Intermediate Macroeconomics 311 Professor Gordon

Final Examination, Fall 2002

NAME: ___________________________________________________________ INSTRUCTIONS: 1. This is a closed book exam. You may use a calculator 2. Write your answers to Part A (multiple-choice) in the space provided below. DO NOT WRITE YOUR ANSWERS ON THE MULTIPLE-CHOICE QUESTIONS. 3. Write your answers for Part B in the spaces provided and to Part C in the bluebook. Be sure to put your name and Student ID number on the cover of both this exam package and of the bluebook.

TIME ALLOCATION POINT ALLOCATION PART A 40 40 PART B 50 50 PART C 30 30 TOTAL 120 120 PART A (40 points) Write your answers to the multiple-choice questions in the space below. WRITE LEGIBLY, USING CAPITAL LETTERS!!!!! 1. _A___ 11. _B___ 21. _C____ 31. _E____

2. _D___ 12. _D___ 22. _B____ 32. _E____

3. _B___ 13. _A___ 23. _C____ 33. _D____

4. _D___ 14. _B___ 24. _A____ 34. _C____

5. _A___ 15. _C___ 25. _D____ 35. _C____

6. _B___ 16. _C____ 26. _C____ 36. _C____

7. _B___ 17. _C____ 27. _D____ 37. _B____

8. _C___ 18. _D____ 28. _E____ 38. _B____

9. _D___ 19. _A____ 29. _C____ 39. _E____

10. _D___ 20. _B____ 30. _A____ 40. _D____

PART A (40 points) Multiple Choice Questions 1) In the context of the neoclassical growth model, which of the following does not explain the growth rates of

countries which are initially poor? A) Nations which are below their steady-state growth paths will grow more slowly until they reach the steady

state. B) The rate of return is higher in poor countries. C) Capital flows from rich countries to poor countries. D) The passage of time allows poor countries to adopt the productive techniques of rich countries.

2) Flexible exchange rates, proving to be much ________ volatile than economists predicted, have led to ________

calls for a return to fixed exchange rates. A) less, few B) less, many C) more, few D) more, many

3) Government debt places a burden on future generations if

A) the debt is used to fund the production of investment goods. B) the debt is used to fund the current consumption of its citizens. C) the debt is used to fund schools and highways. D) All of the above are correct.

4) The U. S. current account balance was negative in each of the past 20 years but one. What happened in that year?

A) Microsoft discovered Windows, leading to a boom in exports B) U.S. economy went into a recession, causing a slump of imports C) Foreigners financed the gulf war D) B) and C)

5) Unemployment that results when individuals who have voluntarily quite their jobs are seeking jobs is called

A) turnover unemployment. B) mismatch unemployment. C) natural unemployment. D) cyclical unemployment.

6) Europes stability and growth pact implies

A) An increase in the growth rate of Europes real GDP B) The elimination of automatic stabilization C) A need for the European Central Bank to raise interest rates D) A need for European governments to cut taxes

7) An economy's real GDP per person doubles every 18 years when it maintains a growth rate of ________ per year.

A) 5.6 percent B) 4.0 percent C) 0.25 percent D) 0.9 percent

8) If a premium-grade blank videocassette sells for 12 euros in Germany and the exchange rate is 2 euros = $1, the

price of that identical videocassette in the U.S. is predicted by PPP theory to be A) $12. B) $2. C) $6. D) $1.

9) The "quantity theory of money" was employed by Classical macroeconomists to predict changes in the price level.

Changes in P were forecast to be A) inversely proportional to changes in real GDP. B) proportional to changes in natural real GDP. C) inversely proportional to changes in velocity. D) proportional to changes in the money supply.

10) The Bank of Japan fears deflation in Japan because of

A) The nominal interest rate cannot go below zero B) The need for the real interest rate to be below the growth rate of real GDP C) The expectations effect D) A) and C)

11) If labor's share of national income is to remain constant, then ________.

