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Economics 215: Intermediate Macroeconomics
Mid-Term Exam
NAME ___________________
Tuesday, March 25 2003
Student ID # ___________________
Multiple Choice (5 points each)
1. Which of the following is not a valid measure of Gross Domestic Product?
a. The sum of household consumption expenditure, government consumption
expenditure, investment plus exports minus imports.
b. The sum of domestic value added of firms.
c. The sum of currency, checking accounts and savings accounts.
d. The sum of worker compensation, net interest payments, proprietor’s
income and corporate profits generated in the domestic economy.
e. Each of the measures is valid.
ANSWER: _____C___________
2. There occurs a rise in the real interest rate. Holding expected inflation and
expected growth in capital prices constant, this event will lead to a
a. A rise in discount bond prices, a fall in savings of borrowers, and a fall in
investment.
b. A rise in discount bond prices, a fall in savings by borrowers, and a rise in
investment.
c. A fall in discount bond prices, a fall in savings by borrowers, and a fall in
investment.
d. A fall in discount bond prices, an increase in savings by borrowers and an
increase in investment.
e. A fall in discount bond prices, an increase in savings by borrowers and a
fall in investment
ANSWER: _______E_________
3. Which of the following is an example of an indirect tax?
a. a social welfare payment to an impoverished senior citizen.
b. a tax on corporate profits.
c. a tax on salaries.
d. gambling revenues generated by the Jockey Club and paid to the
government.
e. a tax on the estate of deceased persons.
ANSWER: ________D________
4. A Caribbean island whose income is mostly based on agriculture is struck by a
harsh hurricane which destroys the year’s crops. If we believed that the islands
residents would like to smooth consumption across time, we would believe that
this temporary negative shock to income would lead to
a. An increase in consumption and an increase in savings on the island
b. An increase in consumption and a reduction in savings on the island.
c. A reduction in consumption and an increase in savings on the island.
d. A reduction in consumption and a reduction in savings on the island.
ANSWER: _________D_______
5. We can say which of the following about the manner in which the Hong Kong
economy has evolved since 1980?
a. Manufacturing as a share of GDP has been increasing and spending on
food as a share of household spending has been increasing.
b. Manufacturing as a share of GDP has been increasing and spending on
food as a share of household spending has been decreasing.
c. Manufacturing as a share of GDP has been decreasing and spending on
food as a share of household spending has been increasing.
d. Manufacturing as a share of GDP has been decreasing and spending on
food as a share of household spending has been decreasing.
ANSWER: __________D______
6. If the liquidity effect and the Fischer effect hold true, a monetary expansion is
likely to:
a. Increase short term interest rates and increase long-term bond prices.
b. Increase short term interest rates and reduce long-term bond prices.
c. Reduce short-term interest rates and increase long-term bond prices
d. Reduce short-term interest rates and reduce long-term bond prices.
ANSWER: __________D______
7. Nominal GDP in year 2000 was HK$1.288 Trillion; nominal GDP in 2001 was
HK$1.278 trillion. Real GDP in 2001 was HK$1.297 Trillion (measured in year
2000 dollars). If we measure nominal prices with the GDP deflator, we can say
that:
a. The inflation rate in year 2001 is positive and the ex post real interest rate
of year 2000 is greater than the nominal interest rate in year 2000.
b. The inflation rate is year 2001 is negative and the ex post real interest rate
of year 2000 is greater than the nominal interest rate in year 2000.
c. The inflation rate in year 2001 is positive and the ex post real interest rate
of year 2000 is less than the nominal interest rate in year 2000.
d. The inflation rate is year 2001 is negative and the ex post real interest rate
of year 2000 is less than the nominal interest rate in year 2000.
ANSWER: ______B__________
8.
An economist at a local commercial bank writes that “Due to higher future oil
prices, we expect to see faster inflation in goods prices in the future. Due to
slowing population growth, we expect to see sharper deflation in property prices
in the future.” If this analysis is true and expected inflation increases while
expected growth in property prices falls we should expect to see:
a. An increase in rental yields and an increase in velocity of money.
b. An increase in rental yields and a decrease in velocity of money.
c. A decrease in rental yields and an increase in the velocity of money.
d. A decrease in rental yields and a decrease in the velocity of money.
