Business Conditions

Second Midterm Examination

November 18, 1998

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. (7 Points). An temporary increase in government spending, financed by temporary increase in wage taxes, will always lead to both a higher price level and higher real interest rates in the short run. Explain whether you agree or disagree with this statement.

Disagree. It depends on just how it shifts the Y and M curves. The Y curve will shift to the left, and the M curve will shift to the right. The net effect will be to raise the price level, but real interest rates can either rise or fall.

2. (7 points). Northern and Southern Waddle are both initially like Neutral. Both introduce a social security system. In Southern Waddle, people are required to contribute to their choice of private pension plans. The contribution must be sufficient so that, when they retire, they get a pension of at least 20% of their final salary. In Northern Waddle, the government also requires a contribution to a private pension plan, but the final pension must be at least 30% of their final salary. Thus, in steady state equilibrium, Northern Waddle will have a lower capital/effective labor ratio than either Southern Waddle or Neutral. Explain whether you agree or disagree with this last statement.

Disagree. Since it is a private pension plan, people who don't want to save this much can simply borrow against it. There will be no effect on the saving rate and hence on the capital/effective labor ratio.

3. (7 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. Consider the difference between wage taxes and interest rates. We spent a lot of time talking about these two and their different effects.

4. (7 points). We all know that when the Federal Reserve System sells a bond to the public, it effectively decreases the money supply and thus is deflationary. Thus, when the government runs a surplus and uses it to buy bonds back from the public, that will be inflationary. Explain whether you agree or disagree with this statement.

Disagree. There is no effect on the money supply from the government running either a surplus or deficit.

5. (7 points). Inflation really does rob us all. We end up paying higher taxes because nominal interest rates are higher and because we get taxed on inflation induced capital gains. Explain whether you agree or disagree with this statement.

Disagree. The effect is to increase the tax on interest income, and thus reduce the tax on wage income. This is simply a choice between consumption now and consumption later.

6. (20 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 Neutral in your answer: in all cases, this is shorthand for Son of Neutral
• North and South Fuddle get into a brief but furious war. The war costs each of them 20 percent of a year's GDP, all spent on sophisticated "smart bombs". Unfortunately - or fortunately - the sophisticated bombs turn out to be high priced duds, falling into the sea separating the two countries, with no loss of life and no damage to either country. Both governments realize they look foolish and peace breaks out.
• But there is the cost of paying for the war. South Fuddle, concerned about future generations, decides to levy a special one-time tax on existing financial assets. Thus the cost of the war will be paid for in one lump sum.
• In North Fuddle, the Council of Economics has read about the optimality of paying for a project over time, decides to borrow all of the funds required to pay for the war. Thus their Debt/GDP ratio becomes 20%. Thereafter they hike taxes enough to keep the Debt/GDP ratio constant.

1. Complete the following table for South Fuddle

In Year One	In Steady State Equilibrium
The capital/effective labor ratio is less than/equal to/greater than Neutral's	The capital/effective labor ratio is less than/equal to/greater than Neutral's
	The wage rate is less than/equal to/greater than Neutral's
The saving rate is less than/equal to/greater than Neutral's	The saving rate is less than/equal to/greater than Neutral's
	The growth rate is less than/equal to/greater than Neutral's

Explain your answers:

2. Complete the following table for North Fuddle

In Year One	In Steady State Equilibrium
	The capital/effective labor ratio is less than/equal to/greater than Neutral's
The wage rate is less than/equal to/greater than Neutral's
	The capital rental rate is less than/equal to/greater than Neutral's
The saving rate is less than/equal to/greater than Neutral's	The saving rate is less than/equal to/greater than Neutral's

Explain your answers:

7. (21 points). You have all read reports about the so-called Year 2000 Problem. Basically, there is a fear that on January 1, 2000, many computer systems around the world will collapse, throwing the global economy in chaos. Among other things, there is a fear that banks, checking accounts, and credit cards will be impossible to use after that period. Without getting into the problem in detail, us assume that many nervous people decide to increase their holdings of real money balances in December 1999. The idea would be that, if there were a problem, there would be no substitute for cash. If there is no problem, the worst loss will be holding a little extra cash and losing a little interest. Suppose further that the Federal Reserve System takes no action to offset these extra withdrawals.

1. Under these conditions, what would be the effect of the withdrawals on real interest rates and the price level in the period just before 12/31/2000? To make life simple, use the following graph. (I was tired and forgot to label the axes. You should do this for me). The Y and M curves as drawn represent the economy as it would be if the Year 2000 problem were only something written about in science fiction magazines or computer "techie" journals. (I realize the two may be the same). Note: this is a question about economics, not the Year 2000 problem. Assume that the problem turns out to be highly overrated, though it does lead to these precautionary withdrawals.

Explain and defend your graph. (You didn't think you would get away without that, did you?

The M curve shifts to the right, because people are demanding more money. Thus the effect is to lower the price level and raise the interest rate.

2. What actions would you recommend the Federal Reserve System take to offset these withdrawals if it wants to insulate the economy from any effects of these withdrawals? Explain and defend your answer with a well-labeled graph. (Yes, you may assume that the Federal Reserve System knows how big the extra withdrawals will be.) If you do not think actions by the Federal Reserve system can completely insulate the economy, explain why.

A temporary increase in the money supply makes sense.