Econ 1120 INTRO MACRO Spring-2012 March 1, 2012

ECON 1120 – INTRO MACRO – Fall-2013 –November 7, 2013

PRELIM #2 (Regular)

PRINT YOUR NAME: ______Your C.U. NetID: ______

YOUR C.U. STUDENT NUMBER: ______

Check YOUR TA’s NAME:

______TA = Naoko Iida (Friday sections)

______TA = Donghwee Kwon (Tuesday sections)

______TA = Jongrim Ha (Thursday sections)

______TA = Bryce Little (Wednesday sections)

INSTRUCTIONS:  There are two parts in this exam.

o Part I: 16 multiple choice questions @ 3 points each (48 points)

o Part II: 4 short essay questions (52 points)

 ANSWER ALL QUESTIONS. TOTAL POINTS=100. TOTAL TIME=90 minutes.  Prelim2 score weights 25% of final grade.  You will have five bluebooks. Write your ID, name on the front page of EACH book.  On the top of the front page of bluebooks, write “Multiple Choice,” “Essay Q1,” “Essay Q2,” “Essay Q3,” and “Essay Q4,” respectively.  Write down your answers in different bluebooks. Your contents should match with the title of the bluebook.  Read all questions carefully.

 Write legibly and remember to label all graphs and axes in diagrams

EXAM TAKING POLICY:  NO QUESTIONS CAN BE ASKED DURING THE EXAM ABOUT EXAM CONTENT: If you need to use the restroom, or you need a pencil or scratch paper, or some other supply that we might have, raise your hand and wait for the proctor to come to you. Only one person can be out of the examination room at a time, and the proctor will hold onto your exam papers while you are out at the restroom.

 NO CELL PHONES. NO CALCULATORS. NO INTERNET-ACCESSIBLE DEVICES. 1  NO BOOKS. NO NOTES. NO HELP SHEETS.

2 Part I: Multiple Choice Questions. 1. If the long-run aggregate supply curve is vertical, then the multiplier effect of a change in net taxes on aggregate output, in the long run,

A) depends on the price level.

B) is one.

C) is zero.

D) is infinitely large.

2. In terms of the Aggregate Supply curve, the “long-run” refers to

A) a period of time in which wages can be adjusted to changes in other prices.

B) a period of time during which an increase in the cost of production causes a change in the NAIRU.

C) a period of time in which new technology allows the production possibility frontier to expand.

D) a period of time in which an expansionary fiscal policy shifts the aggregate demand curve.

3. Given the information in the table, ______millions of people are in the labor force, and unemployment rate is ______. Category Number of people (millions) Less than 16 years old 10 Full-time workers 40 Part-time workers 5 Looking for work 5 16-64 aged, not looking for work 10 Retired 30 A)60; 25%.

B)50; 10%

C)45; 11.1%

D) 50; 20%

E) 70; 21.43%

F) 60; 8.33%

3 4. According to advocates of a vertical long-run Phillips curve, the natural rate of unemployment is determined by

A)frictional and structural unemployment.

B)frictional unemployment only.

C)frictional, structural, and cyclical unemployment.

D) structural and cyclical unemployment.

5. Which of the following statements about wages are true?

I. According to sticky wage theory, wages are just as likely to be stuck in the upward direction as they are in the downward direction. II. One explanation for downwardly sticky wages is that firms enter into social or implicit contracts with workers not to cut wages. III. Workers in one industry may be unwilling to accept a pay decrease because they are concerned that their wage will fall relative to workers in other industries.

A) I, II

B) II, III

C) II only

D) III only

E) I, II, III

6. The NASDAQ Composite is

A) an index based on the stock prices of 30 actively traded large companies.

B) an index based on the stock prices of over 5,000 companies traded on the NASDAQ Stock Market.

C) an index based on the stock prices of the largest 5,000 firms traded on the New York Stock Exchange, the NASDAQ Stock Market, and the American Stock Exchange.

D) an index based on the stock prices of the largest 500 firms traded on the NASDAQ Stock Market.

7. Time lags can limit the effectiveness of stabilization policy. Which of the following statements are true?

A) Implementation lags are usually longer for fiscal than for monetary policy

4 B) Recognition lags are often longer for fiscal policy than for monetary policy

C) Response lags depend on the size of the national debt relative to the deficit

D) All of the above

8. ______is passed by the U.S. Congress and signed by President Reagan in 1986. This law set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991.

