Exam for December 16, 1998

Final Examination
December 16, 1998

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:

1-1	1-2	1-3	1-4
1-5	1-6	2-1	2-2
2-3	2-4

First Part (10 point questions)

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

1. It is often said that unemployment is a sign of resources being reallocated. If there is true, then high unemployment can never be bad for that simply means that a lot of resources are being reallocated and that must mean sweeping gains in economic efficiency.

Disagree. While unemployment is a sign of resources being reallocated, it can also occur because of bad information causing too many searches.

2. If the Federal Reserve System wanted to increase the money supply this month, December 1998, it could do so by simply cutting its reserve requirements. There is no need for open market operations.

Disagree. The reserve requirements that really matter are those set by banks for business reasons. The Federal Reserve System's reserve requirements are generally avoided.

3. A short run Phillips Curve gives the relation between inflation and unemployment.

Disagree. It gives the relation between unexpected inflation and unemployment.

4. If we love our children, the argument that budget deficits mean that we are saddling future generations with a huge tax bill is nonsense.

I'm slipping. This one is true. The reason is loving our children means there is a bequest motive.

5. If a nation has a comparative advantage in producing a product, it is better at it than anyone else in the world.

Disagree. It simply means that it is relatively better, compared to its skills in other products, than any other nation in the world. This statement refers to absolute advantage.

6. The Catch-Up theorem implies that as a developing country catches up with the United States in terms of per capita GDP, its growth rate will slow down. This need not be the case. If it continues to increase the saving rate, it can sustain whatever rate of growth it wants and thus make its citizens better off than those of the United States.

Disagree. Once it gets its saving rate up to 100% then there will be an equilibrium capital labor ratio. The nation will approach that, and its growth rate will decline. Moreover, if 100% of output is going to consumption, its citizens will starve. They will not be better off than those of the United States.

Second Part (20 Point Questions).

(20 points). Consider two countries, North Fuddle and South Fuddle, initially exactly like Son of Neutral in all respects.

To answer the obvious question, SN (Son of Neutral) differs from Neutral in that it has a government that spends 15 percent of GDP on government consumption of Goods and Services. Its entire budget is financed by a tax on wage income. There is no government debt. SN has settled in to an equilibrium capital labor ratio.
(You may wish to talk about SN or Neutral in your answer: in all cases, I will assume you are using shorthand to refer to Son of Neutral]
Just before year 1, the South Fuddle Weather Service (SFWS) forecasts that, in year 2, the country will be hit by cruel rains. 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 build, they hold, and there is little damage save for some rained-out picnics.
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, and the governmetn never gets its act together. The levees are not build and, to make a long story short, the rains come as expected and wipe out 20% of North Fuddle's capital stock.

Compare the following variables in South Fuddle to those in Son of Neutral in year 1.

The wage rate of South Fuddle will be (circle 1)	Equal to	The wage rate in Son of Neutral in year 1
Per capita consumption of South Fuddle will be (circle 1)	Lower than	Per capita consumption in Son of Neutral in year 1

Explain Your Answer

South and North Fuddle and SN all have the same Capital labor ratio in year 1. Thus they have the same wage rate. South Fuddle does have a huge tax bill to pay in year 1, and that means lower wealth and hence lower consumption than in SN.

Compare the following variables in South Fuddle and Son of Neutral in steady state equilibrium (say, year 100).

The capital rental rate of South Fuddle will be (circle 1)	Equal to	The capital rental rate in Son of Neutral in year 100
The rate of growth of South Fuddle will be (circle 1)	Equal to	The rate of growth in Son of Neutral in year 100
Per capita consumption of South Fuddle will be (circle 1)	Equal to	Per capita consumption in Son of Neutral in year 100

Explain Your Answer

The hurricane and the cost of building the protection against it is a transitory phenomenon. Thus, by year 100, any effects would have disappeared.

Compare the following variables in North Fuddle to those in Son of Neutral in year 1.

