Final Examination
December 14/15, 1999
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Directions:
do all work on the exam itself, answering the question in the space
provided. If you require extra space,
use the back of the exam, indicating
that you have done so. |
Name: |
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1-1 |
1-2 |
1-3 |
1-4 |
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1-5 |
2-1 |
2-2 |
2-3 |
1 Suppose that, when I burned a dollar bill in class, the government had increased the money supply by $1, thus keeping the money supply and hence the price level constant. No one would have gained by my action.
Disagree.
The effect would have been to generate either a dollars worth of revenue
for the government, thus reducing someone else’s taxes or else reducing the
debt by a dollar, which would have reduced future taxes.
2 If interest rates in the United States are three percentage points lower than Canadian interest rates, this means the Canadian dollar is likely to rise in value relative to the US dollar people don’t like to get high returns on their assets.
In fact, the Canadian dollar is likely to
decline in value, as interest rate equalization predicts. As to investors who don’t like to get high returns
on their assets…
3 Giving police a hefty raise may be an important step to economic growth.
Agree.
The higher the pay, the less likely they are to steal and engage in
corruption, which is surely a barrier to economic growth and development.
4 Money (i.e., the inflation rate) does not matter.
Agree and disagree. If money is neutral then changes in the
money supply simply impacts the price level, and no real variables. Unanticipated inflation of course, can
impact both wealth transfers and can also thanks to imperfect information, have
an effect on economic output..
5 New York City has recently experimented with some “No sales tax on clothing weekends.” During these weekends, clothing purchases up to $100 are exempt from combined city and state sales taxes of 9%. Economists would argue that the city would be better served by simply reducing the average sales tax.
Agree.
Uniform taxes are better, so why not have a uniform tax rate over the
year?
1. Consider a country Wormwood initially like SIX in many ways. Like SIX it is initially in steady state equilibrium, and government purchases consume a fraction n of G. There are some specific differences:
· The money supply is growing at the biological interest rate
· There is no national debt.
· Government expenditures are financed by taxes on wage income money creation.
· Information is uncertain in Wormwood. People will respond in part to any unexpected inflation or deflation as if it were an increase in their real wage.
The Wormwood minister of Finance has noticed that most “advanced” countries have a modest level of inflation. For his country to be progressive, he has decided that Wormwood should also adopt a policy of inflation, and has therefore announced that, beginning in year two, Wormwood will increase the rate of growth of the money supply by two percentage points a year (Yes, he understands the quantity theory of money).
· Show the effect of this policy on the Y and M curves for year one. (Hint: a well-labeled and well-explained graph will be helpful here). Note also that you are being asked for the effects in year 1, before the rate of growth of the money supply increases but after its increase is announced.
Y curve would shift to the right, for the higher rate of monetary creation means a lower tax rate. That means higher wealth. Thanks to the changed inflationary expectations, the M curve would shift to the left. Thus we know the price level will rise, but the effect on the interest rate is ambiguous.
· Using this graph, show the effect on the following variables. I have provided a table for your use. In every case, you should answer relative to what they would have been if the minister had not gone off his rocker.
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The real interest rate will |
Increase/decrease/ |
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The price level will |
Increase/decrease/ |
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The real wage rate will |
Increase/decrease/ |
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The level of real output |
Increase/decrease/ |
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The capital rental rate |
Increase/decrease/ |
More people will be working, so the wage rate must fall. Of course output will be up.
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The real interest rate will |
Cannot tell. |
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The price level will |
Increase |
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The real wage rate will |
Decrease |
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The level of real output |
Increase |
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The capital rental rate |
Increase |
· Describe the impact of this policy on each of these variables in steady state equilibrium. . In every case, you should answer relative to what they would have been if the minister had not gone off his rocker. Explain your answers.
