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**Economics 470/570Winter 2005 (worth 1 point)Midterm #2**

Part I - Definitions. Define each of the following (3 points each, 18 points total).

1. Autonomous expenditures

2. Crowding out

3. Inflationary and recessionary gaps

4. Policy ineffectiveness proposition

5. Menu costs

6. Wealth effect

**Part II - Short Answer. Answer THREE of the following questions (9 points
each, 27 points total)**.

1. What is the expenditure multiplier? Why is it useful?

2. When is money demand more sensitive to changes in the interest rate, at full employment or in a recession? Explain.

3. Use the IS-LM model to show that the model is classical in the LR, i.e. that (a) output does not change in the LR, (b) monetary shocks do not affect the real interest rate in the LR, (c) real shocks do affect the real interest rate in the LR.

4. Derive the SRAS and LRAS curves for the New Classical model.

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**Part III – Essays and problems. Answer THREE of the following questions (18
points each, 54 points total)**

1. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as investment becomes less sensitive to the interest rate. Explain the result intuitively.

2. (a) What is a liquidity trap and how does it arise? Explain your answer intuitively and graphically. Is the economy more likely to be in a liquidity trap near full employment or in a recession? Explain. (b) Explain and show graphically using the IS-LM model how the economy can become stuck in a liquidity trap with output less than its full employment level. How can wealth effects overcome this problem?

3. Explain the activist and non-activist positions on the use of government policy to stabilize macroeconomic variables such as real output. What problems are encountered in the pursuit of activist policies? Are there substantial differences for monetary and fiscal policy?

4. Suppose the monetary authority wants to reduce the inflation rate. Compare the costs (in terms of output) of reducing inflation in the traditional Keynesian, New Classical, and New Keynesian models. Be sure to cover both an expected and an unexpected change in policy. Why is the credibility of policymakers important?