Midterm 1 True False

say the production function increases. what do the y, c and k graphs look like?

y and c jump up and continue going up (flows) k goes up smoothly (stock)

Suppose that a wave of immigration doubles the size of the US workforce. Assuming that everything else is held constant, output will immediately double.

False. Due to the declining marginal product of capital a doubling of the labor supply will less than double output. (I also gave credit for people assuming that they would be unemployed with reference to search models. I should have made clear that they were all employed immediately.)

An increase in the number of people classified as "employed" always results in a reduction in the unemployment rate.

False. Even though the number of employed people rises, it may be the case that the labor increases enough that UR=U/L falls. [This can sometimes happen in an improving economy. As the job market improves it induces workers to reenter the labor force as unemployed workers.]

An decrease in the number of employed workers always results in an increase in the unemployment rate.

False. If labor force participation drops by enough (through unemployed workers leaving the workforce) it is possible to see the unemployment rate fall despite a decrease in the number of employed workers.

Imported food is not included in the basket of goods for the CPI.

False. Imported food is part of a typical consumer's basket of goods and is therefore part of CPI. It is not a part of the GDP deflator because it is imported.

Assuming China's one child policy continues forever (and that fertility would be higher in the absence of this policy), the Solow model tells us that China will have a permanently higher level of per capita income growth due to the one child policy.

False. In the long run growth in per capita income is a function of technological change, not the rate of population growth [In the transition to the new steady state China will experience faster growth in income per capita].

In the steady state of the Solow model consumption per worker grows at the rate of technological change plus the rate of population growth.

False. In the steady state of the Solow model consumption per capita grows at the rate of technological change.

An increase in the minimum wage will increase search unemployment among teens.

False. It will increase wait unemployment among teens.

The government increases spending and taxes by an identical amount. This has no impact on real interest rates.

False. Private savings fall (even though government savings are unchanged). Lower savings results in higher real interest rates.

Give one example of why the real wage would be above the market clearing wage. Draw a picture showing how this causes an increase in the unemployment rate.

Minimum wages, union bargaining, or efficiency wages can all results in wages above the market clearing wage. This causes labor demand to be lower than labor supply.

All else being equal an increase in the reserve ratio will result in an increase in the money supply.

False. The reserve ratio is in the denominator of the money multiplier. Increases in the rr result in lower levels of the money supply for any given level of the monetary base. More descriptively, a higher reserve ratio leads to less lending for any given deposit and therefore there is less money created by the fractional reserve banking system.

The Federal Reserve has been engaging in large purchases of mortgage backed securities and long run treasuries, more than doubling the size of the Fed's balance sheet. This has resulted in a large increase in the quantity of currency in circulation.

False. The quantity of currency in circulation has not increased abnormally as a result of the increase in the Fed's balance sheet. This is because the Fed has started paying interest on reserves, leading to banks holding large quantities of excess reserves.

. The Golden Rule Level of savings maximizes the level of output per capita.

False. The Golden Rule Level of savings maximizes the level of consumption per capita

The Golden Rule Level of savings maximizes the growth rate of consumption per capita.

False. The Golden rule level of savings maximizes the *level* of consumption per capita, not the growth rate.

The Federal Reserve's Quantitative Easing program has led to a fourfold increase in the Feds security holdings. These purchases of assets has led to a doubling of the M1 measure of the money supply.

False. The M1 measure of the money supply has been growing at a much lower rate before and after the QE programs. (the reason that the feds purchases have not led to increases in measures of the money supply is excess reserves)

If inflation measures are biased downward, measures of real GDP growth are biased upward.

True. Real GDP growth = Nominal GDP growth inflation.

Under a Cobb‐Douglas production function the proportion of output paid to capital increases if there is an increase in the size of the labor force.

False. Under CobbDouglas the proportion paid to capital is constant.

other current events in economics?

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A country has a production function, y=k0.3 and a savings rate equal to 30 percent. They are currently at the long run Solow steady state level of income per worker. A reduction in the savings rate to 25 percent will immediately reduce consumption per worker.

False. The immediate response to a decrease in the savings rate will be an increase in consumption because c=(1-s)*y and y doesn't immediately change. (Over time the capital stock will fall, output will fall, and consumption will fall below the initial value because the new savings rate is lower than the golden rule level.)

In order to increase the money supply the US Federal Reserve exclusively purchases treasury bonds.

False. While historically this has been true over the last 4 years the Fed has used purchases of Mortgage Backed Securities and long term treasuries to increase the money supply.

hurricane destroys 1/2 of capital. y and k graphs?

both drop, then return to normal.

