# AK2m - Second Midterm Exam Spring 2005 Prof Andrew Atkeson...

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Second Midterm Exam Spring 2005 (May 26, 2005) Prof. Andrew Atkeson Econ 106-F Student Name: ___________________________________________________________________ Instructions: You have 70 minutes to complete this exam. There are eight questions. Each question is worth 10 points. Write your answers in the space provided beneath each question. You should use scratch paper to figure out what you want to write and then put down you answer neatly and concisely. For the problems, if some calculation is involved, a typical answer should read something like “Solve this formula for X and then choose to invest in the project only if X>0” and write down the appropriate formula. For the essays, think of 3 or 4 appropriate sentences that express the key idea and write those down. Restrict yourself to writing something legible in the space provided. For example, in response to the question “Explain how the household saving rate can fall at the same time that the ratio of household net worth to income is rising.” You might write the following “Standard accounting measures of household savings do not include capital gains on assets as part of income. Thus, if asset prices rise rapidly, the ratio of household net worth to income can rise even if households save very little of the standard measure of their income” Something that short is perfectly adequate. You should spend the 6-7 minutes you have on the essay figuring out exactly what to say in the space provided.

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Question 1: a) Suppose the current price of gold is \$290 per ounce. The price of gold is expected to grow at 5 % per year for foreseeable future. If the appropriate discount rate is 8%, what is the present value of gold? Explain your answer. The current price of gold represents the discounted value of expected future gold prices. Therefore, the present value of gold is equal to its current price, \$290 per ounce. b) Suppose the current price of gold is \$300 per ounce and the price of gold is expected to increase at a rate of 5% per year for the foreseeable future. What is the current value of 0.2 million ounces of gold to be produced each year for the next five years ( the discount rate is 8% per year)? Explain your answer. By the same reasoning as in part (a), the present value of gold is \$300 per ounce. Since in each year 0.2 million ounces will be produced for the next five years, total production is one million ounces and the present value is \$300 million. One way to think about this is that you can essentially “produce” 0.2 million ounces of gold per year for the next five years by buying one million ounces of gold now, sticking this gold into a warehouse, and then selling 0.2 million of
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