Exam #3 (Final Exam) Solution Notes Spring, 2011

Transcription

1 Economics 1021, Section 1 Prof. Steve Fazzari Exam #3 (Final Exam) Solution Notes Spring, 2011 MULTIPLE CHOICE (5 points each) Write the letter of the alternative that best answers the question in the blank. Make sure you read all four alternatives before making your choice. D 1. There is a good argument to be made that small economies that sell much of their GDP abroad and import a high share of consumption goods have a lower multiplier than large economies like the U.S. Which of the following factors is most likely to explain this result? (A) Higher share of exports in GDP for the small economy. (B) Lower marginal propensity to consume in the small economy. (C) Lower investment accelerator in the small economy. (D) Higher share of imports in GDP for the small economy. A 2. Which of the following alternatives is not a practical challenge of using monetary policy to respond to insufficient aggregate demand? (A) A long lag between identifying an AD problem and implementing stimulative policy. (B) Uncertainty about what the target level of output should be. (C) Lags between policy implementation and the convergence of output to the new equilibrium level. (D) Estimating how much interest rates must fall to reach target output. B 3. Which of the following statements about U.S. federal government spending and taxation is most likely to be false? (A) Federal spending on goods and services fell as a share of output in recent decades. (B) Major percentage reductions in U.S. spending on foreign aid and business regulation will lead to a substantial percentage reduction in total federal spending. (C) The federal deficit increased dramatically in the Great Recession of 2008 and 2009 in large part because a slow economy reduced income growth. (D) Transfer payments constitute a large and growing share of federal spending. B 4. Which of the following aspects of modern monetary policy can be explicitly attributed to inflation targeting rather than more general monetary policy pursued for macroeconomic stabilization? (A) Monetary policy stimulates demand by reducing the federal funds interest rate. (B) Monetary policy transparency helps anchor inflation expectations (C) Stimulative monetary policy causes higher inflation in the long run. (D) An increase in bank reserves through Fed open market purchases drives up inflation immediately. B 5. Which of the following statements accurately describes the dilemma for the new consensus macroeconomic model if the federal funds interest rate hits the zero bound? (A) Inflation will quickly fall to zero and the economy may fall into a damaging deflation. (B) Monetary policy, as described by the Taylor Rule, can no longer effectively boost aggregate demand. (C) Further easing of monetary policy will produce inflation only, with no effect on output and employment. (D) Banks will no longer accept reserve payments from the Fed in return for valuable assets like U.S. Treasury bonds.

2 B 6. For a developed country operating with modern technology, which of the following alternatives most likely describes the long-run source of rising labor productivity and improving living standards? (A) Higher investment that raises the capital stock. (B) Improvements in technology. (C) Effective monetary policy following the Taylor rule. (D) Long-term increases in consumer spending that encourage firms to raise production. A 7. Suppose the Fed wants to reduce the threat of inflation. Which of the following statements best describes the policy action the Fed would take? (A) Open market sale of government bonds to raise the federal funds interest rate. (B) Open market sale of government bonds to lower the federal funds interest rate. (C) Open market purchase of government bonds to raise the federal funds interest rate. (D) Open market purchase of government bonds to lower the federal funds interest rate. B 8. Which statement below best describes the historical link between inflation and the state of the overall U.S. economy? (A) Inflation has been more or less constant regardless of the state of the U.S. economy for the past 30 years. (B) Inflation usually declines when the economy weakens, but there has been little acceleration of inflation in strong economic conditions over recent decades. (C) Inflation accelerates when the Fed attempts to stimulate a weak overall economy. (D) When the economy weakens inflation usually rises creating stagflation as in the 1970s. Any answer was given full credit for the following question, but D is true! D 9. Which of the following alternatives occur when a crazy fraternity boy dressed like a cow runs into a large macroeconomics lecture? (A) Students encourage the silliness by nudging the instructors to go along with the joke. (B) A somewhat flustered professor consumes a drink he doesn t really like. (C) The class breaks into the most rousing applause in the professor s multi-decade teaching career. (D) All of the above.

3 SHORT ANSWER QUESTIONS. Answer in the space provided. Use clear economic reasoning and make sure you write clearly and legibly, otherwise your score may be lower. 1. (30 points) Suppose that the economy is described by the algebraic Keynesian Cross model as follows: (1) Y = C + I + G + Ex Im (2) C = a + (MPC) (Y T) (3) T = t Y (4) DEF = G - T The variables have the standard definitions discussed in class. Note lower-case t represents the proportional tax rate, so that the magnitude of total taxes collected (T) depends on the level of pre-tax income (Y). The variable DEF represents the government deficit. The variables G, I, Im, and Ex are all exogenous. Answer the questions below using this model. a. (10 points) Derive an equation that shows how the equilibrium level of output changes if there is an increase in government spending (that is, derive an expression for Y that depends on G). Plug equations 2 and 3 into equation 1, then solve for equilibrium Y: Y = C + I + G + Ex Im = [a + MPC(Y T)] + I + G + Ex Im = [a + MPC(1 t)y] + I + G + Ex Im Y[(1 MPC(1 t)] = a + I + G + Ex Im Y = a + I + G + Ex Im 1 MPC(1 t) Use this equation to show the effect of a change in G on equilibrium Y: 1 ΔY = 1 MPC(1 t) ΔG b. (10 points) What happens to the multiplier according to this model if the tax rate increases? Explain the economic intuition for why the multiplier changes. The multiplier in this model is 1 / [1 MPC(1-t)]. If the tax rate increases, the multiplier goes down. That is, the denominator of the multiplier expression gets larger. Intuitively, the multiplier effect arises because each time an increase in demand creates new income, consumption rises further, leading to more demand and more income. If a higher share of income is taxed away during each round of this process, the multiplier will not be as large. c. (10 points) Suppose G rises by $100 billion. According to the model, will the deficit rise by $100 billion, more than $100 billion, or less than $100 billion? Explain your answer briefly. (Hint: Think in terms of the deficit as defined by equation 4 above, and pay attention to both changes in G and changes in T predicted by the model.)

