Final Exam: 14 Dec 2004 Econ 200 David Reiley

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1 Your Name: Final Exam: 14 Dec 2004 Econ 200 David Reiley You have 120 minutes to take this exam. There are a total of 100 points possible, on 5 multiple-choice questions, and 2 multi-part essay questions. There are three extra-credit questions (6c, 6k, 7e) worth 5 points each, plus a small extra-credit question (8) worth two points. Please make sure to pace yourself, so that you answer all questions, even incompletely. 1) (2 points) The article you read about Estonia (see attached) stated: Uneducated and older workers, who have trouble adapting to the automated systems that investors demand, are suffering. Which of the following concepts does this best illustrate? a) Structural unemployment. b) Frictional unemployment. c) Cyclical unemployment. d) Cost-push inflation. e) Demand-pull inflation. For this exam, you read a long article about Alan Greenspan s tenure as chairman of the Federal Reserve Board. The next three questions refer to that article. 2) (2 points) In September 1996, Alan Greenspan disagreed with eight of the Fed s regional banks who wanted to raise interest rates to keep inflation in check. They thought that GDP was growing faster than potential GDP. Greenspan convinced the Open Market Committee to keep the federal-funds rate constant. His decision turned out to be a good one because: a) Consumer confidence dropped, which kept inflation down. b) Congress increased government spending, which kept inflation down. c) Congress decreased government spending, which kept inflation down. d) Productivity growth increased significantly in the mid-1990s, so potential GDP was increasing faster than it had during the 1980s and early 1990s. e) The exchange rate with Japan fell, which decreased net exports. 3) (2 points) The recession of 2001 appears to be due in large part to: a) The bursting of the stock-market bubble starting in b) Increased consumer confidence. c) Lack of growth in net exports. d) Large cuts in government spending. e) Large increases in taxes. 4) (2 points) Since the middle of 2000, the Fed s policy has been mainly: a) Contractionary. b) Expansionary. c) Neutral. 1

2 d) Unpredictable. e) To favor increased regulation of banks. 2

3 5) 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. 6) For this question, please read the attached Wall Street Journal article about consumer spending in Europe. a) (5 points) Over the past two years, where has the growth of real GDP been higher: in the United States, or in the Euro zone? Provide evidence from the article. Growth has been higher in the United States. The article forecasts(because 2004 isn t over yet) an annual increase of 3% for the United States from 2002 to 2004, compared with just 1.1% for the Euro zone. b) (5 points) Suppose, as in the real business cycle approach to macroeconomics, that this international difference in GDP growth is due only to international differences in the growth of potential GDP. Name the three main determinants of the growth of potential GDP. Growth in labor (mainly population growth, but can also be growth in human capital through education and training) Growth in capital (through investment in physical assets) Growth in technology (invention of new methods of production) c) (5 extra-credit points) Do you think it is reasonable to assume that the factors in (b) can explain the differences in economic growth in Europe versus the United States? Explain why or why not. It s possible, but these factors seem to me unlikely to explain the difference. Population growth is slower in Europe than in the United States. Though this wasn t in the article, recent annual population growth has been 0.4% in the Euro zone, and 1.1% in the United States. So differences in population growth could probably explain some of the difference, but not all of it. 3

