Sample Mid AK - Vassar College Fall 2007 Sample Midterm...

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Vassar College Fall 2007 Sample Midterm Answer Key Please note that the sample midterm is longer that the actual midterm 1. Discuss the effects of government deficits on the current account. Answer: See pages 306–307 A hard and difficult issue. During the Reagan administration, the creation of twin deficits, where by slashing taxes, government deficits increased, which was accompanied with increased current account deficits. Using the identity, CA = Private Saving – I – (G – T), one can see that if private savings and I are constants, an increase in the deficit, namely an increase in (G – T), necessarily increases the CA deficits by the same magnitude. However, government budget deficit may change both private savings and investment, thus avoiding a creation of the twin deficits. An example is the European countries reducing their budget deficits just prior to the introduction of the euro in January 1999. Now, under the “twin deficits: theory, one would have expected the EU’s current account surpluses to increase. This has never happened. The main reason was sharp reduction in private saving rates. A good answer should discuss Ricardian equivalence that argues that when the government cut taxes and raises its deficit, consumers anticipate that they will face higher taxes later to pay for the resulting government debt. In anticipation, they raise their own private saving to offset the fall in government saving. In addition, one should mention wealth effect in anticipation of one Europe, assets prices increased, lowering private saving rates. 2. “The Balance of payments is always balanced.” Discuss Answer: True. Every international transaction automatically enters the balance of payments twice, once as a credit and once as a debit. Current account + financial account + capital account = 0 3. Explain how government deficits fell yet current account surpluses remained the same in the EU prior to adopting the euro. Also explain this in the context of the “twin deficits” theory. Answer: Current accounts didn’t change due to a sharp fall in the private saving rate, which declined by about 4 percent of output, almost as much as the increase in government saving. The behavior of private savers neutralized the government’s efforts to raise national saving. The twin deficits theory, the idea of government deficit coupled with a sharply increased current account deficit, expects the EU’s current account surplus sharply as a result of the fiscal change. 4. Explain the concept of Ricardian equivalence.
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Answer: This an economic theory of taxes and government deficits. It argues that when the government cuts taxes and raises its deficit, consumers anticipate higher taxes later to pay off the eventual government debt. Thus, they will raise their own private saving to offset the fall in government saving. Governments that lower their deficits will induce the private sector to lower its own saving. However, this doesn’t hold in practice. Economists attribute only half of the decline in
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This note was uploaded on 09/23/2008 for the course ECONOMICS 240 taught by Professor Cramer during the Spring '08 term at American University in Bulgaria.

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Sample Mid AK - Vassar College Fall 2007 Sample Midterm...

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