Download Macroeconomic Theory

Macroeconomic Theory
M. Finkler
Spring 2006
Suggested Answers to Midterm Examination # 1
1. W/P = d0 –d1*L + d2*K + d3*RM
Ls = so + s1*(W/P) + s2*EITC
L = Ls
Y = 100*L.7K.3
AD = k*M/P
AD = C + I + G
C = .8* (Y-T)
T = .25*Y
Y = AD
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
Endogenous
W, P, L, Ls, Y
AD, C, P, T
a.
Solve equations 1 – 3 jointly to determine L.
Plugging 1 into 2 yields
L = so + s1*(do – d1*L + d2*K +d3*RM) +s2*EITC
Exogenous
K, RM, Bar
M, k, I, G
which can be solved to yield
L* = so + s1*do + s1*d2*K + s1*d3*RM + s2*EITC
1 + s1*d1
b. Plug the result into equation 4 to yield the reduced form equation for output
Y* = 100*[so + s1*do + s1*d2*K + s1*d3*RM + s2*EITC ].7K.3
1 + s1*d1
c.
Same answer as b.
d.
An increase in the EITC shifts out the labor supply curve to the right which
(based on L* and Y*) yields an increase in employment and output. If we plug the new
L* into (1), we see that real wages fall. To determine the effect on the price level, set
(5)=(9) to yield Y = k*M/P. Since Y* rose, the right hand side must rise; therefore, P
must fall.
e.
A rise in governmental expenditures only affects equation (6) and (9). Since Y is
unchanged, AD must be unchanged; thus, the increase in G must be countered by a fall in
either C or I. By (7), C does not change since Y and T do not change; thus, I must fall.
2.
a.
CPI - P2Q1 = 118,000 ; P1Q1 = 110,000; thus, the CPI would
increase by
118,000 – 110,000 *100 = 7.27%
110,000
b.
GDP(variable weight) Deflator - P2Q2 = 168,000 ; P1Q2 = 175,000;
thus the GDP Deflator would fall by
168,000 – 175,000 *100 = -4.00%
175,000
c. The chain weight index = sqrt[(1.0727)*(.96)] – 1 = 1.5%
3.
a. The trade weight average for China comes from multiplying the ratio of the
exchange rate in 2006 to that in 2006 by its trade share; thus,
TWER = .4*(.101/.128) + .3*(14.6/12.8) + .3*(.125/.120) = .971 so the TWER fell by
2.9% from 100 in 2000 to 97.1 in 2006.
b.
REX = e * P(china)/P(US)
In growth rate terms REX growth = e growth + P(china)growth – P(US)growth
Thus, REX growth = (.125 - .120) + (120 – 100) - (199.8 – 171.2) = .075 (7.5%)
.120
100
171.2
4.
Year Real GDP
(2000$)
1995 $8,037B
2000 $9,817B
2005 $11,131
Potential
GDP
$8,119B
$9,609B
$11,274
GDP
Gap
1.0%
- 2.2%
1.3%
Unemployment
Rate
5.6%
4.0%
5.1%
Natural
Unemployment Rate
6.1%
2.9%
5.75%
a.
GDP Gap = [(Ypot – Y)/Ypot}*100 and Okun’s Law : GDP Gap = -2*(U-Un)
which can be solved to yield Un = (Gap + 2*U)/2.
b.
1995 – 2000 – Y grew at 22.1% and Ypot grew 18.4%
2000 – 2005 Y grew at 13.4% and Ypot grew at 17.3%
c.
Using Okun’s Law as posited in part a, the natural rate of unemployment was
very volatile between 1995 and 2005. At least four possible reasons for such exist:
 Because productivity (and thus labor demand) varied but labor force
participation did not change
 Because the job acceptance rate varied (thus labor supply was volatile),
but the labor force participation rate did not change
 Because the labor force participation rate was unsteady over the decade or
 Because the constant in Okun’s Law was not steady.
5.
Model 1 incorporates the critical assumption that transactions costs are negligible.
The existence of money, instead of barter, makes this possible. With this critical
assumption, money has no effects on real variables (e.g., Y, L, I, and C.) Money,
however, remains important in Model 1 in that it affects the level of prices, and money
growth affects the inflation rate.
6.
Feldstein’s claim is consistent with the sources equals uses identify. In short, his
statement spells out the equation. X – Im = Sp + Sg – I. A proposal to reduce imports
(or increase exports) must also have an effect on at least one of the other variables in the
system. If exports were to remain the same, then domestic savings must increase relative
to domestic investment. The specifics will depend on whether the proposal would lead to
changes in income or changes in the behavior of our trading partners.
7.
One can treat the 27% tariff proposal as if it were the imposition of a quota. In
the graph below, NX would initially shift to the right, and, as a result, S – I would rise.
The real exchange rate, however, would not remain the same. It would begin to rise as
U.S. demand for imports fell. As a result, exports would fall, and imports would rise
until the resultant REX yielded the original level of net exports and S – I. Of course,
these results would not hold if our trading partners also took such restrictive action.
The only difference between a small and large open economy relates to changes in
domestic interest rates. In a large open economy, real interest rates might absorb some of
the shock from the tariff. As NX increases, S becomes greater than I, which might drive
down interest rates and increase I which would somewhat replace exports as REX rises.
No such effects would take place in a small open economy since real interest rates are
assumed to be set in world capital markets.
REX
S-I
NX
NX