Final Examination December 18, 1997

First Part (10 point questions)

For each of the following statements, indicate whether they are TRUE or FALSE and explain why.

1.       Unemployment, no matter how high or low, is a bad sign, showing the failure of the government's economic policy to keep people at work.

This statement is false. Most unemployment arises from the natural search and reallocation process, in which people are looking for the right position and in which they are being reallocated from one position to another. Unemployment above the natural rate may be a result of a difference between actual and expected inflation, which may or may not be the result of a bad government policy.

2.       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.

This statement is false. While the catch-up theorem generally applies, there are several conditions that can prevent a country from beginning the process of catching up. The list includes political instability, lack of free trade, and lack of property rights.

3.       The counter cyclical nature of the unemployment rate is inconsistent with the theory of real business cycles.

This statement is both true and false. The theory of real business cycles better predicts the pro cyclical nature of the employment rate. To the extent that search is pro cyclical and that the unemployment rate reflects the number of people not working, then the statement is true.

4.       Reserve requirements have changed very little in the past 20 years. In short, they are an ineffective policy, and the fact that they are never changed is proof that they are now meaningless. Were the Federal Reserve to abandon all reserve requirements tomorrow, we would never know the difference.

This statement is true. The meaningful reserve requirements are now set by business policy, and not by the Federal Reserve System. As a technical matter, however, the fact that they are never changed is not proof that they are meaningless. It could just be proof that (a) the Federal Reserve System is lazy or (b) that they are so powerful that the Federal Reserve system never dares use this particular tool.

5.       All business cycles are real, for they all affect real GDP.

This statement is false, and shows a lack of understanding of real business cycles. Of course, all business cycles affect real GDP - what else does one mean by a business cycle - but the question is whether they are caused by changes in total factor productivity or movements along a short run aggregate supply curve.

6.       If the government cuts taxes by $10 for one year, borrowing an additional $10 billion, then all economists would agree that the measure would be inflationary.

This statement is false. Remember what Stockman calls the majority view and the minority view. The majority view is that there would be an increase in aggregate demand, which would be inflationary. The minority view is that there would not be an increase in aggregate demand.

Second Part (10 Point Questions)

1.       If international trade provides net gains to all countries involved, why do countries restrict trade?

Many reasons can be given to answer this question. There are losers and winners when trade occurs. Even though every country reaps a net gain, the losers will argue and lobby against trade. In theory, the gainers could compensate the losers and everyone would be better off. In reality it is very difficult to determine the exact amounts of transfers that would make everyone better off. Also there are political considerations that may conflict with increased trade. National security considerations may result in prohibitions against exporting some items. Politicians respond to interest groups to get re-elected. In addition it may be easy to identify the losers from trade, but the gainers may be widely dispersed.

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.

Because banks keep reserved equal to only a fraction of deposits at the bank, if too many people try to withdraw cash as the same time the bank will run out of reserves. If the bank temporarily closes and cannot come up with needed reserves, it fails and goes out of business. A bank facing a run may sell off assets to obtain reserves, but if it sells the assets at a loss, it will fail. When a bank fails, depositors lose some of their money. When one bank fails in a community and depositors lose money, it can spook other people into running on their banks and bank failures spread. A lender of last resort can temporarily inject reserves into the banking system so a bank facing a run does not have to sell off assets at a loss and fail. By stopping the bank failure depositor's confidence in the safety of their deposits is restored and a bank panic is averted.

3.       Explain why GDP is not a measure of economic welfare.

There are goods produced in the economy that provide people with benefits but are not counted in the GDP. In general, non-market activities are not counted. Examples include home production of goods and services, providing some good or service to a friend without receiving remuneration. The production of some goods is not reported to avoid taxes or because the production is illegal. The pollution created in the manufacture of some products reduces the welfare of people, but GDP is not reduced to reflect this loss of welfare.

4.       Explain why the enforcement of property rights is a factor determining equilibrium real GDP.

Property rights confer ownership rights to goods and services. In order for an economy to operate efficiently, trades must take place. When trades occur ownership of goods and services is transferred from one person to another person. If property rights could not be enforced strong incentives would exist for people to steal goods rather than trade for them. Contracts between employers and employees and between different firms could not be enforced without enforcement of property rights. In short, chaos would result in an economy without enforcement of property rights.