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The saving rate will |
Increase/decrease/ |
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The real interest rate will |
Increase/decrease/ |
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The inflation rate level will |
Increase/decrease/ |
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The real wage rate will |
Increase/decrease/ |
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The rate of growth of GDP will |
Increase/decrease/ |
Remember there is no government debt and there are no taxes
on interest income. We know the inflation
rate will be higher, thus the stock of real money balances will be lower. In turn, this means a higher capital labor
ratio. The rest of the variables are
obvious.
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The saving rate will |
Increase. |
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The real interest rate will |
Decrease |
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The inflation rate level will |
Increase |
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The real wage rate will |
Increase. |
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The rate of growth of GDP will |
Remain the same. |
2. Consider two countries, North Fuddle and South Fuddle, initially exactly like Wormwood.
Just before year 1, the South Fuddle Weather Service (SFWS) forecasts that, in year 2, cruel rains will hit the country. These rains will cause the country's rivers to overflow their banks, and wipe out 20 percent of the country's capital stock. SFWS is highly reliable. To deal with this problem, the government goes on a massive spending program in year 1, amounting to an additional 10% of GDP to build a series of levees to control the flooding. To make a long story short, the levees are built, they hold, and, save for some rained out picnics, there is little damage.
By a curious coincidence, the North Fuddle Weather Service, just as reliable, issues the same forecast. Alas, North Fuddle is going through a political crisis. It is clear that the government will not get its act together to build the levees. To make a long story short, the rains come as expected and wipe out 20% of North Fuddle's capital stock. Although this cannot be anticipated until period 2 begins, the government of North Fuddle gets its act together and borrows enough to compensate the flood victims. Thereafter, it finances enough of the interest payments on the debt to keep the debt/GDP ratio constant. All of the additional taxation takes the form of higher taxes on wage income.
Note: in all cases, give your answers relative to what would have occurred had there been no flood.
· Show the effect of this policy on the Y and M curves for year one. (Hint: a well-labeled and well-explained graph will be helpful here).
People know that the government is
hopelessly inept and thus know the flood is coming. However since they expect
to be hit with a 20% loss a year hence, they go on a spending spree. The effect is to shift the Y curve to the
right. At the same time, the higher
consumption demand shifts the M curve to the right as well. Thus the interest rate rises, while we
cannot tell the impact on the price level.
· Using this graph, show the effect on the following variables. I have provided a table for your use. If your answers cannot be read directly from the graph above, explain your answers.
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The saving rate will |
Increase/decrease/ |
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The real interest rate will |
Increase/decrease/ |
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The price level will |
Increase/decrease/ |
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The real wage rate will |
Increase/decrease/ |
The interest rate and price level effects
are as described above. Thus the saving
rate is ambiguous. The real wage rate,
of course, does not change.
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The saving rate will |
Decrease |
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The real interest rate will |
Increase. |
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The price level will |
Cannot tell |
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The real wage rate will |
Remain the Same |
· Describe the impact of this policy on each of these variables in steady state equilibrium. Explain your answers.
|
The saving rate will |
Increase/decrease/ |
|
The real interest rate will |
Increase/decrease/ |
|
The price level will |
Increase/decrease/ |
|
The real wage rate will |
Increase/decrease/ |
|
The rate of growth of GDP will |
Increase/decrease/ |
The effects of the flood will be
temporary, but not the effects of the government debt. Here, the effects of the government debt
will be to reduce the capital-labor ratio.
Thus the effects will be as follows:
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The saving rate will |
Decrease |
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The real interest rate will |
Increase |
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The price level will |
Increase |
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The real wage rate will |
Decrease |
|
The rate of growth of GDP will |
Remain the same |
· Show the effect of this policy on the Y and M curves for year one. (Hint: a well-labeled and well-explained graph will be helpful here).
The Y curve shifts to the right thanks to
the increased government spending. The
higher taxes cause the M curve to shift to the left. Thus the price level will be up, while the effect on the interest
rate is unclear.
