Econ 201 Spring 2020 Midterm One
1. What are the primary tasks performed by financial intermediaries? 5 points.
The reduce transaction costs, allocate risk, and provide liquidity.
2. Suppose consumption is given by
C(Y ) = 200 + .4Y
and planned investment is 75. What is the level of unplanned inventories when income is 400. Is this an equilibrium? Explain why or why not. 10 points.
We calculate planned aggregate expenditure:
C(400) + Ip = (200 + .4(400)) + 75 = 435
Since spending is greating that income, there must be a decline in actual inventories below planned inventores, so unplanned inventories are negative: Iup = 400 − 435 = −35
3. Suppose that the consumption function is give by
C(Y ) = 700 + .68(Y ),
Planned investment is 500.
(a) Solve for the equilibrium level of income, and sketch the Keynesian cross. 10 points.
We solve:
y = 700 + .68Y + 500 → Y = 3750
See Sketch
(b) What is the multiplier in this economy? 5 points.
It is 1−.68/1 = 3.125
(c) Using the multiplier, calculate the change in the equilibrium income that would result in consumers decide to reduce their spending by 120. 5 points
it will be (−120) ∗ 3.125 = −375
(d) Show this shift graphically. 5 points.
It will shift AE down by 120 and the new cross in by 375. See sketch.
4. Suppose the market for loanable funds is in equilibrium. Suppose further that the budget deficit in zero, and that there are no capital inflows or outflows.
(a) Depict this situation graphically. 5 points
See sketch.
(b) Suppose now the government starts to run a large budget deficit. What effect will this have on the equilibrium interest rate? Show the effect graphically. 5 points.
This shift demand for funds out, increasing the interest rate.
(c) What effect will this have on private investment? Show graphically. What is the term for this effect? 5 points.
This will reduce private investment, since at the higher interest rate fewer projects are worth funding. This is called crowding out.
(d) Finally, suppose that after this rise in the budget deficit, the country starts to run a trade surplus. Show the effect this will have on the market for loanable funds (include the shift you showed in the previous parts). 5 points.
This would cause an outward shift of demand loanable funds as the savings of domestic households become available domestically to be borrowed by foreign firms. This is will further increase interest rates and reduce private investment.