4 Capital growth is likely faster in Europe currently than in the United States. Because the saving rate is so much higher in Europe (especially when you include government saving, which is extremely negative right now in the United States), real interest rates are likely to be lower in Europe than in the United States. This isn t a sure thing, because lack of domestic saving in the US can be compensated by borrowing from foreign investors, but overall we might think real interest rates will be lower in Europe, which will make investment more attractive in Europe. So differences in capital growth probably go in the wrong direction for explaining differences in GDP growth. Technology growth is unlikely to be vastly different between the United States and Europe, since technology usually represents knowhow that can be easily copied. The United States is famous for generating technology at a rapid rate, because of our investment in basic research and our entrepreneurial culture. If US companies were obtaining patents on their technological improvements, and if they refused to use these improvements in Europe or to license these improvements to European companies, it s possible that technological growth would be higher in the US than in Europe. But as shown by the article on the Estonian dairy farm, it is quite common for European firms to use modern American technology. There may be a difference in the growth rate of technology, but it seems unlikely to be large. Since population growth (and maybe technology growth) favors the United States while capital growth favors Europe, it s hard to say for sure whether the sum total of these differences can explain the fact that US GDP is growing at 3% while European GDP is growing at only 1%. But notice the graph of consumption growth in the US versus Europe. Annual consumption growth was much more similar between the two regions in than it has been in This suggests that GDP growth used to be more similar between the two regions than it is today. This suggests that the difference in economic growth in the past two years may be due in part to Europe having a larger percentage deviation from potential GDP than the United States has. d) (5 points) Now suppose that at least part of the international difference in growth rates over the past two years is due to gaps between actual and potential GDP. Which area is more likely to be experiencing a recessionary gap right now, the United States or the Euro zone? Explain your reasoning. If potential GDP is increasing at the same rate of growth internationally, but the growth of real GDP is only 1% in the Euro zone while it is 3% in the US, then the Euro zone must be deviating more from potential GDP than the United States is. That is, the Euro zone likely has a larger recessionary gap. 4

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6 e) (5 points) Suppose real GDP in the Euro zone is currently 3% below potential GDP. Draw an aggregate-demand diagram illustrating this situation. Make sure to label your axes. Potential GDP Inflation rate Inflation adjustment line Aggregate demand GDP in the Euro zone The black circle demonstrates the current situation: a recessionary gap. f) (5 points) Suppose part (e) gives an accurate description of the current situation in Europe. Then how would you expect the inflation rate of the euro to change over the next couple of years? Would it increase, decrease, or stay the same? Use your diagram to explain your reasoning. I would expect euro inflation to decrease over the next couple of years, as firms realize that in order to use their capacity, they need to increase their prices at a slower rate and increase quantities sold. This can be shown as a gradual shift of the inflation-adjustment line downward, so that the equilibrium moves gradually down and to the left, until real GDP equals potential GDP. g) (5 points) Where do you think the propensity to consume is higher, in the United States or in the Euro zone? Provide evidence from the article. The savings rate is considerably higher in the Euro zone (10.5% versus 0.8% of income). Since income is either saved or consumed, this indicates that the consumption rate is much higher in the US than in the Euro zone, and this most likely means that the MPC is higher in the United States. 6

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8 h) (5 points) Suppose the marginal propensity to consume in Europe is 0.6, and that neither imports nor taxes vary with income. If the European Union increased government spending on agriculture by $100 billion, what would be the total increase in European GDP? The simple formula for the multiplier is 1/(1-MPC) = 1/(1-0.6) = 2.5. So we would expect a $100 billion increase in spending to produce a $250 billion increase in GDP. i) (5 points) The article states that Americans currently save 0.8% of their disposable income, so the marginal propensity to consume must be 99.2%. Use your knowledge of the difference between average and marginal quantities to argue why this statement is not correct. The MPC tells us what would be the amount of additional consumption if there were an additional dollar of income, and it should be one minus the marginal propensity to save. However, the saving rate of 0.8% represents an average propensity to save, not a marginal propensity to save. The marginal propensity to save could well be much higher than 0.8%, for example, if people borrow a lot when income is low (negative saving rate) but have a positive marginal propensity to save as income gets higher. Then the marginal propensity to save would be higher than the average, which would pull the average gradually higher as income got higher. So the true MPC need not be 99.2% at all. It should be one minus the marginal propensity to save, not one minus the average propensity to save. j) ( 5 points) According to the article, what is currently happening to the exchange rate between the dollar and the euro? Is the dollar appreciating or depreciating? Provide evidence from the article. The dollar appears to be depreciating versus the euro, since the article describes the euro as up more than 10% since September against the dollar. k) (5 extra-credit points) Why do you think the exchange rate is changing this way? Think about possible international differences in the inflation rate, and about the trade deficit. Provide evidence from the article if possible. If Europe is experiencing more of a recessionary gap than the United States is (see answer to part c), then there would likely be lower inflation in the near future in the Euro zone than in the US. That would tend to make the euro retain more 8

