ECON 211 TEST AND ANSWERS
TICK the preferred choice on the coloured answer sheet provided and attach to your answer booklet
1. A competitive, profit-maximizing firm hires labour until the: A) marginal product of labour equals the wage.
B) price of output multiplied by the marginal product of labour equals the wage.
C) real wage equals the real rental price of capital.
D) wage equals the rental price of capital.
2. Skill-biased technological change ______ the demand for high-skilled workers, while the slowdown in the pace of educational advancement reduces the supply of skilled workers, resulting in relatively _____ wages for skilled workers.
A) increases; higher
B) increases; lower
C) decreases; higher
D) decreases; lower
Use the following to answer Question 3:
(Exhibit: Capital per worker)
3. (Exhibit: Capital per worker) In this graph, starting from capital per worker k1, the capital-labour ratio will:
A) decrease.
B) remain constant.
C) increase.
D) first decrease and then remain constant.
4. In a small open economy, if the government encourages investment, say through an investment tax credit, investment:
(a) does not increase; the interest rate rises instead.
(b) increases and is financed through an inflow of foreign capital.
(c) increases and is financed through an increase in national saving.
(d) increases and is financed through an increase in exports.
5. In a Solow model with technological change, if population grows at a 2 percent rate and the efficiency of labour grows at a 3 percent rate, then in the steady state the real rental price of capital grows at a ______ per cent rate and the real wage rate grows at a ______ per cent rate.
A) 5 and 0
B) 0 and 3
C) 2 and 5 D) 3 and 2
6. The public policy implication of Goldin and Katz's analysis of growing income inequality is that reversing this trend will require that more of society's resources be put into: A) space exploration.
B) capital expenditures.
C) education.
D) transfer payments.
7. If disposable income is 4,000, consumption is 3,500, government spending is 1,000, and taxes minus transfers are 800, national saving is equal to:
A) 300.
B) 500.
C) 700.
D) 1,000.
8. In the Solow growth model, technological change is ______, whereas in endogenous growth theories, technological change is ______.
A) assumed; explained
B) explained; assumed
C) persistent; constant D) constant; persistent
9. In the basic endogenous growth model, income can grow forever—even without exogenous technological progress—because:
A) the saving rate equals the rate of depreciation.
B) the saving rate exceeds the rate of depreciation.
C) capital does not exhibit diminishing returns.
D) capital exhibits diminishing returns.
10. If many banks fail, this is likely to:
A) increase the ratio of currency to deposits.
B) decrease the ratio of currency to deposits.
C) have no effect on the ratio of currency to deposits.
D) decrease the amount of currency in the economy, if the Fed takes no action.
11. Protectionist policies implemented in a small open economy with a trade deficit have the effect of ______ the trade deficit and ______ the quantity of imports and exports.
A) decreasing; decreasing
B) not changing; decreasing
C) decreasing; not changing
D) not changing; not changing
12. If the government of a small open economy wishes to reduce a trade deficit, which policy action will be successful in achieving this goal?
A) increasing taxes
B) increasing government spending
C) increasing investment tax credits
D) imposing protectionist trade policies
13. The percentage change in the nominal exchange rate equals the percentage change in the real exchange rate plus the:
A) foreign inflation rate minus the domestic inflation rate.
B) domestic inflation rate minus the foreign inflation rate.
C) foreign exchange rate minus the domestic exchange rate.
D) domestic interest rate minus the foreign interest rate.
Exhibit for Question 14: Shift in Aggregate Demand
14. In this graph, initially the economy is at point E, with the price P0 and output . Aggregate demand is given by curve AD0, and SRAS and LRAS represent, respectively, shortrun and long-run aggregate supply. Now assume that a demand shock such as a hike in the OCR shifts the aggregate demand curve. The economy moves first to point ______ and then, in the long run, to point ______.
A) A; D
B) C; B
C) B; C
D) D; A
15. An LM curve shows combinations of: A) taxes and government spending.
B) nominal money balances and price levels.
C) interest rates and income, which bring equilibrium in the market for real money balances.
D) interest rates and income, which bring equilibrium in the market for goods and services.
16. An increase in income raises money ______ and ______ the equilibrium interest
rate.
