=0.05

Investments = 1000 -50*0.05=997.5
Trade balance= NX=S-I=750-997.5=-247.5
NX=500-500 => = 1/500*(500+247.5)=1.495

b) Suppose now that G rises to 1,250. Solve for national saving, investment, the trade
balance, and the equilibrium exchange rate. Explain what you find.

If G rises to 1250, then

S= 5000-[250+0.75(5000-1000)]-1250 = 500

Case 1: Assuming r=r*=5

I = 1000 50*5 = 750 (same)
Trade balance = NX = 500 750 = -250
NX = 500 - 500 => -250 = 500 -500 => = 750/500=1.5

Explanation: increase in government spending reduces savings, investments remain

same. I >S => investments must be financed from abroad => reduction in net export
=> currency to appreciate.

Case 2: Assuming r=r*=0.05

I = 1000 50*0.05 = 997.5

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Trade balance = NX = 500 997.5 = -497.5

NX = 500 - 500 => -497.5 = 500 -500 => = 997.5/500=1.995

Explanation: increase in government spending reduces savings, investments remain

same.
I >S => investments must be financed from abroad => reduction in net export =>
currency to appreciate.

c) Now suppose that the world interest rate rises from 5 to 10 percent. (G is again 1,000.)
Solve for national saving, investment, the trade balance, and the equilibrium exchange
rate. Explain what you find. (4+4+4)

G=1000 (same)
S=750;

Case 1: r=10
I = 1000-50*10 (r goes up to 10) =500
NX = S-I = 750-500=250
NX = 500 - 500 =>250=500 - 500 =>=0.5

Higher interest rate =>lower investment =>positive trade surplus => currency to
depreciate

Case 2: r=0.10
I = 1000-50*0.10 =995
NX = S-I = 750-995=-245
NX = 500 - 500 =>-245=500 - 500 =>=1.49

Higher interest rate =>lower investment =>smaller (less negative) trade deficit =>
currency to depreciate

Q24. This question asks you to use the Solow Model to analyses the effects of immigration in
India. As usual, suppose that the output is produced with the production function = 1 .
Capital depreciates at rate , and productivity, A, is assumed constant. The saving rate, , is also
constant.

a) Suppose that initially the economy is in a steady state, with constant population growth
rate, 1 . Depict the steady-state equilibrium in graph. Now, suppose that there is a one-
time increase in immigration, perhaps due to an influx of immigrants from some
neighboring country. Its temporary nature means that there is no change to the economys
underlying population growth rate. Use a graph to illustrate the effect of this on the
economy. How does output change? How do wages change? (Hint: Be sure to distinguish
between the short-run and long-run effects).

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b) Now consider the effects of a changed immigration law, which makes it easier for
immigrants to move to India. As a result, the growth rate of population increases to
2 > 1 . Once again, use your graph to illustrate the effects on output and wages. Be
sure to distinguish short-run and long-run effects, as well as aggregate effects from per
capita effects. (6+6)

Q25. Assume a small open economy with a floating exchange.

The LM curve for this economy is given by Y = 200r - 200 + 2(M/P).

The IS curve is Y = 400 + 3G - 2T + 3NX - 200r.

The function for NX is NX = 200 - 100e, where e is the exchange rate.

The price level (P) is fixed at 1.0. The international interest rate is r* = 2.5 percent.

a) Using the LM curve, find the equilibrium level of Y in the small open economy, if M =
100.

b) Given this value of Y, if G = 100 and T = 100, what must be the equilibrium value of
NX?

c) If this value of NX is to be achieved, what must be the equilibrium exchange rate, e?

a. Equilibrium Y = 200*2.5-200+2*100/1=500.

b. Equilibrium NX = 1/3*[Y-{400+3G-2T-200r}] = 1/3*[500-{700-200-500}]=

1/3*500= 166.67.
c. Equilibrium e = 1/100*[200-NX]= 1/100*[200-166.67]=1/3
(4+4+4)