5.       Explain why there is a connection between how credible policy makers are and how effective are their policies.

It depends on how fast the short run Phillips curves shifts when expectations of inflation change. If people believe Federal Reserve officials when they publicly announce a reduction in the growth rate of the money supply, expected inflation will immediately decrease and the short-run Phillips curve may shift down immediately., If this happens actual inflation will be reduced without a recession and an increase in the unemployment rate occurring. However if people do not believe the announcement of the Fed thew will not change their expectations of inflation. Also, if the {Phillips curve does not shift down quickly when expectations change, the reduction in inflation will require a secession.

6.       In 1990 interest rates in Argentina rose to 600% per month, while interest rates on bank deposits in the United States were less than 10%. Do you think rational financial investors in the United States rushed to take their money out of banks in the U.S. and invest it in banks in Argentina? Explain

Financial investors in the United States did not shift their money into Argentina. Argentina was experiencing a very high rate of inflation, and nominal interest rates in Argentina reflected the high inflation. And, given the high interest rates, the expected rate of devaluation of the Argentinean currency was quite high, and there was no gain from investing there.

Third Part (20 Point Questions)

1.         The Monty Python Book of international economic data report the following data on Central, East, and West Pasta for 1985-1996.

Central Pasta

 

East Pasta

 

West Pasta

Year

GDP (1985 $)

The Price Level

 

Year

GDP (1985 $)

The Price Level

 

Year

GDP (1985 $)

The Price Level

1985

100

100

 

1985

100

100

 

1985

100

100

1986

102

103

 

1986

102

103

 

1986

102

103

1987

104

106

 

1987

104

106

 

1987

104

106

1988

109

111

 

1988

98

95

 

1988

98

95

1989

107

114

 

1989

100

98

 

1989

101

98

1990

110

117

 

1990

102

101

 

1990

104

101

1991

112

120

 

1991

104

103

 

1991

109

103

1992

114

123

 

1992

106

105

 

1992

114

105

1993

116

126

 

1993

108

107

 

1993

116

107

1994

118

129

 

1994

110

109

 

1994

118

109

1995

120

132

 

1995

112

111

 

1995

120

111

1996

122

135

 

1996

114

113

 

1996

122

113

Economists analyzing these data conclude that, in some cases, the unusual fluctuations are due to shifts in aggregate demand and movements along a short run aggregate supply curve. In other cases they are due to shifts in the long run aggregate supply curve, other than the normal 2% a year growth).

In the case of Central Pasta:

In 1988, the inflation rate jumped from 3 percent a year to 5 percent a year. Real output jumped as well. But this was a movement along the short run aggregate supply curve, for next year, 1989, as the economy adjusted to the inflationary surge, real GDP actually fell as the nation moved back to the long run aggregate supply curve.

In the case of East Pasta:

1988 saw a decline in real GDP, at the same time as the inflation rate dropped from 3 percent a year to -11 percent. But this was a drop in aggregate supply. If it were caused by a movement along the short run aggregate supply curve, the 1988 recession would have been followed by a period of rapid growth, and that was not the case.

In the case of West Pasta:

West Pasta is the reverse of East Pasta. The 1988 recession is followed by period of rapid economic growth, indicating that there was a movement along the short run aggregate supply curve.

  1. As part of a research project, a student has collected the following economic data for 1994 and 1995

1994

 

1995

Series

Value

 

Series

Value

Tires Made

30,000

 

Tires Made

37,500

Tires used in new car production

20,000

 

Tires used in new car production

25,000

Price of Tires sold to automobile manufacturers (each)

$20

 

Price of Tires sold to automobile manufacturers (each)

$25

Price of Tires sold directly to consumers

$35

 

Price of Tires sold directly to consumers

$40

Number of New Cars Sold

4,000

 

Number of New Cars Sold

5,000

Retail Price of New Car

$10,000

 

Retail Price of New Car

$11,000

Bushels of Corn Sold

100,000

 

Bushels of Corn Sold

110,000

Price of Corn (per bushel)

$10

 

Price of Corn (per bushel)

$10

Average Household Income

$41,350

 

Average Household Income

$66,500

Number of Households

1,000

 

Number of Households

1,000

No other goods or services were sold either year, and there were no international transactions. As you will note, the student failed to get some data.

