Answers to Third Examination
November 20, 1998

First Part (12 point questions)

1. The Great Depression caused M₂ to fall dramatically. Explain whether you agree or disagree with this statement.

Disagree. The problem is with the direction of causation in this statement. If anything, the decline in M₂ caused the Great Depression

2. Recessions are always caused by a reduction in the inflation rate and vice versa. Explain whether you agree or disagree with this statement.

Disagree. Sometimes they are caused by changes in productive capacity. That is, there are real business cycles.

3. The imperfect information theory of the aggregate supply curve predicts a long run Phillips Curve. Explain whether you agree or disagree with this statement.

Disagree. It predicts that there may be short run relationship between unemployment and unexpected inflation.

4. If the government were to cut tax rates by 10%, then there is no way for revenues to go up. Explain whether you agree or disagree with this statement.

Disagree. Recall the Laffer Curve. If taxes are at extremely high levels, revenues may well go up.

Second Part (26 point questions)

1. The distinguished economist, Professor Alan Edmonds, has just published his inflation forecast for the coming year. Edmonds now predicts that Velocity will fall by 5% in the coming year, meaning prices will also fall five percent next year. Every other economist in the country thinks that Edmonds is nuts, and that prices will rise by one or two percent next year.

1. Show how Edmond's believe that velocity will fall by 5% leads to his prediction of a five- percent fall in prices.

Recall from the equation of exchange that YD = MV/P. If V is down by 5%, aggregate demand will fall by 5%. Assuming movement along the long run aggregate supply curve, we will get a 5% reduction in prices. Alternatively, we could simply look at the quantity equation, which states that the percent change in prices equals the rate of growth of the money supply less the rate of growth of output less the rate of growth of velocity.

2. Of course there are times when people like Edmonds is right and everyone else is wrong. Show how, if Edmonds turns out to be right, there will be a recession in 1999.

If the short run aggregate supply curve does not move (and it will not if people do not believe him), then the shift in aggregate demand will cause us to move along the short run aggregate supply curve.

3. If Edmonds turns out to be right, and everyone else is wrong, what would you expect to happen to the economy in 2000, assuming no further surprises? Explain your answer.

The short run aggregate supply curve will rotate, and we will move back to full employment.

4. Suppose Edmonds were to be able to persuade everyone that he was right, and, in fact, he turns out to be right? Would you now expect a recession in 1999? Why or why not?

There would be no recession. We would simply get a shift in the short run aggregate supply curve. The decline in aggregate demand would keep us still at full employment.

5. Rumor has it that Alan Greenspan is a secret admirer of Alan Edmonds. Assuming that Greenspan believes Edmonds, but knows that he is the only one in the country who does, what action should Greenspan take? Why?

He should increase the money supply by 5% to keep aggregate demand constant.

2. You have just been appointed minister of finance for the Grand Duchy of Fenwick. The Grand Duchess has ordered you to raise a billion dollars to build her a new palace. The duchess has ordered you to raise it by sales taxes, either on pizzas or hamburgers or both. Each year, Fenwick's GDP consists of $2 billion spend on hamburgers and $2 billion spend on pizzas. It turns out that all Fenwickians seem to split their expenditures about 50-50 between the two commodities. You have to decide how to raise the money.

1. One of your advisors, Edward Munch, has suggested you raise the money by a 50% tax on pizza sales this year. Another advisor, Russell Baker, has recommended a 50% tax on hamburgers this year. Both have produced conclusive proof that either tax would raise enough money. A third advisor, William Jennings Brian, has recommended that there be a 25% tax on both pizza and hamburgers, and again has produced proof that this tax will raise enough money. Which advisor should you follow? Why? And how much better is his advice than the other two? Quantify your answer.

Mr. Brian has the right answer. Recall your notes on taxes that minimize distortion. It is probably only half as costly as either alternative.

2. Just before you are prepared to announce the tax plan, a fourth advisor, James Bottlemeyer, comes in with a different proposal. Bottlemeyer suggests borrowing the money to build the palace, paying the debt back at $100 million a year. (Fortunately the interest rate in Grand Fenwick is zero, which, while not perhaps realistic, does simplify the calculations). Is Bottlemeyer's plan better? Why or why not? How much better or worse is it than a pay as you go scheme? Quantity your answer.

Bottlemeyer gets the nod. Each year, he will raise only a tenth as much revenue as Brian, and thus cause only one percent of the efficiency loss that Brian would. Of course, he does this for ten years, so the total efficiency loss under his plan is 10% of Brian's.