Business Conditions

First Midterm Examination

October 13, 1999

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	2	3	4	5
6	7	8	9	S

1. (7 Points). The reason many countries are poor is because they are denied access to new technology. If they were allowed to obtain new technology, they would grow and prosper. Explain whether you agree or disagree with the statement.

Disagree. The factors causing the lack of technology are internal. Basically, innovation takes place where there is money to be made; if these countries gave entrepreneurs the right incentives, development would follow.

2 (7 points). John Smith has a bequest motive, and plans to leave something to his child Yorick. Indeed John, being a prudent planner, has already set up a trust fund that automatically goes to Yorick at John's death. Alas, poor Yorick - we knew him well - loses his job. He suffers a substantial loss of income. Clearly Yorick will have to reduce his consumption. It is rational for John to show support for Yorick by reducing his (John's) consumption as well. It would not be enough simply to give Yorick his trust fund right now. Explain whether you agree or disagree. (And, to clear the air, responses talking about tax laws and the legality of dissolving the trust fund before John's death are non-responsive).

Agree. The budget line for both John's and Yorick's consumption shifted in when Yorick lost his Job. That means that both John's and Yorick's consumption should decline. Just giving Yorick the trust fund would make Yorick no better off; he is going to get that anyway.

3. (7 points). To a Malthusian, policies that lower a death rate are undesirable while policies that lower the birth rate are desirable. Explain why you agree or disagree with this statement.

Agree. Remember the level of income at which the birth and death rates intersect determines the standard of living. If the birth rate drops, the standard of living rises; if the death rate drops, the standard of living drops.

4. (7 points). If there is a one-time increase in the number of effective labor units per worker, the capital effective labor ratio falls. Since the wage rate increases and decreases as the capital effective labor ratio increases or decreases, workers will be made worse off by the new technology. Explain why you agree or disagree with this statement.

Disagree. The effects on the wage rate are correct, but the law of diminishing proportions means that the decline in the wage rate per effective labor unit will be less than the increase in the number of effective labor units per worker.

5. (7 points). A bright young MBA student who has a lifetime utility function of the form

U = log(c₁)+ log (c₂) + log(c₃) +log(c₄)

expects to earn $420,000 in period 2, $600,000 in period 3 and then retire. The discount rate is 100% per period. Compute consumption over his lifetime.

Period	Consumption
1
2
3
4

Answer. Wealth is $420,000/2 + $600,000/4 = $360,000. Thus consumption in period 1 will be $90,000; thereafter it will double. Hence the following table gives consumption:

Period	Consumption
1	90,000
2	180,000
3	360,000
4	720,000

6. (15 points). Consider a country Lower Balderdash, initially exactly like Neutral in all respects. However, beginning in Year 1, the age at which people begin work is suddenly and permanently lowered from 20 to 18, resulting in an increase in the labor force.

Complete the following table for Lower Balderdash (why are some choices boldfaced and some choices left out? Some get extra credit in grading, others -those omitted from the table - get no credit.

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 wage rate is less than/equal to/greater than Neutral's
	The interest rate is less than/equal to/greater than Neutral's
The output per capita is less than/equal to/greater than Neutral's	The output per capita 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 (Yes, you can get the right answers and lose points for an inadequate answer. I don't expect a lengthy answer, but you must provide an explanation.

Answer:

We will start with steady state equilibrium. This experiment is much like that of 60-65, except that here we are lengthening the work period. There is less requirement to borrow during the pre work years, and there are more years to save for retirement. Hence the saving rate will go down, just the opposite of 60. The lower saving rate means a lower capital-effective labor ratio, and hence a lower wage rate and a lower capital rental rate, which means a lower interest rate. It will not mean a lower level of output per capita, for the labor force has increased. As to the growth rate, there is no change in the biological interest rate, so there will be no change in the growth rate.

In year one, the increased labor force means more output, which means more output per capita. But inasmuch as the capital stock cannot change, the wage rate and capital effective labor ratio both fall. To fill in the table:

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

7. (15 points). Consider a country Northwest Balderdash initially like Neutral. Because of prevailing winds, it knows that, a year hence, the volcano that explodes in Northeast Balderdash will dump a significant amount of rich volcanic ash on the country. The effect will be that, a year hence, there will be a one-time increase of about 20% on the capital stock of Northwest Balderdash. Everyone will find their assets increased by 20%.

Complete the following table for Northwest Balderdash (why are some choices boldfaced and some choices left out? Some get extra credit in grading, others -those omitted from the table - get no credit.

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 per worker is less than/equal to/greater than Neutral's	The wage rate per worker is less than/equal to/greater than Neutral's
The capital rental rate is less than/equal to/greater than Neutral's
	The output per capita 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 (Yes, you can get the right answers and lose points for an inadequate answer. I don't expect a lengthy answer, but you must provide an explanation. Comments about the likelihood of air currents moving from east to west will be ignored.

Answer:

First, lets do steady state equilibrium. The county will find itself exactly like Neutral, but with 20% more capital than Neutral. This is winner all over again, and all effects will disappear in steady state. In year one, the notion that there is to be a 20% increase in productivity comes to late to impact the capital rental rate, the wage rate, output per capita. But the notion of an extra 20% return on saving this year acts as a powerful impact on the incentives to save. The saving rate will be higher. To fill in the table:

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

8. (15 points). Consider Central Balderdash, a country initially exactly like Neutral in all respects. However in beginning in period 1, there is a period of social unrest. Each year, riots cause destruction of 2% of the capital stock. These riots last for five years before peace and tranquility returns to the country. (You may assume that the riots in year one, say, do not affect production in year 1, just the amount of capital in year 1 that is also available in year 2, etc.

Complete the following table for Central Balderdash (why are some choices boldfaced and some choices left out? Some get extra credit in grading, others -those omitted from the table - get no credit.

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 interest rate is less than/equal to/greater than Neutral's
The output per capita is less than/equal to/greater than Neutral's	The output per capita 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 (Yes, you can get the right answers and lose points for an inadequate answer. I don't expect a lengthy answer, but you must provide an explanation.

Answer:

Again, lets first do steady state equilibrium. The riots end after 5 years, so there will surely be no steady state effect from the riots. All the variables should be the same as in Neutral. In year one, however, the riots have an impact. While output is the same, next period's capital rental rate will surely be lower. Normally this would mean a lower interest rate, but the impact of the extra depreciation will lead to a jump in the interest rate. To fill in the table:

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

9. (4 Bonus Points) Who won the 1999 Nobel Memorial Prize in Economics? For what? And why is it called the Memorial Prize?

To quote from the press release:

The Royal Swedish Academy of Sciences has awarded
the Bank of Sweden Prize in Economic Sciences
in Memory of Alfred Nobel, 1999
to

Professor Robert A. Mundell, Columbia University, New York, USA

for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas.

And why the Memorial Prize? The other prizes were founded by Mr. Nobel. This one was funded about 30 years ago by the Bank of Sweden (the Swedish equivalent of the Federal Reserve Board).