Download ECON 10020/20020 Principles of Macroeconomics

ECON 10020/20020
Principles of Macroeconomics
Exam I
Solutions
Dennis C. Plott
University of Notre Dame
Department of Economics
Spring 2015
ECON 10020/20020 – Principles of Macroeconomics
Exam I – Spring 2015 – Solutions
Name (print neatly and clearly): Dennis C. Plott
General Instructions
1. Read and follow all instructions/directions carefully.
2. Make sure your exam consists of 11 pages, not including the cover page.
3. An inability to follow instructions/directions will result in points being deducted.
4. The only device allowed is a simple calculator; i.e., anything that can store or retrieve information
(including a graphing calculator) is NOT allowed.
5. Use of books, notes, another person, and/or aid of any kind is absolutely NOT allowed.
6. Answer all questions in blue or black ink only; i.e., no pencils or colored inks. The only exception: graphs
may be drawn in pencil. Note: use a guide of some sort (e.g., a ruler) for all graphs.
7. Do not use white out or similar products, but neatly cross/scratch out anything you do not want graded.
8. Write, mark, and draw your answers neatly and clearly. If your answer is illegible (i.e., difficult to read
in the least), then it will not be graded. It is your job to clearly communicate.
9. Label all graphs fully and completely; i.e., axes, intersections, curves, etc.
10. Support your answers as thoroughly as possible; i.e., graphically, conceptually, and mathematically. Note:
this may not be feasible for all questions asked. State and define any concept utilized and list and name
any equation used. In other words, show all of your work.
11. For the True/False/Uncertain questions clearly indicate your choice by writing either “True”, “False”, or
“Uncertain” underneath the respective question.
12. Unless explicitly instructed otherwise, all questions require a justification to receive credit.
13. Do not use white out or similar products, but neatly cross/scratch out anything you do not want graded.
14. Assume the nominal wage is fixed in the short-run, all markets begin in long-run equilibrium, and capital
stock is fixed in both the short-run and long-run except for negative shocks. For changes in the variables
of interest, reference the initial level, unless instructed otherwise, in both the short-run and long-run.
Amount in today’s dollars = Amount in year T dollars ×
Price level today
Price level in year T
Original Score (%)
Adjustment (%)
Actual Score (%)
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ECON 10020/20020 – Principles of Macroeconomics
Exam I – Spring 2015 – Solutions
1. Currently, ten U.S. states have “bottle bills”; i.e., container deposit laws. Many of those states are also
campaigning for updates and expansions, and still others have active campaigns for new bottle bills. For
example, Michigan bottling law requires that people get a refund of ten cents when they return an empty
bottle or can. Recently, Michigan state senator Rebekah Warren has introduced legislation to expand the
Michigan Beverage Containers Initiated Law of 1976, thereby opening up debate about what direction
the potentially new legislation should take.
(a) [4 points] Why does Michigan and similar states pay people to return bottles? How is this achieved?
[Note: As always, explain using positive economic reasoning. Hint: use general economic principles/concepts to explain.]
• Why?
– Policy makers know that people making choices respond to incentives. Instead of throwing
away bottles and cans, people will now bring the used bottles and cans to the designated
areas for recycling in order to receive their payment.
• How?
– Policy makers have increased the marginal benefit of returning bottles in order to reduce
litter and clean the environment.
– Alternatively, policy makers have have increased the opportunity cost of not recycling. People will substitute away from throwing bottles and cans away and instead turn in the used
bottles and cans to recycling centers.
(b) [4 points] Some groups are pushing for a change in Michigan state law to make recycling mandatory
instead of voluntary using slogans such as “if it’s recyclable, it should be recycled!” Is this statement
in quotes positive or negative. Explain.
• Normative.
• Normative statements are matters of opinion or statements of value. They cannot be tested or
proven.
• The “should” indicates a normative statement or value judgment.
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ECON 10020/20020 – Principles of Macroeconomics
Exam I – Spring 2015 – Solutions
(c) [4 points] One commentator, arguing for the repeal of the law, stated “. . . they [Michigan] should
either lower the bottle return or remove it all together; people would have recycled even without
the ten cents . . . ”. Is there a potential economic (logical) fallacy in this statement? If so, identify
the economic fallacy and briefly explain why the commentator’s statement can be classified as the
logical fallacy you identified.
• The person making the statement seems to imply they know what would happen although not
observed or even observable.
• Counterfactual: expressing what has not happened but could, would, or might under differing
conditions.
• It is possible that the recycling rate would have been the same without the cash incentive.
However, it may have also been (significantly) lower. The problem is: policy makers cannot
view the same world with and without the policy; i.e., the statement is counterfactual and the
commentator pretends to know what the counterfactual world would be like.
