Final Examination
December 10, 2003

 

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.  Each problem has the indicated weight.

Name:

 

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First Part (5 point questions)

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

 

1              Paradoxically, a policy of eliminating income inequality will reduce economic growth because it will reduce the number of individuals with funds to invest in new businesses.

2              If consumption rises, wealth must have gone up.

3              If the Federal Reserve System wanted to increase the money supply this month, December 2003, it could do so by simply cutting its reserve requirements. There is no need for open market operations.

4              The demand for output Y is given by Y=AKaL(1-a).

5              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.

6              A full time MBA student at the University of A**** has an income upon graduation of $40,000 a year.  He spends $26,000 a year, or $500 per week.  His average cash balance is $250.  His counterpart at Kent State University gets a job at $80,000 per year, and decides, after engaging in life cycle consumption maximization, to spend $52,000 per year, or $1,000 per week.  Both students have a demand for money function like that we studied in class. It is unclear whether his average cash balance will also be doubled.

7              We know that if the government taxes wages and spends the money (say) health care, something they would have purchased otherwise, individuals work less.  Ergo, it makes sense for the government to pay for health care; that way people get the benefits of health care without working as hard.

8              We know that, if the tax rate on wage income is above the peak rate on the Laffer Curve, we can get more revenue by reducing the tax rate.  We can get even more revenue if we cut the tax rate and simultaneously raise the sales tax rate.

 

Second Part (15 point questions)

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 £.

a)     Backwater suddenly strikes oil; vast new quantities of crude oil come on the world market.

b)     French vineyards go on a month-long strike, effectively running this years production of wine.

c)      Terrorists destroy a Malaysian plant producing memory chips for Dell Computers.

d)     Santa Claus repeats the Christmas Eve Caper in the member states of the European Union, doubling each person’s supply of Euros.

e)      Santa Claus repeats the Christmas Eve Caper in the United States.  BUT, confused by scenarios (c) and (d), he gives everyone he gives everyone X Euros for each X pounds they hold.

f)       Russian citizens, who currently hold significant numbers of US dollars, decide to hold Euros instead.

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

 

Japan suffers a devastating earthquake, necessitating the rebuilding of much of its infrastructure

 

 

 

 

 

 

 

 

 

California suffers a devastating earthquake, necessitating the rebuilding of much of its infrastructure

 

 

 

 

 

 

Santa Claus repeats the Christmas Eve Caper in the United States.  BUT, confused by perhaps too much Christmas Spirits, he gives everyone X Euros for each X dollars they hold.

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

Buoyed by the Christmas Spirit, France announces plans to pay the debt it owes us from World War I.

 

 

 

 

 

It suddenly becomes more attractive to use debit cards rather than credit cards in the United States

 

 

 

 

 

 

 

 

 

 

 

 

 

Third Part (30 points)

The United States has just enacted some significant tax cuts; at the same time, it is running a large budget deficit.  Two plans have been proposed for dealing with this situation. 

·        The first plan, the DEAN plan calls a special one-time tax bill for everyone equal to X times last year’s income. The money will be used to retire the national debt.  (Accountants are still working out the value of X).  The savings in interest expenses, amounting to hundreds of billions a year, will be sufficient to bring the budget into balance.

·        The second plan, SNOW, freezing government spending.  Over time, economic growth will raise tax revenue and bring the budget into balance.  (Obviously this will mean many government programs will get their funding reduced, but partisans of the SNOW plan assume all government spending is wasteful anyway: you may adopt this assumption for the purpose of answering this question).

Now for the questions.  In answering this question, remember the old proverb that well-labeled and well-explained graphs are worth a thousand or more words.

What will be the effect of these two plans on GDP, the price level, interest rates and the b balance on current account the first year? Tell me specifically which of these variables will go up, down, or remain the same.  Be prepared for some of these answers to be ambiguous.  Should both plans result in (say) an increase in interest rates, tell me which one will have the larger increase in interest rates.