First Midterm -I

I. Short Response

For each of the following statements write a brief answer. Make sure your answers are well organized, neatly written, and explicit. Do not exceed the space provided under the question: these are short responses.

1. What is a market clearing model? What is the difference between sticky and flexible prices, and how does the assumption about price flexibility relate to the time horizon of a particular economic model? Is there any relationship between having sticky or flexible prices and having a market clearing model?

2. What are the four different ways of calculating GDP as described in class and mentioned in the book? Describe double counting and how it relates to the calculation of GDP.

3. The return on capital is set in a competitive market and is equal to $5. A firm currently has a marginal product of capital equal to 8 units of output and the price of output is $0.5. What should the firm do with their level of capital given this information?

4. Define frictional employment. Describe the effect of an increase in unemployment insurance benefits on the level of frictional unemployment.

5. Consider the Quantity Theory of Money in the Classical Model. If the Federal Reserve increases the money supply, what will happen to the price level if the velocity of money is constant? Describe one cost imposed on consumers and one cost imposed on firms by the increase in the money supply.

II. Problems

Answer the following problems in the space provided. Make sure you show all your work and that you write the general form of any formula you use before you enter explicit numbers into the formula. Your work must be neat, legible, and organized in order to get full credit.

1.

Consider an economy that has the aggregate production function of the general form

Y = F(A, K, L) = AK^0.5L^0.5

where A is the level of technology, K is the level of capital, and L is the level of labor. Assume that technology is equal to 1, the level of capital is equal to 81 and the level of labor used is equal to 64 and the price of output is equal to 1.

a) What is the level of output in the economy? Show your work.

b) What is labor productivity and (the average) capital productivity at this level of output? Show your work.

c) What are the general forms of the Marginal Product of Capital (MPK) and Marginal Product of Labor ( MPL), and what do these equal given the level of inputs used? Show your work.

d) What is the level of labor income and capital income in the economy, assuming that input prices are determined in a competitive market? Show your work.

e) What is the level of Money in the economy if the ratio of income that individuals desire to hold is 25%?

2. Consider the following table of price and quantities produced for a small economy.

a) Assume that all grapes in this economy are used to make wine. Compute nominal GDP for 2000 and 2001.

b) Continue to assume that all grapes are used to make wine. Using 2000 as the base year, compute real GDP in 2000 and 2001.

c) Find the GDP Deflator for 2000 and 2001 on a 100-point scale. Report your answers to two decimal places, if necessary.

d) What was the growth rate for real GDP between 2000 and 2001? Express your answer as a percentage.

e) Assume that the typical consumer in this economy purchases 2 footballs, 1 dress, and 4 bottles of wine per year. Using 2000 as the base year, find the CPI in 2000 and 2001 on a 100-point scale.

f) What was the inflation rate in this economy between 2000 and 2001? Express your answer as a percentage.

IV. Essay

General Directions for Essay: You are to write an essay on the following topic. This should be a unified, thoughtful essay. The essay will be graded on content, expression, clarity, organization, and overall quality (including legibility).

1. At the end of the Cold War, the US government was able to reduce government spending on the military by 2% of GDP. Consider the two following plans for reallocating this money:

a) The government saves the entire amount.
b) The government uses the entire amount to start a "homestead" program which subsidizes mortgage payments, which effectively lowers housing prices.

For both a) and b), use the Classical Model to analyze what will happen to the equilibrium real interest rate, consumption, and investment relative to the situation before the defense cut. Assume that households save more when real interest rates increase, and vice versa. Which policy will result in a higher rate of long-term growth of the US economy?

(Note: while graphs may be useful in helping determine the answer, they are not themselves an answer to the question.)