Selva Demiralp/ Erhan Artuc
Econ 202, Final
May 25, 2007
DO NOT open the cover page until you are told to do so.
You have 90 minutes.
DO NOT cheat. If I or one of the proctors suspect that you are cheating or trying to cheat we will mark your exam right away and if you get two marks, your test will be sent to the Dean’s Office.
You are NOT allowed to ask any questions during the exam. The questions are clear. If you cannot understand the question it means you don’t know the material well enough. You can only ask a question regarding the dictionary meaning of a word (but we will not explain technical terms which are the subject material of this course).
You are NOT allowed to leave the room during the exam. If you need to use the restroom, do it before the test starts.
The make-up exam will be on Saturday, June 2, 2007.
Name: ______
Section: ______
Points
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1. Many policymakers are concerned that Americans do not save enough. Using the Solow growth model with no technological change and no population growth:
a. Explain and illustrate graphically why for a given production function and depreciation rate, the saving rate determines the level of output per worker (10 points). Label your graphs properly and explain what the variables are verbally.
Draw the typical Solow diagram with f(k), sf(k), and δ k.
The savings rate determines the steady state that the economy will converge. At the steady state, ∆k=0investment-depreciation=0s f (k) = δ k
b. Explain and illustrate graphically why a higher saving rate will not necessarily generate more consumption per worker. Show the point at which consumption is maximized in your graph. Explain the derivation of this point verbally (10 points).
Graph the golden rule savings rate. Show that any savings rate higher than the golden rule savings rate will reduce consumption.
Verbal explanation: The golden rule is derived to maximize c, which is:
c=y-i=f(k)-δ k.
The difference between the two curves is maximized when the slope of the production function (=mpk) is equal to the slope of δ k (i.e. mpk=δ).
c. Explain why a higher saving rate will not produce faster steady state growth of output per worker (5 points).
In steady state, ∆k =0 ∆y =0. That is, in steady state output is constant regardless of the savings rate.
2. Two identical countries Alpha and Beta can be described by the IS-LM model in the short-run. The governments of both countries cut taxes by the same amount. The central bank of Alpha follows a policy of holding constant money supply. The central bank of Beta follows a policy of holding constant interest rate. Compare graphically the impact of tax cut on income and interest rates in two countries with the help of the IS-LM model. Provide a complete verbal comparison between the countries. (20 points)
Start by drawing an initial IS-LM equilibrium in Alpha and Beta separately. The tax cut is expansioary Fiscal policy, which shifts the IS curve to the right. In Alpha, the central bank doesn’t do anything so the new equilibrium occurs on the new IS and the old LM curve (higher r and Y).
In Beta, after the shift in IS, central bank increases the money supply (and shifts the LM curve to the right) to keep r constant. New equilibrium occurs at a higher level of Y and same r.
3. Compare the effects of an expansionary monetary policy in an open economy (with floating exchange regime) versus a closed economy using IS-LM framework. Illustrate graphically (and verbally state the names of the variables in the axes) and explain verbally the mechanism through which monetary policy affects the economy. Highlight the differences between the two cases. (25 points)
This is a Chapter 12 question.
4. Suppose the government decides to reduce the budget deficit by cutting government spending.
a) Use the Keynesian-cross model to illustrate graphically the impact of an increase in government purchases in equilibrium level of income in the short run. Be sure to label the axes, the curves, the initial equilibrium values, the direction the curve shifts and the final equilibrium values. (5 points)
This is an example of expansionary fiscal policy. It shifts the E line up.
b) What would be the multiplier if government finances half of the increase in its spending though taxes. Calculate the new multiplier. {recall: Y = C + I +G and C=a+b(Y-T) } (10 points)
Y=C+I+G
Y=a+b(Y-T)+I+G
∆Y=b∆Y-b∆T+∆G but ∆T=∆G/2
∆Y=b∆Y-(b/2)∆G+∆G
∆Y(1-b)=∆G(1-b/2)
∆Y/∆G=(1-b/2)/(1-b)
c) Graphically illustrate the impact of this reductionincrease in government purchases in the loanable funds and IS framework. State in words what happens to equilibrium levels of saving, investment, and the interest rate. (10 points)
First, draw the initial equilibrium in the market for loanable funds and the IS curve side by side.
The increase in G reduces S for a given level of income and shifts the S curve to the left, increasing equilibrium real interest rate (and reducing Investment). On the right hand side, IS curve shifts up.
d) How would your answer change in the long-run? Simply explain in words. No graphics are necessary. (5 points)
In the LR, prices increase, LM shifts up, output returns to potential GDP.
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