4 The deficit will rise by less than $100 billion. When G goes up, Y will also rise, which will increase tax revenues to offset a part of the effect of the change in G on the deficit. 2. (35 points) Consumption spending rose substantially in the U.S. in many of the years prior to the Great Recession that began at the end of Answer the questions below about this change in the economy. a) (10 points) Draw a loanable funds diagram below. Show the initial equilibrium interest rate as r 0 and the initial levels of saving and investment as S 0 and I 0. Now suppose that consumers decide to spend more out of a given level of income equal to potential output (Y*). Show the shift of the curve(s) on your diagram and label the new equilibrium values of the variables as r 1, S 1, and I 1. Explain briefly. Intr. Rate r 1 r 0 S 1 = I 1 S 0 = I 0 S, I Your graph should look like the one on the left. The saving curve shifts to the left when people consume more out of a given level of income. b) (5 points) Explain the implications of the change in equilibrium investment derived in part a) for future potential output. Lower investment reduces the capital stock, leading to lower potential output (Y*) in the future. c) (10 points) Why would economists say that the analysis in parts a) and b) is based on a supply-side theory? How would the analysis differ if you considered the effect of higher consumption using demandside (Keynesian) theory? The loanable funds analysis in parts a and b holds income constant at the supply-determined level Y* and ignores any possible shortfall in demand. If consumption demand rises and the economy is initially operating below Y*, the increase in demand will raise output, creating more saving and possibly encouraging firms to invest more. Therefore, the future economy might be stronger because of the rise in current consumption. d) (10 points) Briefly describe what evidence from the performance of the U.S. economy tells us about whether the supply-side or demand-side perspective on rising consumption was correct in this period. Consumption rose quickly in the U.S. economy since the middle 1980s until the beginning of the Great Recession. In support of the demand-side perspective, the U.S. economy performed quite well relative to other developed countries until the Great Recession. Output seemed to rise when consumption demand

5 was higher. There was no indication of a decline in output due to low investment. In addition, the rise of interest rates predicted by the supply-side perspective did not occur. (This was a rather open-ended question, and other answers may have received credit.) Policy Essays (60 points) Answers are not provided for the policy essays. You could have gone in many different directions and addressed various points in different levels of detail. Grading was done as follows. The graders identified good economic points based on course material with a check. Errors or misleading statements were marked with an x. Your final score is based on the number of checks less the number of x s. Policy Essay #1 a) The article on Chinese policy and inflation distributed to the class states that [m]onetary policy in the world's second-largest economy involves dueling bureaucracies, secretive committees and a Communist Party whose influence is hidden but pervasive. How does this description of the monetary policy bureaucracy in China differ from the institutional structure of monetary policy in the U.S.? Briefly discuss how the key mechanism for restoring the economy to Y* in the new consensus macro model might be viewed differently for China than for the U.S. considering this somewhat negative description of Chinese monetary policy institutions. b) The article on China starts with China's premier, Wen Jiabao, warned last month that inflation is like a tiger once unleashed, it is very hard to cage again. What major aspect of the theory of inflation is consistent with this statement? Explain your answer briefly. c) Another theme of the article is the importance of unfavorable supply shocks for inflation, like rising food prices due to a bad harvest. The U.S. is also facing a nasty supply shock at the moment through the rapid rise in petroleum prices. Explain the effect of supply shocks on inflation, both in the short term and over a longer horizon. d) The Chinese central bank recently raised interest rates to fight inflation, as have the Europeans. The U.S. Fed has resisted international pressure to raise interest rates so far. What is the danger of fighting inflation too aggressively with monetary policy? Policy Essay #2 Since the beginning of the Great Recession in late 2007, the budget deficit of the U.S. federal government has risen sharply to a share of GDP. This deficit has caused much controversy and is now a central issue in political discussions. Answer the questions below about the economic effects of the deficit. a) Deficit critics most often argue that the deficit must be reduced because it puts a burden on future generations of citizens. According to the macroeconomic theories we studied in class, under what conditions would this perspective be correct? b) What are the dangers for the U.S. economy of pursing fiscal policies to cut the deficit in economic conditions such as those that prevail in early 2011? c) What fiscal policy do you recommend for the U.S. for the next year or two? Your grade will not depend on your specific recommendations, but on how well you justify your position with economic reasoning. Try to link your argument to recent evidence that helps distinguish between various theories.