ECO102H1S: Principles of Macroeconomics
Midterm 2, Winter 2024
1. (20 points) Consider the Phillips curve equation below:
A. (5 points) Which term in the equation is exogenous? What is it called and what happens to the curve when it increases?
B. (5 points) Which term in the equation is endogenous? What is it called and what happens to the curve when it increases?
C. (10 points) You are studying the Phillips curves of two different countries, Argonia and Farebury. Both countries are initially at their long-run equilibrium and have the same level of inflation, but they make forecasts of inflation differently: Argonians have adaptive expectations, while people from Farebury have rational expectations.
Suppose global oil prices drastically rise for one period before returning to their initial levels. Both Argonia and Farebury are equally impacted and neither is an oil producer. How would this affect the inflation rate in Argonia and Farebury in the period of the shock and the next period when oil prices return to their initial level? Explain your answer, including a definition of both types of expectations.
2. (45 points) The equations below describe aggregate expenditure in an economy:
where 0 < mpc < 1 and 0 < mpi < 1
A. (10 points) Solve for short-run equilibrium output as a function of autonomous spending, parameters, and the real interest rate.
B. (15 points) The parameter mpi represents the marginal propensity to invest. Explain what the mpc and mpi mean economically. Describe how the aggregate expenditure multiplier works and how the mpc and mpi affect the size of the multiplier.
C. (10 points) Suppose the government wishes to stimulate spending by transferring funds to either households or businesses (assume the funds are a gift from a foreign nation, and thus do not impact any other category of spending). If mpc > mpi, who should the government transfer funds to? Why?
D. (10 points) Let the parameter values be as follows:
The central bank wishes to increase short-run output by $150. By how much should they change the interest rate?
3. (40 points) The IS curve is given below:
A. (6 points) Find the real interest rate consistent with long-run equilibrium.
B. (10 points) Draw a graph of the IS curve and the MP curve with the economy in long-run equilibrium. Label the axes as well as the equilibrium values of the output gap and real interest rate.
C. (7 points) Suppose the output gap is currently 2.5% and the real interest rate is the same as you found in part A. What kind of shock could be responsible for this outcome? Give a specific example, related to our PAE model, and describe how it would affect the IS-MP model.
D. (7 points) Suppose the economy begins in long-run equilibrium from part B, and there are no shocks to the IS curve. You observe the central bank lower their policy rate, yet the output gap is negative. What must have occurred for this to be true? Make specific reference to our model.
E. (10 points) Assume the central bank’s objective is to maintain an output gap of zero, and they’d like to change the real interest rate as little as possible. Would the central bank prefer a larger or smaller aggregate expenditure multiplier to accomplish this goal? Explain.
4. (20 points) The graph below depicts the current level of planned aggregate expenditure for an economy.
A. (10 points) Suppose the economy is currently at point J. Is the economy in short-run equilibrium? Why or why not? If you answer no, explain how the economy will adjust to short-run equilibrium. Be specific in your explanation regarding the actions businesses will take.
B. (10 points) Suppose production is fixed at YI. What specific actions could fiscal policy take to move the economy to short-run equilibrium? What specific actions could monetary policy take to move the economy to short-run equilibrium? Your answer must assume production remains fixed at YI.