Final Examination
December 14, 2005

 

Directions: do all work on the exam itself, answering the question in the space provided.  If you require extra space, use the back of the exam, indicating that you have done so.

Name:

Note: this exam is not as bad as it seems.  I gave two exams that day; each of the exams consisted of half of these questions.

 

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First Part (Thirty Points)

For each of the following statements, indicate whether they are TRUE or FALSE and explain why.

1                  The Lorenz curve measures the relation between tax rates and government revenue.

2                  The Laffer curve’s key insight can also be expressed via the gini coefficient.

3                  Suppose that, when I burned a dollar bill in class, the government had increased the money supply by $1, thus keeping the money supply and hence the price level constant.  No one would have gained by my action.

4                  If interest rates in the United States are three percentage points lower than Canadian interest rates, this means the Canadian dollar is likely to rise in value relative to the US dollar people don’t like to get high returns on their assets.

5                  Money does not matter.

6                  If a nation removes a tariff on a good whose domestic demand is met by a combination of domestic production and imports, it is hard to tell whether the gains to consumers will exceed the losses to the producers.

7                  In a nation where there is no trade, a temporary increase in government spending on a wasteful project will invariably increase interest rates more if it is financed by borrowing than if it is financed by a tax based on last year’s income tax liability.

8                  The short run labor supply curve shows how people respond to a temporary increase in taxes on wages.

9                  A permanent increase in wage taxes to fund social security would cause people to move along the long run labor supply curve; a temporary increase would cause them to move along the short run labor supply curve.

10           If a nation has a persistently high rate of unemployment, it must mean a poor educational system.  After all, how else could information be that imperfect?

11           The persistent differences in per capita GDP between wealthy nations and poor nations means that capital does not really matter in the production function.  If it did, capital would simply flow into the poor nations.

12           Economic freedom cannot matter. After all, where is there a term for it in the Cobb-Douglas production function, which is, as we all know, the summum bonum?

Second Part (30 Points)

1)   For each of the following events, what will be the impact on the US trade deficit? Explain your answer. It is not enough to guess the right answers: you must explain why these are the correct answers. I want to see a well-labeled and well-explained graph of the demand for loans.  Note: in all of these questions, you may assume that the only nominal assets and liabilities in the US, Europe and the UK are $, €, and £.

Remember this is the US trade deficit

1.      People become more confident about the future

2.      The nation begins to spend $100 million a year in perpetuity to maintain monuments of no significance.  The cost is paid for by assessing each citizen $300 per year. 

3.      The nation begins to spend $100 million a year in perpetuity to maintain monuments of no significance.  The cost is paid for by a tax on wages.

4.      The nation begins to spend $100 million a year in perpetuity to maintain monuments of no significance.  The cost is paid for by assessing printing additional money each year.

5.      The nation begins to spend $100 million a year in perpetuity to maintain monuments of no significance.  The cost is paid for a higher tax on dividend income.

6.      Asians, who have been accumulating significant reserves in dollars, suddenly convert them all to Euros.  There is no other change in their economic behavior

7.      People become less confident about the future

8.      The nation decides to pay off the national debt, by assessing each citizen $2,000 per year for as long as it takes to pay off the debt. (You may assume a bequest motive).

9.      The nation decides to pay off the national debt, by assessing each citizen $2,000 per year for as long as it takes to pay off the debt. (You may assume a bequest motive).

10. The nation decides to pay off a significant portion of the national debt, by imposing a 3 year surcharge on wage taxes (You may assume a bequest motive).

11. The nation decides to pay off a significant portion of the national debt, by imposing a 3 year surcharge on taxes on dividend and interest income (You may assume a bequest motive).

12. China, announces plan to revalue (upwards) the yuan in three years. (You are asked to analyze this year’s trade deficit)

2)   For each of the following situations, draw the impact on the Y and M curves for the United States and tell me the impacts on the price level and the interest rate.  I have drawn the initial Y and M curves for you.  Explain your reasoning.

