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Econ 100B
Macroeconomic Analysis
Professor Steven Wood
Spring 2010
Exam #1 ANSWERS
The answers on this test are entirely my own work. I neither gave nor received any aid while taking
this test. I will not discuss the questions on this test until after 5:00 p.m. on February 23, 2010.
______________________
Signature
Any test turned in without a signature indicating that you have taken this oath will be assigned a grade
of zero.
Exam Instructions
1. When drawing diagrams, clearly and accurately label all axis, lines, curves, and equilibrium points.
2. Explanations should be written in pencil or black. Legibility is a virtue; practice good penmanship.
3. Explanations should be succinct and to the point; you may use bullet points and commonly used
mnemonics.
Good Luck!
1. Your boss wants to know if the company should lay off any workers. You answer that they should lay off
workers only if the:
2. Originally an unskilled worker, Judy attends the University of California, Berkeley where she acquires new
skills that give her access to a job with a higher hourly wage. Assuming that her preferences about leisure
are not affected by the change in jobs, how would this affect her supply of labor?
a. Judy will supply more labor due to both income and substitution effects.
b. Judy will supply less labor because her decision is based only on the income effect.
c. Judy will supply more labor because her decision is based only on the income effect.
d. The effect on Judy’s labor supply is ambiguous because the income and substitution effects
work in opposite directions.
3. Okun’s law states that the gap between actual output and full-employment output increases by 2 percentage
points for each 1 percentage point increase in the unemployment rate. Why does an increase in
unemployment lead to twice as large an effect on output?
4. An invention that increases the future marginal product of capital would cause an increase in desired
investment, which would cause the investment curve to shift to the _____ and would cause the real interest
rate to _____.
a. Left; increase.
b. Left; decrease.
c. Right; increase.
d. Right; decrease.
5. Your friend claims that the United States is a net international debtor. The best way of testing this claim is
to see whether:
a. The desired amount of exports must equal the desired amount of imports.
b. The desired amount of exports must equal the desired amount of imports minus the current
account balance.
c. The desired amount of national saving must equal the desired amount of domestic investment.
d. The desired amount of national saving must equal the desired amount of domestic
investment plus the current account balance.
7. If business taxes rise in a large open economy it will cause the current account to _____ and saving to
_____.
a. Increase; increase.
b. Increase; decrease.
c. Decrease; decrease.
d. Decrease; increase.
8. Robert Fogel, a Nobel Laureate in economics, has argued that better health and a higher level of nutrition
of workers is important in generating higher standards of living. In the Solow growth model, we could
represents such a change as:
a. An increase in technology.
b. An increase in labor force growth.
c. Higher depreciation rates because there are now more people working.
d. A one-time increase in the labor force because this effectively leads to more workers.
9. The “IT Revolution” has led to an increase in productivity but also to an increase in the depreciation rate
because computers and telecommunications equipment have to be replaced more often. Overall, then:
10. Labor force growth rates tend to fall as a country becomes richer. Compared with the standard Solow
growth model, this would lead to:
1. Open Economy Desired Saving – Desired Investment Model (35 points). Suppose that the world
economy is composed of only two large, open-economy countries—China and the European Union—and
that the European Union is running a substantial current account deficit.
a. Based only on this information, use 2-country Open Economy Desired Saving – Desired
Investment diagrams to clearly and accurately show the initial equilibrium situation in each
country. These diagrams should be drawn in BLACK.
rw1
rw0
Id0 Id1
Id0
In the 2-country large open economy model, the equilibrium real world interest rate is set at
the level where the current account deficit of one country, in this case the European Union,
is exactly equal in magnitude to the current account surplus of the other country, in this
case China. The initial equilibrium world real interest rate is given by rw0.
In the European Union graph above, at the initial equilibrium world real interest rate, rw0,
the European Union has a current account deficit given by CA0 with desired saving of Sd0
and desired investment of Id0.
In the China graph above, at the initial equilibrium world real interest rate, rw0, China has a
current account surplus given by CA0 with desired saving of Sd0 and desired investment of
Id0.
d. Provide a brief economic explanation for the results you have shown in your diagrams above
and explain why these changes take place. Be sure to include in your discussion what happens to
the levels of desired investment and desired saving and the current account balance in each
country.
In China, the increase in government spending is for infrastructure projects so this is also an
increase in desired investment at every real interest rate level. This can be represented by a
rightward shift of the desired investment function from Id0 to Id1 in the China diagram
above.
In the European Union, the increase in government spending financed by borrowing with no
Ricardian equivalence reduces national saving at every real interest rate level. This can be
represented by a leftward shift of the saving function from Sd0 to Sd1 in the European Union
diagram above.
