Name: __________________________ Date: _____________ 1.

Illustrate the short-run and long-run impact of an unexpected monetary contraction using both the ADAS model and the Phillips curve. Assume the economy starts initially at full employment. 2. If the equation for a country's Phillips curve is = 0.02 0.8(u 0.05), where is the rate of inflation and u is the unemployment rate, what is the short-run inflation rate when unemployment is 4 percent (0.04)? A) above 2 percent (0.02) B) below 2 percent (0.02) C) 2 percent (0.02) D) 2 percent (0.02) 3. Based on the Phillips curve, unexpected movements in inflation are related to ______ and based on the short-run aggregate supply curve, unexpected movements in the price level are related to ______. A) sticky wages; sticky prices B) sticky prices; sticky wages C) output; unemployment D) unemployment; output 4. The assumption of adaptive expectations for inflation means that people will form their expectations of inflation by: A) taking all information into account using the best economic model available. B) asking the opinions of experts. C) basing their opinions on recently observed inflation. D) flipping a coin. 5. The assumption of rational expectations for inflation means that people will form their expectations of inflation by: A) optimally using all available information, including information about current policies, to forecast the future. B) asking the opinions of the best experts. C) subscribing to the forecasting service that uses the best econometric model. D) basing their opinions on recently observed inflation.

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6. The percentage of a year's real GDP that must be foregone to reduce inflation by 1 percentage point is called the: A) NAIRU. B) short-run Phillips curve. C) sacrifice ratio. D) Okun's law. 7. The idea that the natural rate of unemployment is increased following extended periods of unemployment is called: A) Okun's law. B) the cold-turkey approach. C) the natural-rate hypothesis. D) hysteresis. 8. Assume that an economy starts at a long-run equilibrium with a natural rate of unemployment equal to 6 percent and an inflation rate of 10 percent. Assume that there is a short-run tradeoff between inflation and unemployment as described by a Phillips curve. Use the Phillips curve to graphically illustrate why a central bank that desires both low inflation and low unemployment has the incentive to renege on an announced policy to reduce inflation to 3 percent, if people set wages and prices on the expectation of 3 percent inflation and the central bank has the discretion to change its monetary policy after these expectations are set. 9. Because monetary and fiscal lags are long and variable: A) stronger policies must be used. B) successful stabilization policy is completely impossible. C) attempts to stabilize the economy are often destabilizing. D) policy must be completely passive. 10. According to the Lucas critique, when economists evaluate alternative policies they must take into consideration: A) how the policies will affect expectations and behavior. B) whether the policy will offset the impact of automatic stabilizers. C) the stage of the political business cycle in which the policy is to be implemented. D) the length of the inside lags associated with the policies.

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11. If past policies kept the economy insulated from shocks to aggregate demand and supply, the historical evidence would support using: A) active macroeconomic policy only. B) passive macroeconomic policy only. C) either active or passive macroeconomic policy. D) neither active nor passive macroeconomic policy. 12. An argument in favor of allowing discretionary macroeconomic policy is that: A) policymakers may make erratic shifts in policy in response to changing political situations. B) uninformed policymakers may choose incorrect policies. C) the objectives of policymakers may be in conflict with the well-being of the public. D) giving policymakers flexibility will allow them to respond to changing conditions. 13. Policymakers may be better able to achieve their goals using a fixed policy rule rather than using discretion if they face the problem of: A) short and predictable inside lags. B) time-inconsistent policy. C) short and predictable outside lags. D) weak automatic stabilizers. 14. Countries with greater central-bank independence can achieve lower rates of inflation: A) at the cost of higher levels of unemployment. B) at the cost of slower growth rates of real GDP. C) at the cost of greater volatility of real GDP. D) with no apparent real economic costs. 15. In the 2008 global financial crisis, many investors considered the U.S. economy a safe place to move their assets. What is the predicted impact of this inflow of financial capital to the United States, which is a large open economy, on the U.S. interest rate and the U.S. exchange rate, holding other factors constant? Illustrate your answer graphically and explain in words. 16. If purchasing-power parity held, if a Big Mac costs $2 in the United States, and if 10 Mexican pesos trade for $1 dollar, then a Big Mac in Cancun, Mexico, should cost: A) 2 pesos. B) 5 pesos. C) 10 pesos. D) 20 pesos.

