ECON 116b: 2010 Midterm Exam Solutions Section 1: True/False/Uncertain (4 marks each) Q1: True. Based on the expectation theory of the term structure of interest rates, the long-term interest rate is equal to the average expected future short-term interest rate. When the Fed raises the short-term interest rate, people expect higher short-term interest rate in the future. Hence at the same time long-term interest rate will rise too. Q2: False. AD curve is not the sum of all market demand curves in the economy. It comes from the equilibrium from both the goods market (IS curve) and the money market (LM curve). It slopes down because when price level goes up, the demand for money will increase. If we hold the money supply fixed, the increase of money demand will increase the interest rate, which will further depress investment. It’s nothing to do with any market for a specific individual good or with the demands of individuals in the economy. Q3: True. The low ratio of inventories to sales implies that firms have inventories close or below their desired or optimal level. This is generally good news. In contrast, if firms have a high stock of inventories relative to sales this will have a negative effect on production in the future because there would be less need to engage in new production to meet future demand. (See text book p309-310) Q4: False. Fiscal policy and monetary policy are both more effective when AS curve is fairly flat. Both fiscal policy and monetary policy only shift the AD curve. When AS curve is flat, the same change of AD curve will result in a larger increase in output. Q5: False. Stock prices are mainly determined by two factors: firm’s future profits and cash flow and the discount rate (because the interest rate is the return on bonds, an alternative investment to stocks, and because the interest rate affects firms’ investment decisions and thereby future firm growth). When the unemployment rate decreased unexpectedly, it was good news for future profits and cash flow and so stock prices can be expected to rise. However, the Fed may increase interest rate in response to the better economic conditions. The increase of benchmark interest will raise discount rate and suppress stock prices. Hence the net effect is uncertain and so it is false that the result will always be and increase in stock prices. Q6: True. It’s the life cycle story. Most Yale students can expect a relatively high salary after graduating. Therefore, under the theory of consumption smoothing, they can borrow money now and pay it back in the future, which will improve their total utility. Q7: False. When government increases transfer payments, households are now wealthier, so they can now afford to work less, and therefore, the income effect will cause a decrease in labor supply. Section 2 (9 marks each) 1. Individuals would adjust their consumption pattern over the 20 years. Because they are poorer after the drop in the value of the stocks, they would decrease their consumption. Each year, consumption would drop by 4000/20 = 200 billion. Now we have to consider the multiplier effect of a drop in consumption on the total drop in income. Therefore, the annual drop is 200 x 2.0 = 400 billions, which is equivalent to 400/14000 = 2.8% drop in the GDP. Finally, regarding labor supply, if individuals are poorer, they would work harder (an income effect). Therefore, we should observe an increase in the labor supply. 2. Note that the question asked about cyclical unemployment, and not about business cycle. Therefore, the correct answer should explain why firms decide to adjust through firing or hiring workers, and therefore changing the level of unemployment, and not through changes in wages. There are several reasons for the cyclical unemployment, such as: I. Sticky wages: The idea is that wages are sticky on the downward side. Therefore, firms adjust using the number of workers, instead of decreasing wages. There are two main reasons for the existence of sticky wages: a. Social, or implicit, contracts: Firms decide to not cut wages, even when they can legally do it. This can be related to sociological or psychological reasons. b. Explicit contracts: Unions and other forms of employees organizations can reach deals with the firm, setting the wages for longer periods of time, and making the wage not contingent to the economic conditions. II. Efficiency wages: Firms pay more than the equilibrium wage in order to increase the productivity of the worker. If wages and productivity are related, firms can use higher wages to encourage workers to increase their productivity. III. Imperfect Information: It is possible that firms do not have enough information to calculate the equilibrium wage. If that is the case, this lack of information can produce a wage that is set too high, and therefore some workers have to be turned away, and the result is unemployment. IV. Minimum wage laws: If the law sets a floor for wage rates, firms cannot decrease wages below that floor, and therefore they would make the adjustment through decreasing labor demand, and consequently increasing unemployment. Cyclical unemployment might not exist because there is a difference between looking for any kind of job, and looking for a job with a specific wage rate. For instance, let’s consider a recently laid off worker, who received in her last job a wage rate of $10 per hour. She quickly finds another offer, but in the new job the wage rate is $8 per hour. She decides to not accept the offer, and wait for a better opportunity. Therefore, she would be counted as unemployed, but actually, she decided to not be employed. Therefore, a better measure of employment should consider the availability of jobs, or the wage in which the workers would accept the offer. 3. Firms invest considering the time and size of the investment. Some investment will last for several years, and therefore, a more realistic model of investment should consider expectations of the economic conditions in the future, among other variables. Other considerations in the investment decisions are the excess of capital and long run capital labor substitution. Section 3 (10 marks each) 1. Simple Multiplier Model Y CIG C .75Y Y .75Y I G .25Y I G Y 4I 4G So the govt. multiplier is 4. The government multiplier will be smaller when: - Tax payments depend on income (income tax) since as income increases so do tax payments. This creates a drag on the economy. - Investment is endogenous. That is, when investment is a function of interest rates, an increase in G “crowds out” private investment. The increase in r that follows from an increase in G lowers I and lowers the increase on Y. - Prices are taken into account. Some parts of economic expansions take the form of higher prices rather than increased output. - When imports are allowed, some domestic spending leaks out into foreign markets. - Fed policy follows a rule so that r=f(Y, P). When the fed leans against the wind, the open market operations will operate to reduce the money supply and increase r, perhaps even beyond the increase in r that comes from crowding out alone. This lowers investment. - Other possibilities include: - Income Taxes - Excess capital/labor - Inventories - Future Expectations - Underground economy 2. If the Government increases G or TR, then the AD curve will shift out to the right increasing both prices and output. Note that the AS curve does not shift at all in this question. Since the fed rule discussed in class, r=f(P, Y), commits the Fed to increasing rates when either prices or output increases, the fed will increase rates in this instance. The Fed does this by selling bonds which lowers the money supply. Note that the Fed action does not move the AD curve because M is endogenous in this model, and endogenous changes do not shift curves. The rule we talked about in class suggests that the Fed leans against the wind. This means that the Fed tempers the effect of stimulus plans that increase Y and P, but it doesn’t go so far as to hold rates constant or drive Y and P below their starting point. We can conclude, then, that Y and P both see a net increase. Since consumption is a function of Y, consumption increases. Since the fed has increased r, investment falls.
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