A) the real wage must grow faster than labor productivity B) the real wage must grow at the same rate as labor productivity C) labor productivity must grow faster than the real wage D) the combined growth rates of labor productivity and the real wage must equal the growth rate of national

income 12) In the graph of the Solow growth model, at any point to the right of the steady-state intersection we have national

saving per person ________ than steady-state investment per person, causing (K/N) to ________ A) greater, increase B) greater, decrease C) less, increase D) less, decrease

13) Keynes' argued that monetary policy would be impotent during the Great Depression, because

A) IS curve was vertical and stuck at a low level of Y. B) both the IS and the LM curve were vertical. C) IS curve was continuously shifting, while the LM curve was stable. D) none of the above

14) The introduction of human capital to the Solow neoclassical growth model ________ the predicted rate of return on

investment in rich countries relative to poor countries. A) increases B) reduces C) may either increase or reduce D) has no effect on

15) Society's rate of time preference refers to

A) the preference people have for leisure compared to working. B) the rate at which corporations can depreciate "preferred" capital goods. C) the extra amount people would be willing to pay to have consumption now instead of in the future. D) the preferred rate of economic growth.

16) A major difference between the costs of unemployment and the costs of inflation is that

A) the former is structural the latter frictional. B) the government pays the latter, the population pays the former. C) unemployment costs are concentrated among a few people, while inflation costs are distributed more broadly

across the entire population. D) unemployment costs are distributed among people, while inflation costs are distributed more narrowly across

the entire population. 17) The output gap is _________ related to ____________ unemployment

A) positively; mismatch B) negatively; turnover C) negatively; cyclical D) positively; mismatch

18) In the United States working overtime is __________ while in France it is _________.

A) illegal; valued B) highly paid; poorly paid C) poorly paid; highly paid D) valued; illegal

19) Keynes said that even should monetary impotence not occur, full self-correction could be short-circuited by

A) the price level failing to fall sufficiently due to downwardly-rigid wages. B) the price level failing to fall sufficiently due to continuously falling wages. C) the price level falling too much due to downwardly-rigid wages. D) the price level falling too much due to continuously falling wages.

20) From 1998 to 2001 the ________ in the Social Security trust fund caused the outstanding government debt in the

hands of the public to ________. A) surplus, increase B) surplus, shrink C) deficit, shrink D) deficit, increase

21) Given that all countries have the same Cobb-Douglas production function, i.e., nY/N = (K/N)b, where b = 0.5, then

a ten-fold difference in per capita income requires a difference in capital per capita by a factor of A) 10,000 B) 1,000 C) 100 D) 10

22) As the output ratio falls below 100%, unemployment

A) falls and inflation rises. B) rises and inflation falls. C) and inflation rise. D) and inflation fall.

23) One of the shortcomings of the Solow growth model is that in it the rate of technological change is

A) assumed to be zero. B) assumed to be equal to the population growth rate. C) left unexplained. D) zero unless the saving rate exceeds the depreciation rate.

24) Supply side economists believe that decreases in marginal tax rates will lead to revenue increases because

A) after tax incomes will increase as will work effort and saving. B) a rightward shift in SAS will force people into higher tax brackets. C) a leftward shift of LAS will mean more revenue per unit of output. D) none of the above

25) It is said that the American and European systems favors different groups in the population. By this, it is meant

that, compared to Europe, the American system _____ the consumer, _________ employed workers, and _________ the unemployed. A) disfavors, disfavors, favors B) favors, disfavors, disfavors C) disfavors, favors, disfavors D) favors, disfavors, favors

26) For inflation to have no real effect on the economy, leaving all decisions and their real outcomes unchanged, five

conditions must be met. Which of the following incorrectly states one of those conditions? A) Inflation is universally and accurately anticipated. B) All savings and money earn the nominal interest rate. C) Inflation of p0 percent lowers the nominal interest rate by p0 below the no-inflation nominal rate. D) Only real interest income is taxable and only the real cost of borrowing is tax-deductible. E) Inflation raises the prices of all goods by the same percentage.

27) An annually balanced federal budget ________ macro- stabilization policy by requiring ________ fiscal policy during recessions. A) assists, easier B) assists, tighter C) inhibits, easier D) inhibits, tighter

28) A feedback from low real wages to low productivity could be caused by

A) an increase in the labor force caused by more immigration. B) a reduction in the power of labor unions. C) a reduction in the real minimum wage. D) increased worker anxiety about job security. E) all of the above

29) U. S. international indebtedness is around $2 trillion while U. S. net international investment income is about $-20

billion. This implies A) The current account balance is negative B) The capital account balance is negative C) U. S. assets abroad earn higher returns than foreign assets in the U. S. D) Foreign assets in the U. S. earn higher returns than U. S. assets abroad

30) What is the "inflation tax"?

