Northeastern University

University College

Economic Principles II November 4, 1994

ECN 4116 Fall 1994

Take-home Mid-term Exam

Use graphs, tables, charts to illustrate your points as necessary. The weight of questions # 1 to #5 is 15 points each and the question #6 is worth 25 points. Please feel free to call me if you have any problem. Good luck !

1. Critically examine if a large public budget deficit crowds out private investment. Explain how the public budget deficit ultimately results in trade deficit. Construct a table of ratios of budget deficit, trade deficit, private investment, public investment, and debt stock to GDP for the United States and her five major trading partners for years 1980, 1985, 1990, and 1993. Do these ratios support crowding-out or crowding-in of private investment due to a public budget deficit? Can you conclude that public budget deficit causes a trade deficit?

2. Evaluate the Keynesian and natural rate hypothesis on a policy trade-off between inflation and unemployment. How does the rational expectation theory come up with a conclusion that demand management policy is ineffective to bring about a positive change in real income, employment and output in an economy? Support your answer with empirical facts as far as possible.

3. Compare and contrast the Keynesian and monetarist position on transmission mechanism of a monetary policy aimed to control the effects of business cycle on income, employment and output. How do the different shapes of demand for money and demand for investment goods produce different outcomes ? Why does the stability or instability of velocity of money matter so much ?

4. Can the Federal Reserve Bank control money supply and the interest rate simultaneously? How many instruments can the Fed use to operate monetary policy. Analyze the strength and weakness of each of these instruments. What kind of difference in foreign trade balance can we expect if Fed switches from tight money policy to a easy money policy? explain.

5. Suppose there are five businessmen in Boston, Chicago, San Francisco, Dallas, New York named B, C, S, D, and N respectively. These customers have demand deposit account in the commercial banks of their own city. As you know from page 257 of the text that a separate Federal Reserve Bank serves each of these cities. Assume that required reserve ratio is 10 percent. These business people keep 20 percent of money in their pockets to spend on daily necessities and save rest of their money in demand deposits of their own bank. Now answer the following.

a) B pays $1000 to S and S saves money received from B in his demand deposit account according to the behavioral rule written above. Now show the balance sheets of B's and S's banks and those of related Federal Reserve Banks. How does the balance sheet of B's bank look like after B gets back the check he wrote for his personal record?

b) Suppose that originally N pays B $1000 by a check drawn on his demand deposit. B keeps 20 percent of this in his pocket and deposits rest in his bank account. Now B draws check worth $1000 amount in favor of S; and S draws in favor of D ant D in favor to C. Each of these business people do keep 20 percent of money from whomever they received and draw a check of $1000 to pay to another businessman as above. Does money supply increase or decrease after a whole round from B to N is complete? Write balance sheet of each of these banks to illustrate your answer.

c) Suppose that each of B, C, D, N, and S save $1000 dollars in their own demand deposits. Now assume that there exist an infinite number of customers in each of these cities asking for loans from the respective commercial banks. Calculate increase in total money supply in the economy after all commercial banks use up all excess reserves to make loans to customers..

6. Write short notes on each of the following.

a) Recardian equivalence theorem

b) Wage-guide post and price guide-post

c) Supply side economics

d) Cost-push and demand-pull inflation

e) Equivalence of equation of exchange and macroeconomic identity

f) Relations between the value of money and the price level

g) Relationship between bond price and the interest rate

h) What "backs" the money supply in the economy

i) Structure of financial system in the United States

j) Functions and types of money

k) Difference between annually balanced vs. cyclically balanced budget