First
Examination
September 25, 1998
First Part (15 point questions)
For each of the
following statements, indicate whether they are TRUE or FALSE and
explain why.
1.
All
this talk about real interest rates is nonsense. If a bank promises me 5% on my
deposit, that is what I really earn, and nothing else matters.
This
statement is false. You will earn 5% in nominal terms, but what really
matters is what you earn in purchasing power terms, or real terms. That is,
what really matters to you is the real rate, the nominal rate less the
inflation rate.
2 There are times when GDP declines for a
year or so. The most prominent example is 1929-1933, the Great Depression.
Perhaps there is nothing the government can do about these declines, but it
is vital that it keeps national income up during these declines. (Respond
to the italicized part).
This
statement is false. How can it be vital to do what is impossible?
Remember that national income equals national product. If GDP declines, then
national income must also decline.
3 The aggregate demand curve is a
downward sloping function of the price level because people are unhappy and
spend less when prices rise.
This
statement is false. People may or not be unhappy, but we know from the equation
of exchange that since MV = PY, higher prices must mean lower values of Y.
4.
The
short run labor supply curve is upward sloping because workers don't expect
periods of high wages or low wages to last long.
This
statement is true. If people really expected high wages to last for a long
time, we would get a different response. We would expect then to be in the
backward bending portion of the labor supply curve.
Second Part (20 Point Questions)
1. The Monty Python Book of international
economic data report the following data on Wurstphalia for 1997.
|
Item |
Amount |
|
Bushels of Corn Raised |
50,000 |
|
Price of Corn |
$5 per bushel |
|
Number of hogs raised |
10,000 |
|
Price of Hogs |
$30 |
|
Corn consumed by each hog |
3 bushels |
No other
goods and services were produced in Wurstphalia
(a) What was
Wurstphalia's GDP? Explain your answer.
Since the
hogs ate 30,000 bushels of corn, only 20,000 bushels count in GDP as a final
product. GDP is thus 5(20,000) +30(10,000) = $400,000.
(b) Monty
Python also reports the following data for 1996.
|
Item |
Amount |
|
Bushels of Corn Raised |
40,000 |
|
Price of Corn |
$4 per bushel |
|
Number of hogs raised |
9,000 |
|
Price of Hogs |
$25 |
|
Corn consumed by each hog |
3 bushels |
How much did
the price level increase from 1996 to 1997? Explain your answer.
1996 GDP
is $25(9,000) + $4(13,000) = $277,000. If we reevaluate 1996 GDP using 1997
prices, we get $30(9,000) + $5(13,000) = $335,000. Thus prices rose by
$335,000/$277,000 -1 = 1.209 -1 or 20.9%. We accept rounding off.
(a)
What is his wealth? Explain your answer.
Wealth
is $20,000 + $60,000 + $80,000/(1+1) = 120,000, the value of current assets and
income plus the present value of future income.
(b)
John was offered another job that paid $40,000 now, but $110,000 later. Explain
why John was right to turn it down.
That
job would have a present value of $40,000 + $110,000/(1+1) = $95,000, less than
the present value of his current job of $100,000
(c)
John is now told that his beloved Aunt Sally has left him $30,000 in her will,
but he will not get the money until next period. On the same day, John is told
that due to unfortunate business conditions (and the fact he alienated the
firm's biggest customer) he will not get his bonus this year. Taking these two
pieces of news into account, will John's consumption go up or down? And will
his saving go up or down?
Two
factors change his wealth. First, his income this period declines by $10,000,
reducing wealth by $10,000. Second, his wealth has increased by the present
value of $30,000 next year, which is $15,000. Thus his wealth increases by
$5,000. That means higher consumption this year. With consumption up and income
down, saving is surely going down.