A) Glass-Steagall Act

B) Gramm-Rudman-Hollings Act

C) Dodd-Frank Act

D) Foghorn-Leghorn amendment

9. Deficit-targeting, automatic spending cuts to eliminate or reduce the deficit, or debt ceiling legislation may have the effect of ______the economy when there is a ______demand shock.

A) destabilizing; negative

B) destabilizing; positive

C) stabilizing; negative

D) stabilizing; positive 10. A household’s consumption and labor supply decisions are ______. A) determined simultaneously. B) determined recursively; once the household decides a level of consumption, a level of labor supply is naturally followed. C) determined independently. D) determined recursively; once the household decides a level of labor supply, a level of consumption is naturally followed.

11. The government influences household behavior mainly through income tax rates and transfer payments. Increases in transfer payments are likely to ______consumption and ______labor supply. A) increase; increase B) decrease; decrease C) increase; decrease 5 D) decrease; increase E) increase; do not change F) do not change; decrease

12. The accelerator effect is the tendency for investment to ______when aggregate output decreases and to ______when aggregate output increases, ______the decline of output or the growth.

A) decrease; increase; decelerating

B) decrease; increase; accelerating

C) increase; decrease; accelerating

D) increase; decrease; decelerating

13. Which of the following is NOT the goal of Social Security?

A) To help ensure adequate retirement income.

B) To help uninsured workers be protected.

C) To reduce dependency of the retired on welfare.

D) To ensure that benefits bear some positive relationship to contributions

E) All of the above are the goals of Social Security.

14. Which of the following statements about Social Security are correct?

I. It is designed to be a pay-as-you-go system II. It contributes to domestic private capital formation III. Interest on the Social Security trust funds is a primary source of the Social Security’s revenue. IV. Social Security has often collected more in taxes than it pays out in benefits.

A) I, II

B) I, III

C) II, IV

D) I, IV

E) II, III

F) I, II, IV

15. The velocity of money can be defined as 6 A) the average number of times a dollar changes hands during the year.

B) the rate at which the Fed expands the money supply.

C) the inverse of time lag of implementing monetary policy.

D) the ratio of the money stock to real GDP.

E) the aggregate withdrawal amount from checking accounts per day divided by population.

16. The Laffer curve demonstrates that

A) reducing tax rates can increase aggregate demand.

B) if expectations are rational, markets will usually clear.

C) increasing tax rates can decrease tax revenues.

D) negative price surprises can decrease output.

E) reducing tax rates can create new jobs.

Part II: Essay Questions

Question 1 (13 points) The following graph shows the short-run aggregate supply (AS) and aggregate demand (AD) curves in equilibrium. Consider the case where the OPEC (Organization of the Petroleum Exporting Countries) decides to boost its official production quotas, resulting in lower energy costs.

Changes in energy costs are assumed to be passed through to overall price level. Please answer the following questions. a) Explain what a Phillips curve is in one sentence (3 Points) A Phillips curve shows the short-run trade-off between unemployment and inflation due to shifts in the AD curve along the short-run AS curve. (full credit only if you mention both unemployment and inflation rate) 7 b) Show the impact of this change in short-run aggregate supply on the short-run Phillips curve. Use graphs. (5 Points) By assumption, lower energy cost implies the AS curve shifts. Therefore, OPEC’s decision shifts the aggregate supply curve to the right from AS1 to AS2. Then, the short-run Phillips curve shifts to the left. (2 pts) Then, the short-run Phillips curve shifts to the left. (3 pts)

c) The government wants to take advantage of this situation to boost the economy. Considering OPEC’s decision, evaluate short-run and long-run expansionary policy effects (5 Points) 1) SR: In the short-run, OPEC’s decision makes them happy because the favorable supply-shock has improved the trade-off between unemployment and inflation as shown in part (a). Put differently, for any given inflation rate, our economy can expect a lower unemployment rate. (2 pts) 2) LR: The long-run Phillips curve is vertical, implying that economic agents can perfectly forecast inflation. Therefore, when the government implements an expansionary policy, they will forecast a higher inflation rate, demanding higher wages. This causes an immediate change in the aggregate supply curve, offsetting the gains from increased spending. The inflation rate rises and the unemployment rate remains at the natural rate (2 pts) One particular thing is that potential GDP can increase. It depends on whether OPEC’s decision is permanent or not. Assume it is permanent and the economy is initially in long-run equilibrium. When it is hit by both a positive supply shock and a shock to potential output, (increasing potential GDP,) or when AD curve is unchanged, output is higher and inflation is lower. On the other hand, the level of potential GDP would remain the same when OPEC’s decision is temporary. (1 pts)

Many people just say that the unemployment rate or output level adjusts back to its original point. What’s the original output level? ‘Considering OPEC’s decision’ implies you need to explain above factor to receive full credit.

