Download QUIZ 1: Macro – Winter 2005

QUIZ 1: Macro – Winter 2010 (Out of 20)
Name:
____________________________
Section Registered: Campus Evening
Question 1 (10 points total, 5 points each)
Put answers in the space provided. Calculators are allowed. Answers will be graded on a
5/3/0 scale. Perfect answers will be given 5 out of 5; answers with an intuitive attempt at the
correct procedure but a wrong answer will be given 3; answers with an incorrect procedure (even
if the answer is correct) will be given a 0 or 1. You must show your work to get full credit!!!!
In this problem, my goal is to show you why we care about the measurement of price indices and
how they affect policy decisions. In 2004, George Bush made a proposal to increase the solvency
of the Social Security Trust Fund by changing the index to which social security earnings are
indexed. We will analyze a simple version of this policy in this question.
Setup: Consider the following simplified economy. Workers work in periods 0, 1 and 2 of their
lives (i.e., they work for 3 years). They are retired in period 3. The government has a social
security program for retired workers. The social security rule is to make a payment to each
worker in period 3 equaling 45% of their average "real" lifetime wages. Average "real" lifetime
wages are computed by taking a simple average of "real" wages from periods 0, 1 and 2. All
"real" values are reported in terms of period 3 prices.
Price Indices: There are currently two prices indices in the economy: a wage price index (WPI)
and a consumer price index (CPI). Between period 0 and period 3, the WPI increased at 6% per
period (i.e., 6% between period 0 and period 1, another 6% between periods 1 and 2, etc.).
Comparatively, the CPI grew at 3% per period between periods 0 and 3. The two facts imply real
wages were growing over this period – a result our model will predict.
Income: Suppose the average worker in the economy earned $100,000 in nominal wages in
period 0, $110,000 in nominal wages in period 1 and $120,000 in nominal wages in period 2
(workers earn no wages when they are retired).
a.
If the government used the WPI to convert nominal variables to real variables, what
would be the social security payment made to the average worker in period 3? (5 points). Hint –
The key is to compute average “real” wages for periods 0, 1 and 2 using the WPI as the relevant
price index. Again, convert all wages into period 3 wages.
This problem was fairly straight forward.
Period 0 wage:
Period 1 wage:
Period 2 wage:
100,000 * (1.06)3 = $119,101.60
110,000 * (1.06)2 = $123,596.00
120,000 * (1.06) = $127,200.00
Avg real wage (in period 4 dollars) = $123,299.20
Social Security = 0.45* Avg Real wage = $55,484.64
$55,484.64
Question 1 (continued)
b.
If the government used the CPI to convert nominal variables to real variables, what
would be the social security payment made to the average worker in period 3? (5 points). Hint –
The key is to compute average “real” wages for periods 0, 1, and 2 using the CPI as the relevant
price index. Again, convert all wages into period 3 wages.
Real wage (in period 3 dollars)
Period 0 wage:
Period 1 wage:
Period 2 wage:
100,000 * (1.03)3 = $109,272.7
110,000 * (1.03)2 = $116,699.0
120,000 * (1.03) = $123,600.0
Avg real wage (in period 4 dollars) = $116,523.90
Social Security = 0.45* Avg Real wage = $52,435.76
$52,435.76
Put answer here!!!
Note: This question was based on a real life policy proposal. The Bush Administration
in mid 2004 proposed changing the index to which social security benefits are indexed.
Currently, during working years, wages are inflated using a wage index. The Bush
administration proposed changing the index to the CPI. Because real wages tend to
grow over time (we will do this in topic 2), the growth in wages tend to outpace the
growth in prices. This was one way to reduce social security payments (index to the CPI
instead of a wage index). The proposal was quickly withdrawn because interest groups
started saying that the Bush administration was going to slash benefits of the elderly.
The administration was going to slash benefits – they were doing it by changing the
index. This is one reason (out of many) why we care about price indices. In this
example, simply changing the index would have reduced benefits by 5% (or so).
Question 2 (6 points total – 2 points each)
For the following question, circle all the true answers to the question stem. Note: There may be
more than one true answer or none of the answers may be true. No explanation is needed.
Given what we learned in class over the last week, which of the following statements are true
about the macroeconomy?
a.
By definition, aggregate income will equal aggregate expenditure plus household saving.
False – by definition: Y = Aggregate income = Aggregate Expenditure (Income
equals expenditures). That is one of the main definitions of our class.
Disposable income equals consumption plus household saving. Notice,
consumption is NOT aggregate expenditure – consumption is only one
component of aggregate spending. See the lecture notes for full details.
b.
Declines in aggregate supply can explain periods of high inflation and low output within
an economy.
True – Declines in aggregate supply will cause prices (inflation) to rise and output to
fall. This is just like the market for apples. A decline in supply will restrict
quantities (lower GDP) and raise prices (result in inflation). See the
discussion in the lecture notes for full details.
c.
By definition, in equilibrium, national savings is equal to investment plus net exports.
True – see notes for details (S = I + NX)
Question 3 (4 points total)
In the Economist article entitled “Square Root Reversal” (11/21/2009), the article discussed how
the 2010 recovery will depend on two forces. First, deep recessions (which we had) are usually
followed by strong recoveries. Second, financial crises (which we had) are usually followed by
weak recoveries. Instead of “u”, “v” or “w” recoveries, the article discussed a “reverse square
root” recovery. The article then defines a reverse square root recovery (that was the whole point
of the article).
According to the article, what is a reverse square root recovery? Your answer should be only
one phrase or one sentence and should be no more than 10-14 words. (Note: the exact answer
from the article – were they define the term - can be expressed in 10 words).
A square root recovery (according to the article) is a rapid increase in GDP out of
the recession followed by a period of stagnant (below normal) growth.
See article for a full discussion.