First Examination
March 1, 2001

 

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First Part (10 point questions)

1                  Explain whether you agree or disagree with this statement: If Y = C + I + G + (X-M), then S = I + (G-T) + (X-M).

2                  In 1960, GDP was approximately $500 billion.  Today, it is approximately $9.5 trillion.  Yet, when we adjust for inflation, we find GDP is only about $2.0 trillion in 1960 prices.  Thus the inflation since 1960 is costing us about $7.5 trillion a year in output.  Explain whether you agree or disagree with the last statement.

3                  Last year Farmer Jones produced $500 worth of Cheese and $500 worth of flour, solely by the dint of his own labor.  He purchased no inputs from anyone else.  He sold half of the Cheese and all of the flour to Miller’s Pizzeria; the other half of the Cheese was sold directly to consumers at a roadside stand.  Miller’s Pizzeria turned the Cheese and Flour into pizzas (miraculously, no tomato sauce, oregano, or other ingredients were used: you should be thankful for this simplifies the question).  The owner paid his workers $1200 and took home a tidy profit for himself of $600.  What was GDP?

4.                Explain whether you agree or disagree with the following: A key reason for the economic success of the United States over the years is its laws and political institutions.  All a backward nation has to do to grow then is simply to adopt our Constitution and our laws.

5.                Explain whether you agree or disagree with the following statement:  If we could drive the unemployment rate to zero, we would make this a better country.

Second Part (25 Point Questions)

1.              The Republic of France is in the process of mandating the 35-hour workweek. If people are now working 40 hours a week and the mandatory 35-hour week becomes standard, what will be the economic consequences?  Trace it through our basic model.  Show the immediate consequences on wage rates, GDP, employment (man hours), interest rates, investment, and the price level.

2.              West Muddle (WM) is a relatively poor country.  The currency is the À, currently trading at 1 À= $1.  The country has a tax rate of 60 percent on incomes above 200,000À.  (Incomes below that rate are exempt from the income tax.).  Surprisingly, the income tax law is actually enforced; people pay their taxes.

 

A new reform party is campaigning on a platform of cutting the tax rate to 20%.  The reform party, running its campaign on a shoestring, has promised that the effect will be to stimulate economic growth and bring about a rise in per capita GDP.  They have invited Professor Axelrod Trump, a distinguished American economist to address political rallies in WM.  Axelrod has been making the argument that the tax bill is a barrier to economic growth in WM.   Axelrod also claims that lower tax rates can mean even higher tax revenues.

 

The incumbents have dismissed these claims, saying that the effect will be a huge increase in the size of the deficit, and thus higher interest rates.  They also argue that the tax measure means a more even distribution of incomes and point to some recent American studies indicating that equal distribution of incomes leads to rapid economic growth.

 

Who is right?  Particularly, address yourself to two questions: 

·        Will a cut in tax rates retard or foster economic growth?  (Hint: economists are comfortable with arguments along the line of “on the one hand this; on the other hand that”).

·        The argument that the government deficit will soar is obvious:  if the government keeps spending constant while slashing tax revenues, it will have to borrow.  Could the reform party be right?  Specifically, under what conditions would they be right?