8 Question 2 (13 points) John is 40 years old. He has assets (wealth) of $30,000 and has no debts or liabilities. He knows that he will work for 20 more years and will live 10 years after that, when he will earn nothing. His salary each year for the rest of his working career is $12,000. There are no taxes. Assume that the interest rate is zero and that John decides not to leave any inheritance to his children. In answering each of the following questions, briefly explain how you arrive at your answers.

a) According to the life-cycle theory of consumption, how much John will consume every year until his retirement? How much will he consume every year after his retirement? How much wealth does he have when he dies? (7 Points) John has $30,000 as assets, and will earn $12,000 each year for 20 years. So $30,000 + $12,000 20 = $270,000 is the maximum amount he can consume in the rest of his life. According to the life-cycle theory of consumption, his consumption will be constant over his life. Therefore he will consume $270,000 30 = $9,000 every year, before and after his retirement. His wealth at his death will be zero.

b) Suppose John receives a tax rebate of $600 per year while he works, so his income is $12,600 for the rest of his working career. According to the life-cycle theory of consumption, how much will he consume this year? (3 Points) Compared to the situation in a), he will receive the extra income of: $600 20 = $12,000. His consumption every year will be increased by: $12,000 30 = $400. So this consumption this year will be: $9,000 + $400 = $9,400.

c) Now suppose John receives a 1-year-only tax refund of $600 -- so his income is $12,600 this year; but it is $12,000 in all succeeding years of his career. According to the life-cycle theory of consumption, how much will he consume this year? (3 Points) Compared to the situation in a), he will receive an extra income of $600 only in this year. His consumption every year will be increased by: $600 30 = $20. So this consumption this year will be: $9,000 + $20 = $9,020.

9 Question 3 (13 points) How Middle East unrest endangers the global economy—and what the world can do about it. - Protest in Bahrain By Nouriel Roubini Political turmoil in the Middle East has powerful economic and financial implications, particularly as it increases the risk of stagflation. Indeed, should stagflation emerge, there is a serious risk of a double-dip recession for a global economy that has barely emerged from its worst crisis in decades. Severe unrest in the Middle East has historically been a source of oil-price spikes, which in turn have triggered three of the last five global recessions. The Yom Kippur War in 1973 caused a sharp increase in oil prices, leading to the global stagflation of 1974-75. The Iranian revolution in 1979 led to a similar stagflationary increase in oil prices, which culminated in the recession of 1980-81. And Iraq's invasion of Kuwait in August 1990 led to a spike in oil prices at a time when a U.S. banking crisis was already tipping America into recession. Oil prices also played a role in the recent finance-driven global recession. By the summer of 2008, just before the collapse of Lehman Bros., oil prices had doubled over the previous 12 months, reaching a peak of $148 a barrel—and delivering the coup de grâce to an already frail and struggling global economy buffeted by financial shocks. We don't know yet how widely the political unrest will spread in the Middle East. The turmoil may yet be contained and recede, sending oil prices back to lower levels. But there is a serious chance that the uprisings will spread, destabilizing Bahrain, Algeria, Oman, Jordan, Yemen, and eventually even Saudi Arabia.

The above article is about the unrest in the Middle East. Please answer the following questions. a) According to the above statement, political turmoil in the Middle East increases the risk of stagflation. State the definition of the stagflation and explain how stagflation occurred in the case of the above oil- shock. Use the AD-AS framework to support your argument. (3 Points) Stagflation is the combination of slow growth and high inflation. If there is a cost shock such as oil shock, AS curve shift left (up) and price level increase and income level decrease. (Figure 13-6 in the chapter 13) b) In lecture, we were taught that there are two types of causes or triggers for inflation (or deflation). Please state the two types of inflation and say which the above article is talking about. (3 Points)

The two are Cost-push (AS curve shift left) inflation and demand-pull (AD curve shift right) inflation. In the above case, the trigger is high oil price, which is about cost-push inflation by the supply side of the economy. c) “In the above situation of oil-shock, d oubts about the nature and the existence of a negatively sloped Phillips Curve could arise”. Is this statement correct? Please state your reasons for your answer. (You should start your discussion by explaining what the “negative sloped Phillips Curve” means) (3 Points)