The increase in desired investment in China increases the worldwide demand for loanable
funds at every real interest rate. The declines in national saving in both China and the
European Union reduce the worldwide supply of loanable funds at every real interest rate.
Because the worldwide demand for loanable funds now exceeds the worldwide supply of
loanable funds, the world real interest rate must rise until a new equilibrium world real
interest rate is reached at rw1 where the current account deficit in the European Union is
equal in magnitude to the current account surplus in China.
As the world real interest rate rises from rw0 to rw1 several things will happen in each
country.
In the European Union, a higher real interest rate will increase desired saving along the new
desired saving function and reduce desired investment along the original desired investment
function. The net effect is that national saving declines from Sd0 to Sd1, desired investment
declines from Id0 to Id1 and the current account deficit declines from CA0 to CA1.
In China, a higher real interest rate will increase desired saving along the new desired
saving function and reduce desired investment along the new desired investment function.
The net effect is that national saving declines from Sd0 to Sd1, desired investment increases
from Id0 to Id1 and the current account surplus declines from CA0 to CA1.
a. Based only on this information, use a Solow growth model diagram to clearly and accurately
show the economy’s its initial steady state. This diagram should be drawn in BLACK.
(Y/N)0
(Y/N)A
(Y/N)B
(Y/N)C (Ib/N)0
(S/N)0
“A”
(S/N)1
“B” (S/N)2
“C”
The U.S. economy is initial at steady state “A” where actual saving (or investment) per-
worker is exactly equal to balanced-investment-per-worker at a capital-to-labor ratio given
by (K/N)A. At this capital-to-labor ratio, the production function indicates that income-per-
worker is (Y/N)A.
In the steady state, income-per-worker, which is (Y/N)A, is not changing. Therefore, the
economy’s long-run equilibrium growth rate is exactly equal to its labor force growth rate,
i.e., ∆Y/Y = ∆N/N.
d. Provide a brief economic explanation for the results of what you have shown on your diagram
above.
Once the saving function has shifted down the economy’s steady state is now at “B” where
the new lower saving-per-worker is exactly equal to balanced-investment-per-worker at a
lower capital-to-labor ratio, given by (K/N)B. At this new lower capital-to-labor ratio, the
production function indicates that income-per-worker has declined from (Y/N)A to (Y/N)B.
f. Provide a brief economic explanation for the results of what you have shown on your diagram
above.
An increase in exports results in a decline in the current account balance, either less net
foreign borrowing or more net foreign lending. Either way, the nation’s saving rate declines.
This can be represented by a downward shift in the saving function from (S/N)1 to (S/N)2.
Once the saving function has shifted down the economy’s new steady state is at “C” where
the new lower saving-per-worker is exactly equal to balanced-investment-per-worker at a
lower capital-to-labor ratio, given by (K/N)C. At this new lower capital-to-labor ratio, the
production function indicates that income-per-worker has declined further from (Y/N)B to
(Y/N)C.
Once government spending and exports have increased, saving-per-worker is less than
balanced-investment-per-worker at the economy’s initial steady state’s capital-to-labor
ratio, (K/N)A. This implies that actual investment is less than what is required to keep the
capital-to-labor ratio constant at (K/N)A.
As a result, the capital-to-labor ratio declines. As the capital-to-labor ratio declines, income-
per-worker will decline along the original production function, (Y/N)0, saving-per-worker
will decline along the new, lower saving function (S/N)2, and balanced-investment-per-
worker will decline along the original balanced investment line, (Ib/N)0.
The capital-to-labor ratio will continue to decline until saving-per-worker once again exactly
equals balanced-investment-per-worker at steady state “C”. Once the economy reaches
steady state “C”, the capital-to-labor ratio will stabilize at (K/N)C and income-per-worker
will have declined from (Y/N)A to (Y/N)C but stabilize at (Y/N)C.
During the transition period from steady state “A” to steady state “C”, the capital-to-labor
ratio declines from (K/N)A to (K/N)C while income-per-worker declines from (Y/N)A to
(Y/N)C. Consequently, economic growth is slower than labor force growth, i.e., ∆Y/Y < ∆N/N
during the transition period.
However, once steady state “C” is reached, the capital-to-labor ratio will stabilize at (K/N)C
and income-per-worker will stabilize at (Y/N)C. As a result, at steady state “C”, economic
growth will exactly equal labor force growth, i.e., ∆Y/Y = ∆N/N. This is the same growth
rate that the economy had in steady state “A” because the labor force growth rate did not
change.