A) the government obtaining goods in exchange for newly created high-powered money that does not add to the real value of private assets due to the resulting inflation

B) the fact that greater government spending leaves fewer goods available to the private sector thus lowering their prices.

C) the fact that our tax system is based on nominal incomes and not real incomes, so that the government collects more taxes due to inflation alone

D) the difference between nominal and real interest rates received on financial assets, due to inflation 31) In a large open economy, a growing current account deficit can coexist with an equally growing capital account

surplus for overall balance of payments, which means traveling ________ BP curve. A) to the right along a horizontal B) straight up a vertical C) down along a downward-sloping D) down along an upward-sloping E) up along an upward-sloping

32) Sachs on Globalisation argues that in poor countries

A) It is only a matter of time before technology creates economic growth B) Tropical diseases require different technological solutions than in rich countries C) Countries can acquire technology by importing it, licensing it, or through foreign investment D) A) and C)

E) B) and C) 33) At any point on the current SP curve that is to the right of the LP line, actual inflation is ________ than expected,

which leads to wage renegotiations that shift SP ________. A) higher, downward B) lower, downward C) lower, upward D) higher, upward

34) If the economy is characterized by constant returns to scale then a

A) doubling of inputs will lead to a more than two-fold increase in output. B) doubling of inputs will lead to a constant output. C) doubling of inputs will lead to a two-fold increase in output. D) doubling of inputs will lead to a less than two-fold increase in output.

35) Markets in the poorest countries generally A) Conduct transactions involving distance B) Conduct transactions involving time C) Conduct self-enforcing transactions D) Enforce property rights rigidly

36) The segment of an adjustment loop in which movement is to the northwest is sometimes called

A) inflation. B) expansion. C) stagflation. D) undershooting.

37) To what phenomenon does "Solow's Paradox" refer?

A) The failure of the Solow growth model to incorporate endogenous growth variables B) The absence of any measured effect of new computer technology on productivity statistics C) The absence of any long term effect of saving on economic growth rates in the Solow growth model D) The failure of the Solow growth model to predict non-convergence of poor countries

38) Krugman thinks that Bushs Social Security proposal is dishonest because

A) The stock market is risky for individual investors B) It fails to provide money to pay off existing obligations C) The Social Security system will go broke in 30 years D) It reduces benefits for current Social Security recipients

39) The crucial incentive to produce new ideas comes from

A) government economic guidance. B) shortages of physical and human capital. C) rising population growth. D) international trade. E) patents and copyrights.

40) In nations where conventional taxes are difficult to collect, the inflation tax is ________, which tends to ________

the inflation rates of those nations. A) also difficult to collect, aggravate B) also difficult to collect, hold down C) a realistic alternative, hold down D) a realistic alternative, aggravate

PART B (50 points)

QUESTION 1 (20 points) Consider the following model: (1) Yt = KtbHtcNt(1-b-c) (2) SK,t = sK Yt (3) SH,t = sH Yt (3) IK,t = Kt+1 (1-dK) Kt (4) IH,t = Ht+1 (1-dH) Ht where Y is output, Si, i=H,K, are savings, K and H represent physical and human capital, and IK and IH represent investment in the two different kinds of capital.

(a) Express the production function as a function relating Y/N to K/N and H/N. (2 points)

Dividing (1) by Nt: Yt / Nt = KtbHtcNt(1-b-c) / Nt = KtbHtcNt(-b-c) = (Kt / Nt)b (Ht / Nt)c

(b) Express the equations for savings and investment in per capita terms, i.e.

involving only Y/N, K/N and H/N (2 points) Scaling equations (2)-(5) by Nt:

SK,t / Nt = sK (Yt / Nt) SH,t / Nt = sH (Yt / Nt) IK,t / Nt = (Kt+1 / Nt+1) (Nt+1/Nt) (1-dK) (Kt / Nt) =

= (1+n) (Kt+1 / Nt+1) (1-dK) (Kt / Nt) IH,t / Nt = (Ht+1 / Nt+1) (Nt+1/Nt) (1-dH) (Ht / Nt) = = (1+n) (Ht+1 / Nt+1) (1-dH) (Ht / Nt)

