ECON 121 Principles of Macroeconomics Exam I Solutions

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3 ECON 121 Principles of Macroeconomics Exam I Solutions Dennis C. Plott University of Illinois at Chicago Department of Economics Summer 2015

4 Name (print neatly and clearly): Dennis C. Plott General Instructions 1. Read and follow all instructions/directions carefully. 2. Make sure your exam consists of 12 pages, not including the cover page. 3. An inability to follow instructions/directions will result in points being deducted. 4. The only device allowed is a simple calculator; i.e., anything that can store or retrieve information (including a graphing calculator) is NOT allowed. 5. Use of books, notes, another person, and/or aid of any kind is absolutely NOT allowed. 6. Answer all questions in blue or black ink only; i.e., no pencils or colored inks. The only exception: graphs may be drawn in pencil. Note: use a guide of some sort (e.g., a ruler) for all graphs. 7. Do not use white out or similar products, but neatly cross/scratch out anything you do not want graded. 8. Write, mark, and draw your answers neatly and clearly. If your answer is illegible (i.e., difficult to read in the least), then it will not be graded. It is your job to clearly communicate. 9. Label all graphs fully and completely; i.e., axes, intersections, curves, etc. 10. Support your answers as thoroughly as possible; i.e., graphically, conceptually, and mathematically. Note: this may not be feasible for all questions asked. State and define any concept utilized and list and name any equation used. In other words, show all of your work. 11. For the True/False/Uncertain questions clearly indicate your choice by writing either True, False, or Uncertain underneath the respective question. 12. Unless explicitly instructed otherwise, all questions require a justification to receive credit. 13. Answer all questions using positive economic reasoning. 14. Assume the nominal wage is fixed in the short-run, all markets begin in long-run equilibrium, and capital stock is fixed in both the short-run and long-run except for negative shocks. For changes in the variables of interest, reference the initial level, unless instructed otherwise, in both the short-run and long-run. Original Score (%) Adjustment (%) 16 Actual Score (%) University of Illinois at Chicago (UIC) 1

5 1. Currently, ten U.S. states have bottle bills ; i.e., container deposit laws. Many of those states are also campaigning for updates and expansions, and still others have active campaigns for new bottle bills. For example, Michigan bottling law requires that people get a refund of ten cents when they return an empty bottle or can. Recently, Michigan state senator Rebekah Warren has introduced legislation to expand the Michigan Beverage Containers Initiated Law of 1976, thereby opening up debate about what direction the potentially new legislation should take. (a) [4 points] Why does Michigan and similar states pay people to return bottles? How is this achieved? [Note: There are two questions. Hint: use general economic principles/concepts to explain.] Why? Policy makers know that people making choices respond to incentives. Instead of throwing away bottles and cans, people will now bring the used bottles and cans to the designated areas for recycling in order to receive their payment. How? Policy makers have increased the marginal benefit of returning bottles in order to reduce litter and clean the environment. Alternatively, policy makers have have increased the opportunity cost of not recycling. People will substitute away from throwing bottles and cans away and instead turn in the used bottles and cans to recycling centers. (b) [4 points] Some groups are pushing for a change in Michigan state law to make recycling mandatory instead of voluntary using slogans such as if it s recyclable, it should be recycled! Is this statement in quotes positive or normative. Explain. Normative. Normative statements are matters of opinion or statements of value. They cannot be tested or proven. The should indicates a normative statement or value judgment. University of Illinois at Chicago (UIC) 2

6 (c) [4 points] One commentator, arguing for the repeal of the law, stated... they [Michigan] should either lower the bottle return or remove it all together; people would have recycled even without the ten cents.... Is there a potential economic (logical) fallacy in this statement? If so, identify the economic fallacy and briefly explain why the commentator s statement can be classified as the logical fallacy you identified. The person making the statement seems to imply they know what would happen although not observed or even observable. Counterfactual: expressing what has not happened but could, would, or might under differing conditions. It is possible that the recycling rate would have been the same without the cash incentive. However, it may have also been (significantly) lower. The problem is: policy makers cannot view the same world with and without the policy; i.e., the statement is counterfactual and the commentator pretends to know what the counterfactual world would be like. (d) [4 points] Another commentator, wanting the law to be expanded, stated [w]hy not also add into the legislation a change to the [bottle and can] return from ten cents to twenty-five cents or fifty cents? Michigan s ten cent return is, to my knowledge, the highest general return in North America. However, ten cents doesn t quite have the power that it did almost four decades ago. What general economics concept, given Michigan has a redemption rate of approximately 95.9%, the highest recycling rate in the nation, is the commentator (potentially) neglecting? (The law of) diminishing (marginal) returns. Diminishing returns means that a sustainability program (e.g., recycling) trying to decrease a state s harmful impact on the environment (e.g., by increasing recycling) can be successful early on, but at some point it will require higher and higher expenditures to obtain the same reductions and eventually it will hit the wall. University of Illinois at Chicago (UIC) 3