9 purchasing power than the dollar will, which in turn reduces demand for dollars relative to euros. The article points out that since consumption rates are much higher in the US than in the Euro zone, the demand for European imports in the US is higher than the demand for US exports in Europe. This is a related reason why the dollar has been depreciating versus the euro. l) ( 5 points) As the exchange rate changes in (j), would you expect the result to have a positive or negative effect on European GDP growth? Explain your reasoning. As the exchange rate changes, this will increase the demand for European imports of US products. This will likely have a negative effect on European GDP growth. m) (5 points) The article points to both differences in culture and differences in economic regulations that favor higher saving rates in Europe than in the United States. Provide three examples of European regulations that promote a high savings rate. Here are six possible examples: i) Restrictions on retail store hours make it less convenient for European consumers to spend money. ii) Laws prohibit discounting of retail items except during official sales in January and July. iii) Belgium s tax law assumes that retail items are sold at an average margin of 50% of purchasing cost. This discourages price competition, because if I sell an item at only 10% over my purchase cost, I still have to pay tax as if I had sold it for an additional 40%. iv) The French central bank requires that credit-cards be clearly labeled to distinguish them from debit cards, potentially causing consumers to be too embarrassed to use a credit card. v) Banking regulations don't allow home-equity loans to finance consumption. vi) There is a cap of about $1600 per consumer on easy consumer credit in Belgium; more credit requires meeting considerable requirements. n) (5 points) According to the article, in July France s parliament tried to boost consumer spending (and hence GDP) by enacting a 2-year tax credit on interest paid on consumer loans. Use the permanent-income model to argue why we should expect this policy s multiplier effect on GDP to be relatively small. 9

10 The permanent-income model argues that consumers prefer to have their consumption be relatively constant from year to year, so they base their consumption on lifetime income instead of merely current-year income. So when a consumer knows she s getting a temporary (2-year) tax credit, she will be likely to spend much less of it than she would if she knew the increase in income were permanent. This means the MPC will be relatively small, and since the multiplier [1(1-MPC)] varies positively with the MPC, the multiplier effect for this policy will also be rather small. 10

11 o) (5 points) The article points out that retail store hours are restricted by law in the Euro zone relative to the United States. Argue why removing this regulation might reduce the average costs in European shops. Retail stores have relatively high fixed costs, due to the costs of renting real estate in desirable shopping areas. Staying open for more hours might increase costs a bit, but these will be marginal costs like electricity and wages, likely less than average costs. More importantly, increased hours could produce increased transactions that more than cover the additional marginal costs. As long as the average fixed costs are higher than the current marginal costs of staying open additional hours, staying open more hours will lower average costs. p) (5 points) Provide examples of someone who wins and someone who loses by having legal restrictions on store hours. They needn t be actual people discussed in the article; you can make up hypothetical examples if you wish. A small-business owner might benefit from the restrictions, as described by Mr. Lernoux in the article: There is no more social life for the self-employed if they have to open 24 hours a day to compete. The idea is that large corporations will find it easier to have longer hours, because they are bigger and can ask employees to work different shifts, whereas a small shop run by a single person cannot so easily stay open all the time because the owner s hours are limited. By staying open longer, large corporate stores could lower their average costs and therefore lower their prices, requiring small shops to stay open longer in order to compete. The regulations prevent small shop owners from having to work long hours. Some entrepreneurs, like Mr. Ivaldi, might actually lose from the restrictions, if they would prefer to keep their shops open longer but can't. Consumers lose from the restrictions, because they will get less convenient hours and higher prices. The article indicates that labor unions prefer such restrictions in order to promote the quality of life of their members, so perhaps corporate retail employees also gain. This argument seems less clear, however, because if retail employees didn't want to work long hours or late shifts, presumably companies would have to pay them more in order to get them to work this way. If they tried to order their employees to work longer hours against their will, employees would likely quit and work for another employer with more favorable working conditions. Only if firms are large enough to have market power in the labor market (so that they could require employees to work unpleasant hours for low pay, without fear of their quitting) would the regulation benefit corporate 11

