PART II - SHORT ANSWER QUESTIONS (65 POINTS) - You must show your work to receive credit on these problems. When shifting curves, clearly label the initial, and new curves using subscripts (e.g., AD1 and AD2) and follow instructions. Failure to clearly label your diagrams will result in no partial credit.

1. Good market, money market, and IS/MP (22 points) Assume the economy behaves according to the assumptions in the Keynesian cross and IS/MP model. Also, assume that the marginal propensity to consume is 0.75

1.1. Using the space below, illustrate the goods market (Keynesian cross) diagram below (top panel) and the IS/MP diagram (bottom panel). Be sure to carefully label the axes (in words and symbols), curves, and initial equilibrium Point A on both diagrams. Label initial equilibrium values Y1* and r1* where applicable. [4]

1.2. Now, suppose that the government increases taxes by $200 in this economy. How much will the expenditure line shift? Does it shift up or down? Compute the size of the shift and illustrate this shift on the top panel above. Label this equilibrium on the top and bottom panels as Point B' and clearly label the new curve on the top panel using the notation from class. [3] University of California, Davis ECN 101: Intermediate Macroeconomic Theory Prof. Van Gaasbeck Sample Exam #2 5

1.3. Compute the change in output resulting from the policy mentioned in #1.2. Show this change in output on your Keynesian cross diagram. Label the new level of output Y' on your diagram. [3]

1.4 Now, illustrate the effects of this policy on the IS/MP on the diagram from #1.1 above. Be sure to clearly label Point B' (the new initial equilibrium in the goods market from #1.2-#1.3) and the final equilibrium Point B on BOTH diagrams. Clearly label any new curves using the notation from class. [4]

1.5 Looking at how the economy transitions from Point B' to Point B, why is this change happening? Be specific in explaining why the economy moves to Point B (as opposed to staying and Point B') [2]

1.6 The policy described in #1.2-#1.4 is an example of (circle the correct answer for each bullet) [3] x Fiscal policy Monetary policy x Contractionary policy Expansionary policy x Monetary neutrality Crowding out/crowding in

1.7 Based on your analysis above, state how the following variables change when the economy moves from point A to point B (circle the correct response for each variable): [3]

Real interest rate Increase Decrease No change Ambiguous

Output Increase Decrease No change Ambiguous

Inflation Increase Decrease No change Ambiguous

Consumption Increase Decrease No change Ambiguous

Investment Increase Decrease No change Ambiguous

Government spending Increase Decrease No change Ambiguous