(d) [4 points] Another commentator, wanting the law to be expanded, stated “[w]hy not also add
into the legislation a change to the [bottle and can] return from ten cents to twenty-five cents or
fifty cents? Michigan’s ten cent return is, to my knowledge, the highest general return in North
America. However, ten cents doesn’t quite have the power that it did almost four decades ago.”
What general economics concept, given Michigan has a redemption rate of approximately 95.9%, the
highest recycling rate in the nation, is the commentator (potentially) neglecting?
• (The law of) diminishing (marginal) returns.
• Diminishing returns means that a sustainability program (e.g., recycling) trying to decrease
a state’s harmful impact on the environment (e.g., by increasing recycling) can be successful
early on, but at some point it will require higher and higher expenditures to obtain the same
reductions and eventually it will “hit the wall”.
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ECON 10020/20020 – Principles of Macroeconomics
Exam I – Spring 2015 – Solutions
2. [8 points] An article in the USA Today 1 examines the wealthiest presidents from Washington to Obama.
The nominal salary paid to the president of the United States along with data for the consumer price
index (CPI) are given for various years below.
Year
President
Nominal
Presidential Salary
CPI
(1982–1984 = 100)
Real
Presidential Salary
1949
1969
2001
2011
Truman
Nixon
Bush
Obama
$100,000
$200,000
$400,000
$400,000
23.8
36.7
177.1
224.9
$420,168
$544,959
$225,861
$177,857
Calculate the president’s real salary measured in in 1982–1984 dollars. Which president, from the list, is
the wealthiest in terms of real salary?
Real Presidential Salary in year t = Nominal Presidential Salary in period t
Real Presidential Salary in 1949 = Nominal Presidential Salary in 1949
100
Real Presidential Salary in 1949 = $100, 000
23.8
CPI1982−1984
CPIperiod t
CPI1982−1984
CPI1949
Real Presidential Salary in 1949 = $420, 168
Real Presidential Salary in 1969 = $544, 959
Real Presidential Salary in 2001 = $225, 861
Real Presidential Salary in 2011 = $177, 857
Nixon has the highest real presidential salary.
3. [8 points] Fill in the missing values in the table of data collected by the Bureau of Labor Statistics’
(BLS) Consumer Population Survey (CPS) (i.e., household survey) for December 1996. The working-age
population, employment, unemployment, and labor force are measured in thousands. Show your work.
Working-Age Population
Employment
Unemployment
Unemployment Rate
Labor Force
Labor Force Participation Rate
201,661
127,817
7,296
5.4%
135,113
67.0%
Unemployment
× 100%
Labor Force
Unemployment
=
= 0.054 =⇒ Unemployment = 7, 296
135, 113
Unemployment Rate =
Labor Force = Unemployment + Employment
135, 113 = 7, 296 + Employment =⇒ Employment = 127, 817
Labor Force
× 100%
Working-Age Population
135, 113
67.0% =
× 100%
Working-Age Population
=⇒ Working-Age Population = 201, 661
Labor Force Participation Rate =
1 USA
Today “Report: The 10 Richest U.S. Presidents” by Ashley C. Allen 17 February 2014
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ECON 10020/20020 – Principles of Macroeconomics
Exam I – Spring 2015 – Solutions
4. A story in The New York Times discussing unemployment interviewed John, an autoworker from Michigan, after being let go from his last place of employment due to the most recent downturn in the economy.
John has not been able to find work in over twenty-four months even though he has diligently applied to
many open positions where his qualifications matched.
(a) [6 points] What type of unemployment is John classified under? Define it.
Cyclical Unemployment: The higher than normal unemployment at a business cycle trough and the
lower than normal unemployment at a business cycle peak.
(b) [6 points] If John and similar people like him find jobs, what will happen to full-employment?
• Nothing will happen to the natural rate of unemployment (full-employment).
• Full-employment: A situation in which the unemployment rate equals the natural unemployment
rate. At full employment, there is no cyclical unemployment – all unemployment is frictional
and structural.
5. The United Nations publishes an assessment of past, current and future population trends every two
years, in a recurrent series known as the World Population Prospects. According to the report, large
developing countries, such as India, have seen a rapid fall in the average number of children per woman.
According to the Census of 2001–2011, India’s population has grown at 17.7 per cent as against 21.5 per
cent in the decade.
(a) [4 points] What is India’s change in population growth in terms of percentage points? Show your
work.
• 17.7% − 21.5% = −3.8 percentage points
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ECON 10020/20020 – Principles of Macroeconomics
Exam I – Spring 2015 – Solutions
(b) [4 points] What does “ceteris paribus” mean? Why do economists use it?
