Econ 116 Mid-Term Exam

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1 Econ 116 Mid-Term Exam Part 1 1. True. Large holdings of excess capital and labor are indeed bad news for future investment and employment demand. This is because if firms increase their output, they will utilize the excess capital and labor to fulfill production requirements. In that sense, they will be less willing to hire additional people or invest in additional capital. 2. True. An increase in government spending leads to an outward shift of the AD curve thereby increasing output. This further leads to an increase in price levels and therefore inflation. The Fed as part of its mandate to manage inflation will utilize the Fed rule to increase interest rates as a result. As interest rates go up, firms would be less willing to invest because of an increase in the cost of capital. 3. True. Increasing transfer payments is a pure increase in wealth and therefore only has an income effect. Since the after tax wage rate does not change there is no substitution effect. People will be incentivized to work less. A decrease in personal tax rate will lead to an increase in after tax wage rate. This will increase the amount of money people have and will incentivize them to work less because of the income effect. However, the opportunity cost of leisure has also gone up as part of the substitution effect. This will incentivize people to work more. In this case, the net effect on labor supply is ambiguous. 4. False. The Goldsmith cannot lend without limits to the public. A situation of excessive lending can lead to a decrease in public confidence levels. This can further translate into a run on the bank kind of a situation where everyone decides to take out their gold at the same time with the Goldsmith not having the ability to meet all its obligations.

2 Part II 1. These fears are not completely groundless. Even if the economy is on the flat part of the AS curve, stagflation might arise if there is a cost shock such oil price shock or increase in import price. It is good to include a graph here indicating the AS shift. This is the key point the question is expecting. You can also add that over time, the economy may move away from the flat part of the AS curve into the steep region. 2. The main assumption is that agents are indifferent to one-year and two-year contracts and are risk neutral. You should write down the equation: (1+r2) 2 =(1+r1)(1+r e 1+1). If the current two-year rate is greater than the current one-year rate, you should be able to infer easily from the above equation that r e 1+1 is greater than both r1 and r2. 3. Interest rate might affect consumption through inter-temporal substitution effect, which refers to the relative cost between current and future consumption. This is the key point the question is expecting, but it is okay to add wealth effect implied by interest rate changes. As for initial wealth, you should not simply state that an increase in wealth lead to greater consumption. To get credit you should bring in life-cycle theory and consumption smoothing seen in class. 4. To get credit you should not simply mention there is cyclical unemployment beyond frictional and structural unemployment. This is because you have not explained why there is cyclical unemployment in the first place? You can offer many answers to this question as seen in lecture and problem sets, such as minimum wage law, labor contract, imperfect information, or labor morale to explain why firms choose to adjust labor force instead of changing wage rate during economic down turns. You can refer the textbook page 266 for more details. 5. There are usually the following points that you can bring in here: - The change in the number of jobs does not follow the change in output exactly: there might be change in working hours, or firms might hold excess labor.

3 - Discrepancy between the change in the number of jobs and the change in the number of people employed. People may hold multiple jobs. - There might be workers discouraged and drop out of the labor force. - Labor productivity may change. There might be additional reasons, you were given credit as long as those points are valid and you managed to explain them well.

4 Midterm Answers Econ 116 Fall 2014 Part III Question 1 The government spending multiplier decreases for the following reasons: 1. If taxes depend on income, then an increase in G would increase Y, but that some of this increase would be subtracted out in the form of taxes. This is because the increase in Y results in consumers having to pay higher taxes and thus having less disposable income. 2. If we add the Fed rule, G increasing leads to Y increasing, which leads to the interest rate increasing and thereby investment going down. This serves as a countervailing force to government spending increasing. 3. If we add the AS curve, we see that if G increases, the AD curve shifts to the right. This means that G has the effect of increasing prices in the economy rather than just increasing output. Further, when prices increase, the Fed rule states that the Fed will want to increase interest rates, which decreases investment. 4. If we add the life cycle model, then government spending is assumed to be temporary. Recall that an increase in G increases Y, which we also refer to as income. An increase in income, under the life cycle model, will not increase current consumption by consumers as much, because consumption smoothing takes place. Consumers will elect to spend some, but not all, of their extra income in the current period, thereby diminishing the size of the multiplier. Question 2 QE3 was the fed s policy of purchasing mortgage backed securities (MBS) and government T- Bills. It has the following effects on the Fed s balance sheet: Buying MBS and T-bills means that the Fed is holding more reserves for commercial banks. In colloquial terms, this increases the size of the Fed s balance sheet. More specifically, QE3 has resulted in greater assets on the Fed s balance sheet (typically called the left hand side ) in the form of the MBS and T-bills that it now owns. Likewise, the Fed s liabilities (or the right hand side of the balance sheet) have increased, because there is more currency in circulation or in reserves. This money is what that the Fed used (or arguably printed) in order to make the securities purchases under QE3 The Fed thought that QE3 would decrease long-term interest rates by increasing money supply in the economy. However, banks have held excess reserves, thereby diminishing the money multiplier. Question 3 If the Fed only cared about prices, then: A cost shock, such as an increase in the price of imports (PM), would increase overall prices. The AD curve will be completely horizontal, because it is willing to sacrifice Y unequivocally to control P. The increasing prices would lead the Fed to increase the interest rate significantly, decreasing investment, consumption, and output. If the Fed only cares about output, then:

5 A cost shock, such as an increase in the price of imports (PM), would increase overall prices. The AD curve will be completely vertical, because the Fed only cares about changes in Y. Thus, the increasing prices would not lead the Fed to change the interest rate. For this reason, investment, consumption, and output do not change. Question 4 There are several reasons why bond prices would increase and the corresponding bond rate decrease: With weak sales, volatility and uncertainty coupled with less faith in continued stock dividends, as explained below drives people to seek out bonds. With greater demand for bonds, bond prices increase. With increasing bond prices, the implied interest rate of the bond falls because of the negative relationship between bond prices and interest rates. With inflation and retail sales lower, investors likely expected that the Fed would either lower rates or keep them at their current level for a longer time period before raising them. An expectation of lower rates drives up prices of bonds, because of the inverse relationship we have discussed previously. There are two countervailing effects on stock prices: Investors expect lower dividends due to the decreased retail sales. Thus, they will sell stocks until the price of stocks matches the new expected discounted future dividends. However, lower expected interest rates would grow output or lower the discount rate for stocks, thereby increasing the present value of future earnings. This would drive stock prices opening up. We can conclude that investors expected the falling stock dividends to outweigh the declining interest rate, as indicated by the stock market opening down.

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