econ101fall11exam2soln

econ101fall11exam2soln - Name: Section: T.A. Name: 180.101...

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Unformatted text preview: Name: Section: T.A. Name: 180.101 ELEMENTS 0E MACROECONOMTCS Fall, 2011 Second Term Examination Prof. Louis J. Maceini Time Allotment for the Exam: 60 Minutes Total Points on the Exam: 180 Points Answer Key INSTRUCTTQNS ' (a) At the top of this page, write your name, section number and TA name. You will get a bonus of 5 points if both the section number and TA name are completed con'ectly. (b) The exam contains 5 pages. Writing is permitted on both sides of each page. Answer each question on the side of the page specified. There will be instructions on where to place answers to questions on each side of each page. Answers that are placed on the wrong page or the wrong side of a page will not be graded. QUESTlQNS NB: You may answer Question 1 on both sides of this page. Question 1. (Total: 60 Points) Answer the following questions surrounding the Great Recession: Question l—a. (30 Points) The decline in nominal wealth in the U.S in 2007 and 2008 is often cited as a major cause of the Great Recession. Explain what the sources of the decline in nominal wealth were. And explain carefully how the decline in nominal wealth contributed to the Great Recession. Use an AD-AS diagram to illustrate your answer. NB: You may continue your answer to Question 1-21 on this side of this page. Answer A major cause of the Great Recession was the decline in nominal wealth that took place in 2007 and 2008. Nominal wealth declined as a result of the decline in housing prices and the decline in the stock market that occurred in 2007 and 2008. The decline in nominal wealth, given the price level, produced a decline in real wealth which produced a substantial decline in consumption spending. The key types of consumption spending that are affected by a decline in nominal wealth and thus real wealth are purchases of durable goods, like automobiles, purchases of new housing, entertainment expenses, etc. The decline in consumption spending reduced over—all aggregate planned spending. This is captured by a shift to the left of the AD curve. See the Graph. Given AS, the shift to the left of AD produced the decline in real income and output, which is a key aspect of the Great Recession. Students may use symbols like: tAo :> ti; 2 tC :> tE :> le which is the way I described the shift in AD on the slide 1 used in class. But this is not enough. There needs to be an explanation of what the symbols mean. 7 \l/ NB: You may answer Question 1-1) on both sides of this page. Question l-h. (30 Points) To counter the Great Recession, the Obama administration passed a bill in February, 2009 that was officially called the ARRA and popularly labeled the Obama Stimulus Package. Economists often break up the government expenditures component of a stimulus package into “new” expenditures and “replacement” expenditures. In the Obama Stimulus Package, identify an example of a “new” government expenditure and an example of a “replacement” government expenditure. Explain why each is a “new” expenditure or a “replacement” expenditure. Use an AD— AS diagram to illustrate the effects of each. (NB: You do not need to state the dollar magnitudes of each type of expenditure. Just state qualitatively what each type of expenditure is and illustrate its effects with an AD-AS diagram.) Answer Examples of new expenditures are infrastructure spending, energy spending, etc. Such expenditures are “new” spending, as they increase on net aggregate planned expenditures and shift the AD curve to the right, which tends to raise the level of real income. See the Graph. I r tr 4/ Ab C. //—’l5 NB: You may continue your answer to Question l-b on this side of this page. An example of “replacemen ” spending is Aid to State and Local Governments. Such spending offsets declines in aggregate spending that were going to take place as State and Local governments were experiencing declines in spending due to balanced budget amendments. In this case, the spending by the Federal Government on Aid to State and Local Governments merely replaces or offsets the declines in spending that were going to take place. It is therefore not a net increase in over-all spending. Such spending helps to prevent the economy from suffering further declines in real income, but it does not produce net increases in government spending and aggregate spending which would help offset the decline in spending that had already taken place. See the Graph. Question 2. (60 Points) Consider the following financial transactions: (i) The Treasurer of Johns Hopkins University deposits $5000 in currency in the University’s checking deposit at a branch of the M&T Bank in Baltimore. (ii) The Fed purchases $5000 in U.S. Government Bonds from XYZ Capital, which is a government security dealer in New York that has a checking deposit account at a branch of Citibank in New York. Compare and contrast the effects of these transactions on the reserves of the banking system, currency in circulation, and the Fed’s balance sheet. Be sure to identify both the similarities and differences. Explain carefully. Use balance sheets of the Fed and the individual banks, where appropriate, to illustrate your answer. Answer (i) The transaction where the J HU Treasurer deposits $5000 in currency in a Hopkins checking account at an M&T bank results in an increase in the J HU demand deposit at the M&T Bank and results in an increase in Reserves of the M&T Bank by $5000 in the form of currency in its vaults. M&T Bank R—Vault Cash + 5000 DD-JHU + 5000 (ii) The Transaction whereby the Fed purchases $5000 in US. Govemment Bonds from XYZ Capital results in an increase of $5000 in the demand deposit of XYZ Capital at Citibank and an increase in the reserves of Citibank of $5000 in the form of an increase V in Citibank’s Reserve Deposit account at the Fed. It also results in an increase of the Fed’s holdings of US. Government Bonds. To elaborate, the Fed pays for the Government Bonds by writing a check on itself. The check is made payable to XYZ Capital. When XYZ Capital deposits the check in its checking account at Citibank, the bank sends the check to the Fed for