7 2. An article in the USA Today 1 examines the wealthiest presidents from Washington to Obama. The nominal salary paid to the president of the United States along with data for the consumer price index (CPI) are given for various years below. Year President Nominal Presidential Salary CPI ( = 100) Real Presidential Salary 1949 Truman $100, $420, Nixon $200, $544, Bush $400, $225, Obama $400, $177,857 (a) [8 points] Calculate the president s real salary measured in in dollars. Which president, from the list, is the wealthiest in terms of real salary? Real Presidential Salary in year t = Nominal Presidential Salary in period t Real Presidential Salary in 1949 = Nominal Presidential Salary in 1949 ( ) 100 Real Presidential Salary in 1949 = $100, Real Presidential Salary in 1949 = $420, 168 ( CPI CPI period t ( CPI CPI 1949 ) ) Real Presidential Salary in 1969 = $544, 959 Real Presidential Salary in 2001 = $225, 861 Real Presidential Salary in 2011 = $177, 857 Nixon has the highest real presidential salary. (b) [4 points] Calculate the inflation rate from 1949 to π = P 2011 P 1949 P % = CP I 2011 CP I 1949 CP I % = π = % 100% 1 USA Today Report: The 10 Richest U.S. Presidents by Ashley C. Allen 17 February 2014 University of Illinois at Chicago (UIC) 4

8 3. [8 points] Fill in the missing values in the table of data collected by the Bureau of Labor Statistics (BLS) Consumer Population Survey (CPS) (i.e., household survey) for December The working-age population, employment, unemployment, and labor force are measured in thousands. Show your work. Working-Age Population 201,661 Employment 127,817 Unemployment 7,296 Unemployment Rate (U 3) 5.4% Labor Force 135,113 Labor Force Participation Rate 67.0% Unemployment Rate = Unemployment Labor Force = Unemployment 135, % = = Unemployment = 7, 296 Labor Force = Unemployment + Employment 135, 113 = 7, Employment = Employment = 127, 817 Labor Force Labor Force Participation Rate = Working-Age Population 100% 67.0% = = Working-Age Population = 201, , 113 Working-Age Population 100% 4. [6 points] An article in the Financial Times discusses the United Kingdom joining Estonia, Austria, Slovenia, Finland, Sweden, and Norway in adding prostitution and illegal drugs to its GDP. True or False: Due to the nature of these particular activities, the United Kingdom s GDP will be negatively affected by this change in national accounts. False. Gross domestic product (GDP): the market value of all final goods and services produced in a country during a period of time, typically one year or quarter. There are shortcomings of GDP as a measure of total production. One important type of production omitted from many countries measurement of GDP involves the underground economy. Buying and selling of goods and services might be concealed from the government to avoid taxes or regulations, or because the goods and services are illegal; e.g., illegal drugs and prostitution. This constitutes the underground economy. The Office of National Statistics (ONS) [the United Kingdom s version of the Bureau of Economic Analysis (BEA)] estimates that [p]rostitutes and drug dealers are set to give Britain a 10bn boost as the country revamps the way it measures its economy. University of Illinois at Chicago (UIC) 5

9 5. According to the Bureau of Labor Statistics (BLS) the U.S. unemployment rate (U-3) peaked in October 2009 reaching 10.0%. This figure has since slowly and consistently declined to its current level of 5.3% (June 2015). The Washington Post 2 reported on the recently released BLS unemployment rate (U 3) of 5.3% where many economists and analysts consider (in the range of) full-employment. (a) [2 points] What is meant by full-employment? Full-employment: A situation in which the unemployment rate equals the natural unemployment rate. At full employment, there is no cyclical unemployment all unemployment is frictional and structural. (b) [4 points] The article quotes the chief economist of the AFL-CIO, a U.S. labor union, as stating [a]s good as these [unemployment rate] numbers are, they aren t good enough. What do you think he means? Interpret and carefully explain using positive economic reasoning. List and discuss any of the following: Discouraged workers: People who are available for work, but have not looked for a job during the previous four weeks because they believe no jobs are available for them. Underemployment (unemployment intensity): A situation in which a worker is employed, but not in the desired capacity, whether in terms of compensation, hours, or level of skill and experience. Additionally: distribution of unemployment Unemployment duration long periods of unemployment are bad for workers, as their skills may atrophy thereby making it more difficult to find work. They increase the risk of becoming discouraged and depressed. Additionally, may push workers into jobs they wouldn t normally take with a healthy economy; e.g., someone with an advanced degree working at McDonalds (a form of underemployment). (c) [4 points] The BLS also reported the labor-force participation rate fell to 62.6 percent. Regarding this, the article quotes an economic analyst for Bankrate.com, a personal finance Web site, Mark Hamrick, as saying [t]here is no way to read a positive on a decline in labor-force participation. Do you agree or disagree? Explain. An important aspect of economic reasoning entails identifying pros and cons. In the quote, the author of the statement gives a con to a declining labor-force participation rate. Your job, so to speak, is to identify a pro. How? A good question to ask is why is the labor-force participating rate decreasing? Both of the following are potentially positive : Men, the majority of the labor force, have been going to school for longer and retiring earlier than before. Increases in Social Security Disability Insurance availability have allowed people with disabilities to stop working The Washington Post, An Unfruitful Jobs Recovery Rewrites the Definition of Full Employment, by Chico Harlan, 2 July University of Illinois at Chicago (UIC) 6

