Second Midterm
I. Short Response
For each of the following statements write a brief answer. Make sure your answers are well organized, neatly written, and explicit. Do not exceed the space provided under the question: these are short responses.
1. For this question use a Solow Growth Model with no technological change and no population change. An economy is initially in steady state at a level of capital per worker above the Golden Rule level of capital per worker. What must a social planner do to the savings rate to reach k*gold? Compare the current steady state values of consumption per worker, investment per worker, and output per worker to those at the Golden Rule steady state.
2. The population growth rate in the US is currently approximately 2% per year. Assume that this falls to 0% per year due to increased border security and lower birth rates. Write out the condition which defines the Golden Rule level of capital per effective worker. If the rate of technological change in the US economy and the capital depreciation rate are constant, what will happen to the level of capital per effective worker after this change in the population growth rate if the social planner wishes to keep the economy at k*gold?
3. The United States decides to increase their level of taxation. Use a long-run model of a small open economy to graph and analyze the effects of increased United States taxation on Jamaica's real exchange rate and trade balance as well as on Jamaica's level of national savings and investment. Assume that everything else that might affect the world loanable funds market is unchanged except for this increased level of taxation in the United States. Furthermore, assume that there is no change in monetary policy in either country.
Using graphs illustrate the effect of this change in US policy on Jamaica's real exchange rate and trade balance as well as on Jamaica's level of national savings and investment. Be sure to label your graph: including the axes, appropriate curves, initial equilibrium values, shifts if they occur, and new long-run equilibrium values. What happens to Jamaica's level of net exports, real exchange rate, equilibrium interest rate, and the equilibrium quantity of investment?
4. Define the term "efficiency wage". What are four reasons why paying an efficiency wage could raise a firm's profits?
5. Define the natural rate of unemployment. What is the natural rate of unemployment if the job separation rate (s) is 2% and the job finding rate (f) is 23%? What will happen to the natural rate of unemployment if state governments create job placement centers all across the country?
II. Problems (worth a total of 30 points)
Answer the following problems in the space provided. Make sure you show all your work and that you write the general form of any formula you use before you enter explicit numbers into the formula, as you may receive partial credit for shown work with an incorrect answer. Your work must be neat, legible, and organized in order to get full credit.
1. A closed economy has an aggregate production function given by where Y is real GDP, K is capital, L is labor, and E is a labor augmenting technology. Assume that E is initially at 1 and that there is no government sector.
a) Rewrite this production function in terms of output per effective worker and capital per effective worker.
b) Suppose there are 100 labor hours and 100 units of capital in this economy. What is the current level of capital per effective worker?
c) Given the information in part (b) as well as the initial information, what is the current level of GDP, Y, for this economy?
d) Assume that 20% of capital depreciates in any given year. If the population is growing at 15% per year and labor-augmenting technology is improving at 15% per year, what savings rate is necessary to sustain the current ratio of capital per effective worker in steady state?
e) Using your answer in d), find the steady state values of consumption per effective worker and investment per effective worker.
f) What will the level of real GDP be in this economy next year?
g) What will the capital/labor ratio be in this economy next year?
2. Use an aggregate demand and aggregate supply model of the economy to answer the following questions.
a) Define aggregate supply.
b) Define aggregate demand.
c) What happens to the US aggregate demand curve if the Federal Reserve Bank sells treasury bonds in an open market operation?
d) Describe what happens in the short run and in the long-run to the equilibrium level of output and equilibrium price level if OPEC reduces the amount of oil produced this year effectively reducing the supply of gas this year.
e) Suppose the economic forecast is for a recession caused by an increase in production prices. Policymakers, once the recession occurs, enact a stabilization policy that will keep the level of output constant at the full employment level. Describe the stabilization policy and how the policy enables the economy to return to the full employment level of output. Draw a graph that illustrates the initial long run equilibrium, the short run effect of the change in production prices, and the final long run equilibrium after the policy intervention. In your graph depict the SRAS, LRAS, and AD curves. In your graph make sure to label each curve, any shifts in the curves, the initial long run equilibrium level of output and aggregate price level, the short run equilibrium levels of output and aggregate price level due to the recession, and the long run equilibrium output and aggregate price level after the effective policy intervention.
III. Essay
General Directions for Essay: You are to write an essay on the following topic. This should be a unified, thoughtful essay. The essay will be graded on content, expression, clarity, organization, and overall quality (including legibility).
1. Great Britain and the Falkland Islands are a large open economy and a small open economy, respectively. During a recent diplomatic meeting, Great Britain agreed to assist the Falkland Islands by implementing one of two policies:
a) Great Britain would offer a tax credit to any of their own citizens who purchase goods made in the Falkland Islands. British citizens who opted to purchase Falkland Island goods would pay lower taxes to Great Britain, which effectively increases the British demand for Falkland goods and services. Great Britain government officials estimate that this policy will effectively reduce their tax collections by a significant amount. In implementing this policy, Great Britain does not alter its money supply.
b) Great Britain would increase its own money supply, while maintaining its existent fiscal policy at the current level.
For your analysis, assume that Great Britain's government spending is unchanged and that private savings in the Falkland Islands does not depend on the real interest rate (i.e., Private savings in the Falkland Islands is constant no matter what the level of the real interest rate). Also assume that the Falkland Islands make no changes in fiscal or monetary policy.
For both policies a) and b), describe the effect these policies would have on the real interest rate, nominal interest rate, and nominal exchange rate in the Falkland Islands. Which policy would result in a higher nominal exchange rate?