clearing. When the Fed receives the check, it raises the Reserve Deposit account of Citibank by $5000 and notes on its balance sheet that its holdings of US. Government Bonds have increased by $5000. Citibank R-RD at Fed + 5000 DD—XYZ Capital + 5000 Fed G8 + 5000 RD-Citibank + 5000 NB: You may continue your answer to Question 2 on this side of this page. Similarities and Differences: The key similarity between the two transactions is that they both result in an injection of reserves of $5000 into the banking system which will set off deposit creation. The differences are: (a) The deposit of currency in a demand deposit account in the M&T Bank results in an increase in reserves of M&T Bank in the form of currency in its vaults, while the purchase of U.S. Government Bonds results in an increase in reserves in the form of an increase in Citibank’s Reserve Deposit account at the Fed. (b) The deposit of currency results in a reduction in currency in circulation since vault cash is not counted as currency in circulation, while the purchase of U.S. Government Bonds does not affect currency in circulation. © The purchase of U.S. Government Bonds affects the Fed’s balance sheet in an increase in its portfolio of government bonds and an increase in its reserve deposits, but the deposit of currency does not immediately affect the Fed’s balance sheet. NB: You may answer Question 3—21 on both sides of this page. Question 3. (Total: 60 Points). Consider two countries: Alpha and Beta. The people of Alpha are opposed to income taxes, instead preferring to raise tax revenue through property taxes and sales taxes, which are autonomous taxes. On the other hand, the people of Beta prefer to raise tax revenue through income taxes rather than autonomous taxes. The economics of both countries are described by the following macroeconomic model operating under “completely slack conditions”: Y=E E=C+I+G C = 400 + (5 / 6m, Ym = Y — TX + TR TR = 360 1 = 400 G = 800 Tax Revenues for each country are different: Alpha: TX =1140 Beta: TX = (1/5)Y where Y is real income or output, E is aggregate real expenditure, C is real consumption expenditure, I is real investment expenditure, G is real government spending, Y is real disposable income, TX is real tax revenues, TR is real transfer dis payments. All dollar magnitudes are measured in billions of constant dollars. Question 3—31. (20 Points) Calculate the equilibrium levels of real income and consumption for each country. Show your work. Answer In general, the equilibrium levels of real income and consumption are determined by: Y*=_~.1_[E+brr_m+7+e] 1—b+bt c*=Y‘—T—G OI‘ C*=E+b[y*+fi-T3?—tr*] NB: You may continue your answer to Question 3—a on this side of this page. Country Alpha For Country Alpha, t z 0, and thus the equilibrium level of real income is detennined by: Y*=_L[E+bfi_bfi+i+a] 1—b = —-—L—[400 +(g—j360 ~(g—jl 140 + 400 + 800] = 1 [400+300—950+400+800] = (6)[950] = 5700 I 6 And the equilibrium level of consumption is * .... .— C" ==Y —-[ «G=5700—400—800=4500 Country Beta For Countiy Beta, T? = 0, and thus the equilibrium level of real income is determined by: 1 Y“: 1—b+bt [aging] =_....L..+_ 400+ 5 360+400+800 5 51 6 1——+~— 6 65 l. 3 6 [400 +300 + 400+ 800] = (3)[1900] = 5700 And the equilibrium level of consumption is c‘ =Y‘ ~T—é=5700—-400—800 =4500 NB: You may answer Question 3-b on both sides of this page. Question 23-h. (40 Points) Each country has been involved in military activities, which have now come to an end. The government estimates that the termination of military activities will result in a decline in military expenditures of $50 billion in each country. Policy—makers in both countries are worried about a recession and a decline in the standard of living. Which country will experience the bigger change in real income and consumption expenditures due to the decline in militaiy expenditures? Make the calculations. Show your work. And, most importantly, explain carefully any differences between the countries in the effects on real income and consumption expenditures of the decline in military expenditures. Answer General Formulas The simplest way to answer this question is to use the relevant multipliers. The general formula for the multiplier for real income is: éZ____1___ A5?” 1—b(1~t) 01‘ 1 _. AY————~————1_b(1_t) AG and AC‘ =AY‘—A@ Country Alpha In Country Alpha, t = O , so the government expenditure multiplier is AY 1 1 1 -——_—_—:—-————:———=—:6 6 6 Hence, AY=——1—AE§=—L(—50)=-L=6(~so)=~3oo 6 and AC' = A1”— A6 = —300 —(-50) = —-250 NB: This question can alternatively be answered using the formulas for Y * and C’. NB: You may continue your answer to Question 3-b on this side of this page. Country Beta In Country Beta, I"? = 0, so the government expenditure multiplier is A5 1——b(1-t) 1_§+§1 3 65 6 Hence, AY= 1 A6: 1 (~50)=i(—50)=3(-50)=-—150 l~b(l——t) 134.5; _2_ 65 6 And Ac“ = AY‘ — AG: —150—(-50) = —100 NB: This question can alternatively be answered using the formulas for Y i and C‘. Explanation This problem illustrates the importance of the principle that income taxes are an automatic stabilizer. When the economy is hit by a negative aggregate demand shock, like a decline in government expenditures, the ultimate decline in real income is lower in an'economy with income taxes than in an economy without income taxes. The basic reason is captured in the multipliers. In terms of the multipliers, in both economies, the primary stage of the multiplier is the same; the decline in government expenditures produces a decline in real income of the same amount in both economies. The differences arise in the secondary stages of the multiplier process. In an economy with income taxes, the decline in disposable income and thus consumption spending is smaller because disposable income drops less than the decline in real income because taxes decline. In an economy without income taxes, disposable income declines by the same amount as the decline in real income because taxes are unaffected by the decline in real income; as a result, consumption declines by a relatively large amount. ...
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econ101fall11exam2soln - Name: Section: T.A. Name: 180.101...

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