Consider an economy described by the Solow model with a Cobb‐Douglas production function. Labor's share of output in this economy is 2/3. At present, the saving rate is 1/3 and the economy is in the long run steady state. Suppose that the saving rate in the economy suddenly rises to 1/2. a. Draw a well labeled graph showing the steady state level of capital per worker before and after the increase in the savings rate. b. Draw three well labeled graphs showing the path of capital per worker, output per worker, and consumption per worker over time. Be sure to label the moment when the saving rate changes.

new c* is lower because the golden rule savings level is 1/3 so moving to s = 1/2 reduces c.

All else being equal, a fall in the labor force participation rate will result in an increase in the unemployment rate.

False. As I said in class, the interpretation of this was a bit of a mess. Assuming that all the people dropping out of the labor force are unemployed (they stop looking for work) the unemployment rate UR=(U+E)/LF will fall because the number of unemployed people will fall.

If money supply growth is zero then inlation is always zero.

False. Assuming constant velocity the inflation rate is equal to the growth rate of the money supply minus the growth rate of income. π = . If income growth is M ΔM − Y ΔY non-zero inflation will not be zero

An economy has a production function of Y=X0.1K0.3L0.6, where X is land, K is capital, and L is labor. Doubling K and L will double output because this production function has constant returns to scale.

False. Because the exponents sum to 1, you would need to double all three factors of production to double output.

what has our recent GDP quarterly growth been?

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Real interest rates are 5%, nominal interest rates are 3%, and gdp is growing at 3%. Assuming constant velocity what is the growth rate of the money supply?

r = i - pi delta M/M = delta Y/Y + pi so 1%

Suppose that an economy has a production function of Y=K0.4H0.3L0.3, where K is capital, H is human capital, and L is labor. Assuming that all factors are paid their marginal product, an increase in H will decrease the real return to capital.

False. If H increases, this will increase the real return to capital. You can show this by taking the derivative of Y with respect to K. MPK = 0.4K-0.6H0.3L0.3.

If the market clearing wage is $15, a $12 min wage causes wait unemployment.

False. If the market clearing wage is above the minimum wage supply equals demand and there is no wait unemployment.

A one time influx of immigrants into the workforce will permanently raise the unemployment rate.

False. In the long run the unemployment rate is determined by the search model. As long as the finding rates and separation rates are unchanged the unemployment rate will fall back to the natural rate after an initial spike as these workers enter the labor force.

In the US payments to capital are roughly equal to payments to labor.

False. Payments to labor are roughly 2/3 of output while payments to capital are about 1/3.

According to the CPI $1,000 in 1972 has the same purchasing power as $5,500 today. Assume that I gave you a choice between consuming $5,000 worth of goods today at today's prices or $1,000 on goods available in 1972 at 1972 prices. a. If you preferred to consume $5000 today what does that suggest about the CPI?

It suggests that the CPI overstates the rate of inflation

Imagine that there were rumors that an imminent terrorist attack was going to take down the US ATM network. In response, people attempted to increase their real money holdings to insure that they don't get caught without money. Assuming that output and the money supply are fixed, what will be the immediate effect on prices and velocity.

An increase in money demand corresponds to a decrease in velocity. Since MV=PY and M and Y are fixed, prices must fall.

A newspaper publisher $10 worth of paper. She then prints newspapers which she sells for $50. These transactions add $60 to GDP.

False. This would double count the paper. Adding the value added (or just the final goods) leads to $50 added to GDP.

If country A has a lower rate of money supply growth than country B, country A will always have lower inflation than country B.

False. π = ΔM/M − ΔY /Y . Differences in real GDP growth rates matter as well. Country A may have a significantly lower level of real GDP growth.

What does it tell us about changes in living standards between 1972 and 2012 as measured using CPI adjusted prices. Be brief.

Growth in Real GDP = Growth in Nominal GDP - change in Prices It suggests that living standards have been growing faster than estimates based on the upwardly biased CPI measure.

explain Quanitiative easing

QE 1, 2, 3 etc

An increase in money supply growth leads to an increase in inflation by 5%. i = r + π so a 5% increase in inflation results in a 5% increase in the nominal interest rate. The nominal interest rate is therefore 10+5 = 15% after the change. Higher nominal interest rates increase the opportunity cost of holding money so money demand falls.

MV=PY. V=PY/M PY=nominal gdp = 17 trillion. M=1,000 billion = 1 trillion. V=PY/M=17/1 = 17

In an economy with a production function of Y = AK0.3L0.6X0.1 = 100 how large are total payments to labor?

The exponent on labor tells us what proportion of output goes to labor. 60 percent of 100 = 60.

Suppose that 100 million new immigrants arrived and are initially unemployed. How would this change your answers on (a) and (b)?

The initial rate of unemployment would be higher, but it still be falling. The natural rate of unemployment is unchanged because there is no change to the rates of separation and finding.

