Download Answers to First Midterm (version 1)

Economics 302
Fall 2009
Answers to First Midterm
October 7, 2009
Name _______________________________
Student ID Number ____________________
Section Number _______________________
This 75 point midterm consists of three parts: a binary choice section with 10 binary choice questions worth
2 points each for a total of 20 points; a short answer/graphing questions section with 5 questions each worth
5 points for a total of 25 points; and an essay/problem section with two parts worth a total of 30 points.
You will want to write legibly since illegible answers will be graded as wrong answers.
You will want to present your work in an orderly fashion since a lack of organization will be
interpreted as a lack of mental clarity and competent expression.
You will want to make sure your answers are clear and easy to find on the test.
All work should be done on the exam booklet and all answers should provide work and any formulas
you used in answering the question. A lack of work for any answer will be penalized by a lower
grade on that section.
Calculators are fine to use.
SCORE:
Binary Choice
20 points
Short Answer/Graphing
25 points
__________________
1.__________________
2.__________________
3.__________________
4.__________________
5.__________________
Essays/Problems
30 points
1.
15 points
__________________
2.
15 points
__________________
75 points
__________________
TOTAL
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I.
Binary Choice (worth 2 points each or 20 points total)
Please circle legibly the letter that corresponds to your answer.
1. Suppose you are a macroeconomist interested in building a short-run
model of the aggregate economy. Most likely your model will assume
that prices are
a. Sticky in the short-run.
b. Flexible in the short-run.
2. Which of the following variables is a flow variable?
a. Wealth
b. Consumer expenditure
3. When calculating real GDP per year using the method outlined in
lecture,
a. Prices are allowed to vary while quantities are equal to the base
year quantities.
b. Prices are equal to the base year prices while quantities are
allowed to vary.
4. The CPI provides a measure of the general price level of
a. All goods and services produced in an economy during a
specific time period.
b. Goods and services that consumers typically purchase.
5. Currently the unemployment rate as calculated by the Bureau of Labor
Statistics does not include discouraged workers in the unemployed
group. What would happen to the unemployment rate if these
discouraged workers were reclassified as part of the unemployed
instead of being treated as not in the labor force?The unemployment
rate would
a. Decrease.
b. Increase.
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6. Suppose you are given the aggregate production function for an
economy. Furthermore, suppose the amount of available capital
increases for this economy. Holding labor constant, this increase in
capital will cause the MPK to
a. Decrease
b. Increase
7. Suppose you are given the aggregate production function for an
economy. Furthermore, suppose the amount of available technology
increases for this economy. Holding labor and capital constant, this
increase in technology causes labor productivity to
a. Increase
b. Decrease
8. Holding everything else constant, when the government increases its
spending while maintaining the same level of taxation this results in
a. A leftward shift in the supply of loanable funds curve.
b. A rightward shift in the supply of loanable funds curve.
9. In the loanable funds framework with a closed economy, when the
interest rate is greater than the equilibrium interest rate this implies
that the supply of goods and services is
a. Greater than the demand for goods and services.
b. Less than the demand for goods and services.
10. The Fisher Effect refers to the
a. Relationship between the demand for money and the supply of
money and how this relationship determines the price level in
an economy.
b. Relationship between the inflation rate and the nominal interest
rate.
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II.
Short Answer/Graphing Questions (worth 5 points each or 25
point total)
Please provide your answer in the provided space. Remember to write legibly
and take the time to organize your answer before you begin to write.
For short essay responses please remember to use complete sentences: sentences
should have a subject, a verb, proper capitalization and proper punctuation. We
reserve the right to lower your graph for responses that are not written in
standard English with these components.
1. (5 points total) Provide a formula for the National Income Accounts Identity using
the expenditure approach in the space below.
YN  C  I  G  NX
Suppose that American exports decrease from $1,662 billion to $1,500 billion and at
the same time American imports decrease from $2,370 billion to $2,100 billion. All
other expenditure components in the American economy during this period of time
are unchanged. What is the change in American GDP due to these changes? Show
your work in the space below.
