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(15 1. points) National Income Accounting Suppose the following data explain the economic activity in a country in the year 2000. Component of spending Consumption Business fixed and residential investment Inventory stock at the end of 1999 Inventory stock at the end of 2000 Depreciation Government outlays Government purchases Total government tax receipts Exports Imports Labor income Capital income Net income of foreigners Sales taxes Given these data, calculate the following: a) Inventory investment Value in billions of dollars 140 27 10 5 12 80 65 65 21 17 126 70 5 28 b) Net exports c) Gross Domestic Product d) Statistical discrepancy e) National saving f) Government saving g) Verify that national saving equals investment plus net exports. 2. (15 points) Labor Market Explain each of the following using labor supply and demand graphs for young workers. a) Decline in the minimum wage. b) Immigration of unskilled workers to the United States. c) Technological change biased against unskilled labor. 2 d) A reduction in the social security tax on wages. 3. (15 points) Share Allocation Suppose the following equations describe the relationship between shares of spending in GDP (Y) and the interest rate (R), measured in decimal fractions (that is, R=.05 means that the interest rate is 5 percent). C Y I Y X Y 0.7 0.2( R 0.05) 0.2 0.8( R 0.05) 0 0.95( R 0.05) a) Suppose the government share of GDP is 20%. Determine the equilibrium interest rate and the investment share of GDP. b) Now suppose the government share of GDP falls to 17%. Determine the new equilibrium values of the interest rate and the investment share of GDP. c) Explain briefly the effect of this decline in the government share of GDP on the long-run growth rate of GDP. 3 d) Describe the long-run impact of defense spending cut if the funds saved from the defense cut are used to increase government expenditures on roads and bridges. 4. (10 points) Fiscal Policy a) Graphically illustrate a scenario in which there exist a structural surplus and an actual deficit. b) Now suppose the government decreases taxes. On the same diagram, illustrate the effects of this action. c) Circle one: The structural surplus will increase/decrease/remain the same/cannot tell with the given information. d) Circle one: The actual surplus will increase/decrease/remain the same/cannot tell with the given information. 5. (15 Points) Monetary Policy a) The economy is in recession. The Fed notices a drop in inflation and decides to bring the economy back to potential GDP. Briefly explain how the Fed accomplishes this. b) Suppose the Fed expands the monetary base by $10 billion. The required reserve ratio is 10%, and 20% of deposits are held in cash. Quantify the effect on the money supply. 4 c) Explain why such an expansion would not be effective if a country utilizes a fixed exchange rate. 6. (15 points) Financial Markets Consider a 3-year bond with a face value of $10,000 and a coupon payment of $400. a) Suppose that the current market interest rate is 3%. How much would this bond be selling for. b) Now suppose that you believe that the market interest rate is 3% in this year, but will increase to 6% in the next two years. Write the bond price formula for this problem. How much are you willing to pay for the 3-year bond today? c) Rank the following financial securities in order of average expected rate of return per year: U.S Treasury Bills Long-term corporate bonds Large-company stocks Small-company stocks Justify your answer. 5 7. (15 pts.) International Trade The Republic of Kreplakhistan has just emerged from 60 years of socialism. Being in the communist bloc meant that Kreplakhistan could not export its primary natural resource, bauxite, to the U.S., the largest consumers of bauxite. On the other hand, Kreplakhistan could not import Kentucky bourbon from the U.S., for political reasons. (Kreplakhistani bourbon is notoriously bad!) The following table shows productivity (measured in units per worker per year) of workers in these two industries in the two countries: Bauxite U.S. Kreplakhistan 1000 2000 Bourbon 2000 500 a) Kreplakhistan's new leaders have decided to liberalize foreign trade by allowing trade with the U.S. at market prices. What are the highest and lowest possible prices of bauxite (in units of bourbon/bauxite) between these two countries? What are the highest and lowest possible prices of bourbon (in units of bauxite/bourbon) between these two countries? b) Assume that the market price of bauxite between these two countries is 1. Kreplakhistan decides to get rid of its bourbon industry entirely and completely specialize in bauxite production. To this end, 1000 workers are transferred from bourbon to bauxite. Fill in the table below, assuming