Midterm Exam

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:

 

 

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1.           (10 Points).  More than any other single number, per capita GDP measures a nation’s well being.  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)

will, in period 1 of his life consume

 

(All of the above is true).  He expects to earn $120,000 in period 2, $600,000 in period 3 and then retire.  (All of the above is true).  The discount rate is 50% per period.  He is subject to a 50% tax on interest income and a 1/3 tax on wage income.  

 

Baring surprises, he will consume $25,000 in the first period of life.  Explain whether you agree or disagree with this statement.  Hint:  disagree, and give me the right number.

3.           (10 Points).  A Rise in the Natural Rate of Unemployment is evidence of good economic policy.  Explain whether you agree or disagree with the statement.

4.           (10 Points).  A permanent increase in the tax rate on wage income could initially cause people to move on their short run labor supply curve.  But once they understand it is a permanent increase, they will invariably cause people to move down their long run labor supply curve.  Explain whether you agree or disagree with the statement.

 

5.           (10 Points).  A deficit on current account is proof of poor economic policy.  Explain whether you agree or disagree with the statement.

 

6.           (10 Points).  If a nation repeals a tariff on a commodity, consumers will gain and domestic producers will lose, but the gains to consumers will exceed the losses to producers.  Explain whether you agree or disagree with the statement. Hint:  A good answer calls for a well-labeled and well explained graph.

7.           (40 Points)  Last year the newspapers were full of stories from Central and Western Backwater, where the governments undertook splashy $100 million programs.  There was general agreement that Central Backwater’s program was foolish, whereas Western Backwater’s was wise and sensible.

 

Eastern Backwater had its own project, which would also cost $100 million.  The project was unveiled today.  Basically, Eastern Backwater has ordered $100 million of additional capital investment from abroad.  While the list of capital equipment is not public, all the nation’s eminent economists (who have looked at the list) agree that the items being ordered are sensible.  That is, if the private sector had undertaken $100 million of orders, they would have been the same.  This is a large order.  Absent this order, private investment was projected to be $250 million. (Take all of these numbers as accurate)

The orders will be placed in Year 1.  The new capital will be available for use by the entrepreneurs in Year 2.

 Financing comes with a wrinkle.  The capital will be lent to entrepreneurs, who will be expected to rent the capital at a fair market rate.  The eminent economists who have looked at the plan have unanimously concluded that the project will bring in enough money cover the initial cost.  That is, if the government chooses to borrow $100 million to pay for the project, the receipts will be enough to pay off the borrowing.  It can borrow the funds at no cost at any time to taxpayers.

The government is considering three approaches to financing the project:

a)     Simply borrowing $100 million, and using the revenue from renting the capital out to pay off the borrowing.

b)     Levy a special tax on wages this year sufficient to raise $100 million.  Thereafter any receipts from renting out the machines will be used to reduce wage taxes in the future.

c)      Levy a special tax on wages this year sufficient to raise $100 million.  Thereafter receipts from renting the machines out will be repaid to the original taxpayers.  The calculation of the eminent economists is that workers will recover everything they pay out in taxes with interest.  (That is, the present value of tax payments and payments from the government will exactly balance).

Your task is to analyze the proposals.  Specifically:

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

 

Proposal a

Proposal b

Proposal c

Private investment will
decline/not change/increase
(circle one)

Private investment will
decline/not change/increase
(circle one)

Private investment will
decline/not change/increase
(circle one)

Total investment (both private and government) will
decline/not change/increase
(circle one)

Total investment (both private and government) will
decline/not change/increase
(circle one)

Total investment (both private and government) will
decline/not change/increase
(circle one)

GDP will
decline/not change/increase
(circle one)

GDP will
decline/not change/increase
(circle one)

GDP will
decline/not change/increase
(circle one)

Interest rates will
decline/not change/increase
(circle one)

Interest rates will
decline/not change/increase
(circle one)

Interest rates will
decline/not change/increase
(circle one)

Now explain your answer

(2)    Rank the proposals in term of their impact on these three variables.   Give answers such as a>b>c or a=b>c

 

 

Variable

Rank

Private Investment

 

Total Investment

 

GDP

 

Interest rates

 

 

Now explain your answer

 

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