Midterm I Econ 110 Spring 2010 Solutions

# Midterm I Econ 110 Spring 2010 Solutions - Duke University...

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1 Duke University Professor Michelle Connolly Department of Economics Spring 2010 Econ 110D: Intermediate Macroeconomics Midterm Exam I Make sure to use a different exam book for each part (i.e. There are 2 parts, so you will need 2 books). Good Luck. I. True, False, Uncertain. Short Answers. Explanation determines the grade. Only a few well chosen sentences are necessary, but you can use models and/or graphs to support your explanations. (36 minutes = 36pts, i.e. approx. 6 minutes per question). a. In the Robinson Crusoe world, a proportional decrease in technology implies that both substitution and wealth effects have occurred. After considering both effects, we conclude that consumption falls and work effort increases. False/Uncertain. A proportional decrease in technology has a negative wealth effect, which decreases consumption and increases work effort. The decrease also causes a substitution away from labor (whose MPL is now lower). Hence there is a shift from consumption to leisure as the price of leisure falls. Overall, consumption falls, but the net effect on labor is ambiguous. b. Assume Robinson Crusoe has utility, U=leisure*C, production y=2L, and of course only 24 hours in the day to divide between labor and leisure. How much will he choose to work per 24 hour period and how much consumption will he have? Since RC can only consume what he produces in that period, C=y=2L. Further, leisure = 24-L. This means that U = (24-L)*2L = 48L-2L 2 . He maximizes this utility: 48-4L=0. Hence, L=12. Since he works 12 hours, his output and consumption = 24 . c. An individual who is a net borrower will borrow more today and consume less next period if the interest rate falls today. False. The inter-temporal substitution effect leads the agent to consume less next period. However, since the agent is a borrower, the fall in interest rates also has a positive wealth effect which leads the agent to consume more in both periods. The net effect on consumption next period is ambiguous. d. Consumption is more volatile in the life-cycle hypothesis than in the permanent income hypothesis. True. In the life-cycle hypothesis, the MPC out of temporary income depends on the number of years left in a person’s lifetime, whereas for the permanent income hypothesis it depends on having an extremely long lived dynasty. For permanent shocks to income, the MPC is 1 under both hypotheses.

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