Finance Macroeconomic Analysis Midterm #1 Summer 2013

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1 Finance Macroeconomic Analysis Midterm #1 Summer 2013 Name Answer all questions. Note that only complete answers will be awarded full credit. Partial credit will be given for incomplete answers. Feel free to make any assumptions that you feel are needed to answer a question. SHOW YOUR WORK!!! You have 75 minutes. Good Luck! 1) (10 points) The current benchmark for measuring inflation in the US is the consumer price index. There are many people that are concerned about the accuracy of the CPI in terms of measuring inflation. a) What are some general problems associated with any price index? How do we deal with new goods entering the index? How do we adjust for quality improvements over time? How do we handle the fact that different people shop at different places? What about housing (rental vs. owner occupied)? b) What are some problems associated specifically with the consumer price index? We might have the weights wrong (formula bias). We can t account for the fact that as goods become cheaper, people tend to buy more while as goods become more expensive, people tend to buy less (substitution bias) 2) ( 5 points) Back in 2011, President Obama linked technology to job losses: There are some structural issues with our economy where a lot of businesses have learned to become more efficient with a lot fewer workers you see it when you go to the bank and you use the ATM, you don t go to a bank teller, or you go to the airport and you re using a kiosk instead of checking in at the gate Given what we have discussed in class, comment on the accuracy of this statement. Specifically, does technological advancement create job losses in the macroeconomy? Several answers are acceptable, but mainly I was looking for the fact that productivity growth (generally associated with technology) is positively correlated with employment.

2 3) (5 points) Suppose that you have the following information: Year GDP Real GDP (2000 prices) 2004 $10,250 $9, $11,400 $10,500 Calculate inflation in 2004 using the GDP deflator. P P $10, $9,750 $11,400 $10, or ln1.086 ln1.051 * % * % ) (5 points) Suppose that you have the following information (assume that capital s share of income is 1/3 and labor s share of income is 2/3). Year GDP Growth Capital Growth Employment Growth % 4% 2% Calculate the rate of productivity growth. Is this country in its steady state? % A % Y (1/ 3) % A 6.5 (1/ 3)(4) % K (2 / 3) % L (2/3) 2 3.9% Capital is growing at a rate that is faster than labor growth no, the country is not in its steady state.

3 5) (5 points) In 2010, it was announced with much fanfare that China surpassed Japan and became the second largest economy on the planet (Second only to the United States). However, the IMF claims that using Purchasing Power Parity adjustments, China actually surpassed Japan back in How would you explain this discrepancy? The discrepancy lies in how output in China (valued in Yuan) is converted to dollars. If we are valuing Chinese output in dollars using the Yuan exchange rate, then we will get a low number given that the Yuan is undervalued. The PPP adjustment values Chinese production using prevailing US prices. 6) ( 5 points) Suppose we the following information for a Honda factory in located outside Columbus, Ohio. Assume that the general labor in this plant is American citizens but that that the management positions are held by Japanese citizens. Also, assume that 20% of the stock in Honda is help by American interests. Total Production $750M Materials Expenses $350M General Labor Expenses $100M Management Labor Expenses $50M Calculate this plant s contribution to GDP and GNP for the US. For GDP, we count the entire value added of $400M. For GNP, we only count what accrues to Americans.20% of the profits ($50M) plus the American labor ($100M) to get $150M total 7) ( 5 points) The United States is currently running a large trade deficit while China is running a sizeable trade surplus. Explain using the national income accounting identities why this is unusual (i.e. China should be running a trade deficit and the US should be running a trade surplus). The Current account equals the difference between domestic saving and domestic borrowing (both public and private) CA = S I (G T) Developing countries with low income will have low savings, but typically very high investment (because the return to investment is so high) and, hence, a trade deficit.. Wealthier countries have higher savings and lower investment and, hence a trade surplus.

