Answers to December 17 Exam

First Part (10 point questions)

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

1. (Suggested by Priscilla Lawrence). Unemployment is never good for businesses, the economy or workers).

False. All persons gain by the process of reallocating resources, which frequently involves unemployment.

2 (Suggested by Arnaud Schmid). The neoclassical model shows that 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 (Suggested by Drew Acertio). Inflation is just another tax.

This statement is true and false. While it is true that inflation is a tax, unanticipated inflation can have several consequences such as income redistribution and causing business cycles.

4 The only problem with taxes is that they take money away from people and reduce their consumption demand

This statement is false. What about the incentive effects.

Second Part (20 Point Questions)

1. The theory of real business cycles argues that an increase in factor productivity explains some key factors about real business cycles:

o The cyclical nature of employment

o The cyclical nature of wage rates

o The cyclical nature of corporate profits

Show how all of these follow from an increase in factor productivity (an increase in the number of effective labor units per worker).

See the notes for an answer to this question.

2. (Suggested by Matthew Fleming). East, Lower and Upper Bonzar have been marked by steady prices with the money supply growing at the rate of GNP. In all three countries, new monetary authorities announce important changes in monetary policy. The changes are as described below. For each country, draw a time path showing the likely price level over the next two years. Explain your answer. Since this is a sample problem, we will put away any suspicions of what the Monetary Authorities say, and we will take their statements at their word. (While this may not be a good strategy in real life, it simplifies the answers to this problem.)

• In the absence of any change, the time path of prices would look like the following:

The Price Level in East, Lower and Upper Bonzar (At least what it would have been without these changes)
The Price Level
1.0
0.0	Now	One Year Later	Two Years Later

• The Finance Minister of East Bonzar announces that he has just doubled the money supply, but thereafter there will be no special increases in money. It will continue to grow at the rate of real output.

This one is a gift.

The Price Level in East Bonzar
The Price Level
2.0
1.0
0.0	Now	One Year Later	Two Years Later

• The finance minister in Lower Bonzar doubles the money supply. By a remarkable coincidence, a volcano that wipes out half of the population and half the capital stock hits the economy. Fortunately the entire money supply, printed on a new fireproof paper, survives and is distributed to the survivors.

So is this one. The effect is to quadruple the price level.

The Price Level in Lower Bonzar
The Price Level
4.0
1.0
0.0	Now	One Year Later	Two Years Later

• The Finance Minister in Upper Bonzar announces that, one year from today, he will double the money supply. While he is fully believed, he ultimately reneges on his promise (you may assume he is fully believed up until the date of the promised doubling).

While this one requires some suspension of belief, there will be an initial move like the Friedman Surge, followed by an immediate drop back to the initial price level. (NB. I have drawn this one properly, and I hope it will come through when I download it).

The Price Level in Upper Bonzar
The Price Level
2.0
1.0
0.0	Now	One Year Later	Two Years Later

3. (Suggested by Thomas Codispoti). Central Waddle is initially like "Six". However the ruler of Central Waddle, the wise and benevolent Emperor Upton, puts Central Waddle into a computerized banking system to make things easier and more efficient for his people. Now instead of wasting resources printing paper money, everyone has their cash in a simple checking account, with debit cards used for all transactions. The extra time is available for the study of economics. Initially the system works well. There is no change in the demand for real money balances, and prices rise at the same rate as they do in "Six". Unfortunately the computer programmer graduated from the University of A**** and there is a bug in the program. On January 1, 2000, while the millennium bug hits around the world, the computer system doubles everyone's checking account balance.

o Compare nominal interest rates and price levels of Central Waddle and 6 immediately after the auctioneer has addressed the problems of this inadvertent doubling. (Graphs are helpful).

The tempting answer is to say that the price level doubles, and that will be the result if there are no assets and liabilities in nominal terms. But this is not the case in "Six", so that there will be some effects on consumption demand. The effect will be to redistribute wealth from creditors to debtors, and since creditors are older than debtors, there will be a reduction in consumption demand. (The effect on destroying government bonds will work the same way). Thus the auctioneer will be forced to reduce the real interest rate to equate supply and demand. We know that this means (a) a lower nominal interest rate and (b) a price level which is less than doubled.

o Assuming that this is a one time disaster, what would the long-term effect of the debacle? That is, how will prices and interest rates change over time?