ANSWER: ___A_____________
Calculations (15 points each)
9. Real Annuity Value. A household lives for three periods, periods 0, 1, and 2. The
household begins with zero financial wealth and expects to earn a real income of
Y0 = 500, Y1 = 990, Y2 = 242. Assume a constant 10% real interest rate (e.g. r =
.1).
a. Calculate the present value of lifetime income.
Y
Y2
990 242
W  Y0  1 
 500 

 500  900  200  1600
2
1  r (1  r )
1.1 1.21
b. Calculate consumption of this household at time 0 if the permanent
income hypothesis is true.
1
1  1.1
1  ( 11r )
C
W
1600  0.3656 1600=584.894
3
1  1.11 3
1   11r 
Answer
1600
584.894
Present Value of Lifetime Income
Consumption
10. Optimal Capital and the Tax Wedge. Assume that we can describe the real
100
marginal product of capital with a simple mathematical function MPK 
.
K
The real interest rate is 1% (i.e. r = .01), the depreciation rate is 4% (i.e. δ = .04).
K
Assume that the relative price of capital is constant at 1 (i.e. ptk  Pt Pt  1 and
gtp1  0 ).
a. Calculate the optimal capital stock when there is a tax wedge of tw = 0,
.05, and .2.
2
MPK  100*  r    tw  g p  .05  tw  K *   .05100
 tw 
k
K
b. Assume that the real revenue generated by the tax wedge is
Revenue = tw ∙K*
Calculate the revenue under each tax wedge. Why doesn’t the largest tax
wedge generate the most tax revenue?
Tw
0
.05
.2
Answers
K*
Revenue
K     2, 000  4, 000, 000 0
2
2
50,000
K *   100
.1   1, 000  1, 000, 000
*
100 2
.05
2
2
K *   100
.25   400  160, 000
2
32,000
Short-Answer (15 points each)
11. Rental Yield. In 2002, the Hong Kong government acted to reduce the difficulties
faced by landlords in evicting delinquent tenants from their property. Think of
this as a reduction in the “other” costs of owning real estate, c∙PRE.
a. Show graphically, how this change will affect the price of real estate.
c↓
Value
R
i    c  tw  gtP1
RE
PRE*
PRE**
PRE
b. Use the available space to finish, in a few sentences, whichever of the
following statements you feel is correct.
The price of real estate is a multiple of the rental price. A decrease in the costs of owning
real estate will increase this multiple because the reduction in costs would reduce the
cost of capital and increase the net return to owning real estate at the current price level.
If the return to owning real estate is above the cost of capital, investors will purchase
more real estate. With a fixed stock of real estate, this will bid up the price.
The price of real estate is a multiple of the rental price. A decrease in the costs of owning
real estate will reduce this multiple because
12. In 1999, the Hang Seng Index which is a weighted average of the stock prices of
local corporations was above 16,000. Now, stock prices have fallen below 10,000.
a. Describe how, according to the Permanent Income Hypothesis, this would
affect consumption in Hong Kong.
A decrease in the prices of stocks will decrease value of the wealth held by Hong Kong
households. Under the permanent income theory, consumption in every period is smooth,
so households consume the annuity value of household wealth. Thus, a decrease in
wealth will decrease consumption (i.e. “the wealth effect”). Because households smooth
consumption over a long life, the effect of any dollar decrease in wealth on consumption
will be small. However, a 40% decline in stock market wealth (such as observed in Hong
Kong) may have a large effect.
b. Describe how, according to the q theory how this would affect investment
in Hong Kong.
A decline in the price of stocks will reduce the financial value of firms, which is the sum
of the market capitalization plus the value of debt. Under the q theory, firms will reduce
investment if their financial value is smaller than the price of their capital because this
would imply that firms are taking a certain amount of capital and generating a smaller
level of economic value. If stock prices fall, then some firms will be likely to be pushed
into this situation and they will reduce investment. Another way of looking at the stock
market fall is that it will increase the cost of financing investment by selling stocks. Thus,
firms will cut on investment financed through this channel.