EconExam+_1+ANSWERS+_Spring+2010_

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Econ 100B Macroeconomic Analysis Professor Steven Wood Spring 2010

Exam #1 ANSWERS Please sign the following oath: The answers on this test are entirely my own work. I neither gave nor received any aid while taking this test. I will not discuss the questions on this test until after 5:00 p.m. on February 23, 2010. ______________________ Signature Any test turned in without a signature indicating that you have taken this oath will be assigned a grade of zero. Exam Instructions 1.

When drawing diagrams, clearly and accurately label all axis, lines, curves, and equilibrium points.

2.

Explanations should be written in pencil or black. Legibility is a virtue; practice good penmanship.

3.

Explanations should be succinct and to the point; you may use bullet points and commonly used mnemonics.

Do NOT open this test until instructed to do so. Good Luck!

Spring 2010 (Exam #1)

Econ 100B

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A. Multiple Choice Questions (30 points). Circle the letter corresponding to the best answer. (3 points each.) 1.

Your boss wants to know if the company should lay off any workers. You answer that they should lay off workers only if the: a. b. c. d.

2.

Originally an unskilled worker, Judy attends the University of California, Berkeley where she acquires new skills that give her access to a job with a higher hourly wage. Assuming that her preferences about leisure are not affected by the change in jobs, how would this affect her supply of labor? a. b. c. d.

3.

According to Okun’s law, every worker produces two units of output. If firms are employing fewer workers, they must also be choosing to producer less output. With fewer workers, the marginal product of labor declines and so output falls by even more. When unemployment rises, the labor force and work hours tend to decline, further reducing output.

An invention that increases the future marginal product of capital would cause an increase in desired investment, which would cause the investment curve to shift to the _____ and would cause the real interest rate to _____. a. b. c. d.

5.

Judy will supply more labor due to both income and substitution effects. Judy will supply less labor because her decision is based only on the income effect. Judy will supply more labor because her decision is based only on the income effect. The effect on Judy’s labor supply is ambiguous because the income and substitution effects work in opposite directions.

Okun’s law states that the gap between actual output and full-employment output increases by 2 percentage points for each 1 percentage point increase in the unemployment rate. Why does an increase in unemployment lead to twice as large an effect on output? a. b. c. d.

4.

Marginal product of labor is less than the real wage rate. Marginal product of labor is greater than the real wage rate. Marginal product of labor is less than the nominal wage rate. Marginal revenue product of labor is greater than the nominal wage rate.

Left; increase. Left; decrease. Right; increase. Right; decrease.

Your friend claims that the United States is a net international debtor. The best way of testing this claim is to see whether: a. b. c. d.

U.S. foreign liabilities exceed U.S. foreign income. U.S. official reserve assets were positive or negative. The U.S. ran a balance of a payments surplus or deficit in the last year. Foreign payments to U.S. owners of foreign assets exceed U.S. payments to foreign owners of U.S. assets.

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Econ 100B

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6.

In goods market equilibrium in an open economy: a. b.

The desired amount of exports must equal the desired amount of imports. The desired amount of exports must equal the desired amount of imports minus the current account balance. c. The desired amount of national saving must equal the desired amount of domestic investment. d. The desired amount of national saving must equal the desired amount of domestic investment plus the current account balance.

7.

If business taxes rise in a large open economy it will cause the current account to _____ and saving to _____. a. b. c. d.

8.

Robert Fogel, a Nobel Laureate in economics, has argued that better health and a higher level of nutrition of workers is important in generating higher standards of living. In the Solow growth model, we could represents such a change as: a. b. c. d.

9.

Increase; increase. Increase; decrease. Decrease; decrease. Decrease; increase.

An increase in technology. An increase in labor force growth. Higher depreciation rates because there are now more people working. A one-time increase in the labor force because this effectively leads to more workers.

The “IT Revolution” has led to an increase in productivity but also to an increase in the depreciation rate because computers and telecommunications equipment have to be replaced more often. Overall, then: a. b. c. d.

The standard of living will unambiguously increase. The standard of living will unambiguously decrease. There is an indeterminate effect on the standard of living. Economic growth will be faster in the new steady state.

10. Labor force growth rates tend to fall as a country becomes richer. Compared with the standard Solow growth model, this would lead to: a. b. c. d.

Higher saving rates in rich countries than in poor countries. Greater income differences between rich and poor countries. Smaller income differences between rich and poor countries. Lower depreciation rates in rich countries than in poor countries.

