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Erik’s First Midterm Macroeconomics Fall 2014 Name (print): _______________________________________ Name (signature): _______________________________________ Section Registered (circle one): Mail Folder (circle one): Tuesday a.m. Tuesday p.m. Harper Center Gleacher Center Exchange Student No Folder Wednesday a.m. TEST GRADE BREAKDOWN Part I: (Consumption Tax: 15 points total) ____________ Part II: (Understanding Macro Models: 16 points) ____________ Part III: (True/False/Uncertain: 45 points) ____________ Part IV: (A Preview of Inequality: 6 points) ____________ Part V: (Income Taxes and Consumption: 18 points) ____________ Total (out of 100) ____________ 1 Exam Preamble As always, that honor code rules are in effect. You know the routine. All the usual disclaimers apply. By signing on page 1, you are pledging to adhere to the honor code guidelines in my syllabus and the student handbook. Any discussing of the exam with students who have yet to take the exam is a blatant violation of the honor code. You have 1 hour and 45 minutes for the exam. will run out of time. Unless otherwise indicated, assume all curves are well behaved (i.e., labor supply slopes up, labor demand slopes down, investment demand slopes down, etc). For discussion problems, explain - but do not be wordy! (The more you say, the more likely you will say something wrong). Please, please, please - read ALL the information for the questions. When you are finished, you can leave the room. However, I will start my lecture promptly at 10:30 (in the morning classes) or 8:00 (in the evening class). We will have a lecture after the midterm. You are allowed: Move quickly through the exam or you One Piece of Paper - Handwritten - Not Photo Copied - Front Side Only A Calculator Good Luck! 2 Exam Assumptions 1. All answers should be provided in terms of the models and discussions developed in class. Some of you provide me with your “own” models of the economy. While these are often fun to read – they are almost always wrong (or, at least, incomplete). So, please try to answer the questions in terms of the models developed in class. Moreover, this is not a philosophy class. I am testing you on the models developed in class. If we have not talked about it in class, I am not going to test you on it. 2. TFP, population, government spending, taxes, transfers, consumer confidence, uncertainty, and business confidence are all held fixed, unless I specifically tell you otherwise. 3. The capital stock (K) is assumed to be constant through our entire analysis (aside from one question later in the exam - for that question I will tell you to assume that K can change). Throughout the rest of the exam, this does not mean that investment (I) is constant. People can invest today – we will just assume that today’s investment does not affect today’s capital stock (unless told otherwise). This assumption just makes our life easier. 4. All changes in TFP, taxes, government spending, etc. are assumed to be permanent and unexpected, unless I specifically tell you otherwise. (Often, I will tell you otherwise. This assumption is here in case I ever forget to tell you about the nature of the change in the variable, this will be the default situation. Again, this is just to reduce any potential exam ambiguity). 5. Unless told otherwise, all consumers in the class are PIH (non-Ricardian) who have the preferences developed in class (log utility, r = 0, β = 1). 6. We will assume, for now, that NX always equals zero. 7. Assume that changes in N have no effect on investment demand (for simplicity). 3 Part I: Consumption Tax (15 points - 3 points each) As government budgets continue to be stressed, the talk of moving to a national sales tax arises from time to time. In this problem, let’s discuss how an increase in consumption taxes will affect some of the curves/markets that we have discussed so far in class. When answering the questions, consider only the models we have built so far. For this problem, let's assume that the labor market will always clear. There are links that you want to put in place between various markets (i.e., aggregate supply and aggregate demand). You do not know those links yet. For now, just think about the models we have built so far and do not try to link aggregate supply (production) and aggregate demand (expenditure). Those links will not affect the answers to the questions below. When answering the questions, assume the change in the consumption tax was unexpected and permanent (and that all consumers are non-liquidity constrained PIH consumers). Finally, let’s assume that income effects on labor supply are large relative to the substitution effects on labor supply in the labor market (resulting from changes in after tax wages). Given the above information, circle the true answer for each of the question stems. explanation is needed. A. No The potential level of GDP (Y*) will: i. Unambiguously increase ii. Unambiguously decrease iii. Unambiguously stay the same iv. Could either increase, decrease, or stay the same B. The marginal utility of consumption (MUC) will: i. Unambiguously increase ii. Unambiguously decrease iii. Unambiguously stay the same iv. Could either increase, decrease, or stay the same 