Answer Key, Midterm #2, Macroeconomics (103)
with Gottheil, Spring 2007
Question 1
The graph should look like that in Exhibit 3, Chapter 8, where the number “$800” is replaced with
“$1000” (and AD3 and AE3 are omitted). The graphs must obviously be fully labeled and must have
some indication of the precise size of the gap.
a. The economy is experiencing a recessionary gap. Equilibrium rGDP is $200 lower than it could be,
at $1200.
b. The government should cause the economy to grow the $200 needed to close the recessionary gap.
Since MPC=0.8, the income multiplier is 5
8.01
1=
−
, so the government should increase aggregate
expenditures by ΔAE·5=$200, or ΔAE=$40. Any combination of expenditure increases and tax
decreases (recalling that the tax multiplier is
M
PC
MPC
−1) is acceptable for this answer.
Question 2
a. The innovation cycle is a theory of externally-generated business cycles. New technologies appear
essentially randomly – whenever someone discovers or invents it. Certain major technological
innovations like railroads, automobiles, and computers change the level of productivity in an
economy and spur rapid growth everywhere. As industries adjust to and integrate with the new
technology, the gains to the innovation diminish and the growth rate falls. As new technologies
appear and “exhaust their potential”, the economy grows and faster and slower rates, creating what
appears to be a business cycle of ups and downs.
b. The important graph to draw is exhibit 8 in Chapter 9. Optimally, countercyclical policy is
administered as soon as the economy begins a downturn, to “smooth out” the downturn and avoid a
major recession. There are two major obstacles to doing this. First, it’s difficult to predict what path
the economy will take. What looks like a major downturn could be a pause in the growth rate, so it’s
not clear whether, many times, expansionary fiscal policy is appropriate. Second, even if it is clear
that the economy is on the brink of a downturn, fiscal policy can’t immediately be applied. Bills
must be written and debated, voted on by both chambers of Congress, signed into law, and then put
into action (which, in itself, may take a while to work). This time from recognition to
implementation is administrative lag.
Question 3
The three graphs are:
(1) Money - interest rate
(2) Investment - interest rate
(3) AS – AD (price level and rGDP)
These graphs should look like those on page 240, exhibit 5, and all graphs need to be labeled at each
axis and each curve.
In graph (3), the Keynesian view is that the economy need not operate under full-employment. When
the money supply increases, if the AD curve originally intersected AS on its horizontal segment, real