The capital rental rate of North Fuddle will be (circle 1)	Equal to	The capital rental rate in Son of Neutral in year 1
Per capita consumption of North Fuddle will be (circle 1)	Higher than	Per capita consumption in Son of Neutral in year 1

Explain Your Answer

South and North Fuddle and SN all have the same Capital labor ratio in year 1. Thus they have the same wage rate. North Fuddle does have an impending disaster which will wipe out the return on their saving. That means a lower incentive to save than in SN.

Compare the following variables in North Fuddle and Son of Neutral in steady state equilibrium (say, year 100).

The wage rate of North Fuddle will be (circle 1)	Equal to	The wage rate in Son of Neutral in year 100
Per capita consumption of North Fuddle will be (circle 1)	Equal to	Per capita consumption in Son of Neutral in year 100
The saving rate of North Fuddle will be (circle 1)	Equal to	The saving rate in Son of Neutral in year 100

Explain Your Answer

The hurricane and damage is a transitory phenomenon. Thus, by year 100, any effects would have disappeared.

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 $40,000, and expects to earn $63,000 next period. Smith has assets of $10,000.	Working in Toronto this period, earning $160,000 Canadian. Will not work after this period, in part because he will receive $88,000 Canadian next period from the estate of his Aunt Helen. No other assets	Now works in San Francisco. Is earning $100,000 this period. Plans to take a job in Canada next period that will pay $220,000 in Canadian Dollars.

Series	Value
US Nominal Interest Rate	5%
Price of Gold in San Francisco	$200 an ounce
Price of Sourdough Bread in San Francisco	$2.00 a loaf
Price of a 2 bedroom apartment in San Francisco	$500 a month
US Unemployment Rate	4.4%
Canadian Unemployment Rate	7.2%
Canadian Nominal Interest Rate	10%
Price of Gold in Vancouver	$400 (Canadian) an ounce
Price of Sourdough Bread in Vancouver	$3.00 (Canadian) a loaf
Price of a 2 bedroom apartment in Vancouver	$800 (Canadian) a month

o Using these data, compute John Smith's wealth in US dollars. Show your work.

This is simple. Wealth consists of income this period ($40,000) plus the value of assets ($10,000), plus the present value next year's income, equal to $63,000/1.05 or $60,000. Thus wealth is $110,000.

Using these data, compute Will Jones's wealth in US dollars. Show your work.

There are two ways to do this problem. First, Will's income this year is $160,000 Canadian. From the relative price of gold in the US and Canada, we know the current exchange rate is $1 C = $0.50 US. Thus his current income is worth $80,000 US. There are two ways you can account for next period's inheritance. First, you can look at the difference in interest rates, which indicates a 5% appreciation for the US dollar against the Canadian dollar. That is, the Canadian dollar will be worth $0.475 US. Thus his inheritance will be worth ($88,000)(0.475) = $41,800 US. When you discount this at 5% you will get a present value of $39,800, for a total wealth of $119,800. The other way you could do it is to discount the $88,000 at 10%, get a present value of $80,000 in Canadian Dollars. Converting at the current exchange rate, you would get a value of $40,000, with a total wealth of $120,000.

Why don't you get the same answer either way? Round off error. I will accept either answer.

Using these data, compute Sally Brown's wealth in US dollars. Show your work.

The job this period is worth $100,000. Next period, the job is worth either $100,000 or $99,500 depending on which approach you use. See the answer to Will above. Thus wealth is either $200,000 or $199,500. I will take either one.

Assuming that they all have the same preferences, whom would you expect to consume the most this year? The least?

Consumption is proportional to wealth. Sally has the highest wealth, while John has the least. Thus Sally has the highest consumption and John has the lowest.

The US inflation rate is expected to be 3% in the coming year. Because Canada and the US economy are closely linked, with free flow of capital, labor, and goods across the border, there is reason to believe you can tell something about Canadian Inflation Rate. What do you expect the Canadian rate to be?

If the two economies are closely linked, they have the same real interest rate. In the US, the real rate is 2%. Remember Fisher's Law. In Canada, the nominal rate is 10%, so that implies an expected inflation rate of 8%.

