Exam 1 Econ 304 Chuderewicz Fall 2016

Exam 1 – Econ 304 – Chuderewicz – Fall 2016

Name ______Last 4 (PSU ID) ______

Section: Please Check:

Section 001 - 10 Thomas 1:25 pm ______

Section 003 - 010 Sparks 3:35 pm ______

PLEASE PUT THE FIRST TWO LETTERS OF YOUR LAST NAME ON TOP RIGHT HAND CORNER OF THIS COVER SHEET – ONLY NON-PROGRAMMABLE CALCULATORS ALLOWED. THANKS AND GOOD LUCK!!!

Total Points for exam = 245

Test time = 120 minutes

Approximately one minute for every two points

To help with time management if spreading time evenly

Question #1 = 45 points..... 23 minutes

Question #2 = 50 points ...... 25 minutes

Question #3 = 60 points.... 30 minutes

Question #4 = 40 points ....20 minutes

Question #5 = 50 points..... 25 minutes

1 Please answer all questions. You must show all work or points will be taken off.

1. (45 points total) Homer Simpson, does not abide by the life cycle theory of consumption. Homer has a “let’s live life like it’s our last day” mentality and thus, he prefers to consume more today, relative to the future. In particular, Homer prefers to consume exactly twice as much today (c), relative to consumption next period (cf). Homer’s current income = $400K and his future expected income = $400K. He has no wealth (neither current nor expected) since he lives like today is his last! Homer faces a real interest rate of 0.05.(5%). Please answer the following questions. a) (5 points) Solve for Homer’s optimal consumption basket today (C*) and his optimal consumption basket next period (Cf*). Please provide a completely labeled graph depicting these results and label this initial point as C*A.

(10 points for a completely labeled graph – be sure to label the no lending / no borrowing point = NL/NB) Use space above. b) (5 points) Janet Yellen and the Fed are not happy with the state of the economy and worry about an impending recession. As a result, the Fed lowers rates so that the new real rate is negative 5%. Recalculate the optimal bundle for Homer

and add this point to your graph and label as point C*B.

2 c) (10 points) Did the Fed policy work as in stimulating the economy as measured by the change in Homer's current consumption? That is, did Homer's consumption rise? Why or why not? Explain using the income and substitution effects. Please use actual numbers to support your answer.

d) (5 points) Now suppose that Homer is credit constrained and banks will not lend to him unless Homer agrees to an r = 15% - his balance sheet is a wreck. So Homer now faces an r = 15%. What is his optimal bundle now?

In the space below, draw the new situation for Homer with the credit constraint imposed. Note, Homer can save at the Fed rate = negative 5% but the borrowing rate he faces is 15% given the credit constraint. Label this point as C*C. Again, please be sure to label your graph completely.

10 points for correct and completely labeled graph

3 2. (50 points total) You own a golf resort and you need to determine how many golf carts you need to buy to maximize profits. Please answer the following questions given the information below. Please be sure to SHOW all work!

A brand new golf cart costs 1800 rounds of golf (this is your output) and the rate of depreciation is 6% (0.06).

The real interest rate is 4% (.04).

And the expected marginal product of capital is given by MPKf = 500 – 10K.

There is a tax on capital so tao (τ) = 25% (.25)

a) (5 points) What is the (tax adjusted) user cost of capital and what is this user cost expressed in? (Show work)

b) (5 points) How many golf carts should you buy to maximize profits? Show work

Draw a uc/K graph depicting the state of affairs and label this initial profit maximizing condition as point A.

A correctly drawn and completely labeled diagram is worth 10 points

4 Now conditions change. The following two shocks occur simultaneously: i) the government offers an investment tax credit = .25 = ITC. ii) the expected marginal product of capital changes and is now MPKf = 400 – 10K. c) (5 points) Resolve for K* and show as point B on your uc/K diagram.

d) (10 points) Given the two shocks as above, explain the intuition underlying the change in the profit maximizing level of golf carts (i.e., why does the firm change its behavior?), making sure you refer to the firm’s profit maximizing condition (write it out!). Be specific and write this like you were a professional economist! Be sure to compare the actual user cost to the actual MPKf after the shocks, holding K constant at its level from part b).

e) (5 points) Suppose that the Federal Reserve had a goal to get the capital stock (the number of golf carts purchased) back to its initial level as in part b. Given the two shocks as above, what would they have to do to the real rate of interest to achieve their objective? Please show all work and I am looking for a specific number (i.e., r = ?). Please add this development to your diagram as point C.

5 f) Finally, draw a desired investment diagram (completely labeled with the relevant shift variables) depicting the initial equilibrium as point A (simply draw a negatively sloped ID curve going through point d A). Label the initial level of desired investment as I A. Note importantly that we do not have numbers for desired investment, but that’s ok, we are focusing on the change in desired investment. Then show, as point B, after the two shocks. Finally, show how the Fed policy maps to your investment diagram and label as d point C with the corresponding level of investment labeled as I C.

