Final Examination
May 8, 2003

 

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.  Each problem has the indicated weight.

Name:

 

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First Part (5 point questions)

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

 

1              Any tax-financed increase in government spending, whether permanent or temporary, will lead to an decrease in consumption demand.

2              There are no important differences between a policy of maintaining a fixed exchange rate and using a currency board..

3              If the government starts increasing the money supply interest rates will fall.

4              To be effective, Monetary Policy Rules must be well publicized.

5              The life cycle model of consumption shows that, both in the long run and in the short run, consumption is proportional to income

6              The money multiplier measures the impact of an increase in the money supply on the Y curve.

7              Whether people work on the short run or long run labor supply curve depends on how long they have been earning their current wage rate.

8              The Theory of Real Business Cycles predicts that real wages will decline during a recession.  By the test of “does it fit the facts” it is inferior to the explanation based on unanticipated inflation.

 

Second Part (15 point questions)

1                 For each of the following events, what will be the impact on the trade deficit? Explain your answer. It is not enough to guess the right answers: you must explain why these are the correct answers.

a)     People become more confident about the future

b)      A sudden one-year increase in national productivity.

c)      The euro falls from 1 €=$1.12 to 1 €=$0.80.

d)     An increase in the corporate profits tax.

e)      .Workers change their perception of a decline in the wage rate.  While they used to believe the decline to be temporary, they now believe it is permanent.

2                 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

 

·        Using these data, compute John, Wills, and Sally’s wealth in US dollars.  NB This is a two period model..

 

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

 

·        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? 

Third Part (30 points)

Consider an economy NEUTRAL, where the unemployment rate is running about a percentage point above the natural rate.  The inflation rate is equal to the expected inflation rate.  Two competing tax plans have been advanced for managing the economy

·        The first, the SNOW plan calls for eliminating taxes on capital income.  Once the SNOW plan is enacted, the government will be running a balanced budget.

·        The second plan, DASCHLE, calls for keeping taxes on capital income and raising the overall tax rate.  The extra funds will be used to provide universal health coverage to residents.  (You may assume that government funded health care will be just as efficient as current health care plans.  No person will get better or worse health care. )

Now for the questions.  In answering this question, remember the old proverb that well-labeled and well-explained graphs are worth a thousand or more words.

1.      What will be the effect of these two plans on GDP, the price level, interest rates and Unemployment  in the first year?

2.      Advocates of both plans claim long term benefits in terms of promoting GDP and economic welfare.  While advocates of the DASCHLE plan claim a benefit of improved health care, I have taken that benefit off the table for the purposes of this exam, with the assumption  that no person will get better or worse health care.  With that caveat, comment on the competing claims.