Business Conditions

First Midterm Examination

November 6, 2002

Mr. Upton

Directions: Each Problem has the indicated weight. Work all problems on the exam itself. If necessary, use the back of the exam sheets, indicating that you have done so.

Name:

 

1

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5

S

 

1.     (10 Points).  The case for Supply Side Economics rests squarely on where you assume we are on the Laffer Curve .  Explain whether you agree or disagree with the statement.

2.     (10 points). A bright young MBA student who has a lifetime utility function of the form

U = log(c1)+ log (c2) + log(c3) +log(c4)+x[ log(m1)+ log (m2) + log(m3)]

will, in period i of his life consume

 

and have a money demand function of the form you expect.  (All of the above is true).  He expects to earn $60,000 in period 2, $360,000 in period 3 and then retire.  (x =0.25)  The inflation rate is fully expected to be 50% a period.  His money balances will be 37.5% of his consumption.  (All these statements are true).  Further, his money holdings will be $30,000 in period one of his life.  Explain whether you agree or disagree with this statement.  Explain whether you agree or disagree with this statement.  Hint:  disagree, and give me the right number.

3.     (10 points).  If the international supply of loans curve is upward sloping, and not a horizontal line, there is a limit to how large a deficit on current account we can run.  Explain why you agree or disagree with this statement.

4.       (20 points). The Government of Central Backwater is about to undertake a $100 million program to build a monumental tomb for its current ruler, who is not in the best of health.  The project is to be completed in the year.

There is a great debate about how to finance the project.  Three proposals have been advanced.

(a)   Impose a special one-time tax on wage incomes in the coming year sufficient to cover the cost of the project.

(b)   Require workers to make an involuntary loan to the government.  The loan will equal the tax called for in proposal (a).  However, the loan will be paid back over time with a special 3% tax on wage incomes.  (The 3% tax will start the year after the project is completed).  The special tax will last as long as is required to pay back the loan.  And yes, it will be paid back.

(c)    Rather than require an involuntary loan, Central Backwater can simply borrow $100 million.  If it elects this option,   the loan will be paid back over time with a special 3% tax on wage incomes.  (The 3% tax will start the year after the project is completed).  The special tax will last as long as is required to pay back the loan.

Your task is to analyze the proposals.  Here are some things to analyze:

(1)    What will be the impact on GDP, Investment and Interest Rates in the coming year?

(2)    Rank the proposals in term of their impact on these three variables.  Say where you do not have enough information.

(3)    On grounds of economic efficiency, which one do you recommend?  Why?

(4)    There is debate in Backwater over the magnitude of the bequest motive.  Show how the magnitude of the bequest motive impacts your answer.  It is probably a wise precaution to explain what is meant by the bequest motive.

(5)    Do you expect to get a lot of points on this question if your answer is not crammed with well-labeled and well-explained graphs and charts?

5        (20 points). Suppose that the Federal Reserve System engaged in a $100 Billion Open Market Operation.   

(a)       Explain what an Open Market Operation is and how the Fed would carry it out.

(b)       Assuming the Quantity Theory of Money works without qualification, explain what the impact of the Open Market Operation would be on the price level.  (You might also want to define the Quantity Theory of Money in your answer).

(c)        Trace through any implications of the Open Market Operation on the level of investment.

(d)       “This Open Market Operation will benefit our children only if we don’t love them”.  Explain why you agree or disagree with this statement.