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Econ 100B

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B. Answer BOTH of the following questions based on the standard models of analysis developed in class.

1.

Open Economy Desired Saving – Desired Investment Model (35 points). Suppose that the world economy is composed of only two large, open-economy countries—China and the European Union—and that the European Union is running a substantial current account deficit. a.

Based only on this information, use 2-country Open Economy Desired Saving – Desired Investment diagrams to clearly and accurately show the initial equilibrium situation in each country. These diagrams should be drawn in BLACK.

European Union

China

Sd1 r

Sd1 Sd0

Sd0

rw1

rw0

Id0

Id1 Id0

Sd1Sd0Id1

Id0

Sd, Id

CA0 < 0

Sd, Id

CA0 > 0

CA1 >0

CA1 < 0

Spring 2010 (Exam #1)

Id0 Id1Sd1 Sd0

Econ 100B

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b.

Provide a brief economic explanation of what you have shown in your diagrams above. In the 2-country large open economy model, the equilibrium real world interest rate is set at the level where the current account deficit of one country, in this case the European Union, is exactly equal in magnitude to the current account surplus of the other country, in this case China. The initial equilibrium world real interest rate is given by rw0. In the European Union graph above, at the initial equilibrium world real interest rate, rw0, the European Union has a current account deficit given by CA0 with desired saving of Sd0 and desired investment of Id0. In the China graph above, at the initial equilibrium world real interest rate, rw0, China has a current account surplus given by CA0 with desired saving of Sd0 and desired investment of Id0.

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Econ 100B

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c.

Now suppose that because of the global economic crisis, both China and the European Union increase government spending. However, the increase in government spending in China is for infrastructure projects, a form of investment, while the increase in government spending in the European Union is for general government services. In both countries, the increased government spending is financed by borrowing, not by higher taxes, and there is no Ricardian equivalence. Based only on this information, clearly and accurately show what, if anything, happens to desired investment in both China and the European Union (in RED), desired savings in both China and the European Union (in BLUE), and to the world interest rate and the current account balances in both countries (in GREEN).

d.

Provide a brief economic explanation for the results you have shown in your diagrams above and explain why these changes take place. Be sure to include in your discussion what happens to the levels of desired investment and desired saving and the current account balance in each country. In China, the increase in government spending is for infrastructure projects so this is also an increase in desired investment at every real interest rate level. This can be represented by a rightward shift of the desired investment function from Id0 to Id1 in the China diagram above. In China, the increase in government spending financed by borrowing with no Ricardian equivalence reduces national saving at every real interest rate level. This can be represented by a leftward shift of the saving function from Sd0 to Sd1 in the China diagram above. In the European Union, the increase in government spending financed by borrowing with no Ricardian equivalence reduces national saving at every real interest rate level. This can be represented by a leftward shift of the saving function from Sd0 to Sd1 in the European Union diagram above. The increase in desired investment in China increases the worldwide demand for loanable funds at every real interest rate. The declines in national saving in both China and the European Union reduce the worldwide supply of loanable funds at every real interest rate. Because the worldwide demand for loanable funds now exceeds the worldwide supply of loanable funds, the world real interest rate must rise until a new equilibrium world real interest rate is reached at rw1 where the current account deficit in the European Union is equal in magnitude to the current account surplus in China. As the world real interest rate rises from rw0 to rw1 several things will happen in each country. In the European Union, a higher real interest rate will increase desired saving along the new desired saving function and reduce desired investment along the original desired investment function. The net effect is that national saving declines from Sd0 to Sd1, desired investment declines from Id0 to Id1 and the current account deficit declines from CA0 to CA1. In China, a higher real interest rate will increase desired saving along the new desired saving function and reduce desired investment along the new desired investment function. The net effect is that national saving declines from Sd0 to Sd1, desired investment increases from Id0 to Id1 and the current account surplus declines from CA0 to CA1.

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Econ 100B

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2.

Solow Growth Model. Suppose that the U.S. economy can be described by the Solow growth model and was at its steady state in 2008. a.

Based only on this information, use a Solow growth model diagram to clearly and accurately show the economy’s its initial steady state. This diagram should be drawn in BLACK.

Y/N, S/N, Ib/N

(Y/N)0 (Y/N)A (Y/N)B (Ib/N)0

(Y/N)C

(S/N)0 “A” “B”

(S/N)1 (S/N)2

“C”

(K/N)C

Spring 2010 (Exam #1)

(K/N)B (K/N)A

Econ 100B

K/N

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b.

