>	Econ 100b Created 4/30/1996 Go to Brad De Long's Home Page

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Midterm Two Answers

Economics 100b; Spring 1996

Part I. Multiple Choice (12 1/2 minutes; 25 points)

1. Assuming no population growth and no increase in the efficiency of labor, the steady-state level of capital per worker is calculated by:

a. dividing the depreciation rate by the savings rate.
b. looking for the intersection of the y=f(k) line with the "dk" depreciation line.
c. dividing the savings rate by the depreciation rate.
d. using the multiplier to determine the level of investment consistent with full employment.

• c. dividing the savings rate by the depreciation rate.

2. The Golden Rule level of capital accumulation is the steady state with:

a. the highest growth rate of output
b. the highest level of output per worker
c. the highest level of depreciation per worker
d. the highest level of consumption per worker

• d. the highest level of consumption per worker: there is no growth path with higher consumption per worker in every generation.

3. The Solow growth model predicts that countries with higher population growth rates will have

a. lower growth rates of output
b. higher growth rates of output per worker
c. the same growth rate of total output, but a lower level of output
d. none of the above

• d

4. In the Solow growth model, persistent increases in standards of living are due to:

a. technological progress
b. faster labor force growth
c. higher levels of net exports
d. a larger initial stock of capital per worker

• a

5. Today, America's capital stock is below the Golden Rule level. We know this because:

a. The return on investment is greater than the sum of the deprecation rates and the growth rates of population and labor efficiency.
b. The U.S. runs a persistent trade deficit.
c. The U.S. has not yet converged to its steady-state growth path.
d. We don't know this; the capital stock is above the Golden Rule level.

• a

6. In the 1950s, the Federal Reserve bought and sold gold on demand at a price of $35 an ounce; the Bank of England bought and sold gold on demand at a price of 14 pounds, 11 shillings, 8 pence an ounce. The dollar-pound sterling exchange rate was thus:

a. impossible to determine from the information given.
b. $5 to the pound sterling.
c. About $2.40 to the pound sterling.
d. About $0.45 to the pound sterling.

• c

7. If national output is $7,000 billion a year, and domestic spending on all goods and services is $7,200 billion a year, then net exports must equal:

a. zero
b. -$200 billion a year
c. +$200 billion a year
d. it depends on the real interest rate.

• b

8. In a small open economy with a floating exchange rate, fiscal policy

a. has powerful effects on employment, but not on output or the exchange rate
b. has powerful effects on the exchange rate, but not on employment or output
c. has powerful effects on output, but not on employment or the exchange rate
d. has powerful effects on all three macroeconomic variables.

• b (the LM* curve is unchanged as the IS* curve shifts out).

9. Monetary policy has the largest effects on output in a:

a. small open economy with a fixed exchange rate
b. small open economy with a floating exchange rate
c. large open economy with a fixed exchange rate
d. closed economy

• b (in a closed economy changes in interest rates mean that output does not increase by the full shift in the LM curve; in an open economy output does increase by the full shift in the LM curve.

10. Imposing high tariffs (and making no other changes in government tax and spending policy) in a floating exchange rate system will:

a. boost net exports because the additional tariff collections will reduce the government deficit and increase total national saving
b. have no effect on net exports, but lower the exchange rate
c. lead to a recession
d. require a tighter monetary policy.

• a (remember, a tariff is a tax--the government collects it. So an increase in tariffs will reduce the deficit and so boost national savings.

• The Mundell-Fleming model is the generalization of the short-run IS-LM framework to the case of a "small open economy": imports and exports depend on the exchange rate, and international capital mobility means that domestic interest rates are set by conditions on the world's capital market. It is usually analyzed by means of a graph with the exchange rate on the vertical and output on the horizontal axis.

2. What does it mean to analyze a situation as if the economy were "small and open"? When is this assumption a good one? When is this assumption a bad one?

• (i) domestic monetary or fiscal policies have no effect on the world rate of interest; (ii) investors and speculators in international currency markets place their money where it will earn the highest rate of return (so it is impossible for, say, the domestic interest rate to differ from the world interest rate for any reason other than expected exchange rate changes). This assumption is a good one when the economy is in fact small and open. It is a bad one when international capital mobility is low, or when domestic policies have large effects on the outside world.

3. What is the "capital account"?

• or "net foreign investment." Any trade balance--any surplus or deficit of exports over imports--must be financed somehow. If foreigners buy more dollars' worth of U.S. products than they sell to the U.S., someone must loan them the difference. If foreigners' sell more dollars' worth of products to the U.S. than they buy, they must invest the difference somewhere. The capital account or net foreign investment is thus equal to the trade balance, and amounts to the necessary financing for the trade balance.

4. In advanced post-industrial economies, is more economic growth generated by better technology and labor efficiency, or by increased investment in physical capital?

• Better technology and labor efficiency. Increased capital intensity plays a relatively small role in post-industrial growth. Note, however, that it plays a large role in industrial growth.

• Start from the Mundell-Fleming IS*-LM* model with a fixed exchange rate. The sudden rise in the world interest rate is (under the fiction that the U.S. is a small open economy) a large backward shift in the IS* curve--a fall in real GDP at a constant exchange rate of some $840 billion a year (given the investment demand curve and given a multiplier of two)
  
  The CEA Chair wants the response to this shock to be to hold the position of the LM* curve steady, so that the exchange rate falls, net exports rise (by $420 billion), and real GDP stays constant. In order to keep real GDP constant, the exchange rate would have to fall to $1=40 yen.
  
  The Under Secretary of the Treasury wants monetary policy tightened to keep the exchange rate at $1 = 100 yen. But so doing would translate all of the shift in the IS* curve into a fall in output--and with current GDP of $7 trillion, an $840 billion fall is a 12% decline in output, and is by Okun's Law about a 6 percentage-point rise in the unemployment rate: a truly fearsome recession.
  
  The way to avoid having to choose between these unpleasant alternatives is to do something to move the IS* curve back to its old position in spite of the high increase in overseas interest rates. The obvious thing to do is to use fiscal policy: tax cuts and spending increases to offset the backward shift in IS* and keep short-run equilibrium at the same level of GDP and of the exchange rate.

• 30%/(5+1+4)% = 3

2. What will the marginal product of capital (rate-of-return on investment) be in this steady state?

• 40%/3 = 13.333% per year is r, the marginal product of capital.

3. When Taiwan reaches its steady-state growth path, will its capital stock be above or below the "Golden Rule" value?

• below

4. What will the long-run rate of growth of total GDP be in the steady state? What will the long-run rate of growth of GDP per worker be in steady state?

• 6% per year; 5% per year