YN  C  I  G  NX
 C  I  G  (EXPORT  IMPORT )
 0  0  0   (1500billion  1662billion)  (2100billion  2370billion) 
 162billion  270billion
 108billion
2. (5 points) Fill in the blank for the following two statements:
An approximation for the percentage change in ( A  B ) is ______________________
An approximation for the percentage change in (A/B) is _______________________
Percentage change in ( A  B ) ≈ Percentage change in A+ Percentage change in B
Percentage change in ( A B ) ≈ Percentage change in A  Percentage change in B
Provide an equation giving the relationship between the real wage and the nominal
wage. Identify clearly any variable abbreviations you use in this equation.
Real wage = Nominal wage/price index
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Use your equation and the relevant approximation technique to provide an
approximation of the inflation rate when during the relevant time period the real wage
grows by 3 percent while the nominal wage grows by 2 percent. Show your work.
Percentage change in real wage ≈ Percentage change in nominal
wage  Percentage change in price
Percentage change in price ≈ Percentage change in nominal wage  Percentage
change in real wage
Percentage change in price ≈ 2%-3% = -1%
3. (5 points) Suppose that a Japanese firm buys an existing U.S. firm (located in the
U.S. and using American workers) and sends some of its Japanese managers to
operate the firm and oversee the American workers. Assume that the firm’s output is
unchanged, but that the former U.S. managers are now unemployed. Describe the
effect of this transaction on U.S. GDP and U.S. GNP in the space below. Be specific
in your answer and make sure you explain why the effect occurred.
The effect on U.S. GDP:
The U.S. GDP will remain unchanged.
The production in the U.S. is unchanged; therefore the U.S. GDP doesn’t change.
The effect on U.S. GNP:
The U.S. GNP will decrease.
The former U.S. managers lose their jobs and this reduction in their income will
decrease U.S. GNP. The income the Japanese managers receive while managing
the firm will not be counted in U.S. GNP since they are not U.S. citizens.
4. (5 points) Wage rigidity is defined as the failure of wages to adjust to a level at
which labor supply equals labor demand. Explain briefly why minimum-wage laws
may cause wage rigidity.
Wage rigidity: the failure of wages to adjust to a level at which labor supply
equals labor demand.
Minimum-wage laws set a legal minimum on the wages that firms pay their
employees. For some workers, especially the unskilled and inexperienced, the
minimum wage raises their wage above its equilibrium level and, therefore,
reduces the quantity of their labor that firms demand. This causes an excess
supply of labor.
(5 points) Suppose that you are analyzing the U.S. economy using a classical
long-run model. You see that the U.S. government increases its level of government
spending while the level of aggregate output, consumption, net exports, and taxes are
held constant. How will this increase in government spending affect the loanable
funds market? Explain your answer verbally and illustrate your answer with a graph
5.
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depicting the effect of this change in the loanable funds market. Be sure your graph is
clearly labeled (horizontal and vertical axis, any curve used in the graph, and any
equilibrium points) and that you identify the initial equilibrium as well as the
equilibrium after the government increases its level of spending. In your answer
identify the effect of this change on the real interest rate.
An increase in government purchase will reduce the level of government saving
and this will cause the supply of loanable funds to shift to the left at every interest
rate.
For a given loanable funds demand curve this implies that the interest rate will
increase.
On the graph the student should have the initial I1, r1 marked as well as the new I2,
r2 marked on the graph. In addition, the supply and demand curves should be
clearly marked (S1, S2, D1) and the two axis labeled.
III.
Essay/Problem (points noted for each question: total points in
this section equal to 30 points)
For the essay response please remember to use complete sentences:
sentences should have a subject, a verb, proper capitalization and
proper punctuation. We reserve the right to lower your graph for
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responses that are not written in standard English with these
components.
α 1α
1) (15 points total) Let Y  f(K¸ L)  AK L
be an aggregate production function
that maps total capital (K) and labor (L) into output (Y). Parameter α is such that
0 ≤ α ≤ 1. Parameter A represents the level of available technology. Fix α and A for the
rest of the problem: leave them as constants in the Cobb-Douglas production function.
