ECO102H1S: Principles of Macroeconomics
Practice Midterm 2, Winter 2024
1) Consider the basic planned aggregate expenditure model below:
a. Solve for short-run equilibrium output in terms of exogenous variables and parameters.
b. What is the effect of a decrease in planned investment on short-run equilibrium output? Your answer should include specific variables from the PAE model.
c. What is the effect of an increase in taxes on short-run equilibrium output? Your answer should include specific variables from the PAE model.
d. Suppose the government is required to always save 20% more than it spends, so T = 1.2G. With this new condition, re-solve the model for short-run equilibrium output.
e. Following part d, what is the effect of an increase in government spending on short-run equilibrium output? Is this more or less than the effect without the government saving condition from part d? Does this make sense?
2) For the following questions, refer to the Keynesian cross diagram below.
a. Assume the economy begins in short-run equilibrium. Suppose that the government starts to spend heavily in order to improve the nation’s public infrastructure. Which PAE line would the economy start and end up at?
b. Assuming prices are fixed in the short-run, what would happen immediately to actual investment compared to planned investment? What would be the resulting level of actual output?
c. Suppose that in the long-run, the government’s efforts are successful: the amount and quality of public infrastructure has increased. Where would the economy end up?
d. Now suppose the opposite occurs: the government’s extra spending on infrastructure is wasted and does little to improve the nation’s capital stock. If the government maintains its higher spending, what would be the effect on prices in the long-run? Why?
3) Suppose planned aggregate expenditure is given by the following values:
a. Solve for short-run equilibrium output as a function of autonomous spending and the real interest rate.
b. What is the value of the aggregate expenditure multiplier? Explain why there is a multiplier and how it works.
c. Suppose the real interest rate is currently 7%. If potential output is 21, what is the value of the output gap? Is this a recessionary gap or expansionary gap?
d. Currently the economy is in a period of high uncertainty. By the next period, the economy begins to settle, causing the risk premium to fall by 2.5 percentage points. What is the new level of the output gap?
e. By how much would the government need to change government spending to return the economy to its long-run equilibrium?
4) For each of the following shocks, assume that the economy starts in long-run equilibrium, and expected inflation stays constant. Specify the type of shock and which curve(s) in the IS-MP-PC model shift (in words, no need to draw). Determine the immediate effect on the output gap , the real interest rate r and unexpected inflation.
a. Business confidence increases unexpectedly.
b. The sudden collapse of a bank in Silicon Valley increases the fear of a nationwide banking crisis.
c. A judge unexpectedly agrees with labor unions: all transportation workers get a 10% wage increase.
5) For the following questions use the Phillips curve described below:
a. Suppose inflation in the economy is currently 7%, but households only believe it will be 5% next year. If there are no shocks affecting the economy, what must be the size of the output gap?
b. Draw a graph of the Phillips curve, labeling the axes as well as the origin point of your graph. What is the slope of the Phillips curve?
c. Next year households adjust their expectations upward, now believing inflation will be 7%. Depict how this will affect the Phillips curve graph. Clearly indicate how the curve has changed.