Queen s University Economics 222 Macroeconomics MID-TERM TEST

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1 Queen s University Economics 222 Macroeconomics MID-TERM TEST Instructions: Answer 4 questions from Part A and 3 questions from Part B. Parts A and B are each worth 50 marks. You have two hours: budget your time carefully. You may use a hand calculator. Do not hand in the question sheet. Part A (50 marks) Answer 4 of the following 7 questions. 1. To try to reduce its foreign debt, Turkey needs to increase its current account balance. Will a lump-sum tax increase achieve this goal? 2. Suppose that the U.S. increases government spending (say, military spending). What will be the predicted effects on Canada s (a) current account and (b) investment? Illustrate your answer with a diagram. 3. Suppose in Canada the unemployment rate is 7%, the participation rate is 65%, and the adult population is 24 million. How many people are employed? Does an increase in the unemployment rate mean that jobs have been lost? 4. Statistics Canada adopted chain weighting in May This change led to a downward revision in investment rates (the rate of change of the capital stock), because the fall in computer prices gives the growth in the volume of computing equipment a smaller weight when more recent prices are used to construct real investment I. What effect will this revision have on measured TFP growth in Canada? 5. An economist writes: Inequality in earnings has risen in most developed economies because female labour force participation has risen during the past twenty-five years, and women tend to have lower wages than men. Comment on whether inequality in earnings has risen and, if so, whether the economist s claim explains part or all of the increase. 6. Over the past decade, the velocity of Canadian M1 has generally been declining. If velocity falls by 4% per year and M1 grows by 8% per year then what is the growth rate of nominal GDP? 7. In Canada, the share of consumption in GDP peaked in about 1998, long before the real value of the stock market peaked in Does this evidence show that wealth is not an important influence on consumption? 1

2 Part B (50 marks) Answer 3 of the following 5 questions. 8. This question treats the U.S. as a closed economy. Suppose that private consumption spending is given by: C = 0.9(100 T) 10r where 100 is the value of national income, Y. Also, T denotes tax revenue and r is the real interest rate (not in percentage points). (a) Find an expression for private saving. (b) Given government spending, G, find an expression for national saving. (c) Suppose that the U.S. plans to increase government spending on armaments and national security, but to do so with a balanced government budget (so that G always equals T ). What effect will this plan have on desired, national saving? Illustrate your answer with a diagram. (d) Suppose that U.S. investment is given by: I = r. If G = T = 25, solve for the U.S. real interest rate and for equilibrium investment. 9. This question uses some differential calculus. Suppose that a typical country s money demand function is given by: M d = P Y 0.7. (a) What is the income elasticity of money demand? (Reminder: The elasticity formula is dm/m dy /Y.) (b) State a formula that predicts the inflation rate given the growth rates of the money supply and of real income. You may use discrete or instantaneous growth rates. (c) If hyperinflations (or very high inflation rates more generally) disrupt economic life then why do they ever get started? 2

3 10. Suppose that the Russian Federation has the following data: Year Output Capital Labour (a) Find the growth rates of output, capital, and labour over this period (i.e. over six years, not the rates per year). (b) If the production function is Y = AK 0.3 N 0.7 then find A 1989, A 1995, and the growth in A over these six years. (c) During this period, the health of Russian workers also declined. Suppose that social scientists take that into account, and conclude that the true labour input in 1995 was only 185, rather than 200. Now what is measured growth in total factor productivity? 11. Suppose that an economy has this production function: Firms are competitive. Y = 2AN 0.5. (a) What is the marginal product of labour? Also, derive the labour demand curve. (b) Suppose that labour supply behaviour can be summarized this way: N S = w(1 τ), where τ is the tax rate on wage earnings. If τ = 1/6 and A = 9.6 then solve for the equilibrium real wage and employment. (c) Suppose that you observed that employment N and the real wage w tended to move in opposite directions during a business cycle. Would you conclude that the cycle was caused by changes in A (for example due to oil price shocks) or by changes in fiscal policy (summarized here by the tax rate τ)? Illustrate your answer with a diagram of labour demand and labour supply. 3

4 12. Suppose that a profit-maximizing firm faces the following problem of planning physical investment. The price of a capital good is 2000, the real interest rate is 5% and the rate of depreciation is 10%. There are no taxes. (a) What is the firm s cost of capital? (b) Suppose that the marginal product of capital is given by: MPK = 1200 K. What is the target capital stock for the firm? (c) If the current capital stock is 3 units, and the depreciation rate is 10% then what will gross investment be? (d) Using a diagram, explain the effect on investment of changes in the real interest rate. 4

