Second Midterm-

I - Identifications:

Identify and briefly explain the importance of each of the following terms.

1. Golden Rule Level of Saving

2. Stabilization Policy

3. Monetary Transmission Mechanism

4. Stagflation

II - Short Responses: 

Discuss each of the following statements.  Explain your answer in a paragraph in the space provided.  Do not exceed the space allowed.

1. BRIEFLY, explain the relationship between the Loanable Funds Market and the IS Curve.

2. BRIEFLY, explain the relationship between the Market for Real Money Balances and the LM curve.

3. "In a Solow Growth Model the steady state level of capital is constant."    Is this statement true or false? Explain your answer, and if it is false, how could you change the statement to make it true?

4. Suppose animal spirits cause consumption to be lower at every level of income.  Describe TWO policy actions that could restore the economy to the original level of output in the short run.  Be sure to illustrate both the consumption shock and the result of the proscribed action with a graph. (Use separate graphs for the two policy actions.)

III - Essay:

1. Answer the following question using the Keynesian Model of a closed economy.  Suppose the Federal government would like to increase output in the short-run and will engage in expansionary fiscal policy.  The President contacts you, the Chair of the Federal Reserve and asks you to take action to keep interest rates close to where they currently are.  You heed the President's request.

a. What action(s) do you take?

b. Illustrate and explain the movements of the IS and LM curves.

c. Illustrate and explain the movement of the aggregate demand curve in both the short run and in the long run assuming no further actions are taken.

d. What potential long term effect should you warn the President about?

2. The following question asks you to compare two steady states and describe the path of the economy in moving from the initial steady state to a new steady state. All answers can be found by using the capital accumulation equation appropriate to the Solow model described below and the national income accounts identity for a closed economy with no government spending.

The country of Kelly exhibits long run growth that is exactly described by a Solow Growth Model.  In Kelly, physical capital needs to be purchased one year in advance:  the capital investment that takes place in 2005 does not enter the capital stock until 2006, and thus firms cannot change their capital stock once a year begins.  Capital depreciates at an annual rate of d%.  The population of Kelly grows at an annual rate of n% while the level of technology is constant.  The economy is a closed economy with the following investment function for each individual:

i(r) = 10 - 20r,  where r is the real interest rate.

a. Suppose in 2005, Kelly is at a steady state, but the marginal propensity to save is less than the golden rule level of savings.  Define what a steady state requires, and describe what happens to consumption per person, investment per person, and TOTAL capital in the economy when the economy is in a steady state.

b. At the beginning of 2006, the marginal propensity to save increases to the golden rule level.  Describe what happens to consumption per person, investment per person, output per person, and the interest rate in 2006. (Hint: Recall the rules governing when capital that is purchased can actually be used.)

For the following part of this question, you will find it useful to include graphs to illustrate what happens to the path of each of these variables over time (e.g., you could graph consumption per person over time indicating in your graph the impact of the changes outlined in the question).  In using a graph to help illustrate your answer, be specific with regard to the labeling of different time periods on the graph. Only partial credit will be given if you do not explain why the graph looks as it does.

EX:

c. Eventually, Kelly establishes a new steady state in response to the change in the marginal propensity to save given in part (b).  Compare consumption per person, investment per person, and the interest rate in this new steady state to the steady state that existed in 2005.

d. Explain why citizens in a country might choose to maintain a savings rate that is lower than the golden rule level of savings.

IV - Problem:

1. Consider the following version of Solow's Growth Model with population growth.  The savings rate is 15%, the depreciation rate is 8%, and the population growth rate is 7%.  The production function for this economy is given to you as

Y = K^1/2(EL)^1/2

where E is the current level of labor-augmenting technology.  Assume for parts (a) through (d) that E equals 1.  Calculate the following in the steady state. Work must clearly support your answer for full credit.  No credit for guessing.)

a. What is the level of capital per worker?

b. At what rate does capital per worker grow?

c. What is the labor income per person (that is, the wage rate)?

d. What is the capital income per person (that is, the rental rate)?

Now amend the model to allow labor-augmenting technology to grow at a rate of 15%. Calculate the following in the new steady state. Hint:  your answers may depend on E, the current level of labor-augmenting technology, and on L, the current level of labor.

e. What is capital per worker? (Calculate the capital per worker and NOT the capital per effective worker.)

f. At what rate does capital per worker grow?

g. What is the level of output?

h. At what rate does output grow?  (Hint:  you may find the percentage change rule helpful here.)

i. What is the labor income per person (that is, the wage rate)?

j. What is the rental rate?