(c) Derive formulas for output per capita, Y/N, physical and human capital per worker, K/N and H/N, in steady state. (10 points)

Equating savings to investment:

SK,t / Nt = sK (Yt / Nt) = sK (Kt / Nt)b (Ht / Nt)c = IK,t / Nt = = (1+n) (Kt+1 / Nt+1) (1-dK) (Kt / Nt)

SH,t / Nt = sH (Yt / Nt) = sH (Kt / Nt)b (Ht / Nt)c = IH,t / Nt = = (1+n) (Ht+1 / Nt+1) (1-dH) (Ht / Nt)

In steady state, K/N and H/N are constant: sK (K / N)b (H / N)c = (1+n) (K/N) (1-dK) (K/N) = (n+dK) (K/N) sH (K / N)b (H / N)c = (1+n) (H/N) (1-dH) (H/N) = (n+dH) (H/N)

Taking logs, the two equations above reduce to two linear equations in two unknowns: b*log(K/N)+c*log(H/N) = log ((n+dK)/sK) + log(K/N) b*log(K/N)+c*log(H/N) = log ((n+dH)/sH) + log(H/N) Solving for log(K/N) and log(H/N): log(K/N) = 1/(1-b-c) * [ c * (aK aH) aK ] log(H/N) = 1/(1-b-c) * [ c * (aH aK) aH ] where aK = log ((n+dK)/sK), and aH = log ((n+dH)/sH). The steady state value of output can be computed as: Y/N = (K/N)b (H/N)c

Assume that: The elasticity of output with respect to both physical and human capital is . People consume 75% of their income; also they save in equal measure towards

the accumulation of physical and human capital. The wear and tear destroys 10% of physical capital every year. Also, 5% of human capital is lost every year to depreciation. Population grows at a rate of 1.5% per year. (d) Given the information above, attribute values to the parameters of the model (b, c,

n, sH, sK, dK, dH) and find values for the steady state variables using the formulas you derived in (c) (2 points)

b = c = 0.25; dK = 0.1; dH = 0.05; n = 0.015; sK = sH = 0.125 Substituting into the formulas derived in (c): log(K/N) = 0.452 log(H/N) = 1.0226 In levels, K/N = 1.5715 H/N = 2.7804 Hence, Y/N = 1.4458

(e) Assume that the productive factor (labor, physical and human capital) are remunerated according to their marginal products. Compute the wage rate, the physical and human capital remuneration in steady state. (If you did not solve part (c) above, you can do the calculations assuming K/N = 1.5 and H/N = 2.7 in steady state) (4 points)

The factor remunerations are given by:

wt = MPL = (1-b-c) Yt / Nt rK,t = MPK = b Yt / Kt rH,t = MPH = c Yt / Ht

In steady state, Y, K, H and N grow all at the same rate, the rate of population growth. Hence,

w = (1-b-c) Y/N = 0.7729 rK = b (Y/N) / (K/N) = 0.23 rH = c (Y/N) / (H/N) = 0.13

QUESTION 2 (10 points) Consider an economy characterized by the following: 1% unexpected inflation corresponds to 5% extra log-output ratio; expected inflation is revised by incorporating 25% of the error committed in forecasting

inflation in the previous period. (a) Write down the equations of the Short-run Phillips curve (SP), of the Long-run Phillips curve (LP), of the DG curve, of the constant output curve (CY), and the rule to update expectations. (2 points) (SP) pt = pet + g tY + zt = p

et + 0.2 tY + zt (LP) tY =0

(DG) tY = 1 tY + tx - pt (CY) tx = pt (E) pet = pet-1 + j(pt-1 - pet-1) = pet-1 + 0.25(pt-1 - pet-1) = 0.25pt-1 + 0.75 pet-1 (b) Assume that the economy is in a long-run equilibrium at t = 0, 0x =p0=p

e0=10, 0Y =0. In

periods 1 and 2 there are supply shocks, z1 = z2 = -2 (minus two). Assuming an accommodating policy, and using the equations derived in part (a) above, complete the following table (6 points):