· Using this graph, show the effect on the following variables. I have provided a table for your use. If your answers cannot be read directly from the graph above, explain your answers
|
The saving rate will |
Increase/decrease/ |
|
The real interest rate will |
Increase/decrease/ |
|
The price level will |
Increase/decrease/ |
|
The real wage rate will |
Increase/decrease/ |
The uncertain interest rate means an uncertain saving rate. The price level is discussed above, and there is obviously no change in the wage rate.
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The saving rate will |
Cannot tell |
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The real interest rate will |
Cannot tell |
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The price level will |
Increase |
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The real wage rate will |
Remain the Same |
· Describe the impact of this policy on each of these variables in steady state equilibrium. Explain your answers.
|
The saving rate will |
Increase/decrease/ |
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The nominal interest rate will |
Increase/decrease/ |
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The price level will |
Increase/decrease/ |
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The real wage rate will |
Increase/decrease/ |
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The rate of growth of GDP will |
Increase/decrease/ |
The effects are not permanent. There are no changes.
3. Lower Freestone, an idyllic Caribbean island, has a recently developed a thriving tourism industry. About half the tourists come from the United States, while the other half come from Germany. The hotels are owned by American Chains (Hilton, Marriott, etc.) While the native tongue is English, the German influx is so pronounced that signs "Wir Spreche Deutsch" can be found throughout the island. Freestone's currency is the Peach (P). Freestone has a currency board which keeps the Peach pegged to the dollar at 1P = $1. Professor Emeritus of Economics Nathan Reingold, a tough old independent minded buzzard is determined to keep the Peach pegged to the dollar, heads the board. In short, whatever any Freestone politicians or we may think, the currency peg is here to stay.
Reingold may be a tough old buzzard, but he is plenty smart. He keeps the Freestoners well briefed on economic events and they seldom suffer from imperfect information.
· Reingold has noted that, since the beginning of this year the Euro (€) has declined from 1 € = 1.16 P to approximately 1 € = 1.00 P. (Inasmuch as the Peach is pegged to the dollar, you should not be surprised that its decline mimics the change of the Euro to the dollar). Reingold is wondering what effect this decline will have on a number of variables, particularly
1. The number of American tourists coming this year
2. The domestic price level in Freestone
3. Interest rates in Freestone
Help him out. (It should come as no surprise that an acceptable answer will include carefully drawn, labeled, and explained Y and M curves. And as a hint, remember that the demand for goods and services is now equal to C + I + G + X-M.)
The Euro will buy less in dollars or
peaches. Thus the demand for vacations
by Germans will decline. In turn, the
decline in the demand for German visits will lower hotel rates in Freestone,
thus increasing the number of American tourists coming this year. Inasmuch as hotels are an important part of
the Freestone economy, we know that the price level will fall.
Interest rates? Draw your Y and M curves.
The reduced export demand will shift the Y curve to the left. However because there is no effect on local
wealth, the M curve will not shift. Thus we know that both prices and interest
rates will fall.
First, the decline in the Euro has
affected European demand. Those effects
will not go away.
Interest rates? Draw your Y and M curves.
Here there is a second effect.
The wealth of Freestoners will be reduced since they now suffer the loss
of income from the hotels. The reduced
export demand and the lower income from hotels will reduce consumption
demand. These two effects will shift
the Y and M curves to the left. We thus
know that the interest rate will decline.
Merely looking at the Y and M curves, we cannot tell what happens to the
price level, but we know domestic prices must fall reflecting the lower demand
for hotel rooms. Yes, it is important
that you see the differential effects on the Y and M curves in the two cases.
First, it may not make much difference as
to whether Freestone fixes or not.
Given the nearness to the US, most local hotels will price in dollars
anyway, and not matter what the government does, the economy will likely be on
a de-facto fixed rate. On top of that,
you might want to make several arguments.
In grading, we will be looking for thoughtful arguments, such as
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The advantage of externally imposed discipline.
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The advantage of eliminating uncertainty (if they go
on a floating rate, will there not be a problem with imperfect information?
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The advantage of insulating itself from the US
market, on which it is only partially dependent.