SOCIAL ANALYSIS 10 FINAL EXAM PART II: ESSAY QUESTIONS MAY 22, 2004

Transcription

1 Name Section Leader Section Time Harvard ID # SOCIAL ANALYSIS 10 FINAL EXAM PART II: ESSAY QUESTIONS MAY 22, 2004 You will be given two hours for this part of the exam. Points per question are proportional to the time indicated. Please write clearly; illegible answers will receive no credit. Label all graphs. Calculators are not allowed. 1. Write your name, your Harvard student ID number, your section leader's name, and your section time on this sheet. 2. Do not write your name on your bluebooks. To ensure anonymous grading, write only your Harvard student ID number, your section leader's name, your section time, and the bluebook number on each bluebook that you use. 3. Use five bluebooks for this portion of the exam. You may write on this exam, but you will only be given credit for answers written in the bluebook. 4. Use one exam booklet for each bluebook section of the exam. You must hand in all 5 bluebooks.

2 Bluebook I: You re In Control!! (28 minutes) 1. (7 minutes) You rule Narcissisia, a country quite similar to the United States, except that you alone control monetary and fiscal policy in Narcissisia. Narcissisia s economy currently is experiencing positive cyclical unemployment. (a) (1 minute) On a well-labeled AD/AS graph, show the current macroeconomic situation in Narcissisia. (b) (1 minute) You are considering doing nothing in response to the current situation in Narcissisia. Explain the long-run consequences of your inaction on the aggregate price level, GDP, and unemployment. (c) (3 minutes) Name and explain three different demand management actions you could take which would reduce cyclical unemployment. (d) (2 minutes) A junior advisor rushes in to tell you that the current situation was caused by a shift in SRAS. Your advisor states that SRAS must have shifted left because oil prices declined, and therefore there is less oil available, and thus supply was negatively affected. Is your advisor right or wrong? Explain fully. 2. (7 minutes) The economy of the country of Bacchanalia is in long-run equilibrium. The government is trying to decide whether to have the Bacchanalian Central Bank buy bonds, or to have the Bacchanalian Revenue Service lower taxes. (a) (5 minutes) Using a separate table for each policy, explain the long-run consequences of each of these policies on GDP and on all of the components of aggregate demand. BLUEBOOK I CONTINUES ON NEXT PAGE

3 (b) (2 minutes) How would your answer differ for the very long run? Explain what accounts for the difference. (You need not draw up another table for this part.) 3. (7 minutes) (a) (3 minutes) Draw a curve showing the trade-off between changes in inflation and unemployment. Assume NAIRU equals 6%. Assume also that the tradeoff represented by the curve you draw is 1 percentage point change in unemployment for each 2 percentage points change in inflation. Be sure to label the axes properly, show the location of the NAIRU, and locate two other points on the curve. (b) (3 minutes) Assume that the rate of inflation is growing by 4 percentage points per year, and that the economy remains on the curve you drew for part (a): i. (.5 minute) Locate the point on the curve you drew for part (a) which represents this situation. ii. (2.5 minutes) For the economy to have moved from the NAIRU to the point you located, calculate approximately how much actual GDP must have changed relative to potential GDP. (c) (1 minute) The Fed decides they want to keep unemployment at 3%. Assuming the Fed achieves this goal, and that the curve from part (a) holds over the next five years, by how much will inflation have changed over the next five years? BLUEBOOK I CONTINUES ON NEXT PAGE

4 4. (7 minutes) The economy of Seventiesville is experiencing a phenomenon known as stagflation. (a) (1 minute) Depict the Seventiesville economy s situation on a well-labeled graph, showing the country s LRAS, SRAS and AD curves as well as the equilibrium price and output. (b) (1.5 minutes) Explain briefly the dilemma facing policy-makers as a result of stagflation. The Seventiesville Central Bank decides to sell bonds in an open market operation in response to the stagflation. (c) (1.5 minutes) Using a well-labeled graph, explain any changes to the equilibrium price level and equilibrium output that occur as a result of this action in the short run. (d) (3 minutes) i. (1.5 minutes) Assuming the Seventiesville money market was in equilibrium before the Central Bank s action, use a well-labeled graph to show what happens in the money market in the short run as a result of the Central Bank s action. ii. (1.5 minutes) Use another well-labeled graph to show what happens in the money market in the long run. END OF BLUEBOOK I PLEASE USE NEW BLUEBOOK FOR BLUEBOOK II QUESTIONS

