Second Midterm

I. Multiple Choice

1. Consider an economy in which the job separation rate, s, is 10% and the job finding rate, f, is 90%. If this economy starts with an unemployment rate of 5%, will the unemployment rate in the subsequent periods be higher or lower than 5%?
a. Higher
b. Lower

2. Holding other factors constant, legislation to cut taxes in an open economy will:
a. Reduce national savings and lead to a trade deficit.
b. Increase national savings and lead to a trade deficit.
c. Increase national savings and lead to a trade surplus.

3. An increase in the trade deficit could be the result of
a. An increase in taxes.
b. A decrease in the world interest rate.
c. An increase in government spending.

4. In a small, open economy, when spending is greater than production this country will import more than it exports, it will run a trade deficit, and it will be a net lender to foreign economies.
a. True
b. False

5. Suppose net exports are greater than zero for a small open economy. Then, it must be the case that this economy has a
a. Positive capital outflow.
b. Positive capital inflow.

6. Suppose that a small, open economy initially is in a situation with balanced trade at the prevailing interest rate. If the world real interest rate increases above this initial level then this small open economy will have
a. A positive net capital outflow.
b. A positive net capital inflow.

7. Suppose a small open economy is initially in a position of balanced trade. An increase in government spending, holding everything else constant, will
a. Reduce national saving and result in a trade deficit for this economy.
b. Reduce national saving and result in a trade surplus for this economy.

8. When a large economy increases its government spending, holding everything else constant, this will result in a
a. Increase in world saving and a decrease in the world real interest rate.
b. Decrease in world saving and an increase in the world real interest rate.

9. When the real exchange rate falls relative to its initial level this makes this economy's exports
a. More attractive to foreign economies.
b. Less attractive to foreign economies.
10. If policy markers wish to reduce the natural rate of unemployment they should
a. Reduce the rate of job separation.
b. Reduce the rate of job finding.

11. When wages are rigid and slow to adjust, this results in structural unemployment or a situation in which there is
a. Excess demand for labor since the real wage does not equal the nominal wage.
b. Excess supply of labor at the prevailing wage rate.

12. If investment is greater than depreciation, holding everything else constant, then
a. The capital stock is increasing.
b. The capital stock is unaffected.

13. Suppose the rate of depreciation of capital in an economy increases. Holding everything else constant, this will
a. Increase the steady state level of capital.
b. Decrease the steady state level of capital.

14. Holding everything else constant, an increase in the saving rate will
a. Reduce the level of consumption per worker.
b. Increase the level of consumption per worker.

15. When the saving rate is relatively high, this implies
a. That the steady state level of capital per worker is relatively low and output per worker is relatively high.
b. That the steady state level of capital per worker is relatively high and output per worker is relatively high.

II. Short Response

For each of the following statements write a brief answer. Make sure your answers are well organized, neatly written, and explicit.

1. Assume a small open economy is initially in a position of trade balance given this economy's real exchange rate. This country is preparing for the Presidential election in the fall of 2008. One of the leading candidates proposes the imposition of a tariff on Korean and European Union imports to this economy as well as the imposition of a smaller tariff on imports from less developed countries. Use a long-run model of a small open economy to illustrate graphically the effect of these policies on this country's real exchange rate and trade balance. Be sure to label your graph carefully: label the axes, the initial equilibrium values, any curves in the graph, the direction of shifts if they occur, and the new long-run equilibrium values. Complete your answer by identifying what happens to the level of net exports, the real exchange rate, the level of imports, the level of exports, and the trade balance.

The residents of Cupid dorm have collected the following date: everyone in the dorm can be classified as either "hitched" or "unhitched" (in a relationship or not in a relationship). Among people who are hitched, fraction "b" of them break up within a given month. Among those who are not hitched, fraction "j" of them meet someone and get hitched within a given month.

a. Derive an expression for the steady-state fraction of dorm residents who are not hitched. Be clear in identifying any abbreviations you are using. To get full credit for this answer you must derive the expression and not just provide a final equation.

b. Suppose that in a given month, 20% break up (b = 20%) and 10% get hitched (j = 10%). What is the steady-state fraction of hitched residents?