6. [8 points] An article in The Economist 3 discusses the United States during the late 1970s where inflation unexpectedly increased and how both borrowers and lenders were affected.

10 6. [8 points] An article in The Economist 3 discusses the United States during the late 1970s where inflation unexpectedly increased and how both borrowers and lenders were affected. Suppose a homeowner (borrower) obtained a fixed rate mortgage (i.e., a loan) prior to inflation unexpectedly increasing. True or False: (Based solely on this information.) It is better to be a borrower compared to a lender of money if actual inflation turns out to be more than the inflation rate that was expected at the time the mortgage was signed. Explain. It is better to be a borrower if actual inflation is more than the inflation rate that was expected at the time the loan was made. The Fisher equation; ex ante and ex post versions, respectively: i = r e + π e i = r + π The nominal rate of interest lenders charge has two parts: the lender s real or required rate of return, and an estimate of the expected inflation rate. The reason for adding expected inflation is to ensure that in the future, when lenders receive repayment of their required rate of return, it has not lost purchasing power due to inflation. If it turns out that actual inflation was more than what was expected, total interest paid to the lender will be less than what was needed to prevent the loss of purchasing power (i.e., the lender should have charged a higher rate of interest; this benefits the borrower). As a result, a lender would lose purchasing power at the borrower s expense or the borrower would be repaying the loan with funds that were worth less in terms of purchasing power. 3 The Economist The Volcker Recession: Who Beat Inflation? 31st March 2010 University of Illinois at Chicago (UIC) 7

11 7. An article in the Financial Times 4 reports [t]he Shanghai index is firmly in bear market territory, down 28.6 per cent since the June peak, while the tech-heavy Shenzhen Composite has fallen 33.2 per cent.. The Chinese government and households are concerns the decline will continue. The stock market, particularly the Shanghai index and Shenzen Composite, is a major source of wealth for Chinese households. An article published on July 10 th in The New York Times 5 reports: As China s stock market tumbled over the last month, some wealthy apartment owners began trying to sell. Shopping malls became quieter. And customers at automobile dealerships across the country asked to defer delivery and payment for previously ordered cars. While share prices have rebounded modestly in recent days, many business owners in China remain nervous, as they start to notice a perceptible economic chill. (a) [10 points] Demonstrate the change in wealth using the closed loanable funds (goods) market, ceteris paribus, in the long-run. State explicitly what occurs to the following variables of interest: (i) real interest rate, (ii) quantity of savings, and (iii) quantity of investment; i.e., increase, decrease, unchanged, or ambiguous. Clearly explain the economic rationale for why the curve(s) shift, if at all, and for the change in the variables of interest. r S d 0(C 0 ) S d 1(C 1 ) r 0 a r 1 z I d S 0 = I 0 S 1 = I 1 S, I stock market decreases (given) rightward ceteris paribus wealth C saving curve (S d ) shifts ceteris paribus S = Y C G; C S for every level of the real interest rate r = S > 0 = r < 0; increasing the quantity of loanable funds decreases the price of loanable r funds: the real interest rate ceteris paribus I; as the real interest rate decreases the opportunity cost of borrowing funds is lowered. Firms will borrow more, thereby increasing the quantity of investment = I > 0 4 Financial Times Chinese Authorities Move to Prop Up Market as Rout Deepens by Gabriel Wildau, 3 July The New York Times, Signs of a Growing Hush in China s Economy, 10 July 2015, by Keith Bradsher University of Illinois at Chicago (UIC) 8

12 (b) [10 points] Demonstrate the change in wealth using the closed AD LRAS graph, ceteris paribus, in the long-run. State explicitly what occurs to the (i) price level, (ii) real GDP, (iii) and natural rate of output; i.e., increase, decrease, unchanged, or ambiguous. Clearly explain the economic rationale for why the curve(s) shift, if at all, and for the change in the variables of interest. P LRAS P 0 a P 1 z AD 0 (C 0 ) Y 0 = Y 0 = Y 1 AD 1 (C 1 ) Y ceteris paribus housing prices decrease (given) wealth C AD curve shifts leftward P < 0 (P 1 < P 0 ) Y = 0 (Y 0 = Y 1 ) Y = 0 Unchanged; the LRAS curve did not shift as total factor productivity (A), capital (K), and labor (L) did not change since they are exogenous variables. University of Illinois at Chicago (UIC) 9