A) demand; raises
B) demand; lowers
C) supply; raises
D) supply; lowers
17. If the government wants to raise investment but keep output constant, it should: A) adopt a loose monetary policy but keep fiscal policy unchanged.
B) adopt a loose monetary policy and a loose fiscal policy.
C) adopt a loose monetary policy and a tight fiscal policy.
D) keep monetary policy unchanged but adopt a tight fiscal policy.
18. An increase in government spending raises income:
A) and the interest rate in the short run, but leaves both unchanged in the long run.
B) in the short run, but leaves it unchanged in the long run, while lowering investment.
C) in the short run, but leaves it unchanged in the long run, while lowering consumption.
D) and the interest rate in both the short and long runs.
19. If short-run equilibrium in the Mundell–Fleming model is represented by a graph with Y along the horizontal axis and the exchange rate along the vertical axis, then the LM* curve:
A) slopes upward and to the right because at a higher income a higher interest rate is needed to increase velocity.
B) is vertical because monetary velocity is independent of the interest rate.
C) is vertical because the exchange rate does not enter into the LM* equation.
D) slopes upward and to the right because a higher exchange rate leads to a higher income.
20. In a small open economy with a floating exchange rate, an effective policy to increase equilibrium output is to:
A) increase government spending.
B) increase taxes.
C) increase the money supply.
D) decrease the money supply.
21. The basic aggregate supply equation implies that output exceeds natural output when the price level is:
A) low.
B) high.
C) less than the expected price level.
D) greater than the expected price level.
22. According to the Phillips curve, other things being equal, inflation depends positively on:
A) expected inflation.
B) the unemployment rate.
C) the rate of technological change.
D) the quantities of capital and labour.
23. Using the sticky-price model, the higher the average rate of inflation, the more frequently firms must adjust their prices, which implies that a high rate of inflation:
A) has no effect on the slope of the short-run aggregate supply curve.
B) should make the short-run aggregate supply curve flatter.
C) makes the short-run aggregate supply curve steeper.
D) causes prices to be sticky.
24. Franco Modigliani's answer to Simon Kuznets's puzzle regarding long-term constancy of the average propensity to consume is that:
A) the average propensity to consume depends on the wealth-to-income ratio, and income and wealth tend to grow together over time.
B) both rich and poor individuals have the same average propensity to consume.
C) demographic shifts have acted to just cancel out movements in the average propensity to consume.
D) every consumer consumes all of his or her income over a lifetime, so the average propensity to consume is constant at one.
25. The life-cycle model predicts that if the proportion of the population that is elderly increases over the next 20 years, then the national saving rate ______ over the next 20 years.
A) will increase
B) will remain unchanged
C) will decrease
D) may first increase and then decrease
SECTION B
(Total marks = 50)
SHORT ANSWER QUESTIONS
Answer ALL questions
Question 26. Models of Economic Growth (10 marks)
(a) Define the golden rule for choosing the saving rate and describe it with reference to
the production technology of an economy. (2 marks)
The golden rule refers to the policy of targeting a saving rate (s_GR) that maximizes consumption per effective unit of labour (c=C/EL).
With reference to the production technology, if we denote the GDP or output by Y, capital by K and the marginal product of capital as MPK then, it turns out that
s_GR = (MPK x K)/Y.
(b) Illustrate your answer to part (a) with an appropriate diagram. In the same diagram show that the rate of saving that satisfies the golden rule may not achieve the
maximum output per capita in the long-run. (2 marks)
(c) If Country A follows the golden rule for saving while Country B does not do so, what other assumptions you need to make before concluding that the long-run consumption per capita would be higher in Country A than in Country B? (2 marks)
Necessary assumptions:
(1) Identical production function (technology)
(2) The same (i) balanced growth rate of output and (ii) depreciation rate
(d) Based on the endogenous growth models of either Romer (1986) or Lucas (1988), provide one concise argument to explain why the austerity programme in Greece may
run the risk of raising the long-term DEBT-to-GDP ratio, despite lowering the budget
deficits every year. (2 marks)
The austerity programme may lead to lower rate of public investment in health and education which the private sector may not be able to and may not want to offset because of a tax hike which typically accompanies an austerity package. A drop in the rate of investment in human capital would lower the long term balanced growth rate of GDP. If the new growth rate is lower than the interest rate then the Debt to GDP ratio would increase.
