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PracticeMidterm - 152 Econ 152 Principles of Macroeconomics...

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Unformatted text preview: 152 Econ 152 Principles of Macroeconomics Colorado College Armando Lopez-Velasco Practice Questions for First Midterm Below are some sample questions for the Midterm. However, by no means these kind of questions are the only kind I will ask. There is some emphasis in this sample questions on the quantitative type which are arguably the harder to grasp and the reason I’m providing you with this handout. However, I could ask other types of questions related to Mankiw’s textbook, in the overheads or in the homeworks. My goal is to give you a balanced midterm. 1. The following table shows the production of goods X and Y in a given country. Table 5.1 a) b) c) d) Compute the Nominal GDP in each Year: Compute Real GDP using Year 1 as the base Year Compute the Deflator each Year What is the inflation rate in Year 3 as measured by the deflator? Answer Year 1 Nominal GDP Year 2 Year 3 110 150 250 Real GDP Year 1 P's 135 178 100 111.1 140.45 Inflation rate (%) 2. 110 Deflator N.A. 11.1 26.4 In a small closed economy (NX=0) there is only 1 firm which produces only wheat which can be consumed or stored for the next year. This firm has the following transactions: it sold wheat for $5000 to households, sold $1000 of wheat to government, and it has $2000 worth of wheat as inventory. The firm also paid $6000 to Households. Households consumed the wheat for $5000, and paid 1000 in taxes and re. The government in this economy runs a balanced budget (Taxes = Government Purchases) and it’s only role is to consume wheat and tax individuals for paying that wheat. a) b) Write the T-Accounts of each agent in the economy Compute GDP by Expenditure, by Income and by Value Added Firm Expenditure Income Wages 6000 5000 Profits 2000 1000 Sales Gov 2000 Inventory Sales HH Households Expenditure Income Buy Wheat 5000 6000 Wages Taxes 1000 2000 Profits Saving 2000 Government Expenditure Buy Wheat 1000 Income 1000 Taxes GDP by Expenditure: C = 5000, G = 1000, I (inventory investment)=2000 C+I+G = 5000 + 2000 + 1000 = 8000 = GDP GDP by Income: Wages = 6000, Profits = 2000 GDP = Wages + Profits = 6000 + 2000 GDP by Value Added: Firm has a value added of $8000 of wheat (It didn’t use any intermediate good) Private Saving = SP = 2000 Public Saving = SG = 0 (Balanced Budget) National Saving = SP + SG = 2000 = Investment 3. In 1996 the Consumer Price Index in the US was at a level of 156.9, and in 2005 the CPI was 195.3 . Please answer the following questions. Answers that don’t show how you arrive to your results won’t earn any points. a) b) c) A family earning 40,000 in 1996 needs how much in 2005 in order to maintain its standard of living? What is the accumulated inflation rate for the period 1996-2005? What is the average inflation rate for that 9 year period? Answer a) b) c) 4. (CPI2005/CPI1996 )*100 = (195.3 / 156.9)*100 = 1.2447 (Prices in 2005 are 1.244 times the prices in )*100 156.9)*100 1. 1.244 40,000*1.24 1996). Thus the family needs 40,000*1.2447 = $49,789.6 $4 24 47% Acc Inflation = ((CPI2005/CPI1996 )-1)*100 = 24.47% )2.467% ((CPI2005/CPI1996 )1/9 -1)* 100 = 2.467% 46 How many years will it take a country to double its GDP percapita if it grows at a rate of 5% per year? Answer: Use the rule of 70. n = 70/g = 70/5 = 14 years 5. If a country growth rate of GDP is 5%, capital (K) grew at 4% and hours-man grew also 4%, compute the following according to growth accounting methodology. Assume the capital share of income (alfa) is 25%. a) The growth rate of technology b) How much of the growth rate in GDP is attributed to increases in capital? c) How much of the growth rate in GDP is attributed to increase in Labor? d) Is this country Experiencing Capital Deepening? Explain why e) How much did GDP per worker (productivity) increased in this period? Answer: Answer: Use growth accounting (1gY = gA +α gK+ (1-α) gL a) gA = gY - α gK - (1-α) gL = 5% - .25 (4%) – (.75) (4%) = 5% - 4% = 1% . Out of the 5% growth in (1GDP, a full 1% is due to technological progress b) Attributed to capital = α gK =.25 (4%) = 1% c) Attributed to Labor = (1-α) gL =.75 (4%) = 3% (1d) There is no capital deepening as capital increased by the same percentage as labor. The same capital/labor ratio stay constant in this period. e) gY – gL = Growth in GDP per worker = 5% - 4% = 1% 6. Use the Supply/Demand of loanable funds to evaluate what would happen to Investment, National