Your Name: Final Exam: 18 Dec 2003 Econ 200 David Reiley

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1 Your Name: Final Exam: 18 Dec 2003 Econ 200 David Reiley You have 120 minutes to take this exam. There are a total of 100 points possible, on 10 multiple-choice questions, and 3 multi-part essay questions. The final parts of problems 11 and 12 are extra-credit questions worth 5 points each. Please make sure to pace yourself, so that you answer all questions, even incompletely. 1) (2 points) To stimulate investment spending, Congress would most likely decrease: a) The money supply. b) Personal income taxes. c) Corporate profits taxes. d) Property taxes. e) Real interest rates. 2) (2 points) Workers in the country of Agora receive an increase in wages of 10 percent at the same time the inflation rate in Agora is 8 percent. Workers in the country of Claustro receive an increase in wages of 3 percent while the inflation rate in Claustro is 1 percent. In which country are workers better off? a) Agora, because their real wages rise by 18 percent. b) Agora, because their nominal wages rise by 10 percent. c) Claustro, because their real wages rise by 33 percent. d) Claustro, because the inflation rate is lower. e) Neither country, because the increase in real wages is the same. 3) (2 points) The People s Republic of China has a much larger real GDP than does the Republic of Austria. This does not mean that the typical Chinese lives better than the typical Austrian because: a) Real GDP is not a good measure of living standards. b) We don t know the real interest rate in each country. c) We don t know the price level in each country. d) The exchange rate for the Chinese yuan is less than that for the Austrian schilling. e) Chinese per-capita GDP is less than Austrian per-capita GDP. 4) (2 points) The principal difference between income and money is that income is a and money is a. a) Schedule, Curve. b) Point, Line. c) Stock, Flow. d) Flow, Stock. e) Cycle, Trend. 5) (2 points) The Fed conducts an open-market sale of Treasury bills of $5 billion. If the required reserve ratio is 20% and banks keep no excess reserves, what change in the money supply can be expected? a) +$25 billion b) +$10 billion c) + $5 billion d) 0 e) -$10 billion 1

2 6) (2 points) If banks keep some excess reserves, the size of the change in the money supply would be: a) Five times as large as in question 5. b) Twice as large as in question 5. c) The same as in question 5. d) Zero. e) Smaller than in question 5. 7) (2 points) The oversimplified formula (1/(1-MPC)) for the Keynesian multiplier ignores variable income taxes, variable imports, and the variable price level. Ignoring these effects causes us to: a) Underestimate the size of the multiplier. b) Overestimate the size of the multiplier. c) Overestimate the multiplier when imports vary strongly with GDP, and underestimate the multiplier when income taxes vary strongly with GDP. d) Make our tax cuts too large. e) Think that the aggregate-supply curve is vertical. 8) (2 points) Proponents of supply-side economic policy advocate a reduction in the capital-gains tax. This is supposed to stimulate increased: a) Consumer spending. b) Net exports. c) Investment spending. d) Government spending. e) Money supply. 9) (2 points) In the past five years, a number of jobs in computer programming and technical support have moved from the United States to India. Which of the following does this likely generate in the United States? a) Cyclical unemployment. b) Structural unemployment. c) Frictional unemployment. d) Increased wages. e) Increased inflation. 10) (2 points) In the period from , the United States economy experienced the unusual combination of: a) Stagflation and high interest rates. b) High unemployment and high inflation. c) High unemployment and low inflation. d) Low unemployment and high inflation. e) Low unemployment and low inflation. 2

3 11) For this question, please read the attached Wall Street Journal article about unemployment statistics. a) (10 points) The U.S. unemployment rate hit an eight-month low of 5.9% in November. In your opinion, does this represent full employment? Explain your reasoning. This is probably below the full-employment level, which, as your textbook notes, is believed by many economists to be an unemployment rate of around 5% or less. This is supported by opinions expressed in the article, such as the comment that current statistics look like the early stages of a recovery and the opinion that the economy isn t out of the woods. Full employment isn t 0% because of structural and frictional unemployment; full employment means 0% cyclical unemployment. b) (5 points) Has there been any productivity growth in the past two years? Provide evidence from the article. The statement that payrolls shrank even as overall economic activity expanded indicates that there has been an increase in labor productivity over the past two years. If output went up while payrolls went down, that means that productivity, the ratio of output to payrolls, has gone up. One caveat to this conclusion is that payrolls can mean just permanent employees, and not include temporary employees, so when temporary workers are being hired and permanent workers are being laid off, payrolls can go down even while the total wage bill remains the same. The author of this article hasn t defined exactly how he s using the word payroll. But most likely the total wage bill has not increased while output has increased over the past two years. c) (5 points) The article mentions that employers often add temps or increase existing workers hours before adding to permanent payrolls. Are firms more likely to use temporary workers (versus permanent workers) when the economy exhibits an inflationary gap, or more likely to use temporary workers when the economy exhibits a recessionary gap? Explain your reasoning. They are more likely to hire temporary workers during a recessionary gap. The reason is that during an inflationary gap, we are above full employment, so it is very hard to find workers. To attract workers during an inflationary gap, firms need to provide attractive compensation packages, including medical and retirement benefits as well as job security, all of which are typically associated with permanent rather than temporary employment contracts. By contrast, during a recessionary gap, workers are relatively easy to find. More workers will be willing to take temporary positions because they can t find attractive permanent positions. Thus, it makes sense that firms would be hiring temporary workers during the current economic environment. 3