Suppose that we wish to modify the Solow model to include the government. Assume that the production function has constant returns to scale. Assume that there is no technological progress or population growth. Assume that the economy is currently at the long run steady state level of capital per worker and that this level of capital per worker is below the consumption maximizing level. Taxes are a fraction of income, t, where t is between zero and one. Disposable income per person can therefore be written as (1-t)*y. Assume that government consumption is always equal to taxes so that government saving is always zero. Personal saving is a proportion of disposable income, s, where s is between zero and one. a. Write the equation that describes capital accumulation for the model. What is the condition for a steady state?

both k and y decrease slowly to a new steady state c total jumps up and then drops lower than before c private jumps down and lower c g jumps up and goes a little lower

The country of Teevania is well described by the Solow model and has a production function of y=k0.5. The country is currently at the long run steady state level of per worker income. The population growth rate is 2 percent per year, depreciation is 6 percent per year and technologicalprogressis2percentperyear. Thesavingsrateis40percent. a. Write down the equation that describes capital accumulation in Teevania.

delta ~k = sf(~k) - (n+g+∂)~k

Suppose that there is an increase in the growth rate of the money supply from 5 percent to 10 percent. Assuming that the nominal interest rate was 10 percent before the change, what is the nominal interest rate after the change? What happens to money demand?

An increase in money supply growth leads to an increase in inflation by 5%. i = r + π so a 5% increase in inflation results in a 5% increase in the nominal interest rate. The nominal interest rate is therefore 10+5 = 15% after the change. Higher nominal interest rates increase the opportunity cost of holding money so money demand falls.

Holding all else equal an increase in the rate of money supply growth will increase the demand for money.

False. An increase in the rate of money supply growth increases inflation which decreases the demand for money.

An unexpected decrease in the growth of the money supply is good for debtors and bad for creditors.

False. A decrease in the growth of the money supply will decrease inflation. This will increase the ex-post real interest interest rate r = i − π for all existing loans that assumed the lower inflation rates. Borrowers (debtors) are worse off and lenders (creditors) are better off.

According to Okun's law, annual US GDP growth of 2 percent is associated with falling unemployment.

False. According to Okun's law, US GDP growth above 3% is associated with falling unemployment. Okun's law predicts rising unemployment with growth of 2%.

All else being equal an increase in money demand will cause an increase in prices

False. An increase in money demand is equivalent to a decrease in velocity. MV=PY, Y and V are fixed, so prices must fall

All else equal an increase in money demand increases prices.

False. An increase in money demand results in a decrease in velocity. MV=PY. Prices fall.

The Federal Reserve's Quantitative Easing program has led to a fourfold increase in the Fed's security holdings. These purchases of assets has led to a doubling of the M1 measure of the money supply. F

False. Short Answer: The M1 measure of the money supply has not increased dramatically because of the Fed's QE program. Long Answer: The Fed's QE program has led to a large increase in the Fed's security holdings. However, that money created to make these purchases has not become part of M1 or M2 because it has mostly been deposited back at the Fed in the form of excess reserves. The banks are holding excess reserves because the Fed began paying interest on reserves.

Suppose that there are two countries with identical production functions, savings rates, population growth rates, depreciation, and rates of technological change. The country with higher current income per worker will grow more quickly in the short run.

False. Since the two countries are identical in all ways except current income, they have identical Solow model steady state levels of income per capita and therefore will have identical income per capita in the long run. The poorer country therefore grows faster as their incomes converge.

The GDP deflator includes imported goods.

False. The GDP deflator is limited to domestically produced goods.

The country of Lindsania has a production function, y=k0.2 and a savings rate equal to 30 percent. Lindsania is at the long run Solow steady state level of income per worker. A reduction in the savings rate to 25 percent will reduce long run consumption per worker.

False. The movement from from a 30 percent savings rate to 25 percent moves toward the 20 percent level that maximizes consumption in the long run. [Note the exponent on capital per worker in the production function.]

By design, in 2140 there will be approximately 21 million Bitcoins in existence and no more will be produced. Suppose that by 2140 the entire world is using a fixed supply of 21 million Bitcoins as the only currency. Assume that technological change is still 2 percent per year. Suppose that reduced fertility means that population will be falling by 4 percent per year in 2140. What is the inflation rate in 2140? Show your work.

From the Solow model we know that steady state growth in aggregate gdp is ΔY =n+g =−4%+2% =−2% . AggregateGDPshrinksby2%peryear. The quantity equation says that ΔM + ΔV = ΔP + ΔY . Since the money supply is not growing MVPY ΔM = 0 . Velocity is fixed ΔV = 0 . Inflation is therefore MV π = ΔP = − ΔY = − (− 2%) = 2% . PY

In the US economy, what is the approximate dollar value of consumption this year?

GDP is approximately $18 trillion, consumption is about 2/3 of that so consumption is approximately $12 trillion.

