MFIN7007B: Economics for Financial Analysis Fall 2021 Term Test #2
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MFIN7007B: Economics for Financial Analysis
Fall 2021
Term Test #2:
Destruction of capital stock ╱ Kt 、due to terrorist bombing
You have 60 minutes. Please answer ALL questions in the space provided.
[Hint: This question is closely related to Section 4.2 (Application #2: Capital dynamics) of my lecture notes, as well as the relevant Panopto videos.]
Recall that, in Term Test #1, we considered a case where some capital stock in an economy was destroyed by terrorist bombing, leading to a decrease in the supply of capital inputs. Due to factor complementarity, the marginal productivity of labor (立pX) ( hence the demand for labor inputs ╱ Xd、( would fall. As a result of the reduction in the employment of both capital and labor inputs, production of output would drop at any given price levelóimplying a leftward shift in both the LR|s and sR|s curves.
While analyzing the short-run e§ects on the real wage and labor employment back then, we assumed that the price level remained unchanged.1 But the leftward shift of the sR|s curve implies that this (partial-equilibrium) assumption would not hold in the Önal (general) equilibrium. Besides the sR|s-shift, one can show that the |D-curve would shift as well (but in the opposite direction).
(o1) [10 points] Applying the law of diminishing marginal productivity of capital (立pK) (
explain why the destruction of capital stock would stimulate investment demand (i.e., right/up-ward shift in the I-curve).
(o2) [10 points] Since investment demand is a component of the demand for loanable funds ╱Cd = I + Xx、( the right/up-ward shift in the I-curve would shift the Cd-curve in the same direction, thus driving up the interest rate in the loanable-funds market to a level above the real interest in the money market (i.e., rcreditt 〕rmoney = Rmoney 一gp(e))! Explain how to close this interest-rate gap (△r) via either ONE of the following two alternative adjustments, and then conclude why the |D-curve would shift right/up- ward.
(a) An adjustment in the price level (p) at any given yd-level
(b) An adjustment in the level of output demanded ╱yd、at any given p-level. [Note: You need NOT explain both p-adjustment and yd-adjustment.]
(o3) [10 points] Combining the sR|s-shift with the |D-shift (and assuming that the
former dominates the latter), explain how the equilibrium price level (p) and output (y) would change in the short run. In particular, state whether these 2 variables would rise or fall.
(o4) [10 points] With the aid of a labor-market diagram, explain how the p-level change
would a§ect the equilibrium real wage (w) and employment (X) in the labor market in the short run. [Recall that the nominal wage is Öxed by contract at W0 and cannot change in the short run.]
(o5) [10 points] Suppose that the economy was in both long-run and short-run equilibria
before the terrorist attack, so that employment gap and output gap did not exist initiallyóviz., X0(LR) = X0 = X0(SR) and y0(LR) = y0 = y0SR ! With the aid of a labor- market diagram, explain why the new labor employment in the short run╱X1(SR)、would likely be smaller than that in the long run ╱X1(LR)、after the attack. [Show X0 ( X1(SR)( X1(LR) clearly on your diagram.] This employment gap implies a negative output gapói.e., △y1 = y0SR 一 y0(LR) ↓ 0!
(o6) [10 points] Explain how this output gap can be eliminated via automatic market
adjustments over time. In particular, how would people revise their price (or ináation) expectations and the nominal wage over time? And in what direction would the sR|s curve move over time as a result of renewal of labor contracts?
(o7) [10 points] Propose a monetary policy that can close this output gap. In particular,
in what way should the central bank adjust its money supply (under 立-policy) or the interest rate (under R-policy)?
(o8) [10 points] Propose a Öscal policy that can close this output gap. In particular,
in what way should the treasury adjust government purchases of goods and services (under c-policy)?
(o9) [10 points] Multiple-choice questions: Long-run e§ects on other macro variables.
macro variable |
|
(a) |
(b) |
(c) |
(d) |
your answer |
consumption (↓) |
|
rise |
fall |
constant |
ambiguous |
|
saving (s) |
|
rise |
fall |
constant |
ambiguous |
|
investment (I) |
|
rise |
fall |
constant |
ambiguous |
|
net exports (Xx) |
|
rise |
fall |
constant |
ambiguous |
|
loanable funds (C) |
|
rise |
fall |
constant |
ambiguous |
|
real balance (m = 立/p) |
rise |
fall |
constant |
ambiguous |
|
|
real interest rate (r) |
|
rise |
fall |
constant |
ambiguous |
|
nominal interest rate (R) |
rise |
fall |
constant |
ambiguous |
|
|
real rental (rk ) |
|
rise |
fall |
constant |
ambiguous |
|
nominal rental (Rk ) |
|
rise |
fall |
constant |
ambiguous |
|
(o10) [10 points] Multiple-choice questions: Long-run e§ects on other macro variables.
macro variable |
|
(a) |
(b) |
(c) |
(d) |
your answer |
consumption (↓) |
|
rise |
fall |
constant |
ambiguous |
|
saving (s) |
|
rise |
fall |
constant |
ambiguous |
|
investment (I) |
|
rise |
fall |
constant |
ambiguous |
|
net exports (Xx) |
|
rise |
fall |
constant |
ambiguous |
|
loanable funds (C) |
|
rise |
fall |
constant |
ambiguous |
|
real balance (m = 立/p) |
rise |
fall |
constant |
ambiguous |
|
|
real interest rate (r) |
|
rise |
fall |
constant |
ambiguous |
|
nominal interest rate (R) |
rise |
fall |
constant |
ambiguous |
|
|
real rental (rk ) |
|
rise |
fall |
constant |
ambiguous |
|
nominal rental (Rk ) |
|
rise |
fall |
constant |
ambiguous |
|
2023-03-07