Provide a brief economic explanation of you what you have shown in your diagram above. Be sure to include a discussion of the economy’s growth rate at the initial steady state. The U.S. economy is initial at steady state “A” where actual saving (or investment) perworker is exactly equal to balanced-investment-per-worker at a capital-to-labor ratio given by (K/N)A. At this capital-to-labor ratio, the production function indicates that income-perworker is (Y/N)A. In the steady state, income-per-worker, which is (Y/N)A, is not changing. Therefore, the economy’s long-run equilibrium growth rate is exactly equal to its labor force growth rate, i.e., ∆Y/Y = ∆N/N.

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Econ 100B

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c.

In 2009, President Obama proposed a huge, sustained increase in government spending to be financed by borrowing rather than by higher taxes. Assume that there is no Ricardian equivalence. On your diagram above, clearly and accurately show the effects of this increased spending on the economy’s capital-to-labor ratio, its income-per-worker, and its steady state (in RED).

d.

Provide a brief economic explanation for the results of what you have shown on your diagram above. A huge, sustained increase in government spending financed by borrowing rather than by higher taxes with no Ricardian equivalence results in a decline in government saving and, therefore, in the nation’s saving rate. This can be represented by a downward shift in the saving function from (S/N)0 to (S/N)1. Once the saving function has shifted down the economy’s steady state is now at “B” where the new lower saving-per-worker is exactly equal to balanced-investment-per-worker at a lower capital-to-labor ratio, given by (K/N)B. At this new lower capital-to-labor ratio, the production function indicates that income-per-worker has declined from (Y/N)A to (Y/N)B.

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Econ 100B

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e.

President Obama has also proposed to double the level of exports from the U.S. Suppose that he is successful in accomplishing this goal. On your diagram above, clearly and accurately show the effects of increased exports on the economy’s capital-to-labor ratio, its income-per-worker, and its steady state (in BLUE).

f.

Provide a brief economic explanation for the results of what you have shown on your diagram above. An increase in exports results in a decline in the current account balance, either less net foreign borrowing or more net foreign lending. Either way, the nation’s saving rate declines. This can be represented by a downward shift in the saving function from (S/N)1 to (S/N)2. Once the saving function has shifted down the economy’s new steady state is at “C” where the new lower saving-per-worker is exactly equal to balanced-investment-per-worker at a lower capital-to-labor ratio, given by (K/N)C. At this new lower capital-to-labor ratio, the production function indicates that income-per-worker has declined further from (Y/N)B to (Y/N)C.

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Econ 100B

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g.

Provide a brief economic explanation of the adjustment process that occurs as the economy moves from its initial steady state to its final steady state. Be sure to include a discussion of what happens to the capital-to-labor ratio, the level of income-per-worker, and the rate of economic growth both during the transition period and at the final steady state (also comparing it to the rate of economic growth at the initial steady state). Once government spending and exports have increased, saving-per-worker is less than balanced-investment-per-worker at the economy’s initial steady state’s capital-to-labor ratio, (K/N)A. This implies that actual investment is less than what is required to keep the capital-to-labor ratio constant at (K/N)A. As a result, the capital-to-labor ratio declines. As the capital-to-labor ratio declines, incomeper-worker will decline along the original production function, (Y/N)0, saving-per-worker will decline along the new, lower saving function (S/N)2, and balanced-investment-perworker will decline along the original balanced investment line, (Ib/N)0. The capital-to-labor ratio will continue to decline until saving-per-worker once again exactly equals balanced-investment-per-worker at steady state “C”. Once the economy reaches steady state “C”, the capital-to-labor ratio will stabilize at (K/N)C and income-per-worker will have declined from (Y/N)A to (Y/N)C but stabilize at (Y/N)C. During the transition period from steady state “A” to steady state “C”, the capital-to-labor ratio declines from (K/N)A to (K/N)C while income-per-worker declines from (Y/N)A to (Y/N)C. Consequently, economic growth is slower than labor force growth, i.e., ∆Y/Y < ∆N/N during the transition period. However, once steady state “C” is reached, the capital-to-labor ratio will stabilize at (K/N)C and income-per-worker will stabilize at (Y/N)C. As a result, at steady state “C”, economic growth will exactly equal labor force growth, i.e., ∆Y/Y = ∆N/N. This is the same growth rate that the economy had in steady state “A” because the labor force growth rate did not change.

Spring 2010 (Exam #1)

Econ 100B

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