Saving, Public and Private Saving if the government finds a way to cut government expenditure on pork-barrel expenditure (expenditure with no good use to the economy pretty much). Also discuss the effects in the long run of this policy. National Saving would increase since Public Saving Increased (or there is a smaller budget deficit). The Saving deficit). The increase in National Saving implies a higher supply of loanable funds at every interest rate level, which Investment. Investment, in equilibrium implies lower interest rate and higher Investment. Since National Saving = Investment, Investment would increase also. This in the long run produces higher growth for some time, but not permanently. See the picture below permanently. int rate S = Sg + Sp S' = S'g + Sp r r' D L 7. L' Loanable Funds Two economists are arguing over the effect of budget deficits on the economy. One was arguing that a budget deficit decreases Investment and future growth, while the other said that budget deficits don’t change investment nor future growth. Explains their positions and assumptions on their analysis. Assume the budget deficit is the result of lower taxes (tax cut), keeping the same level of government expenditure. The first economist has the “traditional” on the effects of budget deficits. He argues that higher budget The deficits implies a decrease in public saving, while private saving won’t increase (or just a little). This in little). turn implies that the supply of savings is lower. Hence the equilibrium implies a higher interest rate that crowds out investment. In other words, many projects are not profitable because of the high cost of financing them. Since investment decreases, there is less capital in the future and this in turn implies decreases, lower growth. The effects are shown below Traditional Effects of Budget Deficits int rate S' = S'g + Sp S = Sg + Sp r' r D L' L Loanable Funds The other economist believes that households respond to this by saving the tax cut in order to be able to exactly pay the future tax rate increase. The story goes like this: individuals see that government increase. expenditure doesn’t change while taxes decrease. The government pays budget deficit by selling debt. decrease. Individuals realize that they will have to pay higher taxes in the future in order to pay the debt, they the debt, therefore save today enough in order to be able to pay the extra taxes in the future. Under these assumptions national saving doesn’t change because the decrease in public saving is exactly offset by the increase of private saving. This is an example of “Ricardian Equivalence”. The idea of Ricardian an Equivalence is that how government expenditure is financed (whether with taxes or with debt) is not important. In this example since national saving doesn’t change, then the interest rate and investment investment doesn’t change, and so future growth is the same. and Ricardian View (A tax cut while G doesn't change) int rate S = S'g + S'p S = Sg + Sp with S'g<S'g S'p>Sp such that S'g + S'p = Sg + Sp r D L Loanable Funds 8. Assume the supply of national saving doesn’t respond to interest rate (fixed at a level of 100 million). Explain why under these circumstances a policy of giving incentives to investment (assuming that those investment incentives represent lower tax revenue, and the government decreases G so that the budget deficit remains constant) won’t generate FUTURE growth in the economy. What would happen if instead of keeping a constant budget deficit the government doesn’t decrease G and therefore incurs in a bigger budget deficit? The idea here is that if private savings is constant, and also the budget deficit doesn’t change, then a policy of giving investment incentives would increase demand of investment. However, the economy has a demand constant national saving (public and private are constant), and therefore Investment doesn’t increase. The only thing that increases is the interest rate. Since investment doesn’t change we have that future growth rate. growth remains the same. The picture below assumes a constant budget deficit (investment incentives don’t mean a budget deficit). An inelastic supply of national saving int rate S = Sg + Sp r' r D' D L L' Loanable Funds The next picture shows what would happen in equilibrium to investment and national saving if giving investment incentives means also that the government loses some tax revenue. Under these circumstances Public saving decreases (either higher budget deficit or a smaller budget surplus), while private savings