(e) Suppose that Country A’s population grows 1% faster than Country B because people from Country A migrates every year to Country B to avoid increased incidences of natural disasters caused by global warming. If the two countries are otherwise identical, in which country, the long-run income per capita would be higher (i) according to Solow (1956) and (ii) according to Kremer (1992)? Illustrate your
answer graphically and carefully label you graphs to describe what they indicate. No additional explanation is necessary. (2 marks)
See Attached Figure.
Question 27. The IS-LM-AD Model (10 marks)
Economists have offered alternative hypotheses as explanations for the Great Depression of the 1930s.
(a) State the hypothesis which may also explain why the Global Financial Crisis (GFC) which began in 2007 lasted for an unusually long period of time and illustrate your answer using the IS-LM-AD model and supportive explanation based on relevant economic insights. (5 marks)
The debt-deflation hypothesis: Expected deflation could be destabilizing and be responsible for triggering a deep recession. If deflation is expected then it could be destabilizing as follows: ↓πe⇒r ↑ for each value of i ⇒I ↓ because I = I (r )⇒planned expenditure & agg. demand ↓ for any given i (causing a leftward shift of the IS) ⇒ income & output ↓.
If deflation is unexpected then the resulting transfers of purchasing power from borrowers to lenders could lead to a drop in spending. However, an attempt to explain a long-term recession by “unexpected” deflation appears a bit far-fetched.
In particular, the logic goes as follows: if borrowers’ propensity to spend is larger than lenders, then aggregate spending falls, the IS curve shifts left, and Y falls.
Also, as the deflation rate increases unexpectedly because financial system collapses and banks simply refuse to lend and households refuse to spend money, a “liquidity trap” (a phrase first coined by Keynes) sets in. Money gets trapped out of circulation unexpectedly, thanks to the panic induced by the unprecedented injection of currency by the central bank into the banking system. This discrepancy between actual deflation and expected deflation hurts the borrowers and helps the savers. Because this additional unexpected deflation raises the real interest rate payments on loans hurting the borrowers and benefitting the savers.
If, as typically is the case during depression, most poor people are borrowers while rich people are savers and hoarders. Moreover, the rich spends a much smaller fraction of their income than the poor. Consequently, the overall effect of the unexpected deflation would be a transfer of wealth from the rich to the poor and a drop in the aggregate consumption. This would lead to a fall in the IS (shifting to the left) as well as a drop in the aggregate demand.
(b) Provide an explanation for the observation that even though expansionary fiscal and monetary policies lifted a number of countries like New Zealand out of the recession caused by the GFC, those policies appeared to be ineffective in some other countries like Greece where the recession continues. (5 marks)
If the public debt level is too high relative to GDP, as it was in the US when President Obama got elected to lead the country, then consumers and investors may reduce spending due to panic driven increase in the real interest rate and, therefore, an expansionary fiscal policy such as outlined in part (b) and (c) of may not lead to a shift in the IS curve at all; moreover, it may cause a shift of the IS leftwards. Because, people in the middle of a war with no exit strategy may fear an impending tax hike without which the government may fail to meet its interest payment obligation.
In general, the extent of the shifts of the IS depend on the initial state of the economy. If the history public debt shows that GDP grows faster than debt ensuring a timely repayment of debt with automatic increase in taxes due to higher GDP rather than periods of tax hikes then the shifts will be larger than if the Debt is larger and grows faster than GDP.
In the US, the Debt to GDP ratio reached close to 100% prior to the crisis while in Greece it was over 200% and it is still as high as 173% today. New Zealand pursued a policy of maintaining budget surplus for almost every year in the 1990s since the passage of the Fiscal Responsibility Act in 1993.
Such policy reduced the public debt to GDP ratio drastically from about 80% in the late 1980s to about 39% prior to the 2007 GFC. Consequently, the concern for a sharp increase in future tax burden, a decline in the saving rate and the consequent decline in the long-tern GDP growth rate did not discourage consumers to spend their additional disposable income, unlike what it did in the US and in Greece.