4 8) (10 points) Neoclassical growth models attempt to explain long run growth trends by looking at productivity, capital accumulation, population growth and technological progress. a) The primary goal of this model is to explain the concept of absolute convergence. What is absolute convergence and how is this explained in the model? Absolute convergence is the general observation that rich countries grow slowly while poor countries grow fast (so, rich and poor countries will converge). In the neoclassical model, a country s rate of growth is proportional to how far away it is from its steady state. If all countries have the same steady state, we get absolute convergence. b) How can we explain the fact that some countries don t follow the general rule of absolute convergence? Some countries don t follow this rule we still have that a country s rate of growth is proportional to how far away it is from its steady state, but due to different structural parameters, different countries have different steady states. 9) (10 points) The US economy has a population of 300M people. Of those 300M, roughly 225M are considered eligible to work. The latest BLS survey reported the following: Household Survey Labor Force Total Employment 150.0M 143.0M a) Calculate the unemployment rate and the participation rate. UR = (7/150)*100 = 4.7% PR = (150/225)*100 = 67%

5 Suppose that at any given time, the breakdown of the unemployed in the US is as follows : Number of People Length of time unemployed 3.5M 2 wks 2.5M 13 wks 1.0 M 26 wks.5m 52 wks b) Calculate the average duration of unemployment. D ) (15 points) Suppose that we have the following information for GDP and the CPI: Year GDP CPI 1947 $237B $14,270B $15,984B 231 a) Calculate real GDP in year 1947 dollars for each of the above years. RGDP RGDP RGDP $237B $14, 270 $1,380B ,984 $1, 453B 231 b) Assuming that real GDP follows an exponential trend (i.e. constant annual growth rate); calculate trend growth using the 1947 and 2010 observations. ln 1,380 ln 237 * % 63

6 c) Using your answer from (b), convert 2013 GDP to deviation from trend ,380e 1,500 1,453 1,500 * % 1,500

7 11) (10 points) Consider the following economy: 1 3 y Ak Parameter Value Savings Rate 5% Depreciation Rate 8% Population Growth Rate 2% Productivity Growth 4% Current Productivity 12 Level Taxes 0 Currently, the economy has a labor force of 5,000 and a capital stock equal to 10,000. a) Calculate this country s current rate of growth in GDP per capita. Calculate this country s current level of GDP per capita. K 10,000 First, calculate per capita capital: k 2 L 5,000 Now, calculate per capita output: y Ak Calculate this country s current level of savings and investment per capita. s y t this country s per capita capital stock next year. (1 ) ki k ' g 1.02 l Calculate this country s current rate of growth in GDP per capita. Now, calculate the new level of output per capita:

8 y ' Finally, calculate the growth rate: % y ln 17 ln 15.1 *100 12% b) How fast will this country grow (in terms of per capita GDP) in the steady state? GDP per capita will grow at the rate of technological progress (4%). 12) (15 points) Suppose that you have 80 hours available per week to work. The nominal wage is $12 per hour and the price of consumption goods is $3. a) Sketch out your constraint for leisure time and consumption. Indicate an initial consumption/leisure choice. What is the logic behind this choice? C L Households are equating the real wage with the marginal rate of substitution.

9 b) Suppose that the wage rises to $15 dollars per hour. Show how this affects your set of consumption/leisure choices. How your choice for hours worked is affected? Explain. Sketch your labor supply curve L The substitution would indicate an increase in hours works while the income effect indicates a decrease in hours worked. Drawn here, the substitution effect dominates. w/p Ls L

10 c) During the last recession, President Obama s plan to create jobs was to cut the social security tax in half (currently both employees and employers pay 6.2% of all income earned under $108,000 per year Obama reduced both rates to 3.1%). Using our labor market model, explain the effect of this plan on labor supply, labor demand, the real wage, and employment. With a social security tax, business are equating the real wage plus the tax equal to the marginal product of labor. w 1 MPK p With a lower tax, the cost of labor drops and the demand for labor rises. Labor demand shifts right. Labor supply could shift either left (people work less because of the income effect) or right (people work more because of the substitution effect) Answer #1: Labor demand increases, labor supply falls, the real wage rises and employment is ambiguous. Answer #2: Labor demand increases, labor supply increases, real wages are ambiguous and employment rises.