4 d) (5 points) The article states that the Federal Reserve is unlikely to raise interest rates because inflation is already as low as they want it to go. Inflation, as measured by the CPI, is currently at a 1.8% annual rate. What would be the disadvantage of using monetary policy to reduce inflation further? To reduce inflation further, the Fed would have to raise interest rates to try to decrease aggregate demand. This would likely have an effect not just on prices, but also on output in particular, the unemployment rate would increase. Cyclical unemployment has very large costs to the economy, so the Fed would prefer not to incur them. Also, if inflation got too low we could actually see deflation. Our economic institutions are much better equipped to deal with rising prices than with falling prices. As just one example, Social Security benefits are indexed to the CPI. If the CPI fell, then the elderly would see a decrease in nominal income. Even though real Social Security income might remain constant, such a change would be politically unpopular. e) (5 points) The article identifies the federal-funds rate charged on overnight loans between banks. What is the nominal federal-funds rate, and what is the real federalfunds rate? Why do they differ? The nominal federal-funds rate is 1%. The real federal-funds rate is the nominal rate adjusted for inflation, which is approximately equal to the nominal rate minus the inflation rate (true for small levels of inflation, not such a good approximation when we have hyperinflation of 100% or more per year). Thus, the real rate is 1% minus 1.8%, or 0.8%. You might wonder why banks would ever loan out money at negative real interest rates. The answer is that, when a bank has excess reserves in its account at the Fed, it has zero opportunity cost of lending out those funds. The bank is better off loaning them out at the overnight real interest rate of 0.8%, than not loaning them out at all and earning a real return of 1.8%. f) (5 extra-credit points) The article speculated on December 5 that at last week s meeting, the Fed would hold the interest rate constant. Was this prediction correct? Yes, this prediction was correct. The federal-funds rate remains at 1%. 4

5 12) For this question, please refer to the attached Wall Street Journal article about the new Medicare law. a) (5 points) According to the article, the new benefits are expected to cost the government approximately $40 billion per year for the next 10 years. No tax increase has been passed to cover these costs. For simplicity, assume that the aggregate-supply curve is completely flat, the marginal propensity to consume is 0.8, and neither taxes nor imports vary with GDP. By what amount would we expect this Medicare policy change to increase (or decrease) annual equilibrium GDP? Explain your reasoning. The above assumptions allow us to use the simplified Keynesian multiplier formula of (1/(1-MPC)). Since MPC=0.8, we have a multiplier of 5. An increase in Medicare spending represents an increase in government transfer payments, which represents an increase of $40 in consumer disposable income. Since the MPC is 0.8, that means an autonomous increase in consumer spending (CI) of (0.8)*($40 billion) = $32 billion per year. After applying the multiplier of 5, we get a total increase in GDP of (5)($32 billion) = $160 billion per year. b) (5 points) Suppose that instead of increasing the Medicare prescription-drug benefit to seniors, the government chose to increase its defense budget by $40 billion. Maintain the assumptions listed in part (a). What would be the effect of this drugpurchase policy on equilibrium GDP? Why is the effect different than the effect in (b), even though the amount spent by the government is the same in both cases? An increase in defense spending of $40 billion per year is an increase in government purchases (G) of $40 billion. Applying the multiplier of 5, we find an increase in equilibrium GDP of (5)($40 billion) = $200 billion per year. Medicare is a transfer rather than a government purchase. It affects consumer spending indirectly, through changing disposable income. Therefore, just like taxes, the effect of an increase in transfers is smaller than the effect of an equivalent increase in government spending. 5