A) (1 point) Characterize the returns to scale of f(K¸ L). Explain your answer.
Constant returns to scale.
B) (2 points) Compute the marginal product of capital (MPK;
product of labor (MPL;
∂Y
) and the marginal
∂K
∂Y
) for f(K¸ L). Are they positive or negative?
∂L
∂Y
=
∂K
The sign of ∂Y/∂K is ______________
∂Y
=
∂L
The sign of ∂Y/∂L is ______________
∂Y
 AαK
∂K
α
 (1  α) 1  α
L
α
∂Y
 AK (1  α)L
∂L
1α
L
 Aα 
K
 
0
α
K
 A(1  α)   0
L
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2
C) (2.5 points) Compute the second partial derivatives ∂
Y
2
∂K
and
2
∂ Y
2
∂L
(just differentiate
f(K¸ L) twice with respect to the same variable in each case). If the second partial
derivative is negative (positive) this indicates that the first derivative is decreasing
(increasing). Given this hint, interpret the significance of the sign of the second
derivatives that you have calculated.
2
∂ Y
=
2
∂K
The sign of
2
∂ Y
2
∂K
is _____________________
2
∂ Y
=
2
∂L
2
∂ Y
The sign of
is _______________
2
∂L
2
∂ Y
∂K
2
2
∂ Y
2
 (2  α) 1  α
  Aα(1  α)K
α
L
1α
  AK (1  α)αL
0
0
∂L
Interpret the significance of the second derivatives in the space below:
Both factors of production are subject to diminishing marginal returns because both α
and (1-α) are less than one. In other words, the marginal product of capital is decreasing
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as capital increases, and the marginal product of labor is decreasing as labor increases,
all else held constant.
D) (2 points) Provide a qualitative graph of output (Y) versus the level of capital (K)
holding technology (A  A ) and labor (L  L ) constant. Output should be on the
(vertical) y-axis, and capital should be on the (horizontal) x-axis. Label your axes.
Output (Y) vs. Capital (K)
2
1.8
1.6
Output (Y)
1.4
1.2
1
0.8
0.6
0.4
0.2
0
0
0.5
1
1.5
2
2.5
3
3.5
4
Capital (K)
Does the slope of this graph correspond with your result for the sign of
2
∂ Y
2
∂K
in part (C)?
The slope of the graph is decreasing as the level of capital increases, which corresponds
2
∂ Y
with 2 <0,
∂K
our result from part (C).
E) (2 points) Assume that factor markets are perfectly competitive, so the factors of
production are paid their marginal products. Let’s say that it is now the long-run, so all
factors of production are fixed, including the level of technology: A  A , L  L , and
K  K . What is the long-run equilibrium wage we? Show your work.
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α
K
Y
∂Y
we  MPL 
 A (1  α)   (1  α)
 L
∂L
L
 
F) (3 points) How much is paid to labor (labor income) in long-run equilibrium? What
is labor’s share of total income?
Labor Income = __________________________________________
Labor’s Share of Total Income = _____________________________
Labor Income  we L
Labors Share 
we L
(1  α)

Y
Y
Y
L
L
 (1  α)
G) (1 points) If you want to predict the long-run distribution of income across factors
according to this production theory, what do you need to estimate in terms of parameters?
In other words, what variables are needed to compute both capital’s share of income and
labor’s share of income?
You only need an estimate for α.
H) (1.5 points) The following graph was provided by the Federal Reserve Bank of St.
Louis. This graph depicts two lines: 1) the total compensation of labor (labor’s share of
total income) over time and 2) the share of labor compensation over time from wages and
salaries.
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Assume that we are in the long-run, with α still fixed. Is this graph consistent with your
result from part (F) on labor’s share of total income? Think about what should happen
over time, not the value.
If α is fixed, our long-run prediction from part (F) is that labor’s share of national
income should remain roughly constant over time. The graph is consistent with this,
although it seems like wages and salaries are becoming less important in terms of how
labor is compensated. I’d assume that fringe benefits and health insurance are growing
over time, accounting for this change (higher health insurance costs).
