204
PAGE ECONOMICS NUMBER 1
UNIVERSITY OF VICTORIA
ECONOMICS 204
ANSWERS MIDTERM 2 FALL 2011
Section 1 (20 marks) Answer ALL 20 multiple-choice questions.
1. B 2. C 3. B 4. A 5. D 6. B 7. A 8. A 9. C 10. C
11. D 12. B 13. C 14. D 15. B 16. C 17. A 18. B 19. A 20. C
Section 2 (20 marks) Answer BOTH questions.
1. Given:
Output (Aggregate production function)
Consumption
Investment
Net export
Government policies
National account identity
Interest rate
(a) Define in a diagram: trade deficit, i.e. NX < 0
(i) From national account identity we have
(ii) Assumption of small open economy implies
(iii) Solve the model:
Given:
implies
;
+0.5
+0.5
+1 for clear labeling; +0.5 for indicating r* is below rc (a.k.a. the Autarky interest rate rA the
equilibrium interest rate in a closed economy); +0.5 for indicating NX < 0 as the difference between
saving and investment at r*.
(b) Define in a diagram: equilibrium real exchange rate.
(i) From (a) we have
ECONOMICS 204
PAGE NUMBER 2
(ii) Net export is a function of real exchange rate
(iii) Solve the model:
+0.5
{Equivalently, the equilibrium is the exchange rate that equates NX with net capital outflow, S I.
+0.5}
+1 for clear labeling; +0.5 for indicating the intersection of the two curves as the equilibrium .
(c) Discuss in a diagram: the impact of protectionist trade policy on and NX.
(i) At any given value of , protectionist trade policy raises trade balance, which increases the net
demand for Canadian dollars. Dollar appreciates, or rises.
+0.5
(ii) Since the trade policy doesnt affect S or I, the capital flows and the supply of dollars remain
fixed. So is NX, i.e. NX = 0.
+0.5
(iii) The appreciation causes EX to fall as foreign goods and services become less expensive. Since
EX is lower but NX is unchanged, it must true that IM is lower too. +1
In summary, protectionist policies reduce both the quantity of IM and EX, leaving NX unchanged.
+1 for clear labeling; +0.5 for indicating the shift in NX curve; +0.5 for indicating an increase in
equilibrium .
ECONOMICS 204
PAGE NUMBER 3
2. Given: Capital accumulates by
;
Production function per worker is
.
(a) Given: no population growth or technological progress, i.e. n = g = 0.
Find: k* = F(s, , ).
The SS value of capital per worker k* is defined the as value of k at which capital per worker is
constant.
That is,
=0
+2
Or
sf(k*) = k*
+0.5
Solving for
we get:
Or
Find: y* = F(s, , ).
Substituting k* into per-worker production function yields y*:
y* = f(k*) = (k*)
+0.5
+0.5
So
+0.5
(b) Demonstrate: The steady state solution in a diagram.
Investment:
Depreciation (or Break-Even investment):
In SS:
+0.25
+0.25
+0.25
+1 for clear labeling; +0.25 for indicating k*.
(c) (i)
Define: the Golden Rule level of capital.
The Golden Rule level of capital is the steady state value of k* that maximizes
consumption.
+0.5
(ii) Find: the Gold Rule condition: MPK = .
+0.5
(iii) In a diagram: +0.5 for clear labeling; +0.25 for indicating at k*Gold the slope of f (k*) is
parallel to the slope of depreciation (i.e., the red line is parallel to the blue one); +0.25 for
indicating c*Gold as the vertical distance between f (k*) and k*.
ECONOMICS 204
PAGE NUMBER 4
(d) (i)
(ii)
*
Given: k * kGR .
*
Find: the policy to pursue kGR .
Initially, there is not enough per-worker capital in SS. The policy should target at a higher
level of SS capital per worker and hence a higher investment. Therefore the policy should
raise the saving rate.
+1
Find: the welfare implication of such policy.
An increased saving rate raises the current saving and increases the current investment,
which, in turn, reduces the current consumption. (+0.5) However as per-worker capital
increases on the transitory path to the new SS per-worker income increases until the new
SS is achieved under which the SS level of consumption is maximized. (+0.5)
{Equivalently, you can state that the current consumption is reduced due to a higher saving
rate and a higher investment. (+0.5) Eventually we maximize the SS consumption once the
Golden Rule level of capital is achieved. (+0.5)}
Thus, the current generation is worse off by consuming less; (+0.5) and yet the future
generation is better off by having a higher consumption. (+0.5)
Bonus. Find: the Golden Rule saving rate sGold.
From (a),
From production function,
From (c),
MPK = k-1
*
MPK (kGR ) 1
11
Solve for k ,
k ( )
*
*
kGR also satisfies the SS condition and hence kGR k *
*
GR
*
GR
1
1
Or
()
Solve for sGR ,
sGR =
s
( )
+0.2
+0.2
+0.3
1
1
correct answer for +0.3