The destruction of the government bonds will lead ultimately to a higher level of output. That means a lower real interest rate, and thus a lower nominal rate. In turn that means a higher demand for real money balances so the price level will not exactly double. It will less than double.

o Suppose instead that, on January 5, 2000, it is discovered that this bug will happen each year, and there is no easy way to fix it. How will that change your answers to the long run effects of the new monetary regime?

Now allow for the Friedman Surge. We will essentially be in the world of "Eight", which means a lower capital labor ratio, and higher nominal interest rates, plus the extra inflation rate.

Third Part (40 point question)

1. (40 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, South Fuddle is hit by a cruel hurricane that decimates the population, killing one of every ten citizens. At the same time, the hurricane wipes out 30 percent of its capital stock. Devastated by the shock of the hurricane, another 20 percent of the islanders decide to leave and emigrate to North Fuddle. The twenty percent who leave represent a cross section of the population. Thus, just as 10% of each age group was killed, 20% of each age group leaves. Obviously those who emigrate owing money leave their debts behind, and those who emigrate with assets are forced to leave their assets behind. Emergency legislation in South Fuddle requires that the 70% of the population who remain behind share either the wealth or the debts of the members of the cohort. The consequence is that, the Fuddles who remain are just as wealthy or just as much in debt as if the hurricane had never hit.
• North Fuddle is spared the effects of the hurricane, but is devastated by the sudden influx of immigrants, just before year 1. In a fit of compassion, the legislature of North Fuddle passes what becomes known as the "Share and Share Alike" law, providing that each Fuddle share his wealth with the new immigrants, but with the new immigrants of the his age cohort. Young new immigrants are forced to share the debts of their counterparts. The consequence is that each inhabitant of North Fuddle who had assets finds himself about 1/6 poorer than he would have been had the immigration not happened, while a resident in debt finds his debts proportionately reduced. A resident who would have been worth $90,000 is now worth $75,000, and one $30,000 in debt is now only $25,000 in debt. While perhaps not the fairest law, it does simplify the discussion.

1. Compare wage rates, the capital rental rate, output per capita, the interest rate, and the level of consumption in South Fuddle to those in Son of Neutral in year 1.

A general answer. South Fuddle's population and capital stock have been scaled back by 30%. For those who remain, there are no impacts. Hence

The wage rate of South Fuddle will be (circle 1)	Equal to	The wage rate in Son of Neutral in year 1
The capital rental rate of South Fuddle will be (circle 1)	Equal to	The capital rental rate in Son of Neutral in year 1
The output per capita of South Fuddle will be (circle 1)	Equal to	The output per capita in Son of Neutral in year 1
The interest rate of South Fuddle will be (circle 1)	Equal to	The interest rate in Son of Neutral in year 1
Per capita consumption of South Fuddle will be (circle 1)	Equal to	Per capita consumption in Son of Neutral in year 1

2. Compare wage rates, the interest rate, output per capita, the rate of growth, and the level of consumption in South Fuddle and Son of Neutral in steady state equilibrium (say, year 100).

The wage rate of South Fuddle will be (circle 1)	Equal to	The wage rate in Son of Neutral in 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 output per capita of South Fuddle will be (circle 1)	Equal to	The output per capita in Son of Neutral in year 100
The interest rate of South Fuddle will be (circle 1)	Equal to	The interest rate 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

3. Compare wage rates, the capital rental rate, output per capita, the interest rate, and the level of consumption in North Fuddle to those in Son of Neutral in year 1.

A general answer. North Fuddle looks like Loser Hence

The wage rate of North Fuddle will be (circle 1)	Lower than	The wage rate in Son of Neutral in year 1
The capital rental rate of North Fuddle will be (circle 1)	Higher than	The capital rental rate in Son of Neutral in year 1
The output per capita of North Fuddle will be (circle 1)	Lower than	The output per capita in Son of Neutral in year 1
The interest rate of North Fuddle will be (circle 1)	Higher than	The interest rate in Son of Neutral in year 1
Per capita consumption of North Fuddle will be (circle 1)	Lower than	Per capita consumption in Son of Neutral in year 1

4. Compare wage rates, the interest rate, output per capita, the rate of growth, and the level of consumption 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
The capital rental rate of North Fuddle will be (circle 1)	Equal to	The capital rental rate in Son of Neutral in year 100
The output per capita of North Fuddle will be (circle 1)	Equal to	The output per capita in Son of Neutral in year 100
The interest rate of North Fuddle will be (circle 1)	Equal to	The interest 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