• Ceteris paribus (“all else equal”): A device used to analyze the relationship between two variables
while the values of other variables are held unchanged.
(c) [8 points] Use the Solow growth model to show graphically, ceteris paribus, what effects, if any, the
change in the population growth rate would have on the: (i) capital to labor equilibrium and (ii)
output per capita equilibrium in the very long-run. State explicitly what happens to each of the
variables of interest; i.e., increase, decrease, unchanged, or ambiguous. No explanation is necessary
for full credit.
y
(n1 + d)kt
(n2 + d)kt
yt = Af (kt )
y2∗
y1∗
sAf (kt ) = sAyt
k1∗
k2∗
k
• ∆k ∗ > 0
• ∆y ∗ > 0
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ECON 10020/20020 – Principles of Macroeconomics
Exam I – Spring 2015 – Solutions
(d) [6 points] India’s change in its population growth rate is also being seen worldwide.
What would the Malthusian and Kremerian theories say about this? Explain ensuring to differentiate
the two theories.
• The Malthusian (1798) model predicts population growth will outstrip the Earth’s ability to
produce food, leading to the impoverishment of humanity.
• The Kremerian (1993) model posits that population growth contributes to economic growth.
More people equals more geniuses, scientists & engineers, so faster technological progress.
• Those abiding by Malthus’ weltanschauung 2 would view this as a good thing whereas people
with Kremer’s view would feel this is likely to hurt the world.
6. [6 points] An article in the Financial Times 3 discusses the United Kingdom joining Estonia, Austria,
Slovenia, Finland, Sweden and Norway in adding prostitution and illegal drugs to its GDP. True or False:
Due to the nature of these particular activities, the United Kingdom’s GDP will be negatively affected
by this change in national accounts.
• False.
• Gross domestic product (GDP): the market value of all final goods and services produced in a country
during a period of time, typically one year or quarter.
• There are shortcomings of GDP as a measure of total production. One important type of production
omitted from many countries measurement of GDP involves the underground economy.
– Buying and selling of goods and services might be concealed from the government to avoid taxes
or regulations, or because the goods and services are illegal; e.g., illegal drugs and prostitution.
This constitutes the underground economy.
• The Office of National Statistics (ONS) [the United Kingdom’s version of the Bureau of Economic
Analysis (BEA)] estimates that “[p]rostitutes and drug dealers are set to give Britain a £10bn boost
as the country revamps the way it measures its economy”.
2 “world
view”
Times “Drugs and Prostitution Add £10bn to UK Economy” by Sarah O’Connor 29 May 2014
3 Financial
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ECON 10020/20020 – Principles of Macroeconomics
Exam I – Spring 2015 – Solutions
7. [6 points] An article in The Economist 4 discusses the United States during the late 1970s where inflation
unexpectedly increased and how both borrowers and lenders were affected.
Suppose a homeowner (borrower) obtained a fixed rate mortgage (i.e., a loan) prior to inflation unexpectedly increasing. True or False: (Based solely on this information.) It is better to be a borrower compared
to a lender of money if actual inflation turns out to be more than the inflation rate that was expected at
the time the mortgage was signed. Explain.
• It is better to be a borrower if actual inflation is more than the inflation rate that was expected at
the time the loan was made.
• The Fisher equation; ex ante and ex post versions, respectively:
i = re + πe
i=r+π
• The nominal rate of interest lenders charge has two parts: the lender’s real or required rate of return,
and an estimate of the expected inflation rate. The reason for adding expected inflation is to ensure
that in the future, when lenders receive repayment of their required rate of return, it has not lost
purchasing power due to inflation. If it turns out that actual inflation was more than what was
expected, total interest paid to the lender will be less than what was needed to prevent the loss of
purchasing power (i.e., the lender should have charged a higher rate of interest; this benefits the
borrower). As a result, a lender would lose purchasing power at the borrower’s expense – or the
borrower would be repaying the loan with funds that were worth less in terms of purchasing power.
4 The
Economist “The Volcker Recession: Who Beat Inflation?” 31st March 2010
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ECON 10020/20020 – Principles of Macroeconomics
Exam I – Spring 2015 – Solutions
8. An article in the Financial Times 5 discusses a “slump in the Chinese real estate [housing] market” where
“property and related sectors account for nearly a quarter of China’s economy”. Housing prices are a
major source of wealth for households.