South Freestone, an idyllic Caribbean island, has a recently developed and thriving tourism industry. About half the tourists come from the United States, while the other half come from Germany. 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). The nation has a flexible exchange rate, so that the rate between the Peach and the Dollar and the Deutsche Mark (DM) fluctuates daily. Right now the Peach is going at 1P = $1, though that rate may change tomorrow. Professor Emeritus of Economics Nathan Reingold, who retired to the island a few years ago has noticed that whenever the DM appreciates against the dollar, the Peach tends to appreciate, and whenever the DM depreciates against the dollar, the Peach tends to depreciate.

There are proposals from time to time to establish a currency board for Freestone and peg the peach to the dollar at 1P = $1. To help the island's minister of finance evaluate the proposal, please analyze the following scenarios. As you read these scenarios, you may think that your analysis is complicated by the imminent arrival of the European Monetary Union. You are probably right, but, for the purposes of this exam, you need not worry about it.

Suppose that Freestone continues on a flexible exchange rate and that, the next winter is a brutal one for the United States. There is an increase in the demand for vacation trips from the US to Freestone. You may assume no change in European weather conditions and that the Freestone Central Bank (which controls their money supply) makes no change in the supply of Peaches. Under those conditions, what would happen to the Peach-Dollar Exchange rate? The domestic price level in Freestone? The number of German tourists? Describe carefully the mechanism by which these changes would come about.

In this case, the demand for nights on the island would increase. However the quantity theory of money would determine the cost of a nights stay on Freestone, say 10 Peaches a night. Under those conditions, the price to outsiders must rise: after all there are only so many beds on the island (and jokes about amorous visitors sharing them will be reported to Kenneth Starr). Thus the cost to outsiders must rise. That means a rise in the exchange rate.

Thus

o The peach-dollar exchange rate rises. More Peaches to the Dollar

o The domestic price level doesn't change. There are, after all, no more and no fewer Peaches.

o The number of German Tourists would fall. There has been no change in their demand function, but if the dollar buys less in Freestone, so does the Mark. Thus there is a movement along the German demand curve.

Suppose that Freestone switches to a currency board. The supply of Peaches is backed by dollars at 1:1. The next winter is a brutal one for the US, and there is an increase in the demand for vacation trips from the US to Freestone. You may assume no change in European weather conditions. Under those conditions, what would happen to the Peach-Dollar Exchange rate? The domestic price level in Freestone? The number of German Tourists? Describe carefully the mechanism by which these changes would come about.

In this case, the quantity of peaches will change as dollars flow to the island. The same rationing will come about because of the increased demand for vacations. The exchange rate of course cannot change. But there will be inflation in Freestone. Hence

o The peach-dollar exchange stays at 1:1. The peach-mark rate remains unchanged.

o The domestic price level rises. There are, after all, more Peaches.

o The number of German Tourists would fall. There has been no change in their demand function, but prices are higher in Freestone, in terms of peaches, dollars and marks.. Thus there is a movement along the German demand curve.

During the 1930's a variety of "crackpot" schemes were advanced for dealing with unemployment. Three are listed below:

"Coupon" money whose value declined periodically according to a schedule printed on the money itself.
The Townsend Plan, which provided for a monthly grant of $200 to senior citizens, paid for by a tax on wage earners. The grant had to be spent in the month in which it was received. (Hint: remember that old people also hold money balances).
The Every-Man-A-King plan of Huey Long, which provided for a grant to all citizens, financed by a tax on interest income.

Using the apparatus of the Y and M curves, show the effects of each of these proposals on the price level in the short run. In some case, the effect is ambiguous. You should show why that ambiguity arises.

Answer

We will take each one up in turn.

Coupon Money

Here, the money supply would simply decline in value each year. Thus the cost of holding real money balances would rise. This effect is very much like the impact of higher inflation on the demand for real money balances, the Friedman Surge. The effect would be to reduce the demand for real money balances. In our terms, the effect would be to shift the M curve to the left to M', as drawn in the following figure.

The net effect would be to raise the price level from P_o to P₁ and lower the interest rate from r_o to r₁.

