Business Conditions

Second Midterm Examination

November 19, 1997

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.

1. (10 Points). While the type of taxes we use to finance government has an impact on who pays the taxes and thus matters to the individual taxpayer, all that matters from an aggregate perspective is the level of taxation, not the particular taxes. Explain whether you agree or disagree with this statement.

Disagree. The mix of taxes (wage taxes and interest taxes, for instance) can clearly impact wealth and hence consumption and saving decisions.

2. (10 Points). It is a fact that East Waddle and West Waddle are initially alike, and indeed are initially like Neutral. If the government of East Waddle now introduces a pay as you go social security system, then its equilibrium capital effective labor unit ratio will decrease relative to that of West Waddle. Explain whether you agree or disagree with this statement.

Agree. This is just the standard social security problem

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. It is unclear whether his average cash balance will also be double.

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.

The question is whether transaction costs will double. If they double, then the existing money strategy is still optimal. If all transaction costs are "shoe leather" costs, involving time, then the cash balance will double. Otherwise, the average cash balance will probably go up, but not double.

4. (10 points). When the Federal Reserve System sells a $1,000 bond to the public in an open market operation, it increases the amount of government debt held by the public by $1,000. When the United States Treasury sells a $1,000 bond to the public to finance (say) a new irrigation project, it too increases the amount of government debt held by the public. Thus it is clear that they must have the same effect on the money supply. Explain whether you agree or disagree with this statement.

Disagree. The treasury doesn't print new money. The Federal Reserve System does.

A warning: while the form of this question is familiar, I have changed some of the particulars.

5. (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

· South Fuddle, concerned about the equity in placing all of the tax burden on wage income, decides to go to a tax on all income. That is, both wage and capital income will be taxed at the same rate. The new tax system goes into effect in year 1.

· By a cruel twist of irony, North Fuddle also has a debate about tax policy, but the debate is so fierce that the High Assembly of North Fuddle adjourns at the beginning of year one, after passing legislation authorizing the usual rate of government spending, but without authorizing any taxation. A conference of political leaders agrees that they will borrow the ¨15,000,000 (North Fuddle's GDP is ¨100,000,000 in year one) to get through the year and then pay the debt off in years 2, 3 and 4. That is, the national debt will be ¨15,000,000 at the end of year one, ¨10,000,000 at the end of year 2, ¨5,000,000 at the end of year 3 and nothing thereafter. All the inhabitants of North Fuddle expect the agreement to be followed, and so should you.

a. 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.

Series	Comparison with Son of Neutral
Wage Rate	The Same
Capital Rental Rate	The Same
Output per Capita	The Same
The Interest Rate	Higher in SF
The Level of Consumption	Higher in SF (the lower after tax rate leads to higher wealth calculations. In turn that will cause higher consumption and less saving, and hence a lower capital labor ratio next period. Thus the higher interest rate.

b. 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).

Series	Comparison with Son of Neutral
Wage Rate	Lower in SF
Capital Rental Rate	Higher in SF
Output per Capita	Lower in SF
The Rate of Growth	The same
The Level of Consumption	Lower in SF

c. 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.

Series	Comparison with Son of Neutral
Wage Rate	The Same
Capital Rental Rate	The Same
Output per Capita	The Same
The Interest Rate	Higher
The Level of Consumption	Higher. Tax burdens will be shifted from persons 63, 64, and 65 to persons 17, 18, and 19. The increase in consumption by the old will more than offset the decrease in consumption by the young. That has implications for the saving rate and hence the interest rate.

d. 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).

Series	Comparison with Son of Neutral
Wage Rate	The same
Capital Rental Rate	The same
Output per Capita	The same
The Rate of Growth	The same
The Level of Consumption	The same