Questions:
1.) You are working at an investment firm that has many investments in Lithuania. You have been asked to do a simple simulation showing the potential effects of Lithuania building a high-speed rail network, and what will happen if there is worldwide pressure on interest rates. All amounts are in millions of Litas. (The Lita is the Lithuanian currency. For this example use the exchange rate you compute, not the actual exchange rate). Government spending is projected to rise by 50 percent due to construction of the high-speed rail network
This is the status quo scenario
Total Output is equal to 5,000
Government spending is equal to 1,000
Tax revenue is equal to 1,000
Consumption is equal to 250+0.75*(Y-T);
The level of investment is 1,000-50r;
Net Exports are 500-500ε,
the world real interest rate is five percent
Assume that there are three political parties in Lithuania and each think that building the high speed rail network will have different effects on the economy. They have hired you as a consultant (moonlighting from your investment firm) to do an analysis showing what happens if their beliefs end up being true.
a. THE LIBERAL PARTY believes that increasing government spending to build the high speed rail network will increase both G and GDP. That is G, will increase to 1,500 and GDP will increase by 500 too. Compare what happens to the economy if the Liberal party is correct. How do private savings, public savings, national savings, Net exports, and the exchange rate change from the status quo?
b. THE CONSERVATIVE PARTY believes that building a high speed rail network will put people to work (thus increasing G), but that it will ultimately be useless (there will be no overall wealth created), so GDP will be unchanged. The conservatives are also concerned that the government taking on new debt will be a bad sign to Lithuania's creditors, and that borrowing the money for the high-speed rail system will cause the interest rate to rise 20 percent. Under this scenario, how do private savings, public savings, national savings, Net exports, and the exchange rate change from the status quo?
c. THE LIBERTARIAN PARTY believes that taking tax money and using it to build a high-speed rail network does nothing more than take money from one group of people (taxpayers) and give it to another group of people (the construction industry) and that there is no productive economic impact. How do private savings, public savings, national savings, Net exports, and the exchange rate change from the status quo?
d. Please compare situations a, b, and c. Who do you think is correct, and why?
e. The Libertarians use a microeconomics explanation about taxation to argue that the economy will be helped most by simply reducing taxes, even if people only save the money that they don't spend on taxes (C is not affected). They say that this phenomenon is assumed away by most macro-economists. What are they referring to?
2.) Why can't the Federal Reserve directly control the money supply? What changes in behavior on the part of people or banks can make it harder for an increase in the monetary base to increase M2?
3.) The country of Luxembourg is a small, open economy. Suddenly, a change in world fashions makes the exports of Luxembourg very un-popular. Explain what happens to savings, investment, net exports, the interest rate, and the exchange rate.
4) Assume that the country of Iran is a small, open economy. George W. Bush's inclusion of Iran as a member of "the Axis of Evil," however, has complicated trade with Iran. Assume that every good coming out of Iran is subject to a "Terrorism Tariff" that makes every quantity of exports effectively more expensive to any nation that buys them. As a result, the willingness to pay by the international community for every quantity of exports from Iran is lower. Explain what happens to savings, investment, net exports, the interest rate, and the exchange rate.
5.) What are your predictions for the US economy over the next two years? Use the macroeconomic models you have learned to present a reasoned answer. Explain your assumptions clearly.
Please also address what could happen if the Fed proceeds with a third round of quantitative easing. Please answer the scenarios that could occur, then state which scenario you think is most likely to occur, and state your reasons.
6) What is the difference between the Federal Funds Rate and the Discount Rate? Please give the difference by providing an explanation of each rate and their purposes?
7.) Assume that the GDP deflator was 100 in 2008, 97.5 in 2009, and 96.8 in 2010. How much would a salary offer of $80,000 in 2010 have been worth in 2008?
8) If the CPI value for 1960 was 0.5 and 2.5 in 2010, and a GMC four-door sedan cost $2,500 and $20,000 in 2010, what conclusions can you draw? (hint: Be careful what you say!)
Please answer the next five questions as "True," "False," or "Uncertain." "Uncertain" indicates that the statement may or many not be true (not that the respondent is uncertain). Feel free to provide a justification for your answer in the space provided, if you think that will be helpful.
9.) An increase in interest rates will cause a decrease in Aggregate Demand, and a slow- down in the economy.
10.) A decrease in interest rates will cause an increase in Aggregate Demand, and an expansion in the economy.
11.) If the economy is not expanding, and the world interest rate is exogenous, an increase in the money supply will only cause an increase in current prices.
12.) The Consumer Price Index has difficulty accounting for changes in technology such as the developments in computers, while the chain-weighted GDP deflator does not.
13.) In the US, over the last 50 years, the Consumption component of gross domestic product has been more volatile than the Investment component
14) All else held equal, higher budget deficits should be associated with higher trade deficits.
-BONUS-
4.) What would a family who made $200,000 in 1995 make today? Use the 2012 index value for "today."
When should the Fed have increased the money supply according to this table? Provide a detailed answer of how could they have increased the money supply. (12 points)
If gasoline had gone up at only the rate of inflation, how much would it have cost per gallon in 1994? Assume the price of gasoline today is $4.00 per gallon.
Year CPI
1993 144.5
1994 148.2
1995 152.4
1996 156.9
1997 160.5
1998 163
1999 166.6
2000 172.2
2001 177.1
2002 179.9
2003 184
2004 188.9
2005 195.3
2006 201.6
2007 207.342
2008 215.303
2009 214.537
2010 218.056
2011 224.939
2012` 229.594