Midterm I - FORM B with solutions

Economics 259
Midterm I – Form B
Fall 2014
Name: ________________________________
You have 50 minutes to complete the 100 points worth exam. Make sure you show all your work
so you can get partial credit. If you get stuck in a problem, make an assumption (reasonable),
indicate it clearly, and continue with the problem. Before beginning the exam, please verify
that you have 6 pages with 23 questions in your exam booklet. Good luck!
Multiple Choice (each 3 points)
1. GDP is the market value of all ______ goods and services produced within an economy in a
given period of time.
a. consumer
b. used
c. final
d. intermediate
e. final and intermediate
2. Since 1960, the U.S. ratio of labor income to total income has:
a. been about 0.3.
b. been about 0.7.
c. increased steadily.
d. decreased steadily.
e. been about 2.5 to 1.
3. An increase in the price of imported goods will show up in:
a. neither the CPI nor the GDP deflator.
b. the GDP deflator but not in the CPI.
c. both the CPI and the GDP deflator.
d. the CPI but not in the GDP deflator.
e. definitely the CPI and possibly the GDP deflator.
4. In a classical model with fixed factors of production and flexible prices, the amount of
consumption spending depends on ______, the amount of investment spending depends on
______, and the amount of government spending is determined ______.
a. labor's share of output; capital's share of output; by the interest rate
b. the interest rate; disposable income; by tax revenue
c. the real wage; the real rental price of capital; by factor prices
d. taxes; the MPL; exogenously
e. disposable income; the interest rate; exogenously
5. If Y = AK0.5L0.5 and A, K, and L are all 100, the marginal product of capital is:
a. 200
b. 50
c. 1,000
d. 100
e. 500
6. The inconvenience associated with reducing money holdings to avoid the inflation tax is
a. shoeleather costs.
b. fixed costs.
c. menu costs.
d. variable yardstick costs.
e. debtor’s prison.
7. Which of the following is considered unemployed?
a. Jennifer Temple is working as a second-grade schoolteacher.
b. Frank Peabody is attending college full-time to earn a degree in elementary
c. Martin Hampton is working as a high school social science teacher, but is at home
sick with the flu.
d. Brenda Dewey does not currently have a job. She has sent her resume to several
school districts in the past week in the hope of finding a teaching position.
e. Kyle Brown does not currently have a job. He wants to be an elementary
schoolteacher. He has the appropriate degree. He has not looked for a position in the
last month because he doesn't believe schools are currently hiring.
8. Real GDP is a better measure of economic well-being than nominal GDP, because real GDP:
a. includes the value of government transfer payments.
b. adjusts the value of goods and services produced for changes in the foreign exchange
c. measures changes in the quantity of goods and services produced by holding prices
d. excludes the value of goods and services exported abroad.
e. includes producer, and not only consumer, basket of goods and services.
9. If the fraction of employed workers who lose their jobs each month (the rate of job
separation) is 0.01 and the fraction of the unemployed who find a job each month is 0.09 (the
rate of job findings), then the natural rate of unemployment is:
a. 9 percent.
b. about 11 percent.
c. 1 percent.
d. 90 percent.
e. 10 percent.
10. In the national income accounts, all of the following are classified as government purchases
a. purchases of military hardware.
b. payments made to Social Security recipients.
c. services provided by U.S. senators.
d. services provided by police officers.
e. services provided by U.S. military personnel
11. According to the neoclassical theory of distribution, in an economy described by a
Cobb-Douglas production function, workers should experience high rates of real wage
growth when:
a. average labor productivity is growing rapidly.
b. real interest rates are low.
c. capital's share of income is growing rapidly.
d. real interest rates are high.
e. there is a major inflow of immigrant workers.
12. The marginal product of labor is:
a. value of additional output when one dollar's worth of additional labor is added.
b. additional output produced when one additional unit of labor and one additional unit
of capital are added.
c. output divided by labor input.
d. additional output produced when one additional unit of labor is added.
e. additional output divided by total labor used.
13. One possible benefit of moderate inflation is:
a. the elimination of menu costs.
b. increased certainty about the future.
c. better functioning labor markets.
d. a reduction in boredom attributable to the changing prices.
e. a decrease in money velocity.
14. Crowding out occurs when an increase in government spending ______ the interest rate and
investment ______.
a. decreases; increases
b. increases; decreases
c. decreases; decreases
d. increases; increases
e. increase; remains unchanged
15. In principle, the GDP accounts should—but do not—have an imputation for:
a. meals cooked in restaurants.
b. housing services enjoyed by renters.
c. housing services enjoyed by homeowners.
d. purchasing a haircut at a local hair salon.
e. rental services of automobiles driven by owners.
16. If nominal GDP increased by 5 percent and the GDP deflator increased by 3 percent, then
real GDP ______ by ______ percent.
a. increased; 2
b. increased; 8
c. decreased; 8
d. decreased; 2
e. increased; 5
Short Answers
17. Unemployment I (3 points) When an unemployed person becomes discouraged and stops
looking for work, what happens to the rate of unemployment?
18. GDP (4 points) What was the approximate size of the US GDP in 2013?
19. Capital Inflow (8 points) Assume that a competitive economy can be described by a
constant returns to scale (Cobb-Douglas) production function and all factors of production
are fully employed. Holding other factors constant, including the quantity of labor and
technology, carefully explain how a one-time, 10 percent increase in the quantity of capital
(perhaps the result of a massive inflow of multinational companies) will change each of the
following (Hint: include both direction and magnitude of change)
a. the level of output produced;
b. the real wage of labor;
c. the real rental price of capital;
d. capital's share of total income.