Suppose that Congress increases taxes by $200 billion this year. Assume that output unchanged. Draw a diagram showing the effect on saving, investment, and interest rates. Label magnitudes where possible.

Government savings increases by $200B. Private savings fall by (1-mpc)*$200B. Adding them together, overall savings increase by mpc*$200B. Investment increases by mpc*$200B because S=I(r). Interest rates fall.

Assuming that the recent tax cut is roughly $1 trillion in size, what will be the impact on government savings, private savings, investment, and the real interest rate?

Government savings will fall by $1 Trillion. Private savings will rise by (1-MPC) * $1 trillion. Overall savings will fall by MPC* $1 trillion. Investment falls by the same amount because I(r)=S. Real interest rates will rise.

[15 points] In Latveria, the labor force consists of 200 million people. Currently, half are unemployed. Each month, three quarters of the unemployed people find work and one quarter of the employed people lose their jobs. a. Is the unemployment rate currently rising or falling?

Of the 100 million employed, 25 million lose their jobs each month. Of the 100 million unemployed, 75 million find jobs each month. Since more are finding than losing unemployment falls.

What is the natural rate of unemployment?

The steady state is where the number of people finding and losing jobs is the same. s*E=f*U E=L=U sLsU=fU 0.25L0.25U=0.75U 0.25L=U U/L=0.25 > 25%

Two countries, Romagnolia and Cookistan have identical rates of saving, population growth, depreciation, and technological change and are well described by the Solow model. Cookistan currently has a lower level of GDP per worker. Cookistan currently has faster growth in GDP per worker than Romagnolia.

True. Both countries share the same steady state level of income per worker. The poorer country therefore grows faster so that both countries end up at the same level of income per worker in the long run.

If taxes and government spending are both increased by $1 billion there will be crowding out of investment.

True. Government savings is unchanged (T and G changes cancel each other out) but private savings fall by (1-MPC)*1 billion. Since S=I(r) the fall in savings causes lower investment (crowding out) and higher real interest rates.

Assume no population growth and no technological change. If the marginal product of capital is lower than the depreciation rate it is possible to raise steady state consumption by decreasing the savings rate.

True. If MPK<δ in the steady state of the Solow model this means that capital per worker is above the golden rule level. Reducing savings will move toward the golden rule level of capital per worker which increases consumption (even as capital per worker falls).

If inflation measures are biased downward, measures of real GDP growth are biased upward.

True. Real GDP growth = nominal GDP growth - inflation. If inflation measures are biased downward this biases real GDP growth measures upward. (Note: Thequestionwasaskingwhatwouldhappenifmeasuresofinflationwere biased downward. Pointing out that inflation measures tend to be biased upward does not make this statement false.

Ina countrywelldescribedbytheSolowmodelthemarginalproductofcapitalis0.04,populationgrowthis2percent,anddepreciationis0.03.Andecreaseinthesavingsratewillincreasethelongrunlevelofconsumptionpercapita.

True. Since the marginal product of capital is larger than the sum of populationgrowth and depreciation we know that the capital stock is above the golden rulelevel. It is therefore possible to increase consumption per capita in the steady stateby reducing the savings rate.

French wine is not included in the basket of goods for the GDP deflator.

True. The GDP Deflator only includes domestically produced goods.

Suppose that there are two countries with identical production functions. Income per capita in both countries is currently $10,000 and they both have population growth of 2% per year. The country with the higher savings rate will grow more quickly in the short run.

True. The country with a higher savings rate will have higher growth in the capital stock due to higher levels of investment. Higher capital stock growth generates higher income growth. (Note: The higher savings rate country will have a lower level of consumption due to the higher savings rate.)

If the decline in house construction in the US is permanent, this could lead to a higher level of search unemployment over the next few years.

True. This is an example of a structural shift, which raises search (or frictional) unemployment because workers skills are mismatched with the available jobs.

Write down the national income accounting identity. Approximately how large is each of the components of GDP in the US?

Y=C + I + G + NX. Approximate sizes -- C ~71% I~13% G~20% NX~-4%. Anything that is close gets full credit. NX should be negative.

It has been reported that North Korea has printing presses that can produce nearly perfectcounterfeit $100and$50USbills(seehttp://en.wikipedia.org/wiki/Superdollar). Suppose that the US currency supply were $1 trillion and that the North Koreans started producing $100 billion per year in undetectable fakes and spending the currency on US goods. If currency were the only form of money available for transactions, what would the immediate effect be on the US inflation rate over the next year assuming that nothing else changes?

ΔM/M + ΔV/V = ΔP/P + ΔY/Y π=ΔY/Y −ΔM/M M will increase by 10% more than it would if there were no North Korean Superdollars entering the economy. Therefore inflation will be 10% higher than it would have been without the Superdollars.