Instructions:

Answer 4 questions from Part A and 3 questions from Part B. Part A is worth 40 marks and B is worth 60 marks. You have two hours: budget your time carefully.

You may use a hand calculator. Do not hand in the question sheet.

Part A (40 marks) Answer 4 of the following 7 questions.

1. Government economists have argued that a tax cut is required to offset the impact of a severe contraction in government expenditures. An economist working for Poverty Watch, a volunteer organization, agrees with the positive implications of this policy but not with the normative. Explain.

2. Economists often compare the standard of living across countries on the basis of per capita GNP or GDP. Explain the problems with such associations.

3. What happens to net public income and private disposable income when the government increases its transfer payments? What happens to total income?

4. Suppose in 1990 mortgage interest rates were 9% and inflation was 5%. Suppose inflation is currently 2%. A real estate agent argues that 1995 is a better time to borrow to buy a house since the prevailing mortgage interest rate now is only 7%. How would you respond?

5. If a large number of students drop out of school to seek employment, predict the effect on real wages and employment. What are the consequences for measured labour force and unemployment?

6. What are the predictions for private savings in an open economy if the government announces a policy of reducing current taxes? What are the crucial issues in your predictions?

7. What factors determine the growth rate in the velocity of money? Can you write a formula for this growth rate?

Part B (60 marks) Answer 3 of the following 4 questions.

8. Consider two countries, Oz and Wiz. In a certain year, Oz's total output grew by twice that of Wiz which grew at 2.5 percent. Imagine Oz and Wiz share the same capital stock (one half each) which depreciated by 5%. There was no gross investment in either country.

For Oz  employment increased from 1200 to 1300,
a_K^Oz=.3 and
a_N^Oz=.7.
For Wiz  employment increased from 2000 to 2500,
a_K^Wiz=.4 and
a_N^Wiz=.6

(b) Calculate the differences in productivity growth between the two countries.

(c) Calculate the end-of-period employment in Wiz that would increase its output growth to Oz's while maintaining Wiz's current productivity growth.

9.In a closed economy with NFP=0, suppose the consumption function is

 C^d = 200 + 0.8(Y - T)

(a) With T=750 and Y=3000 and G=500, calculate C^d and S^d, and graph them against Y. What is I?

(b) If current income increases by 100 (with everything else the same) what is the change in C^d and S^d?

(c) Now suppose that taxes are not lump sum but T = 450 + 0.1(Y) What is your answer to (a) and (b)? Are these tax functions the same? Can you interpret why taxes such as these as called built-in stabilizers for income fluctuations?

10. The central bank of a certain country wants to stabilize prices at a 2% growth rate with a nominal interest rate of 4%. Suppose the economy's output has been growing at 3% per year and the authority sets monetary growth at 3%. Assume real money demand does not depend on the nominal interest rate.

(a) What is the central bank's estimate of the income elasticity of money demand?

(b) Suppose they overestimate this by a factor of two (i.e., the true elasticity is half your answer in (a)), what are the consequences for prices and the nominal interest rate? Would this miscalculation influence investment demand?

(c) Can you think of factors in the economic environment which might cause the income elasticity to fall and hence cause this overestimate?

11. You are the manager of a clothing factory and the cost of a sewing machine is 200 each. The number of socks you can produce with each machine is as follows:

                Sewing Machines       Production Level
                      0                      0
                      1                     250
                      2                     400
                      3                     500
                      4                     565
                      5                     600

(a) What is the firm's tax-adjusted user cost of capital?

(b) What is the marginal product of capital for each of the sewing machines (1,2,3,4, and 5)?

(c) How many sewing machines should the firm buy? What is their production, pretax revenue, and profit after taxes, interest, and depreciation?

PART A

1. The Poverty Watch economist agrees that the tax cut will offset the impact of a severe contraction in government expenditures (positive implications) but disagrees about the desirability of such a policy (normative implications). The economist may view that tax cuts as a policy aimed at helping the rich and the cuts in government expenditures centered on the poor. Hence this Poverty Watch economist may disagree with the fairness of the policy.

2. Standard of living comparisons using GNP or GDP are unclear for a variety of reasons. For instance GNP or GDP do not measure all economic activity of a country (home production, black market) nor do these measures convey income distribution or what goods are produced (defense equipment or consumer goods).