20. Inflation (8 points) Consider two countries, Hitech and Lotech. In Hitech new arrangements
for making payments, such as credit cards and ATMs, have been enthusiastically adopted by
the population thereby reducing the proportion of income that is held as real money balances.
Over this period no such changes occurred in Lotech. If the rate of money growth and the
growth rate of real GDP were the same in Hitech and Lotech over this period, then how
would the rate of inflation differ between the two countries? Carefully explain your answer.
21. Unemployment II (9 points) Changes in economic policies will frequently have an impact
on the unemployment rate. Explain whether each of the policy changes described is likely to:
1) affect frictional or structural unemployment and 2) increase or decrease the measured
unemployment rate.
a. The government reduces the number of weeks of unemployment insurance that
unemployed workers can receive.
b. The government raises the minimum wage.
c. The government increases spending on job-training programs.
22. Money demand (10 points) If the demand for money depends positively on real income and
depends negatively on the nominal interest rate, what will happen to the price level today, if
the central bank announces (and people believe) that it will decrease the money growth rate
in the future, but it does not change the money supply today?
23. Reagan’s 1980s Policies (10 points) In the early 1980s President Ronald Reagan increased
defense spending and implemented large tax cuts at the same time. Use the model of the
long-run economy to analyze the effects of these policies.
a. (7 points) Use the long-run model of the economy to graphically illustrate the impact
of Reagan’s policies. Indicate what the model predicts will happen to i) public saving,
ii) national saving, iii) real interest rate, and iv) investment.
Increases (↑), decreases (↓)
or remains unchanged (--)
Public Saving
National Saving
Real Interest Rate
b. (3 points) Below you are given the actual data. How do model results fit with data
and if there are any differences, explain why data is not consistent with the model.
Note: Public Saving, National Saving and Investment are expressed as a percent of
GDP. All figures are averages over the decade shown.
Public Saving
National Saving
Real Interest Rate
Extra Credit
If you have not missed more than one class since the beginning of the semester, you can answer
the question below and earn 3 points extra credit.
24. The total income of everyone in the economy adjusted for the level of prices is called:
a. a recession.
b. an inflation.
c. a business fluctuation.
d. real GDP.
e. nominal GDP.
1. C
2. B
3. D
4. E
5. B
6. A
7. D
8. C
9. E
10. B
11. A
12. D
13. C
14. B
15. E
16. A
17. Around $17 trillion
17. Both U and L decrease by 1, but since U decreases by a larger percentage, U/L decreases.
Just by looking at the unemployment rate, one would say that conditions in the labor market are
improving. However, this is not the case as a person was so discouraged from trying to look for a
job that he quit looking.
19.a. Output increases by less than 10 percent because of diminishing returns to capital.
19.b. The real wage increases because the average productivity of labor increases (Y/L increases,
as Y increases and L is constant), so the MPL, which equals (1 – )Y/L, increases.
19.c. The real rental price of capital decreases because the average productivity of capital
decreases (Y/K decreases, as Y increases proportionally less than K), so the MPK, (пЃЎ)Y/K
19.d. Capital's share of income is unchanged since it depends only on the parameter (пЃЎ) from the
production function, which does not change.
20. The rate of inflation would be higher in Hitech.
There are two ways one can explain this. 1) Since money demand decreases in Hitech, supply of
real money balances (M/P) needs to decrease as well (or, better say, growth rates of money
demand and money supply need to be the same). To lower (or reduce growth of) M/P, P needs to
increase. Since Hitech and Lotech are the same in every other way, P will grow faster in Hitech.
2) According to the quantity theory, if the rates of money growth and real GDP growth are the
same, differences in rates of inflation are related to differences in velocity. The faster increase in
velocity leads to a higher rate of inflation, holding other factors constant. In Hitech the reduction
in the proportion of income held as real balances is the equivalent of a speedup in the rate of
velocity and, consequently, a higher rate of inflation in Hitech than in Lotech.
21.a. Frictional unemployment is likely to be reduced as unemployed workers take fewer weeks
to search for new jobs because of reduced benefits. This process is likely to reduce the measured
unemployment rate.
21.b. Structural unemployment will probably increase for those workers with marginal product
valued below the higher minimum wage. This policy change is likely to increase the measured
unemployment rate.
21.c. Frictional unemployment will be reduced if workers with obsolete skills receive training
that prepares them for available jobs. This policy change is intended to reduce the measured rate
of unemployment.
22. People will expect lower inflation in the future. The nominal interest rate will fall. Money
demand will increase. Since the central bank does not immediately decrease the money supply,
prices must fall to keep the newly increased money demand equal to the constant money supply.
Thus, current prices fall as a result of expected future decreases in money growth rates.
23. a. As G increased and T decreased, public saving (T-G) decreased. At the same time, national
saving (S=Y-C-G) decreased.
i) public saving - decreased
ii) national saving – decreased
iii) interest rate - increased
iv) investment - decreased
23.b. The model predicts all variables except investment well. The model predicts that
investment will decrease by the same amount as national saving, but data does not support that.
One possible reason is that we are not in a closed economy and a decrease in domestic saving
was accompanied by a larger inflow of saving from abroad, possibly because of a higher interest
rate. Hence, investment did not decrease by the full amount of a decrease in national saving.
24. D