5 Bluebook II: Need a Little Loan(able Funds)? (19.5 minutes) 1. (13.5 minutes) (a) (1 minute) Write down the loanable funds equation, identifying which components represent the supply of loanable funds and which represent the demand for loanable funds. (b) (4 minutes) Draw the market for loanable funds, showing the supply curve of loanable funds and the demand curve for loanable funds. Explain why the curves you draw slope up or down. (c) (4 minutes) Using new graphs, show the effect on the market for loanable funds of: i. (2 minutes) A permanent increase in government spending ii. (2 minutes) An investment tax credit for firms (d) (2.5 minutes) Consider what happens if there is an influx of funds from foreign savers into the nation of Cashstrapped. i. (.5 minute) What happens to Cashstrapped s capital account? ii. (2 minutes) On your graph from part (b), illustrate what happens when the foreign funds flow in. BLUEBOOK II CONTINUES ON NEXT PAGE

6 (e) (2 minutes) Assume loanable funds continue to flow into Cashstrapped from abroad. (i) (.5 minute) What does this inflow imply about the real interest rate abroad versus in Cashstrapped? (ii) (.5 minute) What will be the effect of a continued capital inflow on Cashstrapped s current account? (iii)(1 minute) Given the inflow, is Cashstrapped s currency likely to appreciate or depreciate relative to other currencies. Explain your answer. BLUEBOOK II CONTINUES ON NEXT PAGE

7 2. (6 minutes) Imagine that there are two economies in the world: Bostonia and New Yorkland. Bostonia s currency is the sock and New Yorkland s is the yank. Despite the longstanding rivalry between their citizens, Bostonia and New Yorkland are trading partners. The Central Bank of New Yorkland decides to conduct contractionary monetary policy. Explain the short run effect, if any, on the following: (a) (2 minutes) The yank/sock nominal exchange rate (b) (1 minute) The New Yorkland current account (c) (1 minute) The Bostonia capital account GDP in New Yorkland recently plummeted. At first, the citizens in Bostonia cheered, happy to see their rivals taken down a notch. But then an economist (always a killjoy) asserts that the fall in New Yorkland s GDP is likely to hurt Bostonia s GDP in the short run. (d) (2 minutes) Could the economist be correct? Why or why not? END OF BLUEBOOK II PLEASE USE NEW BLUEBOOK FOR BLUEBOOK III QUESTIONS

8 Bluebook III: Tales of Countries Far and Farther (32 minutes) 1. (6 minutes) Consider two economies: Discretia and Fixedland. In both countries, banks hold excess reserves. In Discretia, banks hold less in excess reserves as the opportunity cost of holding reserves increases. In Fixedland, all banks always hold exactly 2% in excess reserves. Discretia and Fixedland are identical in every other way. (a) (1.5 minutes) Show the money market in Discretia on a well-labeled graph, showing Discretia s money supply and money demand curves as well as the equilibrium interest rate. (b) (1.5 minutes) Show the money market in Fixedland on a well-labeled graph, showing Fixland s money supply and money demand curves as well as the equilibrium interest rate. (c) (3 minutes) Suppose that the current equilibrium interest rate is initially the same in both countries. Then, the central banks of Discretia and Fixedland simultaneously conduct expansionary open market operations of equal magnitude. Will the expansionary open market operation have a greater short-run effect on the interest rate in Discretia or Fixedland? Explain with reference to one graph. 2. (12 minutes) The economy of Lower Slobovia is currently in long-run equilibrium, but has decided to conduct contractionary fiscal policy by permanently raising taxes. The Lower Slobovian government decides to leave government expenditures unchanged. (a) (2 minutes) How will the tax increase affect the real interest rate in Lower Slobovia in the short run? Explain with reference to a graph of the money market, assuming the money market was in equilibrium before the tax increase. State any assumptions you make. BLUEBOOK III CONTINUES ON NEXT PAGE

9 (b) (4 minutes) Slobovian government economists have determined the following: The income elasticity of both consumption and investment is very high. The interest rate elasticity of both consumption and investment is very low. Based on this information, make a chart showing the short-run effects of the tax increase on each of the components of aggregate demand through the two main channels ( Y and r); and the net effect on each component. (c) (3 minutes) Make a chart showing the net long-run effects of the tax increase on each of the components of aggregate demand. (d) (3 minutes) How would the long-run effects differ if, instead of the government raising taxes, the Slobovian Central Bank engaged in contractionary monetary policy? Explain what accounts for the difference in long-run effects? (You need not do another chart.) BLUEBOOK III CONTINUES ON NEXT PAGE