Question 28.The Mundell-Fleming Model (10 marks)
The Mundell-Fleming model takes the world interest rate r* as an exogenous variable. Let's consider what happens when this variable changes.
(a) List two examples of “shocks” which might cause the world interest rate to decline. (2 marks)
(b) In the Mundell-Fleming model with a floating exchange rate, what happens to the aggregate income, the exchange rate, and the trade balance of a small open economy when the world interest rate declines? Explain your answer with graphical illustrations. (4 marks)
(c) In the Mundell-Fleming model with a fixed exchange rate, what happens to the aggregate income, the exchange rate, and the trade balance of a small open economy when the world interest rate declines? Explain your answer with graphical illustrations. (4 marks)
Please refer to the Tutorial 7 answers guide for Topic 7.
Question 29. Short Run Aggregate Supply and the Phillips Curve (10 marks)
Suppose that the Phillips Curve in New Zealand takes the form π = .04 – .25 (u – .04), where π is the actual inflation rate and u is the unemployment rate. The current unemployment rate is 12 percent (0.12). Use the expectation augmented Phillips curve hypothesis to answer the following questions.
(a) (i) What is the natural rate of unemployment?
4%
(1 mark)
(ii) What is the expected inflation rate?
4%
(1 mark)
(iii) What is the inflation rate?
(1 mark)
π = .04 – .25 (0.12 – .04) = 2%.
(b) Suppose that monetary policy fixes the actual inflation rate at the same level as determined in part (a) (iii) above. With that policy target how might the expected inflation rate change? (2 marks)
It depends on whether people believe in the ability and sincerity of the monetary policy objective (i.e., if the policy target of 2% inflation rate in credible). A credible policy would lower the inflation rate to 2%. Otherwise, the expectation may remain above 2%.
(c) What happens to the unemployment rate if the expected inflation rate decreases to 2% while the inflation rate remains unchanged? (1 mark)
If the expected inflation rate drops to 2% while the actual inflation rate remains steady at 2% then the unemployment rate would drop to 4%: 0.02 = .02 – .25 (u – .04).
(d) Assume that an economy is initially operating at the natural rate of output. What happens to the unemployment rate if the expected inflation rate remains unchanged while the contractionary monetary policy swiftly brings the inflation rate down to 2%? Support your answer with a clear and concise statements, based on insights from any theories of the short-run aggregate supply.
(2 marks) The unemployment rate would increase sharply to 12%: 0.02 = .04 – .25 (u – .04), implies that the equilibrium unemployment rate: u=0.12
(e) Use your answers to parts (a)-(d) to provide a clear and concise explanation for the sudden increase in unemployment in New Zealand between 1989 and 1992, following the RBNZ ACT of 1989. (2 marks)
It’s clear from the answers for (a) to (d) that if the inflation rate drops faster than the rate at which people’s expectation of “disinflation” changes then the unemployment arises as an equilibrium outcome from that “disinflation surprise”. One may reasonably argue that an inappropriate sequencing of the reforms (monetary reforms of 1989 came prior to labour and fiscal reforms which occurred in 1991 and 1993 respectively) compromised the credibility of a low inflation target. Consequently, the SRPC did not shift downward as fast as inflation to ensure a vertical slide along the LRPC. Instead, the “disinflation surprise” caused rise in real wage (as workers adjusted wages downward ONLY at the rate of decline of inflation expectation while the actual inflation fell much faster) and that made employers laying off workers causing a sharp increase in the unemployment rate.
Question 30. Theories of Consumption (10 marks)
(a) Assume that the typical person lives for two periods, behaves according to the Irving Fisher's two-period model and that consumption in both periods is a normal good. Assume that the disposable income in the period 2 is higher than the disposable income in period 1.
i. Illustrate graphically how a tax cut in period 1 one affects consumption in both periods, assuming that everyone believes that no additional taxes to be paid in period
2. How would your answer change if people cannot borrow against their future
income? (5 marks)
[Note that the question asks about a temporary tax cut and NOT an announcement for a temporary tax cut in future. Then carefully note from the following discussion that people who are bowing constrained WOULD RESPOND by raising their consumption by a higher amount than those who are not constrained.]
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