6 c) (5 points) By how much would you expect the annual budget deficit to increase as a result of the Medicare policy change described in (a)? Name one macroeconomic disadvantage of increased budget deficits. With no increase in taxes, the budget deficit will likely increase by $40 billion per year. This ignores the resulting slight increase in the national debt, which would add compounding interest payments of several percent per year, increasing the budget deficit slightly more. It also ignores how income taxes vary with income when Y goes up, T will go up, slightly reducing the budget deficit. Ignoring the debt-interest-payments effect causes us to underestimate the size of the budget deficit, while ignoring the increased-tax-receipts effect causes us to overestimate the size of the budget deficit with our simple calculation. Since the marginal federalincome-tax rate for many individuals is around 20 percent and interest rates on Treasury bills are closer to 5 percent, the overall change in the budget deficit will likely be a bit less than $40 billion perhaps $35 billion. A disadvantage of increased budget deficits is that government borrowing can crowd out private investment. That is, when the government issues lots of debt, this tends to drive up interest rates, which discourages investment. Decreased investment can sometimes cause cyclical downturns (recession), and always results in decreased long-run economic growth. d) (5 points) The article describes how the new Medicare prescription-drug benefit will work as of the year Suppose I have already purchased $2000 worth of drugs in What is the marginal price I pay for the next dollar s worth of drugs? Since $2000 is more than $250 and less than $3600, the article tells us that the marginal price is $0.25 (the government covers 75%). e) (5 points) Since the idea of a prescription-drug benefit is to ease senior citizen s financial burden of purchasing drugs, why not just make prescription drugs free to all seniors? Suppose that the government were to offer a benefit that made prescription drugs entirely free to senior citizens, instead of having them pay a positive marginal price (or copayment ). Why might a policy of zero copayment be less economically efficient than a policy of a positive copayment? With a zero price, seniors would be more likely to consume too many drugs. Seniors would likely consume drugs to the point where the marginal utility is less than the marginal cost of producing those drugs, thus lowering overall economic surplus in the prescription-drug market. Many prescription drugs have a very large markup (retail prices several hundred percent above marginal cost) when they enjoy patent protection. Therefore, subsidizing drugs to lower the price to individuals may actually improve economic efficiency, if it brings the consumer price closer to the marginal cost of production (so MU gets closer to MC instead of MU >> MC at the monopoly price). However, if the copayment goes all the way to zero, then consumers will consume to the point where marginal utility equals zero and thus MU < MC. Giving consumers free prescription drugs gives them no incentive to economize on unnecessary treatments. 6

7 f) (5 points) The article notes that I would have to have an annual prescription drug bill of at least $810 in order to break even on participation in the drug-benefit plan. How much money would I lose on the plan if I only bought $500 worth of drugs in a year? The cost of subscribing to the prescription-drug benefit is $35 per month, or a total of (12)($35) = $420 per year. When I buy $500 worth of drugs, I pay for the first $250 without any subsidy. On the remaining $250, I get a benefit from the government of 75% of that purchase amount, or (0.75)($250) = $ With a cost of $420 and a benefit of $187.50, I have a net loss of $420-$ = $ per year. g) (5 extra-credit points) The article notes that there is a gap in coverage: a participant in the plan will have to pay the full price of any drugs purchased between $2,200 and $3,600 for the year. For additional drugs beyond $3,600, the benefit returns, and seniors only have to pay $0.05 for each additional dollar s worth of drugs. Since the idea of the program is to make prescription drugs easier for seniors to purchase, it seems a bit strange to have this middle region with no coverage. The article claims that this structure is because Congress is under intense pressure to limit spending. Describe an alternative way to structure the plan so that it would have the same budget as the plan that passed Congress, but does not contain a gap in coverage. There s no reason why there has to be a gap in coverage between $2,200 and $3,600 in order to be within budgetary guidelines. There are lots of ways to change the plan so that seniors purchasing between $2,200 and $3,600 in drugs won t be penalized relative to seniors with other drug purchase amounts. One way to save money would be to increase the deductible for example, require seniors to pay for the first $500 in drugs purchased every year, instead of $250. Another would be to increase the copayments for example, require seniors who purchase lots of drugs to have a 10% copayment instead of a 5% copayment. So, for example, one could have a $1 marginal price per dollar s worth of drugs for the first $500 purchased, a $0.50 marginal price on the next $3000 purchased, and a 10% marginal price on any amounts purchased beyond $3500 per year. This would save money in three places relative to the current plan (between $250 and $500 per year, between $500 and $3500 per year, and over $3600 per year); only the range from $3500 to $3600 would cost more in this plan, so this proposed plan would clearly cost less than the actual plan, and have no gap in coverage. The exact details of the plan should depend on the actual expected amounts of drugs to be purchased, but here we have demonstrated the point that the budget requirement certainly does not necessitate a gap in coverage. 7