Kreplakhistan that will have zero net gain in bourbon and the U.S. will have zero net gain in bauxite. KREPLAKHISTAN Bauxite Bourbon UNITED STATES Bauxite Bourbon in Production Amount Traded Net Gain in Production Amount Traded Net Gain 6 c) The U.S. Department of Commerce has determined that Kreplakhistan is subsidizing its bauxite industry. Given this determination, briefly discuss who would benefit from a U.S. tariff on Kreplakhistani bauxite (other than the U.S. government) and on what grounds would this argument be made? 8. (15 pts.) Economic Development Suppose GDP per capita is $32,000 in the U.S. and $16,000 in Mexico. Consider the following data for the U.S. and Mexico: Country U.S. Mexico Percent. Growth in K/L 2.0 6.0 Percent. Growth in Technology 2.5 4.0 a) Calculate the growth in productivity for both countries. Assume that capital's share of income is 1/4 in the U.S. and 1/3 in Mexico. b) Using your answers to part a, approximately how long will it take Mexico to catch up with the United States? (Hint: The rule of 72 will make your calculations much easier.) 7 c) Based on the notion of the catch-up line, why would you expect Mexico to take longer to catch-up to the U.S. than predicted in part b? (Hint: Think about why Mexico's growth rate would or would not be constant during the catch-up period.) 9. (20 points) The Real World The following diagram shows quarterly percentage deviations from potential GDP against inflation for the years 1972-1976 for the US. Use the ADI-PA framework to answer the following questions related to this picture. You do not need to incorporate the monetary policy rule or a spending balance diagram into your analysis unless you desire to do so. Do not use potential GDP as the starting point to your answer unless the data given in the plot dictates it. a) From the second quarter of 1972 (72.2) to the beginning of 1973 (73.1), GDP growth was strong with little increased inflation. Diagram and explain how this can result from an increase in government expenditures. 8 b) In your diagram for part (a), draw your prediction for the adjustment of the US economy to its long-run equilibrium, assuming no other supply or demand shocks occurred in the interim. Briefly explain the adjustment process below. c) The period 73.1-75.1 exhibits rapidly rising inflation and unemployment a situation sometimes called 'stagflation.' Use a new ADI-PA diagram to explain how stagflation can result from a price shock. d) Using your diagram from part (c), draw and explain the adjustment process to a long-run equilibrium from the 75.1 inflation and unemployment peak. Does your answer correspond to what actually happened or is some additional supply or demand shock necessary to explain the actual movement from 75.1 to 76.1? 10. (20 points) The Real World In the past few years, the U.S. economy has gone from the tail-end of the longest expansion in its history into a short recession and is currently in the beginning stages of a recovery. Specifically GDP growth has gone from being well above the long-term trend to being slightly negative for a couple of quarters and is now slightly above the long-term trend. Throughout this period, the inflation rate has remained low and fairly constant. 9 a) Some have argued that the advent of the recession was precipitated by the strong contraction of the stock market and a resulting demand shock. Discuss how the stock market contraction could lead to a recession. Using ADI/IA analysis trace the expected path of the economy in the SR, MR, and LR as in adjusting to this shock. How does this path differ from the actual experience outlined above? b) Others have argued that a contraction in GDP resulted from the events of 9/11/01 which lead to a supply shock. Discuss how such an event might lead to a supply contraction. Using ADI/IA analysis trace the expected path of the economy in the SR, MR, and LR as in adjusting to this shock. Discuss how the two alternative scenarios can be combined to provide an explanation to the actual experience that was discussed above. c) In addition, as the economy softened and moved into recession, the Fed has repeatedly lowered interest rates. Assuming the economy was initially at full employment use ADI/IA analysis to trace the resulting path of the economy in the SR, MR, and LR. If the economy is already in recession, as a result of the demand shock in a) what would be the path of the economy as a result of the monetary policy actions. 10 d) The Bush administration has succeeded in implementing a permanent tax cut in the current budget. Assuming the economy is now back at full employment discuss the impact in the SR, MR, and LR of this policy action. Is this the scenario that the Bush administration is looking for? 11

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