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17. If the nominal exchange rate falls 10 percent, the domestic price level rises 4 percent, and the foreign price level rises 6 percent, the real exchange rate will fall: A) 0 percent. B) 8 percent. C) 10 percent. D) 12 percent. 18. Protectionist policies in a small open economy do not alter the trade balance because the: A) quantity of imports and exports is fixed. B) interest rate adjusts to offset any reductions in imports. C) exchange rate appreciates to offset the increase in net exports. D) level of net capital outflow is fixed by the world interest rate. 19. As the U.S. budget deficit shrank in the 1990s, the increase in U.S. national saving was ______ than the expansionary shift in the U.S. investment function, resulting in a trade ______. A) stronger; deficit B) stronger; surplus C) weaker; deficit D) weaker; surplus 20. If the government of a small open economy wishes to reduce a trade deficit, which policy action will be successful in achieving this goal? A) increasing taxes B) increasing government spending C) increasing investment tax credits D) imposing protectionist trade policies 21. Graphically illustrate and explain how a steep decline in the value of the stock market and housing prices would affect the level of domestic output, the interest rate, and the exchange rate in a large open economy with a floating exchange rate.

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22. Between 1995 and 2005, China chose to: A) conduct independent monetary policy, allow free international-capital flows, and maintain a fixed exchange rate. B) maintain a fixed exchange rate, allow free international-capital flows, and give up the use of monetary policy for domestic stabilization. C) conduct an independent monetary policy, restrict international-capital flows, and maintain a fixed exchange rate. D) allow a flexible exchange rate, conduct an independent monetary policy, and allow free international-capital flows. 23. One argument favoring a fixed-exchange-rate system is that it: A) allows monetary policy to be used for stabilizing output and prices. B) reduces exchange-rate uncertainty, thereby promoting more international trade. C) leads to excessive growth of the money supply. D) requires no actions on the part of the central bank to implement. 24. One argument favoring a floating-exchange-rate system is that it: A) makes international trade less difficult. B) minimizes destabilizing speculation by international investors. C) allows monetary policy to be used for other purposes. D) helps prevent excessive growth in the money supply. 25. At the end of 1994 the Mexican government was unable to maintain a fixed exchange rate because it: A) ran out of foreign-currency reserves. B) was unable to increase the supply of Mexican pesos. C) was forced by the IMF to let the peso float. D) joined an exchange-rate union. 26. Country risk included in the risk premium in interest rates refers to the: A) additional costs incurred when loans are made in currencies other than the domestic currency. B) possibility that loans in some countries may not be repaid because of political upheaval. C) expectation that the exchange rate may change in the future. D) potential change in the terms of trade between countries.

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Answer Key
1.

2. 3. 4. 5. 6. 7. 8.

In the ADAS model, the unexpected monetary contraction shifts aggregate demand from AD1 to AD2. The new short-run equilibrium at B has a lower price level and lower output. In the long run when the lower price level (and lower inflation) becomes expected, the aggregate supply curve shifts from AS1 to AS2 and the long run equilibrium is at the natural level of output at C. Using the Phillips curve, the unexpected monetary contraction reduces the inflation rate in the short run. The lower inflation rate results in a higher unemployment rate at a point like B on the same Phillips curve. In the long run when the lower inflation rate becomes expected, the Phillips curve shifts down and the unemployment rate returns to the natural rate at C. A D C A C D

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9. 10. 11. 12. 13. 14. 15.

Starting from equilibrium at A, if people adjust their expectations from 10 percent to 3 percent inflation, then the Phillips curve shifts down. If the central bank follows through on its announcement and achieves a 3 percent inflation rate, the economy is at point B on the new Phillips curve, with lower inflation but the same unemployment rate. However, if the central bank reneges on its announcement and conducts monetary policy to reduce inflation to 5 percent, rather than the announced 3 percent, for example, then the economy would be at C and have both lower inflation and lower unemployment. However, people would recognize that the central bank has the incentive to renege and not expect 3 percent inflation. The Phillips curve would not shift down and the opportunity for central bankers to gain would go away. C A A D B D

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16. 17. 18. 19. 20. 21.

The reduction in net capital outflows reduces the demand for loanable funds, which reduces the domestic interest rate. The lower domestic interest rate partially offsets some of the initial decrease in net capital outflows from the United States, but there is an overall decrease in net capital outflows. The reduction in net capital inflows reduces the supply of dollars in the foreign exchange market and increases the real exchange rate. D D C C A The stock market and housing price declines reduce consumption spending and shift the IS curve to the left, resulting in lower output and a lower domestic interest rate. The lower interest rate makes domestic investment opportunities less attractive and increases net capital outflows, which reduces the exchange rate and increases net exports. Thus, output, the interest rate, and the exchange rate all decline as a result of the stock market and housing price declines.

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22. 23. 24. 25. 26.

C B C A B

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