Remember: these are the Y and M curves for the United States

 

The government announces plans to spend $10,000,000 this year to build a monument to Irving Fisher, to be paid for with freshly printed dollar bills.  (You may treat this as a useless project if you can name two major contributions Fisher made to macroeconomics

 

 

 

 

 

 

 

 

 

People want to double the amount of money the hold (formally, ξ doubles).  The Federal Reserve System responds by open market operations to double the money supply.

 

 

The government announces plans to raise the tax rate on wage income by 5%, the proceeds to be used to pay for things that people are already consuming. 

 

 

 

 

 

 

 

Santa Claus repeats the Christmas Eve Caper in the United Kingdom.  BUT definitely confused by Christmas Spirits, he gives everyone X yen for each X pounds they hold.

 

 

A new poll reveals that the Democrats are quite likely to sweep to victory in the next election on a pledge of repealing the lower tax rates on dividend and interest income.  (Just concentrate on this pledge.)

 

 

 

 

 

A new poll reveals that the Republicans are quite likely to sweep to victory in the next election on a pledge of maintaining the lower tax rates on dividend and interest income.  (Just concentrate on this pledge.)

 

 

 

 

 

Reliable word spreads that Santa Claus will in fact be carrying out the Christmas Eve Caper this year. (Hint: draw the Y and M curves for 12/24)

 

 

 

 

 

 

 

 

 

 

 

 

 

By way of patching relations with the United States, the French government spends €100 million repairing insignificant monuments in the United States

 

 

 

 

 

 

 

Third Part (20 points)

  1. Elmer Fudd expects to live for four time periods, earning $120,000 in period 2 and $180,000 in period 3.  His wage income is taxed at 25% and his interest income is taxed at 50%.  The before tax interest rate is 100%. Compute Elmer’s consumption in period 1 of his life.
  2. Daffy Duck expects to live for four time periods, earning $120,000 in period 2 and $180,000 in period 3.  All numbers here are in nominal terms.  He pays a 25% wage tax; the real interest rate is 50% and the expected inflation rate is  50%.  His value of ξ is 1/3.  Compute Daffy’s demand for real money balances in period 1 of his life.
  3. Real GDP is $100; nominal GDP is $1000. The M2 velocity of money is 4 and the M2 multiplier is 5.  What is the monetary base?
  4. People in Knockwurst consume Sauerkraut and (what else?) Knockwurst.  Last year, individuals ate 100 pounds of Sauerkraut and 400 pounds of Knockwurst; each cost 5 Snickers each (the local currency).  This year Knockwurst is costing 8 Snickers. What is the inflation rate?

Third Part (20 points)

  1. Elmer Fudd expects to live for four time periods, earning $160,000 in period 2 and $220,000 in period 3.  His wage income is taxed at 25% and his interest income is taxed at 25%.  The before tax interest rate is 100%. Compute Elmer’s consumption in period 1 of his life.
  2. Daffy Duck expects to live for four time periods, earning $120,000 in period 2 and $180,000 in period 3.  All numbers here are in nominal terms.  He pays a 25% wage tax; the real interest rate is 50% and the expected inflation rate is  50%.  His value of ξ is 1/4.  Compute Daffy’s demand for real money balances in period 1 of his life.
  3. Real GDP is $100; nominal GDP is $1000. The M2 velocity of money is 4 and the M2 multiplier is 5.  What is the monetary base?
  4. People in Knockwurst consume Sauerkraut and (what else?) Knockwurst.  Last year, individuals ate 100 pounds of Sauerkraut and 400 pounds of Knockwurst; each cost 5 Snickers each (the local currency).  This year Knockwurst is costing 8 Snickers. What is the inflation rate?