Period tx zt pt tY p

et

0 10* 0* 10* 0* 10* 1 8 -2* 8 0* 10 2 7.5 -2* 7.5 0* 9.5

* known at 0 - notice that an accommodating police gives tY =0 for all t. The relevant equations are: tx = pt = jpt-1 + (1-j) p

et-1 + zt = 0.25pt-1 + 0.75 pet-1 + zt

pet = jpt-1 + (1-j) pet-1 = 0.25pt-1 + 0.75 pet-1 Hence: 1x = p1 = 0.25*5 + 0.75*5 - 2 = 8 pe1 = 0.25*10 + 0.75*10 = 10 2x = p2 = 0.25*8 + 0.75*10 - 2 = 7.5 pe2 = 0.25*8 + 0.75*10 = 9.5

(c) Redo part (b) assuming that the policymakers pursue an extinguishing policy (6 points). Period tx zt pt tY p

et

0 10* 0* 10* 0* 10* 1 20 -2* 10* 10 10* 2 10 -2* 10* 10 10*

* known at 0 - notice that an extinguishing police implies pt=pet=10 for all t. The relevant equations are: tx = 10 - 1 tY - zt / g = 5 - 1 tY - 5 zt tY = 1 tY + tx - 10 Thus, 1x = 10 - 0 - 5*(-2) = 20 1Y = 0 +20 - 10 = 10

2x = 10 - 10 - 5* (-2) = 10 2Y = 10 + 10 -10 = 10

QUESTION 3 (20 points) Consider the following economy:

Real Government Spending on Goods and Services 200 (excluding interest payments on the national debt) Real Taxes Net of Transfers 208 Real High powered money 400 Real Interest-bearing bonds 500

Nominal Interest rate 7 % Inflation rate 3 % Inflation and interest rates as well as the stock of bonds and high powered money are constant in time.

. (a) Write down the government budget constraint, using the symbols used in the

textbook. (3 points) [Make sure that the inflation rate appears in the expression] G-T=pH/P-(i-p)B/P

(b) What is the total and basic government deficit of this economy? (4 points)

[Answer first in symbols, then compute figures using the data provided above]

G-T+iB/P = 200 208 + (0.07)500 = 27 G-T = 200 208=-8

(c) What is the real interest expense of servicing the bonds? (3 points)

[Answer first in symbols, then compute figures using the data provided above]

(i-p)B/P=(.07-.03)*500=20

(d) What is the rate of increase of nominal high powered money and nominal bonds

in the current period? (3 points) [Answer first in symbols, then compute figures using the data provided above]

Given that real stocks are stable, nominal stocks have to increase by the rate of inflation; that is by 3%.

(e) Suppose now that last period inflation rate was 4% instead of 3% and that

nominal stocks of money and bonds increased so as to leave the economy with the same amount of real quantities at the beginning of the current period. Calculate the new level of the basic government deficit (4 points) [Answer first in symbols, then compute figures using the data provided above]

G-T =pnewH/P+pnewB/P-iB/P =.04(900)-.07(500)=36-35=1

(f) The level of total government deficit in (e) is different than the one in (b) Describe the channels of action of the change of inflation rate in the government budget constraint. (3 points) The increase in inflation has two effects on the budget constraint: 1. Increases seignorage by: (pnew-p)H/P 2. Decreases real interest expense of servicing the bonds by: (-pnew+p)B/P Both channels help increasing the basic government deficit

PART C (30 points) BE SURE TO WRITE YOUR NAME AND ID NUMBER ON THE COVER OF YOUR BLUE BOOK AND TO WRITE YOUR ANSWERS IN PEN You have 30 minutes to write an organized essay on the failure of many poor countries to converge over the past four decades. Your essay should have an introduction that focuses on the main points that you want to stress, and hopefully a conclusion as well. Here are some of the points that you can cover how you arrange them, explain them, and use examples to illustrate them will determine your grade. Here are suggested sections to include in your essay.

(1) Why does basic growth theory fail to explain the problems of the poor nations?

(2) What general concepts going beyond basic growth theory did you learn about in the text and lectures?

(3) What examples did you learn from the book of outside readings that illustrate

how these general concepts work to hold back the standard of living of poor countries?

(4) In (3), you want to give examples of general classes of handicaps from which

poor countries suffer. In the final section (4) you should come up with at least one or two examples of specific countries that illustrate either how the handicaps work in the real world, and/or countries which have overcome these handicaps.