A completely labeled and correct diagram is worth 10 points (make sure you include the relevant shift variables in parentheses or points will be taken off).

6 3. (60 points) We discussed the article ‘2% is not enough' from the Economist magazine. We also discussed the speech made by Ben Bernanke in 2005. Please answer the following questions: a) (15 points) The article from the Economist discussed the idea that the equilibrium real interest rate has changed in the last few years. In the space below, draw a graph, using our goods market equilibrium condition (S = I) to depict this change in r*. Start with the initial r* and label as point A. Then show the movement to point B and the new, current value of r*. Hint, we calculated the change in the r* in HW #1. Please label your graph completely and EXPLAIN, referring to your graph, why the equilibrium r has changed.

b) (15 points) The article mentions that at one point, this natural (equilibrium) real rate of interest was as high as 3.5%. Similar to what you did in part a) above, draw a graph and explain why this equilibrium rate rose - start with an initial r* = 2% and label as point A. Then show on the graph the movement to r* = 3.5% and label as point B. Please explain the intuition as to why r* rose and when did this development likely occur?

7 c)(10 points) The title of the article is 2% is not enough. What is that all about???...... 2 % of what and why is it not enough? Explain in detail! Use an equation (or two) to support your answer.

d)(20 points) Early in Ben Bernanke speech titled The Global Saving Glut and the U.S. Current Account Deficit in March of 2005, he argues that he can explain in both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today. In the space below, draw two diagrams side by side, with the US on the left and China on the right and show exactly how Bernanke explains 1) the increase in the current account (trade) deficit and 2) the low level of long-term interest rates. Please label your graph completely - and explain....we did this in class!

8 4. (40 points total) Initial conditions in the goods market

Cd = 800 + .50(Y-T) – 400r Id = 400 – 600r G = 200 T= 200 Y= 2500 a) (10 points) Given the initial conditions, solve for the equilibrium real rate of interest (that clears the goods market) and the associated levels of desired savings and desired investment (note, Y is given for you).

Draw a Sd = Id diagram in the space below locating this initial equilibrium as point A.

10 points for correct and completely labeled diagram (be sure to put relevant shift variables in parentheses next to each function)..

WE NOW EXPERIENCE TWO SHOCKS THAT OCCUR SIMULTANEOUSLY (Y does not change) i) The new consumption function: Cd = 820 + .5(Y - T) - 400r ii) The new investment function: Id = 420 - 600r b) (5 points) What could cause such a change in the consumption function? Please give two specific and well supported reasons. Be sure to explain your answer.

9 c)(5 points) solve for the new goods market clearing equilibrium and label as point B on your graph.

d) (10 points) Assuming the shock to investment was due to a change in animal spirits (AS), draw a user cost - MPK diagram depicting point A and point B. Note: we don't know the value of K* so simply label it as K*A and K*B.

10 points for correct and completely labeled diagram

10 5. (50 points total) We assume that the world consists of two large open economies, USA and China.

USA Initial Conditions

Cd = 400 + 0.5(Y-T) – 300rw Id = 450 – 200rw Y = 2400 T = 200 G =500

China Initial Conditions

d w C F = 500 + .5(YF – TF) – 300r d w I F = 400 – 200r YF = 2000 TF = 400 GF = 300 a) (10 points) What is the equilibrium interest rate that clears the international goods market? Show all work

11 b) (5 points) Now calculate the levels of desired savings and investment for each country at this equilibrium world real interest rate .

c) (5 points) Which country is ‘spending beyond its means’ and which country is the saver? What exactly do we mean by the phrase ‘spending beyond its means’ in this context. Be sure to define and use the word absorption in your answer and compare the level of in each country to its income. Explain.

Draw two diagrams side by side, with the US on the left and the China on right. Locate this initial equilibrium as points A on both diagrams Be sure to label diagram completely with only the relevant shift variables in parentheses.

15 points for correct and completely labeled diagrams

12 We now have a change in conditions: The new President of the United States along with Congress pass a tax hike so that taxes in the US are now T = 280. All else remain the same. d) (5 points) Resolve for the world real interest rate that clears the international goods markets along with the ‘new’ Sd and Id for each country and add these results to your diagram labeling this new equilibrium as point B on both of your diagrams. (10 points)

e) (10 points) Now comment on what has happened to the trade balance for each country and relate to the movie clip from Colbert about spending beyond our means. Recall that Fareed Zakaria (the guest) suggested that we (the US) needed to go to alcoholics anonymous (AA). Are your results consistent with the US going to AA? Why or why not? Explain and please be specific. Also, what happened to investment in both countries and why. Again, be specific.