2) (15 points) This question takes your knowledge of the article “How Did Economists
Get It So Wrong?” by Paul Krugman in The New York Times Magazine as given.
John Cochrane is a professor at the University of Chicago, a “freshwater” school
according to Krugman. On 9/16, he published a response to Krugman’s article on his
website. Here is a short passage from Cochrane’s response to Krugman.
“The sad fact is that few in Washington pay the slightest attention to modern
macroeconomic research, in particular anything with a serious intertemporal [over
time] dimension. Paul’s simple Keynesianism has dominated policy analysis for
decades and continues to do so … everyone just adds up consumer, investment
and government “demand” to forecast output and uses simple Phillips curves to
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think about inflation. If a failure of ideas caused bad policy, it’s a simpleminded
Keynesianism that failed.”
Please write a few paragraphs discussing Krugman’s assertions in his article and
Cochrane’s response to those claims. You should briefly address the following questions:
I.
II.
(4 points) What was Krugman’s problem with economic policy before the recession?
(4 points) What type of economic policy did Krugman argue for? Why use this
policy?
III.
(3 points) According to Cochrane (see the above quote), what type of economic
policy is really used? Why is it flawed?
IV.
(4 points) For each author, what was the cause of the recession? Contrast their views.
Part I. [4; poor financial system regulation, Federal Reserve monetary policy, laissezfaire attitude (need two out of the three for full credit)]
Krugman argues that economic policy did not actively address the root causes of the
financial crisis. For example, the financial system was loosely regulated, which led to
fraud, abuse, and an overextension of credit to households and firms. The Federal
Reserve engaged in expansionary monetary policy with low real interest rates, so
borrowing money was low-cost and the economy overheated. Due to the ideology of the
“freshwater” school of macroeconomics, government officials thought that the markets
would regulate themselves and find the optimal outcome in terms of growth. This turned
out to not be the case with the financial and housing markets.
Part II. [4; Keynesian economic policy, especially fiscal policy/stimulus, to stimulate
aggregate demand]
Paul Krugman makes the case for traditional Keynesian economic policy. He argues for
a very large fiscal stimulus on the part of the US federal government. The purpose of
this increase in government expenditure is to shore up aggregate demand, or just
demand in general, for goods and services across the economy. The idea here is that
such an economic stimulus will shorten the duration of the recession and more rapidly
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restore the economy to the full employment level of output (long-run growth path).
Krugman also supports expansionary monetary policy, the lowering of real interest
rates by the Federal Reserve. However, due to the severity of the financial crisis,
monetary policy hit the zero interest rate lower bound, i.e. the Fed couldn’t push the
nominal interest rate any lower (below zero). Therefore, monetary policy was ineffective
and large fiscal policy measures were necessary.
Part III. [3; Keynesian, the analysis is too simple and outdated]
Cochrane says that traditional Keynesian economic policy is currently the modus
operandi for the government officials. Those in charge of public policy do not use the
most modern and up-to-date dynamic macroeconomic models, which are implicitly
better than the old Keynesian models (AD/AS, IS/LM, etc.). Therefore, Krugman’s
claims about the effects of “freshwater” economic thinking on policy are incorrect.
Keynesian economic policy is flawed because its ideas are outdated and overly
simplistic. Such policy was proven wrong in the past, and has proven itself to be wrong
again in the last few years.
Part IV. [4; Krugman: caused by “freshwater” influence on policy, Cochrane: caused
by Keynesianism]
Krugman: recession caused by irresponsible traders on Wall Street, lax regulation, and
expansionary monetary policy. Due to the influence of the “freshwater” school, laissezfaire was popular again. Regulators were encouraged to not to intervene in the “free”
market system. Bubble in housing prices; credit was abundant and too easy to get.
Cochrane: recession caused by bad macroeconomic policy. Keynesian-type analysis is
too simple and misses important features of the macroeconomy. Using Keynesian ideas,
those in charge of policy couldn’t respond to a recession brought about due to a
financial crisis because their economic tools were obsolete. Too much influence from
the “saltwater” school of thought, which includes Krugman.
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