Fourth Part (20 points)

Lower Freestone, an idyllic Caribbean island, has a recently developed a thriving tourism industry.  About half the tourists come from the United States, while the other half come from Germany.  The hotels are owned by American Chains (Hilton, Marriott, etc.) While the native tongue is English, the German influx is so pronounced that signs "Wir Spreche Deutsch" can be found throughout the island.  Freestone's currency is the Peach (P).  Freestone has a currency board which keeps the Peach pegged to the dollar at 1P = $1.  Professor Emeritus of Economics Nathan Reingold, a tough old independent minded buzzard is determined to keep the Peach pegged to the dollar, heads the board.  In short, whatever any Freestone politicians or we may think, the currency peg is here to stay. 

Reingold may be a tough old buzzard, but he is plenty smart.  He keeps the Freestoners well briefed on economic events and they seldom suffer from imperfect information.

·        Reingold has noted that, since the beginning of this year the Euro (€) has declined from 1 € = 1.30 P to approximately 1 € = 1.20 P.  (Inasmuch as the Peach is pegged to the dollar, you should not be surprised that its decline mimics the change of the Euro to the dollar).  Reingold is wondering what effect this decline will have on a number of variables, particularly

1.      The number of American tourists coming this year

2.      The domestic price level in Freestone

3.      Interest rates in Freestone

Help him out.  (It should come as no surprise that an acceptable answer will include carefully drawn, labeled, and explained Y and M curves.  And as a hint, remember that the demand for goods and services is now equal to C + I + G + X-M.)

  • Suppose that, instead of the resorts being owned by American investors, the Freestoners themselves owned them.  How would this have changed your answers?    (It should come as no surprise that an acceptable answer will include carefully drawn, labeled, and explained Y and M curves.)


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  • Recently, Reingold spoke to the Freestone Chamber of Commerce.  The otherwise uneventful speech was marred by an unruly mob of demonstrators against the fixed exchange rate.  They argued that going on a fixed exchange rate involved a loss of national sovereignty and that Freestone should float the Peach.  While the demonstrators are certainly right that fixing the Peach means that Freestone has given up its rights to an independent monetary policy, there remains the issue of whether Freestone was right to give up its monetary independence.  Reingold later strongly defended the fixed exchange rate as being in Freestone’s national interest.  Do you agree with him?  Why or why not?

Fourth Part (20 points)

West Freshwater is a mid sized country, well off the beaten trail for trade and tourism.  While scholars visit the country from time to time, it is essentially a closed economy.  Professor Arthur Dour, Freshwater’s most distinguished economist recently gave a lecture on economic conditions in Freshwater.  As he noted, traditionally:

1.      The money supply is growing at about 6% a year.

2.       The country has a long history of growth, in real terms, of 3% a year

3.       There is no national debt.

4.      Government purchases consume a fraction n of GDP.

5.      Government expenditures are financed by taxes on wage income and money creation.

6.      While the people in the country are relatively knowledgeable, they do suffer from time to time from imperfect information.

 

Alas, all is not well in Freshwater.  Its citizens love music and have, for years, been pirating music from western countries; the latest hits have been reproduced by its thriving CD industry.  Its citizens have just discovered the internet and, with it, the ability to download music illegally.  (Since Freshwater has tolerated for years the pirating of music from abroad, the government is in no position to object to pirating of music by its own citizens.)
In Freshwater, this is a big deal.  Dour is concerned about its implications for the economy.  He fears layoffs throughout the music industry, and a recession.  Voters in Dodgeville, the center of Freshwater’s music industry are particularly concerned.
The government has decided to deal with these employment problems by a major expenditure to improve parks around Dodgeville, an effort that will take a year to complete.  It will finance the expenditure with a special one year surcharge on wage taxes.  The program will come as a complete surprise.

·        Show the effect of this unexpected increase in spending on prices, interest rates, and the short run level of output.  (And remember, that a well-labeled and well-explained graph is worth a thousand words).  Explain why these effects come about.

·        How would your answers change if the increase in spending was fully anticipated?  Why?