Midterm Exam

Directions: Each Problem has the indicated weight. Work all problems on the exam itself. If necessary, use the back of the exam sheets, indicating that you have done so.

Name:

 

 

1

2

3

4

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6

7

S

1.           (10 Points).  A nation that wants to promote economic growth should work to reduce income inequality.  Explain whether you agree or disagree with the statement.

2.           (10 Points).  A bright young MBA student who has a lifetime utility function of the form

U = log(c1)+ log (c2) + log(c3) +log(c4)

will, in period 1 of his life consume

 

(All of the above is true).  He expects to earn $90,000 in period 2, $450,000 in period 3 and then retire.  (All of the above is true).  The discount rate is 50% per period.  He is subject to a 50% tax on interest income and a 1/3 tax on wage income.  

 

Baring surprises, he will consume $25,000 in the first period of life.  Explain whether you agree or disagree with this statement.  Hint:  disagree, and give me the right number.

3.           (10 Points).  A Rise in the Natural Rate of Unemployment is evidence of poor economic policy.  Explain whether you agree or disagree with the statement.

4.           (10 Points).  If we cut the tax rate on dividend or interest income, people will feel wealthier, spend more and shift the demand for loans curve to the right.  Explain whether you agree or disagree with the statement.

 

5.           (10 Points).  If the long run labor supply curve is backward bending, people will reduce the hours they work if they get an opportunity to work for a higher wage rate.  Explain whether you agree or disagree with the statement.

 

6.           (10 Points).  We know – or ought to know – two facts.  First, a rise in consumer confidence will lead people to feel wealthier and increase the demand for consumption.  Second, a nations output is determined by your friend and mine, the equation Y = AKaL1-a.   But there is no way for these two statements to be consistent in the short run unless people respond to a rise in consumer confidence by working harder.  Explain whether you agree or disagree with the statement.

7.           (40 Points)  Last year the newspapers were full of stories from Central Backwater, where its government undertook a $100 million program to build a monumental tomb for its current ruler, who was not in the best of health.   There was general agreement that this proposal was truly a monument to vanity and folly.

 

Unbeknownst to the world’s press, Western Backwater was planning a project, which would also cost $100 million.  The project was unveiled today.  While details of the project are hazy, all the nations eminent economists agree that this project will add boost A in Western Backwaters production function (Y = AKaL1-a) and add $25 million a year to its GDP.  The project will be undertaken in year one and the benefits from the project will begin in year two. (Take all of these numbers as accurate)

The government is considering two approaches to financing the project:

a)     Impose a special tax surcharge on last year’s income tax bill sufficient to cover the project.

b)     Borrow the money.  Beginning in year 2, impose a special tax on wage income sufficient to repay the debt over a 10 year period.  (Accountants are working out the precise tax rate; you need not worry about that).

Your task is to analyze the proposals.  Specifically:

(1)    What will be the impact on GDP, Investment and Interest Rates in the coming year?

(2)    Rank the proposals in term of their impact on these three variables.  Say where you do not have enough information.

(3)    On grounds of economic efficiency, which one do you recommend?  Why?