3. private disposable income=Y+NFP+TR+INT-T and net government income= T-TR-INT. If TR goes up clearly private disposable income goes up by the same amount as net government income goes down. Total income is unaffected.

4. The person contemplating borrowing for a house cares about real interest rates not nominal. In 1990 the real rate was 4% (9%-5%), whereas today the real rate is higher at 5% (7%-2%). Hence the cost of borrowing is higher today. An insightful answer would include an observation that it is the expected rate of inflation for 1996 that is pertinent to evaluate what the real interest rate over the course of next year will be.

5. If a large number of students drop out of school to join the labour force, this would shift the NS curve down to the right and we would predict that employment would rise and that real wages would decline. Since students are not considered to be in the labour force we could expect measured labour force and unemployment to increase.

6. The crucial issue here is one of Ricardian equivalence. If the government lowers current taxes and individuals believe that this just implies higher future taxes, then national savings is unchanged and private savings increases by the same amount that public savings decreased. In this case there would be no change in net exports. On the other hand, if there is not Ricardian equivalence we would see some increase in desired consumption and hence national savings would fall since private savings would not increase as much as the decline in public savings. The decline in national savings would imply an increase in the current account deficit.

7. V=PY/M. If nominal income rises or the money supply falls then velocity rises. Let v, pi, g, and m be the growth rates of velocity, prices (inflation) , real output and the nominal money supply respectively. Then v=pi+g-m.

PART B

8. (a) Clearly Wiz is better able to use capital input to produce output than Oz. (Oz is more efficient in its use of labour).Hence if we were trying to maximize world output we would not have a fiftyfifty split in the use of capital.

(b) Let g,A,kk and nn denote growth rate of output, total factor productivity, capital and labour respectively.
We are asked to calculate A: A=g-ak kk - an nn
For Oz we have G= .05, ak=.3, kk= -.05, an=.7, nn=.083 (1300-1200/1200) and therefore A=.0069
For Wiz we have g= .025, ak=.4, kk= -.05, an=.6, nn=.25 (2500-2000/2000) and therefore A=-.105

(c) The formula that we need is N=(g-A-ak kk)/an= (.05+.105+.4(.05))/.6=.29 (almost a 30% increase in employment)

9.(a) C=200+.8(3000-750)= 2000
S=Y-C-G=3000-1800-500= 500
The only way we can determine I is if we assume a closed economy or NX=0. Then S=I and therefore I=500. Note also that Sd=Spvt +Sgovt=250+250=500. The graph of Cd and Sd slopes upward with a slope of .8 and .2 respectively.

(b) If Y=3100, then the change in C is 80 (C=2080) and change in S is 20 (S=I=520)

(c) (i) Must substitute T=450 +.1(Y) into consumption function and solve: C=2000 and S=I=500, same as (a)
(ii) The change in C is 72 and change in S =28.

The difference in the two tax functions is that in (c) taxes are positively related to income. As income rises so do taxesand as income falls taxes fall. Therefore if national income is fluctuating over the business cycle, we see that in downturns the government will tax less and therefore consumption will not fall by as much. This kind of tax function acts as a stabilizer since it depends upon the current level of economic activity.

10. Let p, m, g be growth rate of prices (inflation), nominal money and real output, Also let ny be the income elasticity of money demand.
We know that: p=m-ny g
Therefore we can get an estimate of the Bank's income elasticity (denoted by ny*) by solving for ny from the above using the values stated in the question:
ny*= (m-p)/g= (3-2)/3=1/3

(b) If the true income elasticity is half that estimated, ny=1/6 then p=3-1/6 3=2.5%. Thus inflation would be 2.5% rather than the expected 2%. The nominal interest rate would be 4.5% instead of 4% but investment would not change since this depends on real interest rates and not nominal.

(c) The introduction of new technologies that allow for economizing on cash balances would lower the income elasticities. New computer technologies like direct payments and overnight banking would be two examples.

11. (a) Tax-adjusted user cost=(r+d)Pk/(1-t)=(.10+.15)x200/(1-.2)=$62.50

(b) We need to calculate the MPK for each additional sewing machine and then equate it to the user cost of capital adjusted for taxes. First the MPK's for each production level:

Sewing Machines    Production Level  MPK
 0                       0            -
 1                     250            250
 2                     400            150
 3                     500            100
 4                     565             65
 5                     600             35