Download Practice Midterm 1 - The University of Chicago Booth School of

Erik’s First Midterm
Macroeconomics
Fall 2014
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TEST GRADE BREAKDOWN
Part I: (Consumption Tax: 15 points total)
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Part II: (Understanding Macro Models: 16 points)
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Part III: (True/False/Uncertain: 45 points)
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Part IV: (A Preview of Inequality: 6 points)
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Part V: (Income Taxes and Consumption: 18 points)
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Total (out of 100)
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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
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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.
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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.
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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)
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(No Need to Write Below This Line)
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