The Townsend Plan

Clearly this would increase consumption. The fact that old people were getting $200 a month, which had to be spent, would increase their wealth. The fact that others had to pay the taxes would lower their wealth. But, since old people spend a higher percentage of their wealth than the young do, the net effect would be to increase consumption. That means the Y curve is shifting to the right to Y', as illustrated in the following graph. At the same time, recall that the demand for money is proportional to consumption. That means money demand is increasing, so the M curve shifts to the right as well to M'. The combined effect is to raise the interest rate from r_o to r₁. As to the price level, depending on the magnitude of the shifts, it can go up or down. Thus, its change is ambiguous. As drawn the price level seems to rise slightly, but, depending on the exact shifts of the Y and M curves, the effect could go either way.

The Every Man a King Plan

Wealth would go up. People would add the benefits of the grants to their wealth, and would use a lower after tax discount rate. That would also raise wealth. The increase in wealth would increase consumption demand. That would cause the Y curve to shift to the right.

The effects on the M curve are similar. Increased consumption demand would mean higher money demand, and the lower after tax interest rate would further increase the demand for money balances. Thus the M curve would also shift to the right.

That means, of course, that the answers are just like those given for the Townsend plan. See the graph and explanation given above.

President Clinton and the Republican leadership, have, over a cup of well spiced eggnog, come up with agreement on a further one time cut of $100 billion in Government Purchases of Goods and Services, with the funds spent on a tax cut. They have the job of selling the plan to Congress, and have hired the eminent economist Elmer Fudd (Daffy Duck was the alternative) to work out a plan. Fudd is considering two plans.

o Cut tax revenues by a new across-the board earned income credit.

o Cut tax revenues by a special rebate on capital gains and interest income

When Fudd picks a tax plan, the combination spending cut-tax plan will be submitted to Congress for a straight up or down vote (it is, after all, the Christmas season and so we can believe that Congress is as capable of up and down votes just as well as we can believe in Santa Claus or that the two parties got together). Congress is not particularly interested in where the cuts in purchases of goods and services will come from (Defense, Education, etc.), so you need not worry about fleshing out the details of the spending cut.

What you do need to worry about the tax cut. Fudd secretly wants Congress to turn down the budget cuts. He also knows that Congress is in a pro-growth mood. The more anti-growth the tax alternative, the more likely Congress will vote against the budget cut.

For each of the tax proposals, evaluate their impact on economic growth. How will each one affect economic growth over the next five years? Why?
Which one would Fudd be best advised to recommend to Congress to achieve his secret agenda? Why?
How would your answers change if the President and the Speaker had agreed on a $100 billion cut in transfer payments?

Hint: don't worry about the type of spending or transfer payments, and don't worry about rich-poor effects. Worry about the impact on people who have economic life cycle considerations. Also, remember that transfer programs add to wealth just as does wage income. You may also assume that the US looks just like Neutral.

The question is really one about the saving rate. One might be tempted to argue that a $100 billion cut in Government purchases of goods and services will lead to a $100 billion cut in the amount available for investment. However both proposals will impact wealth and hence consumption. Suppose that Elmer went with the earned income credit, which is really a cut in wage taxes. This would increase wealth and hence increase consumption, let us say by $X. Thus the amount of investment would be $100 - $X. If Elmer went with the tax rebates on interest income, the impact would be to reduce wealth (people would be using higher discount rates). Thus consumption would fall, let us say by $Y. Thus the amount of investment would be $100 + $Y.

It is possible, but not likely that $X > $100. Thus we expect that both would be pro-growth, but the one that is the least pro-growth is clearly the earned income rebate. If Elmer wants the program to go down to defeat, this is the one he should push.

If the cuts are in transfer payments, then there is no reduction in government purchases of goods and services.. The wage tax cut is thus balanced in wealth by the reduction in the transfer payments, and so there is no impact on consumption. The cut in interest taxes would definitely cut consumption, both because of the loss in transfer payments and because of the effects of the new taxes.

The Great Depression, which began in 1929, was a signal event in the economic life of the nation in this century. People still ask a variety of questions about the great depression.

Why did it happen?
Why did it take so long for the economy to unravel?
Why did the recovery take as long as it did?

Answer those questions. In answering these questions, remember that some well-labeled and well-explained graphs are expected.

See the lecture notes.