Fill in the blanks and explain your reasoning behind your answer

I have filled in the blanks with boldface answers. In the case of 1994 average household income, note that GDP equals

(10,000 Retail Tires Sold) (Price of $35) + (4,000 cars sold)(Price of $10,000) + (100,000 bushels of corn)($10 price) = $350,000 +$40,000,000 + $1,000,000 = $41,350,000.

Since GDP equals national income and since there are 1,000 households, we know that average household income is $41,350,000/1,000 = $41,350.

In the case of 1995 corn prices, we know that GDP =National Income = ($66,500)(1,000) = $66,500,000. But GDP includes cars worth (5,000)($11,000) = $55,000,000 and retail tires worth (12,500)($40) = $500,000. Thus corn must be worth

$66,500,000 - $55,000,000 - $500,000 = $11,000,000

and that implies a price of $10 a bushel for corn. We cal also answer some other questions

1994 GDP was $41,350,000

1995 GDP was $66,500,000

From 1994 to 1995, prices rose
by 9.8 percent

Explain Your Answer

Reevaluate 1994 GDP at 1995 prices, and you will get

(10,000 Retail Tires Sold) (Price of $40) + (4,000 cars sold)(Price of $11,000) + (100,000 bushels of corn)($10 price) = $400,000 +$44,000,000 + $1,000,000 = $45,400,000.

The percent increase is $45,400,000/$41,350,000- 1 = 9.8%

  1. Lincoln's Law states that while you can fool some of the people all of the time, and you can fool all of the people some of the time, you can't fool all of the people all of the time. What would Abe have had to say about aggregate supply curves?

In your answer, be sure to

The long run aggregate supply curve reflects the productive capacity given capital, labor and factor productivity, assuming perfect adjustment to the price level. The short run aggregate supply curve shows how supply will change with changes in the price level until people adjust to the changes in the price level.

There are a number of reasons, but basically they all come down to people being confused about differences in real and nominal price changes.

People cannot be fooled indefinitely. As they change expectations per Lincoln, the short run aggregate supply curve will rotate back to the long run aggregate supply curve. (Note, even though not shown here, graphs are expected as part of the answer).

  1. The following table gives data on the assets of three individuals: John Smith, Will Jones, and Sally Brown, as well as some basic financial data on the U.S. and Canada. (You may assume that all financial data are correct, though some of it has been adjusted to make for easier computation.).

 

 

John Smith

Will Jones

Sally Brown

Income this period of $100,000, and expects to earn $100,000 next period. Smith has assets of $50,000.

Not working this period, but firmly expects a job next period paying $165,000. He also has $60,000 in Canadian dollars which he inherited his Aunt Helen. No other assets

Income this period of $100,000 and plans to take a job in Canada next period which will pay $138,000 in Canadian Dollars.

 

Series

Value

US Nominal Interest Rate

10%

Price of Gold in San Francisco

$300 an ounce

Price of Sourdough Bread in San Francisco

$3.00 a loaf

Price of a 2 bedroom apartment in San Francisco

$500 a month

US Unemployment Rate

4.6%

Canadian Unemployment Rate

6.5%

Consensus forecast of next years exchange rate

In terms of American dollars, the Canadian dollar will be worth 5% less

Price of Gold in Vancouver

$450 (Canadian) an ounce

Price of Sourdough Bread in Vancouver

$5.00 (Canadian) a loaf

Price of a 2 bedroom apartment in Vancouver

$700 (Canadian) a month

John Smith: $150,000 in assets and income this period. The present value of next period's income is $100,000/1.1 = $90,909, for a total wealth of $240,909.

Will Jones: the present value of the $165,000 he expects to earn next period worth ($165,000/1.1 = $150,000) plus the $60,000 from Aunt Helen. The exchange rate is given by looking at the price of gold in the US and Canada, the only traded good on the list. Those data mean that a Canadian dollar is worth 2/3 of an American dollar, so that his $60,000 is worth $40,000 US. Thus is wealth is $190,000.

Sally Brown: the $100,000 she earns next period plus the present value of next period's Canadian salary. If the exchange rate is expected to depreciate a 5 percent a year, then the Canadian interest rate is 15 percent, so that the present value is $138,000/1.15 = $120,000 Canadian, or $80,000 American. Thus her wealth is $180,000.

Since consumption is a function of wealth, we would expect that

Consumption of Smith > Consumption of Jones > Consumption of Brown