was assumed to be constant (Individuals don’t behave as in the ricardian equivalence). Therefore National Saving equivalence). would decrease, together with an increase in demand. This would result in lower national saving and lower investment, with also a higher interest rate. Since Investment decreases, growth in the future would decrease as there would be less capital in the economy. An inelastic supply of private saving Investment incentives that mean larger budget deficit int rate S' = S'g + S'p S = Sg + Sp r' r D' D L' L Loanable Funds 9. Compute the Present Value of the following cash flows a) You will receive $220 in one year. Current interest rate is 10% b) You will receive $100 today, 110 in one year and 121 in two years, r=10%. Answer a) FV =220. Then PV = 220/1.1 = $200 b) PV = 100 + 110/1.1 + 220/(1.1)2 = 100 + 100 + 100 = 300 10. A firm is considering whether to invest in a project with the following characteristics. The firm would have to construct and operate a factory after one year, which yields a negative cash flow. The project generates positive cash flows in periods 2, 3. The cash flows each period are given by {0,-2m, 1.5m, 1.5m}. Should the firm invest in this project if the interest rate is 10%? Hint: if the Hint PV of the positive cash flows is higher than the cost of the project, then the project is profitable. That is if Net Present Value (NPV) is positive, then the firm should take the project. Present Value of this investment is given by PV = 0 – 2m/(1.1) + 1.5 m / (1.1)2 + 1.5 m / (1.1)3 = $548,460 Since the present value of benefits, net of the present value of costs is positive, this is a good investment. Another way to see this is the following. By taking this project the firm earns more money than putting the present value of 2 millions today (2m/1.1 = 1.8m) into the bank at 10%. This in turn can be translated into the following. If the present value of the investment including the costs is positive, that means that the investment generates a rate of return (interest rate) that is higher than the opportunity cost given by the 10% available at the bank. Thus the firm is better off by investing in this project. 11. What should the price of an asset be today if it pays the following cash flows, {0, $5, $5, $5, $5, $105} and the interest rate is 4%? This could be an example of a coupon-paying bond. PV = Price = 0+ 5/(1.04) + 5/(1.04)2 + 5/(1.04)3 + 5/(1.04)4 + 105/(1.04)5 Price = $104.45 12. According to the Efficient Market Hypothesis, why is it typically a good idea to invest in index funds instead of actively managed index funds? It is very hard (impossible) to consistently beat the market. In general, active fund managers that beat the market one year tend to do worse off than the market the next year. When we talk about the market we all mean all of the stocks in the index (say S&P 500). That is pretty much like flipping a coin and winning by chance and losing by chance. In addition, actively managed funds have to pay very high transaction costs since they buy and sell very often. Empirically if you buy the whole index you are typically better off. This help explains why portfolio chosen by monkeys are not worse off than by professionals. 13. What is the future Value after 10 years of $200 today, if the interest rate is 5%? FV = PV(1+r)n = 200(1.05)10= $325.78 14. Explain what is the “catch-up” effect discussed in class. The “catch-up” effect refers to the fact that countries that start off poor tend to grow faster than economies “catchthat start up rich. This can be explained by the marginal productivity of capital, which is very high in catchcountries with low capital per worker (which in turn imply countries with low wages), the catch-up effect is the result of capital deepening in countries that start poor. 15. Mention 2 reasons why the CPI is thought to overstate the cost of living. Any 2 of the following 3 are right. 1) The substitution bias. 2) The introduction of new goods bias, 3) Unmeasured quality change. 16. Explain why sometimes the inflation as calculated by the deflator differs from inflation calculated by the CPI. There are 2 reasons. 1) GDP deflator reflects only the goods that are being produced domestically, while the CPI considers goods that are part of the typical consumption basket (which can be produced domestically or typical imported). 2) The basket for the CPI is fixed, while the GDP deflator compares goods that are currently produced to the prices of the same goods in the base year. ...
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