In the typical Phillips curve, inflation and unemployment are assumed to have a negative relationship. In

10 the above situation of oil shock or stagflation, however, both price level and unemployment could soar simultaneously. Empirical data during those periods can make people doubt about the typical Phillips Curve.

d) Responding to the cost shock above, Fed would like to implement an appropriate monetary policy. In which direction should it be implemented? (Let’s assume that there are two directions of monetary policy; expansionary and contractionary). Please describe the expected consequence of both expansionary and contractionary monetary policy in the AD-AS curve framework. (4 Points)

If the Fed implements an expansionary monetary policy, which makes AD curve shift out, we expect that income (GDP) rise but inflation will be even higher. On the contrary, if the Fed takes a contractionary monetary policy (AD curve shift in), inflation rate will be lowered but output growth could be very week or even negative. Fed should be very careful in taking the direction of monetary policy depending upon the economic situation such as output growth, inflation, unemployment, and so forth.

Question 4 (13 points) In shutdown debate, focus should be on growth instead of deficit By Lawrence Summers Washington is consumed by the impasse over reopening the government and raising the debt limit. It seems likely that this episode, like the 1995-96 government shutdowns and the 2011 debt-limit scare, will be remembered mainly by the people directly involved. But future historians may well see today’s crisis as the turning point at which American democracy was shown to be dysfunctional — an example to be avoided rather than emulated.

This tragedy is compounded by the fact that most of the substance being debated in the current crisis is only tangentially relevant to the major challenges and opportunities facing the United States. This is the case with respect to the endless discussions about the precise timing of continuing resolutions and debt-limit extensions, or the proposals to change congressional staff health-care packages or cut a medical-device tax that represents only about .015 percent of gross domestic product.

More fundamental is this: Current and future budget deficits are now a second-order problem relative to other, more pressing issues facing the U.S. economy. Projections that there is a major deficit problem are highly uncertain. And policies that indirectly address deficit issues by focusing on growth are sounder in economic terms and more plausible in political terms than the long-term budget deals much of the policy community is obsessed with.

To be sure, some steps that matter profoundly for the long run should be priorities today. Data from the CBO imply that an increase of just 0.2 percent in annual growth would entirely eliminate the projected long-term budget gap. Increasing growth, in addition to solving debt problems, would also raise household incomes, increase U.S. economic strength relative to other nations, help state and local governments meet their obligations and prompt investments in research and development.

Beyond the fact that spurring growth has a multiplicity of benefits, of which reduced federal debt is only one, growth-enhancing policies have more widely felt benefits than measures that raise taxes or cut spending.

Spurring growth is an area where neither side of the political spectrum has a monopoly on good ideas. We need more public infrastructure investment, but we also need to reduce regulatory barriers that hold back private infrastructure. We need more investment in education but also increase in accountability for those who provide it. We need more investment in the basic science behind renewable energy technologies, but in the medium term we need to take advantage of the remarkable natural gas resources that have recently become available to the United States. We need to ensure that government has the tools to work effectively in the information age but also to ensure that public policy promotes entrepreneurship. 11 If even half the energy that has been devoted over the past five years to “budget deals” were devoted instead to “growth strategies,” we could enjoy sounder government finances and a restoration of the power of the American example. At a time when the majority of the United States thinks that it is moving in the wrong direction, and family incomes have been stagnant, a reduction in political fighting is not enough. We have to start focusing on the issues that actually are most important.

a) If the debt-to-GDP ratio is 75% as mentioned in the article, and U.S. GDP is $16 trillion, then what is the dollar value of outstanding U.S. debt (in trillions of US dollars)? (3 Points)

b) Suppose taxes T = 2 and G = 2.5, meaning tax revenues are $2 trillion and government spending is $2.5 trillion. Holding G constant, how much would tax revenues need to increase (in $) for the deficit to fall by $0.5 trillion in a year? How much must tax revenues increase by (in %) to meet this ambitious budget goal? (4 points)

- The deficit is . Thus, creates a surplus of . (2 points)

- Tax revenues must increase by 50%, . (2 points) c) Prof. Summers informally mentions two types of policies affecting US debt and deficits: “growth strategies” and “budget deals.” In the context of this article, which of these two types of policies is deficit targeting? (3 Points) In the context of the article, deficit targeting is a “budget deal.” d) Is deficit targeting an automatic stabilizer, or an automatic destabilizer? Please choose only one, and write down the definition only for that choice. (3 Points) Automatic Destabilizer: revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize GDP.