Second Midterm Examination
October 24, 1997

 

 

First Part (15 point questions)

For each of the following statement, state whether you agree or disagree with the statement and explain why. It is not sufficient simply to write "True" or "False". Your reason is as important, if not more so.

  1. Inflation robs us all. A 10% inflation rate, even if it comes as no surprise, means we will lose money on our savings.

False. If the inflation rate is anticipated, it will lead to a higher nominal interest rate so that neither borrowers or lenders will gain from inflation.

  1. Given the following data, it is clear that the money supply has been growing at 5% a year:

Variable

Magnitude

Unemployment Rate

4%

Nominal Interest Rate

7%

Real Interest Rate

3%

Rate of Growth of Real GDP

3%

Velocity

Constant

Investment as a Percent of GDP

Up from 17% to 18%

 

Recall that the inflation rate is given by

Percent Change in Prices = Percent Change in the Money Supply less Percent Change in Real GDP plus Percent Change in Velocity.

If the money supply has been growing at 5% and real GDP is growing at 3%, and if velocity is constant, then the rate of inflation is 2%. Since the nominal interest rate is 4% greater than the real rate, it is clear that people expect a four- percent inflation rate. Thus the money supply cannot have been growing at 5%. The data on the unemployment rate and investment as a percent of GDP are brought to you by the Department of Irrelevant Information.

  1. If the government deficit rises, we all know that crowding out will occur and the level of investment will fall.

False. The rise in the deficit leads to a rise in the demand for loans. The disagreement is whether there is an offsetting increase in the supply of loans. As Stockman points out, many economists believe the increase will be less than the rise in the demand, so that there will be crowding out. But there is a strong minority view that the increase will be an exact offset. Thus the statement "we all know" is untrue.

  1. Senator Dilworthy made a major speech yesterday saying that while the decline in unemployment was welcome, the fact that people are still unemployed is proof that all is not well in the American Economy, and we must not rest until it is zero. (Note: you may accept this as an accurate report of his speech.) When economists hear of this statement, they will sneer at the Senator.

True. Senator Dilworthy (a Mark Twain Character) doesn't understand about the natural rate of unemployment.

Second Part (20 point questions)

  1. Suppose that, when you go home after this exam, you get some news.
    1. For each of these events, predict what effect it will have on your wealth and hence your consumption. Show the logic by which you arrive at your answer. I expect clear well labeled graphs in these answers.

Note: assume that these stories are true. Don't worry about whether the check is good, whether the newspaper stories or accurate, or that you might change your major, etc.

                                                                                 i.            Your Uncle Frank has written, surprisingly enclosing a check for $500.

Your budget line shifts out, thus leading to an increase in wealth and consumption now.

                                                                               ii.            You read a newspaper story that salaries for persons with your major are expected to fall.

Your budget line shifts in, leading to a decrease in wealth and consumption.

                                                                              iii.            You read of a new law requiring an additional year of study for persons in your major.

Your budget line shifts in, leading to a decrease in wealth and consumption.

  1. Using your prediction, show what effect it will have on the real interest rate and the level of investment. Again, show your work. Again, I expect clear well labeled graphs in these answers.

                                                                                 i.            Your Uncle Frank has written, surprisingly enclosing a check for $500.

The increase in consumption leads to an increased supply of loans and hence a lower interest rate and an increase in the level of investment.

                                                                               ii.            You read a newspaper story that salaries for persons with your major are expected to fall.

The decrease in consumption leads to a reduced supply of loans and hence a higher interest rate and a decrease in the level of investment.

                                                                              iii.            You read of a new law requiring an additional year of study for persons in your major.

The decrease in consumption leads to a decreased supply of loans and hence a higher interest rate and a decrease in the level of investment.

  1. The United States has had a relatively constant rate of growth of real GDP since the end of World War II. European countries initially had high growth rates, but they have recently declined. In other countries, such as Malaysia, growth rates are very high and continue to be high.
  1. Make Sense of this pattern.

This is Catch-Up 101. The Europeans have caught up, and hence the decline in their growth rates. The Malaysians have not yet caught up.

  1. What do you expect will be the pattern for Malaysia's growth rate? Why?

As they catch up, the growth rate will decline.

(c)        Still other countries have had very low or negative growth rates? Why has this occurred?

They don’t meet the conditions for catching up. They have problems such as political instability, non-market economies, and they don't know how to play baseball.