4 Part I: Consumption Tax (15 points - 3 points each) C. The marginal utility of leisure (MUL) will: i. Unambiguously increase ii. Unambiguously decrease iii. Unambiguously stay the same iv. Could either increase, decrease, or stay the same D. The Investment-Savings (IS) curve (on net) will i. Unambiguously increase ii. Unambiguously decrease iii. Unambiguously stay the same iv. Could either increase, decrease, or stay the same E. Labor income tax revenues will: i. Unambiguously increase ii. Unambiguously decrease iii. Unambiguously stay the same iv. Could either increase, decrease, or stay the same 5 Part II: Understanding our Macro Models (16 points total, 4 points each) For each of the questions below, choose the correct answer to the question stem (choose only one answer). When answering this question, all the assumptions on page 3 hold. In particular, when I am changing one exogenous variable I am assuming all other exogenous variables are held fixed (unless told otherwise). Note: We will grade this question on a 0/4 scale. If you pick the correct answer, you get four points. A. Which of the following are true about a permanent and unexpected increase in TFP (A) today? For this sub-question, assume that the substitution effect on labor supply dominates the income effect on labor supply. i. The long run aggregate supply (LRAS) curve will shift to the right today and the labor supply (NS) curve will shift to the left today. ii. The labor demand (ND) curve will shift to the right today and the labor supply (NS) curve will shift to the right today. iii. The long run aggregate supply (LRAS) curve will shift to the right today and the IS curve will shift to the right today. iv. Answers (i) and (iii) above are true. v. Answers (ii) and (iii) above are true. vi. Answers (i), (ii) and (iii) above are true. vii. None of the above answers are true. 6 Part II: Understanding our Macro Models (16 points total, 4 points each) (continued) B. Which of the following are true about a permanent and unexpected increase in government spending (G) today? For this sub-question, assume that the substitution effect on labor supply dominates the income effect on labor supply. i. The IS curve will shift to the right today and the long run aggregate supply (LRAS) curve will shift to the right today. ii. The IS curve will shift to the right today and the labor demand (ND) curve will shift to the right today. iii. The IS curve will shift to the right today and the labor supply (NS) curve will shift to the right today. iv. Answers (i) and (iii) above are true. v. Answers (ii) and (iii) above are true. vi. Answers (i), (ii) and (iii) above are true. vii. None of the above answers are true. C. Which of the following are true about a permanent and unexpected decline in labor income taxes today? For this sub-question, assume that the income effect on labor supply dominates the substitution effect on labor supply. i. The IS curve will shift to the right today and the long run aggregate (LRAS) supply curve will shift to the left today. ii. The IS curve will shift to the right today and the labor demand (ND) curve will not change today. iii. The IS curve will shift to the right today and the labor supply (NS) curve will shift to the left today. iv. Answers (i) and (iii) above are true. v. Answers (ii) and (iii) above are true. vi. Answers (i), (ii) and (iii) above are true. vii. None of the above answers are true. 7 Part II: Understanding our Macro Models (16 points total, 4 points each) (continued) D. Which of the following are true about a permanent and unexpected increase in labor income taxes starting tomorrow? For this sub-question, assume that the substitution effect on labor supply equals the income effect on labor supply. Also, assume that households many remaining periods of their life (LL is large). i. The IS curve will shift to the right today and the labor supply (NS) curve will shift to the left today. ii. The IS curve will shift to the right today but the labor supply (NS) curve will not change today. iii. The IS curve will not change today and the labor supply (NS) curve will not change today. iv. Answers (i) and (iii) above are true. v. Answers (ii) and (iii) above are true. vi. Answers (i), (ii) and (iii) above are true. vii. None of the above answers are true. 8 Part III: True/False/Uncertain: Explanation Determines the Grade (5 points each - 45 points total) Each of the parts below sets up a scenario (in italics) and ends with a statement. In this section, you are to discuss whether that final statement is True, False or Uncertain. As on the practice exams - explanation determines all of your grade! I will give no credit for writing true when the answer is true but your logic is wrong. Each of your answers should be at most 3-4 sentences. To receive full credit, you need to be explicit about the mechanism that is driving your results. Finally, if it is a two pronged question (where I asked you about two separate things like employment and wages), you need to address both parts to get full credit! Each question is worth 5 points each. Please write as clearly as you can – it makes it so much easier for us to follow your logic! If we cannot read your writing (or follow your logic), we will deduct points. A. Across many