Business Conditions

Second Midterm Examination

November 15, 2000

Mr. Upton

Directions: Each Problem has the indicated weight. Work all problems on the exam itself. I think I have left adequate space, but if necessary, use the back of the exam sheets, indicating that you have done so.

Name:

1	2	S
3	4	S

Short Answer Questions

1. (10 Points). Explain whether you agree or disagree with the following statement: The Quantity Theory of Money tells us that money does matter. Since it is also true that money is the root of all evil, we should simply abolish money in our society.

I don’t know about money being the root of all evil, but if we were to abolish money, then we would have a terrible time running our economy; barter is terribly inefficient.

2. (10 Points). Show why it makes sense to have uniform tax rates on different commodities.

See the notes on this one.

3. (10 Points). A full time MBA student at the University of A**** has an income upon graduation of $40,000 a year. He spends $26,000 a year, or $500 per week. His average cash balance is $250. His counterpart at Kent State University gets a job at $80,000 per year, and decides, after engaging in life cycle consumption maximization, to spend $52,000 per year, or $1,000 per week. Explain, preferably with an example, why his average cash balance might also be twice as large as his counterpart at the University of A****. Explain the conditions under which it would not be twice as large.

This is a question in cash management strategies. Does shoe leather cost double with income. If it does, then he will maintain twice the cash balance. If it does not, he will not.

Long Answer Question

(70 points) Consider a country BEFUDDLED initially like SIX in many ways. But

1. The money supply is growing at the biological interest rate

2. The country is in steady state equilibrium

3. There is no national debt.

4. Government purchases consume a fraction n of GDP.

5. Government expenditures are financed by taxes on wage income and money creation.

BEFUDDLED has recently had a presidential election, where the results were very close. The process of deciding who won is still dragging on. To offset lower morale, the government decides to increase the money supply by 10%. (Why this increases morale is an issue best left for psychology classes). It uses the funds to purchase assets from individuals, with the intention of keeping the bonds forever and using the interest income to fund government operations.

1. Short Run Equilibrium

Show the effect of this policy on the Y and M curves for year one. Explain your answer.

P_o

Y’

M’

M

Y

r_o

2. Short Run Tables

Using this graph, show the effect on the following variables. I have provided a table for your use.

The saving rate will	Increase/decrease/ remain the same/cannot tell.
The real interest rate will	Increase/decrease/ remain the same/cannot tell.
The price level will	Increase/decrease/ remain the same/cannot tell.
The real wage rate will	Increase/decrease/ remain the same/cannot tell.
Real output will	Increase/decrease/ remain the same/cannot tell.
The capital stock will	Increase/decrease/ remain the same/cannot tell.

Explain your answers. Your grade will depend on both your answers and your explanation.

I have combined my answers. The trust fund means lower taxes in the future, thus increasing wealth. The effect is to shift the Y curve to the right. As to the M curve, there are two effects. In part the higher wealth would cause more money demand and hence shift the M to the right. However, the major effect will be the increase in the money supply, moving the M curve to the left. The net effect is to raise the price level and leave the interest rate ambiguous. With these answers understood, we can draw the following table. The price level and interest rate effects are clear. As to the other two variables, if the interest rate is indeterminate so too must be the saving rate. The wage rate is of course unchanged in the first year, as are the capital stock and real output.

*The saving rate will*	*cannot tell.*
The real interest rate will	cannot tell.
*The price level will*	*Increase*
The real wage rate will	remain the same.
Real output will	remain the same.
The capital stock will	remain the same.

3. Long run Equilibrium

In time, it turns out that the presidential race is decided and life goes back to normal. The new president continues all the policies currently in effect. However, he likes the idea of a government endowment that he decides to keep it going. He devotes part of the earnings to paying for the cost of the government, but enough of the earnings to reinvestment into the fund that it grows, in real terms, at the biological interest rate. Your task is to predict the effect of the uncertainty on steady state equilibrium. Fill in the table and explain your answers. And remember that economists love well labeled and well explained graphs.

The saving rate will	Increase/decrease/ remain the same/cannot tell.
The real interest rate will	Increase/decrease/ remain the same/cannot tell.
The price level will	Increase/decrease/ remain the same/cannot tell.
The real wage rate will	Increase/decrease/ remain the same/cannot tell.
The rate of growth of GDP will	Increase/decrease/ remain the same/cannot tell.
The inflation rate will	Increase/decrease/ remain the same/cannot tell.

There are two permanent effects. One is a 10% higher stock of money. That means a 10% higher price level, though no change in the money supply. The other change is a negative government debt, so we get the effect of the government debt in reverse. The following graph shows the saving line increasing and hence the equilibrium capital effective labor ratio growing.

In turn that means a lower real interest rate.

Clearly there will be no change in the rate of growth of GDP and the inflation rate. (There is no change in the biological interest rate and no change in money growth). What about the price level? Because of the higher saving rate, we know there will be more consumption. The increased consumption and the lower interest rate will increase the demand for money balances. This effect will be deflationary. However the 10% increase in money supply is clearly inflationary. Thus we cannot tell which effect will predominate and the price level must be marked as uncertain.

S₂

S₁

The saving rate will	Increase.
*The real interest rate will*	*decrease.*
*The price level will*	*Cannot tell*
The real wage rate will	Increase.
The rate of growth of GDP will	remain the same.
*The inflation rate will*	*remain the same.*