China is highly dependent on its real estate sector, which comprises 16 percent of the country’s GDP
growth. And as Chinese exports have grown less competitive in recent years, the economy has relied on
fixed asset investment to maintain high GDP growth levels. The process works like this: Chinese state
banks provide local governments with more credit, which the governments lend to property developers,
whose tall, modern housing complexes dot China’s urban landscape. China’s citizens, fearful of investing
in the country’s volatile stock markets, pump their savings into real estate, with the wealthy snapping up
multiple apartments in a speculative frenzy.
(a) [10 points] Demonstrate the change in wealth using the closed loanable funds (goods) market,
ceteris paribus, in the long-run. Clearly explain the economic rationale for why the curve(s) shift,
if at all. State explicitly what occurs to the (i) real interest rate, (ii) quantity of savings, and (iii)
quantity of investment; i.e., increase, decrease, unchanged, or ambiguous.
r
S0d (C0 )
r0
S1d (C1 )
a
b
r1
Id
S0 = I0
S, I
S1 = I1
ceteris paribus
• housing prices decrease (given) −→ ↓ wealth −−−−−−−−−−→ ↓ C −→ saving curve (S d ) shifts
rightward
ceteris paribus
– S = Y − C − G; ↓ C −−−−−−−−−−→↑ S for every level of the real interest rate r
=⇒ ∆S > 0
=⇒ ∆r < 0; increasing the quantity of loanable funds decreases the “price” of loanable
funds: the real interest rate
ceteris paribus
– ↓ r −−−−−−−−−−→↑ I; as the real interest rate decreases the opportunity cost of borrowing
funds is lowered. Firms will borrow more, thereby increasing the quantity of investment
=⇒ ∆I > 0
5 Financial
Times “Chinese Cities See Property Prices Fall” by Jamil Anderlini 18 January 2015
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ECON 10020/20020 – Principles of Macroeconomics
Exam I – Spring 2015 – Solutions
(b) [12 points] Demonstrate the change in wealth using the closed AD − SRAS − LRAS graph, ceteris
paribus, in both the short-run and long-run. Clearly explain the economic rationale for why the
curve(s) shift, if at all. State explicitly what occurs to the (i) price level, (ii) natural rate of output,
(iii) output, (iv) and nominal wage; i.e., increase, decrease, unchanged, or ambiguous.
P
LRAS
AS0 (W0 )
AS1 (W1 )
a
P0
P1
b
z
P2
AD0 (C0 )
AD1 (C1 )
Y1
Y
Y 0 = Y0 = Y2
ceteris paribus
• housing prices decrease (given) −→ ↓ wealth −−−−−−−−−−→ ↓ C −→ AD curve shifts leftward
– Short-Run (a − b)
∆P < 0 (P1 < P0 )
∆Y < 0 (Y < Y )
∆Y = 0
∆W = 0
– Long-Run (b − z)
Nominal wages become flexible in the long-run. In the short-run, due to the decline in
consumption, Y < Y ; i.e., recessionary pressure. When contracts are renegotiated or new
workers hired, workers will receive a lower nominal wage (↓ W ). ↓ W −→ lowers input prices
for firms allowing for increased production. The SRAS will subsequently shift rightward
until the economy returns to long-run equilibrium (Y = Y ).
∆P < 0 (P1 < P0 )
∆Y = 0 (Y = Y )
∆Y = 0
∆W < 0
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ECON 10020/20020 – Principles of Macroeconomics
Exam I – Spring 2015 – Solutions
Bonus Questions
1. [1 points] What is “the answer to the great question . . . of life, the Universe and everything”? [For
reference, see the cover page picture.]
• 42
• Hitchhiker’s Guide to the Galaxy LINK
• “In many of the more relaxed civilizations on the Outer Eastern Rim of the Galaxy, the Hitchhiker’s
Guide has already supplanted the great Encyclopaedia Galactica as the standard repository of all
knowledge and wisdom, for though it has many omissions and contains much that is apocryphal, or
at least wildly inaccurate, it scores over the older, more pedestrian work in two important respects.
First, it is slightly cheaper; and secondly it has the words DON’T PANIC inscribed in large
friendly letters on its cover.”
2. [1 points] What is your instructor’s name for ECON 10020/20020 in Spring 2015? [Spelling counts.]
Dennis Plott
3. [1 points] What country experienced the greatest rate of monthly inflation ever recorded?
Hungary
4. [1 points] What did John Maynard Keynes call fluctuations in contagious swings of optimism and
pessimism among the public? What about former Federal Reserve chairman Alan Greenspan?
“animal spirits”; “irrational exuberance”
5. [1 points] What is the German word for “capital”? [Spelling counts.]
Kapital
6. [1 points] What organization is responsible for dating the business cycle in the United States?
National Bureau of Economic Research (NBER)
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