10 3. (14 minutes) The government of Slobovia issues bonds which never mature, i.e., consols. All of these instruments pay $100 per year, every year, forever. (a) (5 minutes) Bond traders estimate that on August 31, the interest rate (expected to prevail indefinitely after August 31) on comparable assets will be: 10% with 30% probability 20% with 50% probability i % with x% probability Assume that 10%, 20% and i% are the only interest rates traders think are possible on and after August 31. Suppose that the option and consol markets are efficient, and that the premium of a call option that gives the holder the right to buy a consol for $1,000 on August 31 is $200. Find i and x. Show your work. (b) (3 minutes) Suppose now that bond traders think the Slobovian Central Bank will either engage in severe contractionary monetary policy or highly expansionary policy. They revise their estimates of the possible interest rates on comparable assets on August 31 to: 2% with 50% probability 25% with 50% probability If the consol market is efficient, for what price will consols sell now? Show your work. (c) (4 minutes) Using the rates and probabilities from part (b), suppose the price for which a trader can write (i.e. sell) a put with a strike (or exercise) price of $2,000, which expires on August 31, is $1,000. What is the trader s expected profit from writing the put? Show your work. (Note that, for this particular question, the option market is not necessarily efficient.) BLUEBOOK III CONTINUES ON NEXT PAGE

11 (d) (2 minutes) What is the relationship between the volatility of an asset s price and the value of an option on that asset? Explain. END OF BLUEBOOK III PLEASE USE NEW BLUEBOOK FOR BLUEBOOK IV QUESTIONS

12 Bluebook IV: Back to the Future (18.5 minutes) 1. (4 minutes) Consider the following data for the U.S. and China: Country Percent Growth in K/L Percent Growth in TFP United States 3 1 China 18.5 (a) (1 minute) Assuming the capital share of income in China is 1/6, calculate the growth in productivity (i.e. labor productivity) for China. (b) (3 minutes) If population is growing in China at 2% and in the US at 1%, and there is no change in the labor force participation rate in either country, what is the rate of growth of the capital stock in the two countries? 2. (8.5 minutes) Partyland and Sayvland used to both consume 50% of their income. Starting this year, however, Partyland s citizens now consume 80% of their income, while Sayvland still consumes only 50%. Real GDP, population, labor productivity and labor force participation rates in both countries are currently the same. (a) (1 minute) How would you compare living standards in Partyland and Sayvland immediately after the change in Partyland s consumption rate? (b) (3 minutes) Assuming the only difference between the countries continues to be their consumption rates, explain any differences you would forecast in the future living standards of the two countries. BLUEBOOK IV CONTINUES ON NEXT PAGE

13 In a neighboring region there are two other countries, Badland and Growland. You have the following information about them: City Per capita GDP in 1960 ($) Avg. annual growth of per capita GDP Growland % Badland % (c) (1 minute) Approximately how many years will it take for Badland to double its per capita GDP? (d) (3.5 minutes) When will Badland catch up to Growland in terms of per capita GDP? 3. (6 minutes) (a) (3 minutes) Explain the two reasons we would expect to see convergence in per capita GDP among countries. (b) (3 minutes) How would increasing prevalence of home bias affect the rate of convergence? Explain. END OF BLUEBOOK IV PLEASE USE NEW BLUEBOOK FOR BLUEBOOK V QUESTIONS

14 Bluebook V: Almost Home Free (22 minutes) 1. (3 minutes) In the 1970 s, the Fed allowed inflation to rise from 2% to 13%. According to Professor Feldstein, what mistake did the Fed make that allowed this to happen? Explain. 2. (4 minutes) What were the two reasons Professor Feldstein said that, in the short run, trying to control the money supply is not a reliable tool for managing aggregate demand? 3. (2 minutes) In his lecture on The U.S. Current Account and the Dollar, Professor Rogoff explained that the current accounts of the world should add up to zero. Why is this the case? 4. (3 minutes) In his lecture on Fiscal Policy, what did Professor Feldstein list as the three main reasons why budget deficits are bad? 5. (3 minutes) According to the Economist article, A faded green, what are four reasons why currency depreciation may be less effective in decreasing trade imbalances than it once was. 6. (3 minutes) Consider the article, Two kinds of openness, from The Economist. What were the domestic defects in Asian financial systems that made those systems more vulnerable? What is the primary reason these defects persisted for so long? BLUEBOOK V CONTINUES ON NEXT PAGE

15 7. (4 minutes) Recall the Remarks by Chairman Greenspan from his speech in November of last year, reprinted in your Readings/Workbook. In a flexible world economy, what four economic variables will change so as to reduce trade imbalances between countries? END OF BLUEBOOK V