Exam 1 –Econ 304 – Chuderewicz –Fall 2017
Name ______Last 4 (PSU ID) ______
Section: Please Check:
Section 001 - 112 Chambers 9:05 - 9:55 am ______
Section 002 - 112 Chambers11:15 am - 12:05 pm ______
PLEASE PUT THE FIRST TWO LETTERS OF YOUR LAST NAME ON TOP RIGHT HAND CORNER OF THIS COVER SHEET – ONLY NON-PROGRAMMABLE CALCULATORS ALLOWED. THANKS AND GOOD LUCK!!!
Total Points for exam = 270
Test time = 120 minutes
Approximately one minute for every two points
To help with time management if spreading time evenly
Question #1 = 50 points..... 22 minutes
Question #2 = 50 points ...... 22 minutes
Question #3.1 = 55 points.... 24 minutes
Question #3.2 = 60 points ....27minutes
Question #5 = 55 points.....24 minutes
Please answer all questions. You must show all work or points will be taken off.
1. (50 points total) ) Homer Simpson, does not abide by the life cycle theory of consumption. Homer has a “let’s live life like it’s our last day” mentality and thus, he prefers to consume more today, relative to the future. In particular, Homer prefers to consume exactly twice as much today (c), relative to consumption next period (cf). Homer’s current income = $200K and his future expected income = $100K. He has no wealth (neither current nor expected) since he lives like today is his last. Given that Homer faces a real interest rate of 5% ( 0. 05). Please answer the following questions.
a) (5 points) Calculate Homer's optimal consumption bundle showing all work. Then draw a completely labeled graph (the two period consumption model) depicting this initial optimal consumption bundle as point C*A.
(10 points for a completely labeled graph – be sure to label the no lending / no borrowing points =
NL/NB) Use space above.
b)(5 points) Homer works in the steel industry and given the decision to continue with the Dakota pipeline and the fact the President Trump wants it to be made by American produced steel, Homer's conditions change. Given that this project is expected to get finished relatively quickly, Homer plans on taking advantage of working overtime so his current income rises to $300K. His expected income has not changed. Resolve for Homer'soptimal consumption bundle and label as point C*B..
c) (5 points) Janet Yellen and the Fed are not happy with the state of the economy and worry about an impending recession. As a result, the Fed lowers rates so that the new real rate is negative 5%. Recalculate the optimal bundle for Homer and add this point to your graph and label as point C*C.
d) (10 points) Did the Fed policy work as in stimulating the economy as measured by the change in Homer'scurrent consumption? That is, did Homer's consumption rise? Why or why not? Explain using the income and substitution effects. Please use actual numbers to support your answer.
e) (15 points total)In the space below, draw two savings functions for Homer. The first savings function is for the initial conditions, before Homer gets the news about extra demand in the steel industry (before his current income rose). Label as point A where r = .05 and point B when r = -.05.
Now draw another savings function representing the conditions after Homer's current income rose. Label as point C where r = .05 and then point D, where r = -.05. Please put only the relevant shift variables in parentheses next to each savings function. Please show work for each of the four points (A, B, C, D)
15 points for correct and completely labeled graph
2. (50 points total) You own a golf resort and you need to determine how many golf carts you need to buy to maximize profits. Please answer the following questions given the information below. Please be sure to SHOW all work!
A brand new golf cart costs 200 rounds of golf (this is your output) and the rate of depreciation is 6% (0.06).
The real interest rate is 4% (.04).
And the expected marginal product of capital is given by MPKf = 250 – 5K.
There is a tax on capital so tao (τ) = 20% (.20)
a) (5 points) What is the (tax adjusted) user cost of capital and what is this user cost expressed in? (Show work)
b) (5 points) How many golf carts should you buy to maximize profits? Show work
Draw a uc/K graph depicting the state of affairs and label this initial profit maximizing condition as point A.
A correctly drawn and completely labeled diagram is worth 10 points
Now conditions change. The following two shocks occur simultaneously:
i) the price of golf carts rises to 240 rounds of golf.
ii) the expected marginal product of capital changes and is now MPKf = 275 – 5K.
c) (5 points) Resolve for K* and show as point B on your uc/K diagram.
d) (10 points) Given the two shocks as above, explain the intuition underlying the change in the profit maximizing level of carts (i.e., why does the firm change its behavior?), making sure you refer to the firm’s profit maximizing condition (write it out!). Be specific and write this like you were a professional economist! Be sure to compare the actual user cost to the actual MPKf after the shocks, holding K constant at its level from part b).
e) (5 points) Suppose that the Federal Reserve had a goal to get the capital stock, the number of golf carts purchased to equal 48. Given the two shocks as above, what would they have to do to the real rate of interest to achieve their objective? Please show all work and I am looking for a specific number (i.e., r = ?). Please add this development to your diagram as point C.
f) Finally, draw a desired investment diagram (completely labeled with the relevant shift variables) depicting the initial equilibrium as point A (simply draw a negatively sloped ID curve going through point A). Label the initial level of desired investment as IdA. Note importantly that we do not have numbers for desired investment, but that’s ok, we are focusing on the change in desired investment. Then show, as point B, after the two shocks. Finally, show how the Fed policy maps to your investment diagram and label as point C with the corresponding level of investment labeled as IdC.
