Business Conditions

Second Midterm Examination

November 17, 1999

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	3	4
5	6	7	S

1. (7 Points). Explain whether you agree or disagree with the following statement: If 51% of the population had a bequest motive, then an increase in the national debt would have no impact on the equilibrium capital labor ratio.

Disagree. If some people do not have a bequest motive, then some future taxes will not be considered in wealth calculations, and the debt will have an impact.

2. (7 Points). In recent years the government has been issuing purchasing power bonds, whose nominal value would be increase every year in proportion to the change in the price level. Explain whether you agree or disagree with the following statement: There is no advantage to these bonds, because standard bonds include a premium for expected inflation

Disagree. The bonds will have different returns if actual and expected inflation are different.

3. (7 Points). We know that, in an economy without a bequest motive, the higher the national debt, the lower the capital labor ratio. The Federal Reserve System holds several hundred billion of government bonds. The interest it collects on these bonds is turned back into the treasury. Explain whether you agree or disagree with the following statement. If we simply recognized this for a sham transaction and cancelled these bonds, thus reducing the national debt, we would increase the capital labor ratio.

Disagree. The real sham is that we don’t cancel the bonds right now.

4. (7 Points). Explain whether you agree or disagree with this statement. A tax of $1 on each trip to the bank would be deflationary. Hint: the correct answer is “agree”. Explain why.

Agree. This would increase the cost of getting money. The optimal cash management strategy would change.

5. (7 Points). Explain whether you agree or disagree with this statement. The natural rate of unemployment measures the unemployment rate after an adjustment for seasonal variation.

Disagree. It measures the amount of unemployment with normal turnover.

6. (20 Points). Consider a country TRUMP initially like SIX in many ways. But

· The money supply is growing at the biological interest rate

· The country is in steady state equilibrium

· There is no national debt.

· Government purchases consumer a fraction n of GDP.

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

Concerned about the poverty of the young, the government enacts a one –time tax of 15 percent on all assets. While there is no exemption for a minimum level of assets, those with negative assets are exempt from paying the tax. The proceeds of the tax are used to pay back part of the debts of those with negative assets. Thus, a person in debt will find that r percent of their debts will be repaid with the tax proceeds. The actual value of r will, of course depend on the value of the tax collected.

· Show the effect of this policy on the Y and M curves for year one. (Hint: a well-labeled and well-explained graph will be helpful here).

The Y curve would shift to the left. Wealth is being transferred from the old to the young. The old consume a higher percentage of their wealth than do the young, so the net effect would be a reduction in consumption. By the same logic, the M curve would also shift to the left. Thus we know the interest rate would decline, but the effect on the price level is ambiguous.

· 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.

Explain your answers.

The effect on the price level is ambiguous. The saving rate would be increasing and the interest rate would be declining. See above. The real wage rate would of course be unaffected.

The saving rate will	Increase
The real interest rate will	Decrease.
The price level will	Cannot Tell
The real wage rate will	Remain the Same

· Describe the impact of this policy on each of these variables in steady state equilibrium. Explain your answers.

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.

This is a temporary policy. There are no effects on steady state. All answers should be “remain the same”

7. (25 Points). Eastern and Western Waddle are both initially like Six. They fight a vigorous but fortunately short war, consuming an extra 5% of GDP in year one. There is no loss of life or destruction of the capital stock. In Eastern Waddle, the war is paid for with a special, one time tax on wage income. In Western Waddle, the war is financed by borrowing. Thereafter the government increases taxes so as to keep the new debt/GDP ratio constant. All of the extra taxes come from interest income.

For East Waddle

· Show the effect of this policy on the Y and M curves for year one. (Hint: a well-labeled and well-explained graph will be helpful here).

The Y curve shifts to the right. While government spending increases, wealth decreases by the amount of increased spending. But consumption decreases by only a fraction of that. But the M curve moves up and to the left, given the decreased consumption demand. Thus the price level is up, but the effect on the interest rate is unclear.

· Using this graph, show the effect on the following variables. I have provided a table for your use. If your answers cannot be read directly from the graph above, explain your answers.

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 interest rate and price level effects are as described above. Thus the saving rate is ambiguous. The real wage rate, of course, does not change.

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

· Describe the impact of this policy on each of these variables in steady state equilibrium. Explain your answers.

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.

Again, this is a temporary policy. No permanent effects.

For West Waddle

· Show the effect of this policy on the Y and M curves for year one. (Hint: a well-labeled and well-explained graph will be helpful here).

The Y curve shifts to the right, as does the M curve. Remember there is increased money demand. Thus interest rate is up, the price level is ambiguous.

· Using this graph, show the effect on the following variables. I have provided a table for your use. If your answers cannot be read directly from the graph above, explain your answers

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 higher interest rate means a lower saving rate. The price level is discussed above, and there is obviously no change in the wage rate.

The saving rate will	Decrease
The real interest rate will	Increase
The price level will	Cannot Tell
The real wage rate will	Remain the Same

· Describe the impact of this policy on each of these variables in steady state equilibrium. Explain your answers.

The saving rate will	Increase/decrease/ remain the same/cannot tell.
The nominal 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.

We know the existence of debt and a higher interest rate tax will reduce the saving rate. Thus the real interest rate will be up, and, since there are no changes in inflationary expectations, there will be no change in the nominal rate. The lower capital labor ratio means a lower real wage rate. The growth rate is obviously unaffected.

As to the price level, we also know that consumption will go down with the capital labor ratio. Since the interest rate is also rising, the effect will be to reduce the demand for money. Thus the price level will have to be higher.

The saving rate will	Decrease
The nominal interest rate will	Increase
The price level will	Increase
The real wage rate will	Decrease
The rate of growth of GDP will	Remain the same