developing economies, the working age population often changes due to changing fertility rates. As economies grow rapidly, fertility rates usually start to decline. If income effects are large relative to substitution effects on labor supply, a permanent decline in the working age population will – on net – shift the labor supply (NS) curve to the left. B. Suppose TFP (A) increases permanently starting today. Assume further that real interest rates are permanently held fixed. In this question, we will let the capital stock (K) adjust optimally (if firms desire). Also, for simplicity, we will assume that income and substitution effects on labor supply cancel such that N is remained fixed through the problem. Given firm profit maximization (as described in class), a permanent increase in TFP (starting today) will result in an increased marginal product of capital (MPK) tomorrow. 9 Part II: True/False/Uncertain: Explanation Determines the Grade (continued) C. Consider the labor market developed in class. Assume income effects are small relative to substitution effects. Since 2000, the U.S. economy has experienced both large increases in TFP and declining marginal tax rates on income. Theoretically, our model of the labor market predicts that a permanent increase in TFP coupled with a permanent decline in labor income tax rates would unambiguously increase both the amount of workers in the economy (N) and the after tax wage. D. Economists and demographers have long predicted that there will be a sharp decline in the work force starting in 2013 as baby boomers start to retire. Such predictions have been widely publicized during the last decade. According to the standard PIH theory developed in class, we should see a sharp increase in consumption for those remaining in the work force between 2012 (prior to the baby boomers starting to retire) and 2014 (after they start retiring). E. Assume income effects are small relative to substitution effects. Consider the models developed in class. A permanent increase in TFP will reduce the equilibrium unemployment rate in the economy. 10 Part II: True/False/Uncertain: Explanation Determines the Grade (continued) For parts F and G, consider the following information. During the late 1990s and early 2000s, we saw large run ups in stock market wealth. For simplicity, let’s refer to the run up in stock market wealth as being a magnitude of X dollars. For simplicity, let’s assume that there is only one individual in the economy and that individual owns stocks. This individual is expected to live 25 more years (i.e., LL = 25). From the perspective of today’s individual, suppose the stock market unexpectedly increased by X today (measured in dollars). Lastly, assume that this representative individual in the economy is a non-liquidity constrained PIH consumer of the type modeled in class (has log utility, β=1, r = 0, etc.). F. Given the above information, if the individual believes that the unexpected increase in the stock market today of X was permanent (i.e., increase by X dollars today and remain constant at that new level forever), their annual consumption today (C) should increase by X/25 dollars. G. Given the above information, if the individual believes that the unexpected increase in the stock market today of X was temporary (i.e., increase by X dollars today and decrease by X dollars tomorrow such that the total change in the stock market value is zero over the next 30 years), their annual consumption today (C) should increase by X/25 dollars. 11 Part II: True/False/Uncertain: Explanation Determines the Grade (continued) H. Over the past few weeks, Kansas has made the news with respect to early outcomes of their "Economic Experiment". In 2010, Kansas cut labor income taxes dramatically across the board. The plan was for the tax cut to stimulate employment and "pay for itself" (raising more tax revenue). The net result was no change in employment growth (relative to neighboring states that didn't cut taxes) and massive deficits. In this question, we will consider how a large decline in labor income taxes will effect government budget deficits. Throughout the problem, assume all other exogenous variables are held fixed (i.e., A, G, Tr, etc.). According to the models developed in class, a large decline in labor income taxes will unambiguously reduce tax revenues if the income effects on labor supply are roughly the same magnitude as the substitution effects on labor supply. I. Some have argued that during recent years, there has been a large expansion of government transfers (Tr) to the household sector. Consider the models built in class. Suppose there was a large unexpected permanent increase in government transfers (Tr). Lastly, suppose nothing else changes with respect to government spending (G) or tax rates. Theoretically, our models predict that a large unexpected permanent increase in government transfers (Tr) will shift the IS curve to the right and the labor supply curve to the left. 12 Part IV: A Preview of Our Inequality Discussion (6 points total) In Topic 4, we are going to have a discussion of inequality. One common discussion in the inequality literature is that rich individuals own the capital and that the return to capital (real interest rates) have been high