# mt1ans - Economics 202 Spring 2008 First Midterm Name...

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Economics 202 Name: _______________ Spring 2008 Professor Melick First Midterm 1. Suppose GDP in an economy amounts to 14000 in period 1 and that it is known with certainty that GDP will amount to 14700 in period 2. In this economy, the real interest rate is 5 percent and wealth (accumulated assets) amounts to 8000 in period 1. There is no government in this economy. a) Consumers in this simple two period economy desire to equate the present value of consumption in period 2 to twice the present value of consumption in period 1. Solve for the value of desired savings in period 1. How much do households borrow or lend in period 1? We start be setting the present value of consumption in the two periods equal to the present value of the resources available to finance that consumption and by setting the present value of future consumption equal to twice consumption in the present period. 2 1 1 1 14700 2 14000 8000 36000 1 1.05 3 36000 12000 14000 12000 2000 f f f f c y c c y a and c r r r y c c y a r c c s y c + = + + ⋅ = + + + + ⋅ = + + = + + = + ⋅ = = = - = - = Savings amounts to 2000. This is added to the household’s assets of 8000, giving a total of 10,000 that the household lends in order to finance the large increase in consumption in the second period.

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b) Suppose that a housing bubble bursts in this economy and housing prices plummet, with the implication that the value of wealth in period 1 falls from 8000 to 2000. If this is the case, solve for the value of desired savings in period 1. 2 1 1 1 14700 2 14000 2000 30000 1 1.05 3 30000 10000 14000 10000 4000 f f f f c y c c y a and c r r r y c c y a r c c s y c + = + + ⋅ = + + + + ⋅ = + + = + + = + ⋅ = = = - = - = c) In the space below, using a carefully labeled graph, illustrate and explain the effect of the crash in housing prices on goods market equilibrium. Discuss the predicted effect of the crash on the equilibrium real interest rate. The decline in wealth leads to an increase in savings because consumption falls but income
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## This note was uploaded on 05/13/2010 for the course ECON 323 taught by Professor Jakes during the Spring '10 term at Alcorn State.

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mt1ans - Economics 202 Spring 2008 First Midterm Name...

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