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Final ECON301C

1. Since 1960 there has been a substantial increase in unemployment rates in major European countries. Give two reasons for this happening in Europe.

2. Suppose a government has a tax revenue shortfall. Will hyperinflation inevitably follow unless the government cuts its fiscal expenditures?

3. Ifthere are no unexpected changes in money supply in an economy, can there still be unexpected inflation in the economy?

4. Suppose that two countries are exactly alike in every respect except that population grows at a faster rate in country A than in country B.

a.    Which country will have the higher level of output per worker in the steady state? Illustrate graphically.

b.    Which country will have the faster rate of growth of output per worker in the steady state?

5. How does population growth affect the steady state?

6. When an economy enters expansion, the unemployment rate first increases and then decreases. Why does this happen?

7. The government of an economy has increased its spending and its taxes by the same amount. What is the effect on investment?

8. Consider a production function for an economy:

Y= 20(L.5K.4N.1)

where L is labor, K is capital, and N is land. In this economy, the factors ofproduction are in fixed supply with L = 100, K = 100, and N = 100.

a.    What is the level of output in this country?

b.    Does this production function exhibit constant returns to scale? Demonstrate by example.

c.    If the economy is competitive so that factors ofproduction are paid the value of their marginal products, what is the share of total income will go to land?

9. Assume that the economy is initially in a short-run equilibrium at a level of output below the natural rate.

a.    Use the ISLM model to graphically illustrate (1) how the economy will adjust in the long-run ifthe no policy action is taken and (2) the long-run equilibrium if fiscal policy is used to return the           economy to the natural rate of output.

b.    Explain how investment, the interest rate, and the price level differ in the new long-run equilibrium in the two cases.

10. When an economy reaches a steady state other than the Golden Rule, what actions should policymakers take to achieve the Golden Rule steady state when:

a. the economy begins with more capital than in the Golden Rule steady state?

b. the economy begins with less capital than in the Golden Rule steady state?


Answer Key

1. One reason supporting this increase is the generous unemployment programs for those without jobs. Another reason supporting this increase is that Europeans are more leisure seeking.

2. No. A government has the option ofborrowing money just like any other economic entity. It is only when a           government is deemed as a poor borrower and lenders refuse to lend to it that the government is forced to print money to cover its expenses, which might trigger hyperinflation.

3. Yes. If there are shocks in the real economy affecting the factors ofproduction and production function such that total output Yis affected (say, falls), for a given money supply M and fixed velocity ofmoney V, P will rise leading to     unexpected inflation levels.

4.

a.     Country B will have the higher level of output per worker.

 

b.    In the steady state, the growth rate of output per worker will be zero in both country A and country B.

5. Population growth along with investment and depreciation affect the accumulation of capital per worker. The change in the capital stock per worker is

Δk = i  (δ + n)k

where n is the rate of population growth, δ is the rate of depreciation, and (δ + n)k is the break-even investment. The equation shows that population growth reduces the accumulation of capital per worker much the way           depreciation does. Depreciation reduces k by wearing out the capital stock, and population growth reduces k by spreading the capital stock more thinly among a larger population ofworkers.

6. Discouraged workers are counted out of the labor force. When the economy moves into expansion, these                  discouraged workers start actively looking for a job and will be counted in the labor force as unemployed workers. Therefore, this phenomenon first increases the unemployment rate even ifthe economy is expanding.

 

7. With increased taxes, people will have less money to consume and save, so there will be a reduction in private saving. With increased government spending, public saving will also be reduced. Reductions in both private saving and       public saving will lead to a reduction in national saving, and as national saving is equal to investment, this implies a   decrease in investment.

8.

a.    2,000

b.    Yes, the production function exhibits constant returns to scale. Doubling each factor ofproduction to 200 will double output to 4,000.

c.    10 percent

9.

a.    The economy starts in equilibrium at A. (1) With no policy change the price level will eventually  fall, shifting LM1 to LM2. The new long-run equilibrium will be at B. (2) If fiscal policy is used to restore the natural rate, IS1 will shift to IS2 and the new equilibrium will be a C.

b.    Ifno policy is used to restore full employment, the interest rate and the price level fall. Since the long-run interest rate will be lower, investment will be larger. If fiscal policy is used, the IS curve will shift to the right. The price level will not change, but the long-run interest rate will increase.  This will reduce the amount ofprivate investment at the new equilibrium, C.

10. a. When the economy begins with more capital than it would have in the Golden Rule steady state, policymakers     should provide policies aimed at reducing the rate of saving in order to reduce the capital stock. The reduction in   saving rate results in an immediate rise in consumption and fall in investment. Consumption must be higher than it    was before the change in the saving rate, even though output and investment are lower, to achieve the Golden Rule steady state.

 

b. When the economy begins with less capital than it would have in the Golden Rule steady state, policymakers      must focus on raising the saving rate in order to increase the capital stock and reach the Golden Rule level. The      increase in the saving rate results in an immediate rise in investment and fall in consumption. Eventually, this will lead the capital stock to rise.