Download EXAM I

EXAM I
ECON 3900
FALL 2005
POSSIBLE ANSWERS
NAME (PRINT):
Part I
1)
(20%) Simply complete the rest of the table below
Year
Price
Index**
Px
Py
Inflation
w* = 0.40
w=0.60
use year 2
as base year
1
10
5
89.74358974
2
12
5
100
11.42857143
3
4
13
13
6
7
112.8205128
120.5128205
12.82051282
6.818181818
5
12
8
123.0769231
2.127659574
*Where w’s represent the weight of the product in the expenditures basket.
**Assume accuracy up to 1/1000
First: Compute the average price using the specified weights: (P-aver = Px*Wx+Py*Wy)
Second: Compute the price index [(Pt/Pb)*100] with the second year as the base year.
Third: Compute inflation as the rate of growth in the price index: ((PI(t+1) – PI(t))/PI(t))*100
2)
(10%) Consider the following economy:
Population: 1000000
Adult population: 850000
Level of employment: 540000
Unemployment rate: 10%
What is the number of the unemployed?
LF = Unemployed + Employed
Unemployment rate = (unemployed/LF)*100
Thus: unemployment rate = [unemployed/(unemployed+employed)]*100
Or, alternatively, you could argue that the employed constitute 90% of the LF, hence the total LF
is 540000/0.9=600000; hence the unemployed are 60000 (10% of the LF).
2)
(30% - each part accounting for 5%)
economy:
Assume the following information about an
Employment level: L = 90,000
Physical Capital level: K = 10,000
Level of output is determined based on the following production function:
Y(L,K) = (L^0.5)*(K^0.5)
Consumption function is given as: C = 2000 + 0.75 (Y-T)
Where T represents taxes
Investment is governed by the following relationship: I(r) = 5000 – 500 r
Government spending: G = 5000
Taxes: T = 5000
a)
What is the level of output at the capacity of the economy?
Output is determined by the ability of the economy. Here, the economy has certain endowment of
labor and capital and is subject to certain production technology (captured by the production
function):
Y = (90000^0.5)*(10000^0.5)=300*100=30000
b)
What is the level of national saving?
NS = Public Sector Saving + Private Sector Saving
Public Sector Saving simply represents the budget of the government sector: Taxes – Government
Spending = 5000 – 50000 = 0
Private Sector Saving represents the amount of disposable income that is not directed into
consumption, i.e. disposable income minus consumption spending. Note that the disposable
income is defines as the after tax (or more precisely net tax, net of transfers, in our problem here
things are much more simple and you can simply consider that either T is the net tax, or transfers
are zero). Private Saving = Y – T – C = Y – T – 2000 – 0.75 * ( Y – T ) = 0.25*( Y – T ) – 2000 =
= 0.25*( 30000 – 5000 ) – 2000 = 4250
NS = 0 + 4250 = 4250
c)
What is the equilibrium real interest rate?
To answer this we must look at the loanable funds market. The demand for loanable funds is
represented by the Investment Function (I ( r ) = 5000 – 500*r). Recall that investment is the
spending on firms for acquisition of new capital goods, and regardless of whether that spending is
financed through borrowing or with cash, interest rate is still the cost component. The supply in
this market (given that this is a closed economy) is simply the national saving.
In equilibrium Supply must equal Demand:
4250 = 5000 – 500 * r
r = 1.5%
d)
What is the marginal product of labor at the capacity level of output?
MPL = change in output / change in labor ; It is ideal when the change in the input, in this case
labor, is defined as simply 1 unit.
MPL = (change in Y) / (change in L = 1)
If we increase the level of labor to 90001 then the output level will increase to 30000.17; thus the
MPL is 0.17. Note the output level changed from 30000 to 30000.17 as a result of the change in
the labor from 90000 to 90001
e)
What would be the real interest rate if the level of government spending increased to
6000 (nothing else changes but G = 6000)?
First of all, this change would have an impact on public sector saving = 5000 – 6000 = -1000
Thus, the overall saving (NS) will decrease by 1000 to 3250. In which case the new equilibrium
in the loanable funds market will be 3250 = 5000 – 500 * r  r = 3.5%
f)
What would be to the real interest rate if both, G and T were set to 6000?