12 employees much. 12

13 7) For this question, please refer to the attached Wall Street Journal article about economic growth in Estonia. a) (5 points) According to the article, what will the growth rate of Estonian GDP likely be during 2004? Why is this considered to be a high growth rate? GDP growth is predicted at 5.6% for 2004, according to the article. This is considered to be quite large compared with 2% in the euro zone and 3% in the United States. We learned in class that long-term real GDP growth in the United States has been a bit less than 3% per year on average since World War II, so we can see that Estonian GDP growth this year is twice as high as long-term US GDP growth. b) (5 points) We have learned that productivity growth is the only way to raise percapita income in the long run, and that productivity growth has two components. Give examples from the article to illustrate each of the two contributions to productivity growth in Estonia. The two determinants of productivity growth are (1) growth in the capital-labor ratio, and (2) growth in technology. The first is illustrated by the fact that foreign investment in Estonia has increased dramatically, from 200 million euros in 1996 to 800 million euros in It is also illustrated by Mr. Helenius investment of 3 million euros into the Estonian dairy farm, some of which went to buy land and some of which went to buy new equipment. As Ms. Tamme says, Everything is mechanical now we want low costs and efficiency. The second is illustrated by the fact that Mr. Helenius was determined to turn his farm into a US-style dairy farm with the latest milking technology, which can predict which cows are likely to be more productive each day by measuring their movements and temperature. Note that in a country like Estonia, a large part of the technological growth may consist of catching up with the technological frontier by adopting practices from a country like the United States; it needn t consist entirely of new inventions. c) (5 points) The article mentions two different EU policies that are likely boosting economic output in Estonia: agricultural subsidies, and infrastructure spending such as the rebuilding of the road from Narva to Tallinn. Which of these two policies do you think is more likely to contribute to long-run economic growth? Explain your reasoning. To the extent that the subsidies encourage more investment in physical capital by 13

14 people such as Mr. Helenius, they will promote economic growth in the agricultural sector. To the extent that they just put tax money into the pockets of people with farms, they likely won t increase growth much. In the short run, new investment is taking place because the subsidies are new in Estonia. In the long run, the subsidies won t have much incentive effect, but will continue to use tax dollars. Finally, the subsidies might actually be attracting capital to the agricultural sector when it could be better used in some other sector of the economy, like the call centers the article describes. The building of roads will have a positive effect not just on the agricultural sector, but on other sectors, such as manufacturing and tourism, as well. I m inclined to believe that road-building will have promote more long-run economic growth (per dollar of government expenditure) than agricultural subsidies will. d) (5 points) Would you expect EU agricultural subsidies to increase or decrease worldwide economic efficiency? Explain your reasoning. I expect a decrease, because we know that whenever subsidies are applied, they tend to distort efficiency. In this case, for example, the subsidies might cause some milk to get produced even though it costs more than people would be willing to pay for it in the absence of the subsidy, so the social benefit of the milk is less than the social cost. In addition, as mentioned above, the subsidy might cause capital investment to take place in agriculture when it would be more productively used in some other sector instead, which is another source of inefficiency. e) (5 extra-credit points) The GDP growth figure for the Euro zone reported in this article is higher than the growth figure reported in the previous article on European consumption spending. But it turns out that both are approximately correct. How can you reconcile the two figures? This article reports a GDP growth figure of 2% in the euro zone for 2004, compared with the previous article s figure of 1.1% in the euro zone from 2002 to We can reconcile these figure by noting that they are for different time periods: the first is for just 2004, while the second is the average over two years. We could easily get these figures if growth in the euro zone were close to zero in 2003, so that the average of almost zero and 2% would be approximately 1.1%. 8) (2 extra-credit points, to be written on the back of the exam) The Federal Reserve s Open Market Committee meets today to decide what interest rate to target. What 14

15 federal-funds rate do you think they will target? You will receive credit if your prediction is correct. The FOMC raised its federal-funds rate target from 2% to 2.25%. 15

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

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.