8 13) For this question, please refer to the attached Wall Street Journal article about Paul Krugman s new textbook for introductory economics. a) (5 points) What do you think is the market structure that best describes the market for introductory economics textbooks? Monopoly, monopolistic competition, oligopoly, or perfect competition? Explain your answer. The market structure is likely an oligopoly, because the textbooks seem to have prices much higher than marginal cost. Once a book is written, the marginal cost is merely the cost of printing an additional unit, which is likely under $50 for a $100 book (given that hardback editions of classic books, which have fallen out of copyright, sell for under $50). Markups aren t sufficient evidence of oligopoly, however, because monopolistic competition also involves markups over marginal cost. Specific to oligopoly is the idea that there are barriers to entry, so economic profits can be positive, and therefore prices are not only above marginal cost, but also above average cost. Here, barriers to entry can include copyright law (no one can publish another author s copyrighted work) and perhaps economies of scale in publishing or marketing textbooks. Another good answer would be monopolistic competition. This is a good answer because textbooks are clearly differentiated from each other (different text, different graphs, different selections of topics). There are at least dozens of different introductory economics textbooks, which suggests that entry barriers may be small. On the other hand, it turns out that there are less than ten major publishers, each of which publishes multiple differentiated economics books, so perhaps it is an oligopoly after all. It is clearly not a monopoly, because there are multiple publishers, and it is clearly not perfect competition, because product differentiation is important. b) (5 points) The article notes that some U.S. college students have started buying their textbooks from foreign Web sites, in order to take advantage of lower prices. Explain why a textbook publisher might want to charge a lower price for the same book in different countries. A publisher can often make higher profits if it engages in price discrimination. If students in India have lower income than students in the United States, then they are likely willing to pay less for textbooks on average. This means the monopoly price in the USA will be higher than the monopoly price in India. The firm can make more profits by charging different prices, because if forced to price equally in both countries, the firm would either give up lots of sales in India, or give up lots of dollars on each sale in the USA. Unfortunately for the publisher, the ability of students to order books on the Internet from other countries is limiting their ability to do this price discrimination. Every time an American student buys a book from a British or Indian bookseller, the publisher gives up a number of dollars in profits. 8

9 c) (5 points) Worth Publishers plans to offer the electronic version of the textbook at a price of $60 and the hardcover version of the textbook at a price of $100. The publisher s president says she is not worried about the possibility that the electronic version might cannibalize hardcover textbook sales. Suppose that the existence of the electronic version does in fact cause hardcover sales to be 50% lower than they would be if the electronic version didn t exist. Give two reasons why offering the electronic version could still be good for profits. First, as the Worth executive notes, some customers might prefer the electronic edition: for example, people who don t like to carry heavy books and who have broadband Internet access at home might find the electronic version more convenient. By providing a second version, one might actually pick up new customers that one wouldn t have had with a hardcover-only book. Second, if professors require the online exercises in their classes, then the publisher will sell a copy of the electronic book to every single member of the class. Students won t be able to share their books, and they won t be able to resell their books to other students who ll take the class in future semesters. So while new hardcover books might only be sold to oen out of every three students taking the course, the electronic version will be sold to every student taking the course. Third, the marginal profit per unit on the electronic version might be higher than the marginal profit per unit on the hardcover version. For example, if the marginal cost of the hardcover version is $50 while the marginal cost of the Internet version is $5, then at prices of $100 and $60 the profit per unit will be $50 for the hardcover book and $55 for the electronic version. That means that even when a hardcover sale gets cannibalized by an electronic book, the firm actually increases its profits. The above cost figures might not be correct, so it s possible that cannibalization might actually hurt profits, and therefore this reason is a bit weaker than the other two. But it s at least possible that the firm could be better off trading a hardcover sale for an electronic sale. d) (5 points) If electronic college textbooks become popular, what effect would you expect such a change to have on economic productivity? Explain. The publishing industry would save the costs of printing, transporting, and inventorying hundreds of thousands of hardcover textbooks per year. Ideally, the same learning could be accomplished at much lower cost, which represents an increase in economic productivity. The main issue is whether the electronic books will, in fact, produce learning as high in quality as the hardcover books produce. Hardcover books are generally more portable and more convenient for browsing than are electronic books. On the other hand, the animated graphcs, interactive quizzes, and simulation games provided electronically might provide better learning than could ever be done with a static textbook. 9