Business Conditions

First Midterm Examination

October 14, 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). There are times when GDP declines for a year or so. The most prominent example is 1929-1933, the Great Depression. Perhaps there is nothing the government can do about these declines, but it is vital that it keeps national income up during these declines. Explain whether you agree or disagree with the statement in italics.

Disagree. Income and Product must be the same. There is a nit about domestic product and national income, but basically they must be the same.

2 (7 points). I'm not wealthy. I only earn $25,000 a year. It is true that fifteen years from now I will receive an inheritance of $10,000,000. Then, I will be wealthy. But now, I am not wealthy. Explain whether you agree or disagree with this answer.

Disagree. Wealth is the present value of all current and future income. In my book an inheritance of $10,000,000 fifteen years from now makes you wealthy. It must be included in wealth.

3. (10 Points). The United States has had a relatively constant rate of growth of real GDP since the end of World War II. European countries initially had high growth rates, but they have recently declined. In other countries, such as Malaysia, growth rates are very high and continue to be high.

1. Make Sense of this pattern.

This is Catch-Up 101. The Europeans have caught up, and hence the decline in their growth rates. The Malaysians have not yet caught up.

2. What do you expect will be the pattern for Malaysia's growth rate? Why?

As they catch up, the growth rate will decline.

(c) Still other countries have had very low or negative growth rates? Why has this occurred?

They don’t meet the conditions for catching up. They have problems such as political instability, non-market economies, and they don't know how to play baseball.

4. (20 points). A bright young MBA student who now has a lifetime utility function of the form

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

expects to earn $400,000 in period 2, $500,000 in period 3 and then retire. He also has student loans to pay back. The payments on these loans will be $50,000 in period 2 and $80,000 in period 3. The discount rate is 100% per period.

1. Show how much the student will consume in each period of life. Explain your calculations.

Wealth is 400/2 +500/4 -50/2 -80/4 = 280 (I drop the thousands). Thus c1 = 70

Period	Consumption
1	70,000
2	140,000
3	280,000
4	560,000

2. At the beginning of period 3, the MBA student is delighted to hear that the government has decided to forgive that year's installment on the student loan. Show what consumption will look like over the life cycle.

This is like getting an additional 80,000 of wealth in period 3. Thus.

Period	Consumption
1	70,000
2	140,000
3	320,000
4	640,000

5. (30 points). Consider two countries, East and West Fuddle, initially exactly like Neutral in all respects. Twin brothers rule the two economies. At a recent family gathering, the two brothers agreed that both of their nations looked unsightly. In particularly a lot of plants looked old and decrepit. Upon returning to their respective kingdoms, the two brothers instructed their Grand Viziers to "do something" about this.

• In East Fuddle, the Grand Vizier decided to order an immediate 50% demolition of all existing plants and equipment. A specially trained team went around the country and picked the worst looking plants, and ordered their immediate destruction. The demolition was complete by the beginning of year 1.
• The Grand Vizier of West Fuddle ordered a more incremental plan. He knew that 4% of the capital stock wore out each year in Neutral. He ordered that, from now on, beginning in year 1, 6% of the capital stock would be replaced each year. He sold the ruler on this scheme by commenting on the advantages of a gradual approach.

1. Complete the following table for East Fuddle

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

Explain your answers:

This is just Loser in another guise.

2. Complete the following table for West Fuddle

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

Explain your answers:

Here, there is a permanent effect on investment. The saving rate will drop given the lower return. However the effects on wage rate, etc, will not be felt the first year.

1. Without going into discussions of political freedom, etc, rank as best you can, the three countries (Neutral, East Fuddle, West Fuddle) according to the wisdom of their economic policy. Explain your answer.

Neutral is best. Both East and West Fuddle follow foolish policies of needless destruction of the capital stock. As to a comparison of East and West Fuddle, it depends on your preferences for consumption now versus consumption later.

6. (6 points) The Monty Python Book of international economic data report the following data on Wurstphalia for 1997.

Item	Amount
Bushels of Corn Raised	50,000
Price of Corn	$5 per bushel
Number of hogs raised	10,000
Price of Hogs	$30
Corn consumed by each hog	3 bushels

No other goods and services were produced in Wurstphalia. What was Wurstphalia's GDP? Explain your answer.

$400,000. Do not make the mistake of counting the intermediate productin of corn consumed by the hogs.

7. (Bonus Points)

(a) Two points. Who won the 1998 Nobel Prize in Economics?

(b) Three points. For what?

You can go to the web for this one.