relative to the growth rate in wages. In this problem, we will consider the implications of an increase in real interest rates on share of income going to capital owners using the model we have developed (holding all else equal). In particular, we will assume our Cobb-Douglas production function holds such that: Y AK N 1 Assume that α is fixed over time. Additionally, we will assume that firms maximize profits and are price takers in the aggregate economy (as we did in class). For this question, I want you to discuss whether the following statement (in italics) is true, false, or uncertain given the model we developed in class. Use equations from class to prove your answer. The use of equations to prove your point will determine your entire grade. Question: Hint: According to the model developed in class, an increase in real interest rates will increase the share of income flowing to capital owners in the economy. Marginal product equations and some algebra will be needed. Make sure you define the share of income going to capital owners in your answer. Label all equations clearly! Also, circle whether you think the answer is true, false or uncertain (it will help us with grading) before launching into equations to defend your answer. The above statement is: True False Uncertain (circle one) 13 Part V: Income Taxes and Consumption (18 points total - 3 points each) During both the 2001 and 2008 recessions, tax policy was put front and center as a way to stimulate the economy. In this question, we will explore different policies to stimulate consumption using the models we have built in class. Formally, we will make the following assumptions: All individuals live three periods (t = 1, t = 2, and t = 3). All consumers have log utility over consumption with β = 1 and r = 0, such that: U (C1 , C2 , C3 ) ln(C1 ) ln(C2 ) ln(C3 ) There are no transfers implying disposable income is after tax income (Yd = (1-tn) Y) All individuals are liquidity constrained PIH. The liquidity constraint is defined such that wealth must always be non-negative (Wealtht ≥ 0 for all t). Baseline parameters. Initial wealth (Wealth0) = 90 and labor income tax (tn) = 0.2. Assume pre-tax income evolves over time such that all individuals have income: Y1 = 140, Y2 = 185, and Y3 = 185. (Don't forget to adjust for taxes!) Note: When answering the questions, you can report consumption in each period up to one significant digit after the decimal (if need) (i.e., XXX.X). A. Given the baseline assumptions, what is the consumption of individuals in this economy in period 1? Briefly show your work. Put your answer in the box (3 points). C1 = B. Suppose there is a housing market collapse such that initial wealth falls from W 0 = 90 to W0 = 18. Notice, the wealth decline occurs before people make their consumption decision in period 1. Further, assume households think the decline is permanent. Given this assumption, what is the new level of consumption for individuals in this economy in period 1? Briefly show your work. Put your answer in the box (3 points). C1 = 14 Part V: Income Taxes and Consumption (18 points) (continued) C. Suppose that wealth remains at its new level such that W0 = 18 (as in part B). Now suppose the government wants to stimulate the economy by unexpectedly cutting taxes permanently such that tn falls from 0.2 to 0.1 (i.e., tn = 0.1 for all periods). Given this, what is the new level of consumption for individuals in this economy in period 1? Briefly show your work. Put your answer in the box (3 points). C1 = D. Some politicians found it hard to pass a permanent tax cut. Instead they talked about passing a temporary tax cut. Suppose that wealth remains at its new level such that W0 = 18 (as in part B). Now suppose the government wants to stimulate the economy by unexpectedly cutting taxes temporarily such that tn falls from 0.2 to 0.1 only in period (i.e., tn = 0.1 in period 1). In all other periods, tn is expected to remain at 0.2 Given this, what is the new level of consumption for individuals in this economy in period 1? Briefly show your work. Put your answer in the box (3 points). C1 = E. Some politicians talked about "Mortgage Debt Relief" instead of tax cuts to stimulate the economy. In essence, this is equivalent to increasing household wealth. Suppose that policy makers could forgive debt such that initial wealth in the economy is now 69 (i.e., Wealth0 = 69). Notice, this increase in wealth of 51 is about the same cost as a permanent tax cut of 10% (as in part C). Supposing tax rates permanently remain at 0.2, what is the new level of consumption for individuals in this economy in period 1 when initial wealth is increased to 69? Briefly show your work. Put your answer in the box (3 points). C1 = 15 Part V: Income Taxes and Consumption (18 points) (continued) F. The permanent tax cut (Part C) cost roughly the same amount as the debt forgiveness policy (Part E). Both gave individuals an increase in lifetime resources of about 50. Why did the consumption response in period 1 differ so dramatically between the two policies? Provide the intuition for your answer! (3 points) ____________________________________________________ (No Need to Write Below This Line) 16 Scrap Paper 1 17 Scrap Paper 2 18 Scrap Paper 3 19 Scrap Paper 4 20