A completely labeled and correct diagram is worth 10 points (make sure you include the relevant shift variables in parentheses or points will be taken off).
3. PART 1(55 points total for this part) This problem is broken into two parts that are totally connected to each other. In this first part of the question, you apply Chapter 3 (labor mkt., etc) material and in PART 2, you get to use Chapter 4 (goods market equilibrium) material. Please take all calculations to two decimal places where appropriate except with real interest rate calculations (PART 2), where you need to take the calculation to three decimal places, if appropriate. PLEASE SHOW ALL WORK AND COMPLETELY LABEL ALL DIAGRAMS.
The following equations characterize a country’s closed economy.
Production function: Y = A·K·N – N2/2
Marginal product of labor: MPN = A·K – N.
where the initial values of A = 10 and K = 10.
The initial labor supply curve is given as: NS = 20 + 9w.
a) (10 points) Find the equilibrium levels of the real wage, employment and output (show work).
In the space below, draw two diagrams vertically with the labor market on the bottom graph and the production function on the top graph. Be sure to label everything including these initial equilibrium points as point A.
(20 points for completely labeled and correct diagrams)
We now have numerous changes to our economic conditions (all is not constant). Think of all these changes happening together, that is, we go from one state of economic affairs to a different state of economic affairs. Below are the changes.
- The labor supply changes and is now: NS = 30 + 9w .
- K goes down from 10 to 9.
b) (5 points) What could cause such a change in labor supply? Please give two specific and well supported reasons. Be sure to explain your answer.
c) (10 points) Given the change in NS and K, repeat part a) (i.e., find the equilibrium levels of the real wage, employment and output). Add these results to your labor market and production function diagrams respectively and label as point(s) B. Be sure to label the diagram completely with the relevant shift variables in parentheses next to the function.
d) (10 points) Explain exactly why the profit maximizing level of labor has changed given the change in NS and K. Be very specific with your answer as in using numbers. Begin your answer with: At the same level of labor input N = (what it was at point A), the firm is no longer ......
3. PART 2 (60 points total for PART 2)
Before we start this problem, put the initial Y as computed in part a) here ______.
And the new Y (after the change in conditions) here ______.
Initial conditions in the goods market
Cd = 1500 + .50(Y-T) – 500r
Id = 604 – 500r
G = 500
T= 100
e) (10 points) Given the initial conditions, solve for the equilibrium real rate of interest (that clears the goods market) and the associated levels of desired savings and desired investment.
Draw a Sd = Id diagram in the space below locating this initial equilibrium as point A.
10 points for correct and completely labeled diagram (be sure to put relevant shift variables in parentheses next to each function).
NOW WE TAKE INTO ACCOUNT THE CHANGES FROM PART 1 (the change in Y) ALONG WITH A CHANGE IN THE CONSUMPTION FUNCTION.
The new consumption function is Cd = 1012 + .50(Y-T) – 500r
f) (5 points) What could cause such a change in the consumption function? Please give two specific and well supported reasons. Be sure to explain your answer.
g) (10 points) Given these changes, i.e., changes in Y from part 1 and the change in the consumption function, calculate the new equilibrium levels of the real interest rate, desired savings and investment. Please add this new equilibrium point to your diagram and label as point B.
h) (10 points) Explain the movement to the new equilibrium from point A to point B. Start with at the same r, savings does not equal investment. Give the actual numbers. At the same interest rate, which is larger, Y or C + I + G? Use this expression to argue why interest rates changed the way they did.
i) (15 points) Considering this entire problem, are your results consistent with the Great Recession - why or why not? Please focus your discussion exclusively to the change in labor supply, the change in Y, and the change in the consumption function. Use real world developments / statistics that we mentioned in class to support your explanations (5 points for each explanation).
4. (55 points total) Open Economy – Two Large country problem
USA Initial Conditions
Cd = 320 + 0.4(Y-T) – 200rw
Id = 120 – 200rw
Y = 1000
T = 200
G =275
China Initial Conditions
CdF = 480 + .4(YF – TF) – 300rw
IdF = 255 – 300 rw
YF = 1500
TF = 300
GF = 300
a) (5 points) What is the equilibrium real interest rate that clears the international goods market? Show all work.
b) (10 points) Compare the level of absorption in each country to the income generated in each country. Is the US spending beyond its means? Is China the lender? Explain using real numbers
In the space below, draw two diagrams side by side, with the USA on the left and China country on right. Locate this initial equilibrium as points A on both diagrams (there are four point A’s, two on each diagram). Be sure to label diagrams completely labeling the trade deficit/surplus on each graph, etc.
(15 points for correct and completely labeled diagram)
c) (10 points) Now let the US suffer an adverse shock to the investment function so that the new investment function for the US is:
Id = 95 – 200rw
Solve for the new equilibrium r and S and I for each country.
d) (10 points) What has happened to the USA’s trade balance and why? Make sure you define absorption and comment on the influence that the adverse investment shock has on absorption in the US. What happened to absorption in China and why?
e) (5 points) Are these results (in part d)) consistent with the US going to AA, the proposition put forth by Fareed-Zakaria in the Colbert clip? Put differently, are your results consistent with the US "living within it's means?" Why or why not?
1