Second Examination
October 23, 1998

First Part (10 point questions)

1. If the inflation rate drops, interest rates will drop and senior citizens will suffer because they will get lower returns on their savings. Explain whether you agree or disagree with this statement.

Disagree. While people will get lower returns on their savings, the returns were compensation for the loss in purchasing power. So, while they will get lower returns, they will lose less in purchasing power from inflation. The net effect will be a wash item.

2 The Federal Reserve was created to be a lender of last resort, and thereby prevent bank panics. Explain how a lender of last resort prevents bank panics.

A lender of last resort prevents bank panics by willing to lend when no one else will or can. If we all tried to withdraw our money from our banks at the same time, then there would be a panic, for the banks don't have enough money to pay us all off. But the Federal Reserve, with its power to create new money could lend banks enough to pay us all off and thus stop the panic.

3. Helen Jones has the following assets:

1. $5,000 in Cash
2. $10,000 in a checking account at the 87^th National Bank
3. $20,000 of General Motors Stock
4. $7,500 in a certificate of deposit at the Fifth-Third National Bank.
5. A collection of antique china, just appraised for $12,400.

How much money does she have? Two hints. In preparing your answer, be sure to consider the three characteristics of money. Second, this is a question you might want to give two answers to. If you do, be prepared to defend your answers.

Money must be a medium of exchange, a unit of account and a storer of value. All of these are storers of values, but the china and the stocks are not mediums of exchange. The first two items clearly are, and thus are counted in M1. The CD is more questionable, but it is counted in M2. Thus M1 for Helen = $15,000 and M2 equals $22,500

Second Part

1. (20 points) No matter what ever their initial differences, a poorer country will always catch up with the richer country; that is, it is only a matter of time until they have the same level of per-capita output.

Explain why this statement is incorrect, giving at least four factors that can cause a poor nation not to be able to catch up with a richer country. Under what conditions would you expect this statement to be true?

The nation may not meet the prerequisites for catching up. These would include

(a) free-or reasonably free- trade

(b) a market economy

(c) respect for property rights

(d) the rule of law

(e) stable political systems

This is not a complete list. If the nation does meet these prerequisites, catchup would occur.

2. (30 points) Projections from the Congressional Budget Office indicate that the United States Government will run a surplus of $1.6 trillion over the next five years. There are two schools of thought as to how to use the surplus. One school of thought is that we should use the funds to "save social security". In practical terms, that means we should pay down the national debt. A second school of thought is that we should use the funds to cut taxes.

One argument for a tax cut is that the government's credibility is not to be trusted. That is, the debt will not be paid down, but new government spending programs will be enacted. One argument against the tax cut is that projections of the Congressional Budget Office are notoriously unreliable. In answering this question put these arguments aside. For the purposes of this problem, assume that the projections will turn out to be correct, and that, if the government does not cut taxes, the surplus will be used to cut the national debt.

You should answer two questions

1. Which policy will lead to a lower real interest rate?
2. Which policy will lead to a higher level of investment?

Of course, as Stockman would point out, there is both a minority view and a majority view on the correct answer to these questions. You should work both. And remember the old Chinese proverb. A well-labeled graph is worth 1,000 words. In fact, it will be virtually impossible to answer this question without a graph or two.

This is actually a homework question, so let me repeat the answer I gave on the web:

First, let's see what happens to the demand for loans. If the government does not cut taxes, then, assuming that the CBO projections are to be believed, then the demand for loans for investment is being reduced by the $1.6 trillion of the debt the government is repaying. If they do not pay the debt down, the demand for loans will be higher by $1.6 trillion. All economists would agree to this point. In short, if the demand curve for loans without a tax cut is D. then the demand curve with a tax cut D', lies to the right.

Now let's see what happens to the supply of loans.

We will begin with the majority view. The majority view is that people will view the $1.6 trillion tax cut as an increase in their wealth. They will increase consumption spending. While people would disagree on the increase, lets' assume for the sake of our example that it is $100 billion. Thus, after tax income will have increased by $1.6 trillion, consumption will have increased by $100 billion and the supply of loans will have increased by $1.5 trillion, an amount less than the increase in the demand for loans. (We will get that whether the increase in consumption spending is $50 billion or $100 billion or $150 billion or whatever). Thus the supply curve will shift to the right to S', by an amount less than the increase in the demand for loans. That means interest rates must rise.

And, if interest rates rise, that means the quantity of investment will decline.

The minority view is different. Basically, it is that the $1.6 trillion tax cut means higher taxes in the future. If we do not pay the debt down, then taxes will be higher in the future than without the tax cut. The present value of the payments on the interest and principal of the $1.6 trillion tax cut is, of course, $1.6 trillion. Thus there will be no change in wealth, for the benefits of the tax cut will be offset by the costs of higher taxes in the future. And, if there is no increase in wealth, the extra $1.6 trillion in after tax income means an extra $1.6 trillion increase in saving. Thus the saving curve shifts to the right to S' by exactly $1.6 trillion. Thus there is no increase in interest rates and no change in the quantity of investment.

2. (20 points). This question is really several short questions, but I could not resist putting them together as one. Be sure to show your work.

1. If velocity rises from 5 to 6, and real GDP and M are unchanged, how much (in percent) will the price level change?

Recall the equation MV = PY. If V goes up by 20% and M and Y are unchanged, then P must go up by 20%

2. If the M1 multiplier is 5, M1 is $1000, the price level is 5.0, real GDP is $1000, and M2 velocity is 4, what is the M2 multiplier?

If M1 is $1000 and the M1 multiplier is 5, then the monetary base is $200. We also know that MV = PY, if Y = $1000, V = 4, the price level equals 5, then M2 = $1250. The M2 multiplier must then be 6.25

3. If the M2 is growing at 10% a year, and real GDP is growing at 6%, then what does the quantity theory of money tell us about the inflation rate.

The quantity theory says that the rate of growth of prices, or the inflation rate, equals the rate of money growth less the rate of growth of GDP. Thus the inflation rate will be 4%.

4. The kingdom of Bratwurst expects that factor productivity will grow by 6% next year. Both population and the labor force are expected to grow by 1%, and the capital stock is expected to grow by 7%. What will be the rate of growth of total output?

From our basic growth equation, we know that the rate of growth of output is equals the rate of growth of factor productivity (6%) plus the rate of population growth (1%) plus 1/3 of the difference between the rate of capital growth (7%) and the rate of growth of the labor force. That difference is 6%, so we know this contributes another 2% to GDP growth. Thus GDP is growing at 9%.