5 MidTerm Test Answers (without diagrams) 1. A policy will increase the CA balance if it raises national saving or lowers national investment. A lump-sum tax increase will raise government saving. It will not affect investment, since it will not change the tax-adjusted user-cost of capital. National saving will rise if private saving falls by less than government saving rises. That will not happen if consumers are Ricardian, because if they are Ricardian they will pay for the tax increase out of saving, reckoning on the implied future tax cut to replenish their wealth. But if they are short-sighted or do not have savings then consumption will fall, so national saving will indeed rise. 2. An increase in G in the U.S. will reduce U.S. national saving and raise the world real interest rate. For Canada, a small open economy, that will lead to a larger current account surplus and lower investment, as the horizontal r w line shifts up. (Note that the increase in the US current account deficit need not equal the increase in the Canadian surplus.) 3. The labour force is 0.65 times 24 million or 15.6 million. Of those, 7% or million are unemployed, so million are employed. The unemployment rate can rise without employment falling, if the labour force rises due to a rise in participation rate (as at the end of the school year) or due to a rise in the population. The key feature is that the unemployment rate for new participants must be higher than that of incumbents. 4. A downward revision in I (gross investment) will lead to a downward revision in net investment, which is the growth rate of K. Thus there will be an upward revision in measured TFP growth, since that is found by subtracting weighted input growth from output growth. 5. Earnings inequality has risen, but not for this reason. The gap between male and female earnings has fallen. Among male workers, inequality has risen; see evidence from chapter 3. Therefore the increase in inequality must have a different cause, such as skill-biased technical change. 6. V = PY M so clearly the growth rate of PY must be 4% per year. (Note that this is an approximation, but it is the only one available, for we are not given any levels.) 7. This fact does not prove that wealth changes have no effect. First, the stock market is not a comprehensive measure of wealth, though admittedly it may account for much of the variation in wealth over business cycles. Second, it could be that some other influence on consumption (of the four listed in chapter 4.1) was also at work. The most likely suspect is the interest rate. It rose after 1998, which is predicted to raise saving and reduce consumption. That effect may have outweighed the effect of changes in stock market wealth. 5

6 8. (a) (b) S gvt = T G so S pvt = Y T C = T + 10r S = T G + 10r. (c) Directly from the answer to part (b) we see that if G and T both rise then national saving will fall. The desired saving curve will shift northwest. (d) Setting saving equal to investment gives r = and so I = (a) The elasticity is 0.7, shown by differentiation. (b) The formula is: π = dm dy 0.7 M Y. (c) Very high rates of inflation usually emerge as governments lose access to traditional taxes and so resort to expanding the money supply to finance government spending. As the formula (b) shows, these high growth rates of the money supply usually lead to high rates of inflation. 10. (a) Output growth was -20%, capital growth was -20%, and labour input growth was 5.26%. (b) A 1989 = , A 1995 = and so TFP fell by 17.5%. (c) With this revision, A 1995 = and so TFP fell by 12.85%. As usual, a downward revision in input growth leads to an upward revision in measured productivity growth. 11. (a) The marginal product of labour is AN 0.5 and so the labour demand curve is: w = AN 0.5. (b) At τ = 1/6 and A = 9.6 we find that w = 4.8 and N = 4. (c) You can answer this question by experimenting with different values of A or τ. That, or the diagram, shows that if w and N move in opposite directions there must be a shock to the labour supply curve, for example from a change in the tax rate. Explain how τ rotates the labour supply curve. An oil price shock, in contrast, will shift the labour demand curve so that the wage and employment will change in the same direction. 12. (a) The user cost is uc = (r + d)p K = 0.15(2000) = 300. (b) The firm sets the marginal product of capital equal to the user cost, which gives K =4. (c) Gross investment will be 1.3 units or $2600. (d) Using the standard diagram, a decrease in r, for example, lowers the user cost of capital relative to the MPK, so that the target capital stock rises. Thus gross investment rises also. 6

Economics 222 Exercise A due Thursday 27 September in class

Economics 222 Exercise A due Thursday 27 September in class 1. To answer this question, start by retrieving (from CANSIM) GDP at market prices for Ontario (D24082) and Québec (D24363) for 1996-1999. Next,