In this case, the public sector saving will remain the same as in the starting setup of the problem,
i.e. zero, as the government’s budget is balanced. But, the change in taxes changes the disposable
income, thus effecting private sector saving.
Private sector saving = Y – T – C = 0.25* (Y – T) – 2000 = 0.25*(30000-6000) – 2000 =
= 4000
In this case, the new equilibrium in the loanable funds market will be achieved when:
4000 = 5000 – 500 r
r = 2%
3)
(30%) True/False + Explain! State whether the statement is true/false and briefly justify
your answer (your explanation will count for half of the credit).
a) (6%) Consider the following scenario: Delta Airlines purchases fuel at $1.80/gallon on
September 1, but by September 5 the price of fuel increases to $2.50/gallon. Would you
argue that on September 5th the economic cost of using the fuel purchased on September
1st is $1.80?
False, the economic cost is based on the concept of opportunity cost. The forgone opportunity
when the fuel is being used on September 5th is to sell it for the currently available market value,
which is 2.50, thus the economic cost of using the fuel is 2.50/gallon. The initial cost of the fuel
can be viewed as simply sunk cost (note this answer ignores any possible tax implications)
b) (6%) If a country has been a net recipient of foreign investment in the past, then it is
likely that its GDP will exceed its GNP.
The statement seems to be true (although there is some uncertainty here due to the uncertainty
about the productivity of such investments). The GDP statistics will include the entire market
value of the final output produced within the boundaries of the country, regardless of who
actually owns the means of production. The GNP measure will exclude the income from the
production that is made to foreigners (i.e. the foreign contribution to the domestic production).
Thus, if a country is home to a lot of foreign capital investment, the GDP value will likely be
higher than the GNP value
c) (6%) Unanticipated Inflation is capable of redistributing wealth from borrowers to
lenders
Bad question for now, as we haven’t formally discussed this yet. So, don’t worry about it for the
sake of this exam.
False, unanticipated inflation is likely to redistribute wealth from lenders to borrowers and not the
other way around.
d) (6%) In the long run, if an economy experiences no real output growth (real GDP) and
no money supply growth it should have growth in nominal GDP equal to zero.
Again, this question is inflation related…. Next exam.
True (assuming that the velocity of money stays constant). In the Classical model (long-run) if we
apply the quantity theory of money, then the rate of inflation can be written as:
Inflation = changes in the velocity of money + money supply growth – real output growth rate
e) (6%) Based on the Classical economic model studied in the class we can argue that the
fiscal policy has no real effect on the output level. However, government actions can
impact the real interest rate. If both, government spending and taxes increase by the same
amount the real interest rate will increase.
To answer this question simply look at problem 2 and compare parts c and f, and you will see
that the statement above is indeed TRUE. The first part of the statement is clearly true as the
fiscal policy (a stabilization policy, i.e. a policy aimed at correcting cyclical fluctuations in
the business cycle) will have no impact on the long-run path of economic development. And
in the long-run the output level is determined by the capacity of the economy. So, unless you
could make a case that fiscal policy can change our composition of factor endowments, or
change the production function, the long-run effect is non existent. However, equal increases
in G and T will have an interest rate impact, because the change in T affects the disposable
incomes and hence the private saving.
Short Answers:
1) (10%) In the late summer of 2003 the unemployment rate decreased in the US, while the
job creation remained negative. Can you explain this paradox?
This peculiar observation arises because the statistics come from two different sources. The
payroll numbers come from the survey of businesses, while the unemployment numbers are a
product of a population survey. There are two possible and conflicting with each other
explanations:
1)
If you are an optimist you could argue that the unemployment survey projects a more
adequate representation of reality as more and more people find jobs in either newly
emerging businesses (small firms) or find self-employment opportunities. Note, in
this case, these individuals will not be picked up by the unemployment survey (CPS)
and yet they are not part of the business survey yet.
2)
If you are a pessimist, you could argue that the business survey is painting a more
correct picture of what is going on. And the fact that the unemployment numbers are
decreasing could be a signal of a growing discouraged worker phenomenon as
workers stop seeking employment because the perceived probability of finding
employment is so low that the costs of job search are not justified.