III. 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. Suppose a country's aggregate production function is given by the following equation:

Y = 10K^1/2L^1/2

where Y is aggregate output, K is capital, and L is labor. Furthermore, assume this economy is a closed economy with no government sector.

a. Rewrite this production function as a per-worker production function (i.e., y = f(k) where y = Y/L and k = K/L). Show your work.

y = f(k) = _____________________________________________________

b. Suppose initially this economy has 1600 units of capital and 4 units of labor. What is aggregate output, Y? Show your work. Be sure to include the units of measurement in your answer.

Aggregate Output = ______________________________________________

c. Suppose we define labor productivity as output per worker. What is labor productivity equal to in this economy? Show your work and be sure to include the units of measurement in your answer.

Output per worker = _____________________________________________

d. What is the level of capital per worker, k, in this economy? Show your work and be sure to include the units of measurement in your answer.

Capital per worker = _________________________________________

e. Assume that 10% of capital depreciates each year. What gross saving rate, s, is necessary to make the capital/labor ratio you found in part (d) the steady-state capital/labor ratio? Show your work.

s, the gross saving rate for the steady state = ________________________

f. If the saving rate equals the level necessary for your value of k in part (d) to be the steady state level of capital per worker, what is the steady state level of consumption per worker, c? Show your work and be sure to include the units of measurement in your answer.

Steady state consumption per worker = ______________________________

g. Suppose this economy changes its saving rate to .4. With this change, what are the values of capital per worker, output per worker, and consumption per worker in the new steady state? Assume the depreciation rate is unchanged and still equal to 10% of the capital stock per year. Show your work.

Capital per worker = k*=________________________________________

Output per worker = y* = ________________________________________

Consumption per worker = c* = ___________________________________
h. Sketch a graph illustrating the two different saving scenarios. In your graph label both axes, any curves you draw, the steady state level of k for the first saving rate, the steady state level of k for the second saving rate, and the steady state levels of output per worker.

2. Consider an economy with Cobb-Douglass production, Y = AKαL1 - α, where K = 100, L = 100, A = 7, and α = 0.5. In addition, aggregate consumption is the following linear function of disposable income: C = 75 + .25(Y - T). Government spending is 120 and the government's budget is balanced.

a. What is national savings?

b. If domestic investment is given by I = 400 - 20r, where r is the real interest rate in percent, what would the equilibrium interest rate be if the economy were closed?

c. Now suppose the economy opens its borders to the free flow of capital and goods. The world interest rate is 10 percent. What will investment be?

d. What will the trade surplus or deficit be in the open economy case? What will net capital outflow be?

e. If the world interest rate increased, would you expect the real exchange rate to increase or decrease? Why?

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).

Consider two countries, A and B, both of which have developed to the point that their capital stock per worker is no longer changing. The two countries are exactly alike in every respect except that the citizens of country A have a higher savings rate than the citizens of country B. At the same time, the citizens of country A are less happy than the citizens in country B, which from a very narrow-minded perspective we interpret to mean that they consumer less.

Suppose that you are an economic consultant hired by country A. The policymakers who hire you say that their only goal is to maximize the long-run living standards of their citizens (again, high living standards are equated with high levels of consumption). Using at least one graph to supplement your argument, explain your advice for the policymakers in country A. Be sure to include answers to the following questions:

- What should country A do? (If you advocate that the policymakers change the savings rate of citizens, then be sure to include at least one concrete suggestion as to how they might change the savings rate.)

- Why should country A pursue the suggestion(s) you are making? In particular, explain to the policymakers your argument for why it should do what you suggest. Be explicit as to how the comparisons stated at the beginning of the question about countries A and B enter your argument.

- Next, explain the implications of your advice for the citizens of country A in the long-run.

- Finally, explain to the policymakers what the implications of your advice would be for the citizens of country A in the short-run.