13 8. The Japanese economy is increasingly discussed in the media as the prime minister, Shinzo Abe, attempts to boost the economy after two decades of economic stagnation and inflation near zero. For example, a Bloomberg 6 article discusses recent spending trends of relatively young (i.e., people in their twenties) Japanese households. Additionally, The Wall Street Journal 7 reports on Japan s unexpected upward revision of its GDP. (a) [4 points] The first article states [t]he animal spirits of young Japanese workers [households] are stirring again, at least when it comes to spending. What is meant by the phrase animal spirits? Animal spirits refers to the state of confidence (i.e., optimism or pessimism) held by consumers (households) and businesses (firms). Animal spirits is a term coined by John Maynard Keynes to describe the gloom and despondence that led to the Great Depression and the changing psychology that accompanied recovery. (b) [4 points] Would increasing consumption from animal spirits be considered autonomous or induced expenditure? Explain. Autonomous expenditure since animal spirits involves optimism/pessimism or confidence. Autonomous expenditures are expenditures that are unrelated to and unaffected by the level of income or production. Induced expenditures are based on the level income or production. (c) [4 points] The second article states [t]he initial reading for first-quarter growth was an annualized rate of 2.4%... but the extent of the revision to 3.9% was a surprise. What is the change in percentage points? 3.9% 2.4% = 1.5 percentage points Note: NOT percent change which is % GDP = 3.9% 2.4% 2.4% = 62.5% 100% 6 Bloomberg, Abe s Pleased Young Japanese Are Saving Less and Buying More, by Keiko Ujikane, 1 July The Wall Street Journal, Five Highlights of Japan s Revised GDP Report, 7 June 2015 University of Illinois at Chicago (UIC) 10

14 (d) [4 points] If Japan maintains an average annual growth rate of 3.9%, approximately how many years would it take for Japan s GDP to double? Rule of 70 or years years 3.9 (e) [4 points] According to the Bloomberg report, Japanese stocks decreased after data showed Japan s GDP grew more than expected. Stronger GDP growth is generally beneficial for financial investors. Does knowing growth in business inventories accounted for slightly more than half of the 3.9% annualized growth rate help or hurt in explaining GDP increasing followed by the stock market decreasing? Explain. It helps. The upward revision to Japan s GDP was unexpected. If over half of the upward revision was due to increasing inventories, then these are likely unplanned inventories. A (rapid) rise in unplanned inventories are an indication of future recessionary pressure. A recession, or downturn in the economy, would negatively affect stock markets. University of Illinois at Chicago (UIC) 11

Bonus Questions 1. [1 points] What is the answer to the great question... of life, the Universe and everything? [For reference, see the cover page picture.

15 Bonus Questions 1. [1 points] What is the answer to the great question... of life, the Universe and everything? [For reference, see the cover page picture.] 42 Hitchhiker s Guide to the Galaxy LINK In many of the more relaxed civilizations on the Outer Eastern Rim of the Galaxy, the Hitchhiker s Guide has already supplanted the great Encyclopaedia Galactica as the standard repository of all knowledge and wisdom, for though it has many omissions and contains much that is apocryphal, or at least wildly inaccurate, it scores over the older, more pedestrian work in two important respects. First, it is slightly cheaper; and secondly it has the words DON T PANIC inscribed in large friendly letters on its cover. 2. [2 points] What are the names of your teaching assistants for ECON 121 in Summer 2015? [Spelling counts.] Jeff Cline Nam Nguyen Tam Hoai 3. [1 points] What country experienced the greatest rate of monthly inflation ever recorded? Hungary 4. [1 points] Who coined the phrase animal spirits? John Maynard Keynes 5. [2 points] What is data dredging? Data dredging: selecting statistics that support a particular thesis and drawing attention to those numbers, while ignoring other figures that might lead to a different conclusion; cherry picking. 6. [2 points] What organization is responsible for dating the business cycle in the United States? National Bureau of Economic Research (NBER) 7. [1 points] What is Dan C. s favorite Canadian beer? Molson University of Illinois at Chicago (UIC) 12

ECON 121 Principles of Macroeconomics Practice Exam I (Partial) Solutions

ECON 121 Principles of Macroeconomics Practice Exam I (Partial) Solutions Dennis C. Plott University of Illinois at Chicago Department of Economics Summer 2015 Name (print neatly and clearly): General