This is the final from Prof. Olney's Fall 2017 offering of Economics 1.
The exam was written and administered in two parts (Parts I & II during the final exam period; Part III due during RRR week).
Part I. Questions based on the last
third of the course (55 points total; 49 minutes total)
Question 1 (20 points total; 17 minutes total)
This question is based on reader article #24, “Federal Funds and Interest on Reserves,” Federal Reserve Bank of New York, and “FAQs about Interest on Reserves and the Implementation of Monetary Policy,” Federal Reserve Bank of New York.
A. (5 points) Define IOER. Define FFR. When we talk about the FFR (also known as, FFER), what is the market we are discussing? (One phrase answers to each question are sufficient.)
B. (10 points) How does the New York Fed traditionally use Federal Open Market Operations (FOMO) to facilitate an increase the FFR? Be specific about what actions are taken. Include a graph of the FF market in your answer.
C. (5 points) After November 2008, who became the primary sellers of federal funds? How does this explain the fact that since 2008, the FFR has consistently been less than the IOER?
Question 2 (8 points; 7 minutes)
Suppose the federal government passes a bill that simultaneously does two things:
• taxes are decreased for high wealth households, saving them a total of $100 billion per year
• transfer payments (Medicaid, Social Security) are decreased for low income and elderly households, with a total cut of $100 billion per year
What is the effect of this bill on aggregate demand (possible answers: increase, decrease, stay the same)? What is the effect of this bill on employment? Defend your answers.
Question 3 (12 points total; 11 minutes total)
The Phillips curve remains, at least for now, a useful tool for monetary policy authorities.
A. (4 points) At the right, draw and label a Phillips curve. Indicate on the curve approximately where the U.S. economy is currently.
B. (8 points) The Fed (and other central banks around the globe) now practices “forward guidance.” What is forward guidance? How does the Fed’s use of forward guidance decrease the likelihood of the Phillips curve shifting?
Question 4 (15 points total; 13 minutes total)
Estimated values of the Taylor rule for the U.S. Fed are expressed by the following equation. Subscripts “t” refer to the time period. When all subscripts are “t” that means we are using the values for those variables in the same time period. For instance, if t = 2017:I, then any variable with a subscript “t” refers to the 2017:I value of that variable. A variable with a subscript “t+1” refers to the 2017:II value of that variable.
Target nominal FFRt = 4.63 + 1.28*(actual inflation ratet - 2.0) - 1.95*(actual unemployment ratet - 4.7)
A. (3 points) Using this estimated equation, what is the neutral value of the federal funds rate? What is the Fed’s target for the inflation rate? What is the Fed’s target for the unemployment rate?
B. (7 points) What is an “inflation hawk”? What is an “inflation dove”? Based on this estimated equation, would you characterize the Fed as hawkish or dovish? Why?
C. (5 points) When setting the target for the FFR, the Fed is actually forward-looking. That is, the Fed considers both current values of inflation and also what the inflation rate would be in the near future if the Fed were to do nothing. Does the equation above (in the prompt) capture this forward-looking behavior? Defend your answer.
Part II. Questions from the entire course (85 points total; 74 minutes total)
Question 5 (20 points total; 17 minutes total)
A. (8 points) Why does a decrease in interest rates typically lead to an increase in investment spending? In your answer, be sure to distinguish between the interest rate(s) that are relevant for firms using internal finance versus the interest rate(s) that are relevant for firms using external finance.
B. (12 points) Why does a decrease in interest rates typically lead to an increase in net export spending? (Assume this economy is the only economy that decreases interest rates.) Be complete.
Question 6 (7 points; 6 minutes)
The California economy, as measured by its real GDP, has been growing about 3.5 percent per year. Analysts expect that California’s economic growth will slow to about 2 percent per year as the economy reaches full employment and labor shortages appear.
Use one or more of these concepts to explain why analysts would expect growth to slow: PPF, AD, actual real GDP, potential real GDP.
(Inspiration: https://mynewsla.com/business/2017/12/06/economic-uh-oh-for-california-growth-slows-employment-booms-housing-tight/)
Question 7 (15 points total; 13 minutes total)
San Francisco announced a new parking meter policy. Under the old policy, the price for an hour of parking was fixed at $2.50 per hour. Under the new policy, the price for an hour of parking will vary, neighborhood by neighborhood, hour by hour, depending upon how many parking places are available. If there are lots of empty parking places when the price is $2.50 per hour, the price for an hour of parking will be decreased. If there are no empty parking places when the price is $2.50 per hour, the price for an hour of parking will be increased.
A. (6points) At the right, draw a supply and demand graph that captures the new policy. Show an instance in which the price would be low. Show an instance in which the price would be high.
B. (4 points) Analysts working for San Francisco believe the new policy will increase total revenue. Do we need to know the price-elasticity of demand for parking in order to determine if the new policy will increase revenue? Explain.
C. (5 points) Comparing the old policy (fixed price) and the new policy (variable price), what is the effect on consumer surplus at times when there are lots of empty parking places at a price of $2.50 per hour? At the right, sketch in the old and new CS. (Your graph at the right is your defense of your answer.)
(Inspiration: http://www.sfgate.com/bayarea/article/SF-set-to-become-first-U-S-to-price-metered-12393425.php
http://www.sfexaminer.com/transit-agency-approves-surge-pricing-lower-raise-parking-meter-costs/)
Question 8 (15 points total; 13 minutes total)
A recent study of taxes assessed on goods sold showed that sellers will raise prices when taxes are increased, but do not lower prices when taxes are decreased.
A. (10 points) Below, show the effect of an increase in a tax on the price of output in the short run and the long run, assuming the market is perfectly competitive. Assume the tax is a constant dollar amount. Assume the tax revenue is remitted to the government by the seller. Use subscripts “1" to depict the initial condition, subscripts “2" to depict the new short-run equilibrium, and subscripts “3" to depict the new long-run equilibrium.
B. (5 points) The result of this recent study is surprising. One explanation the authors offered for why businesses would not lower their prices when taxes are lowered was that business owners are loss averse. How might loss aversion explain the tendency of businesses to increase prices when taxes are raised, but not decrease prices when taxes are lowered. (No graph is required for this part.)
(Inspiration: https://t.co/ZvmxgG5TdG which expands to
https://www.law.ucla.edu/~/media/Assets/Tax%20Policy%20Colloquium/Documents/Spring%202017/Benzarti%20Final%20Paper.ashx)
Question 9 (13 points total; 12 minutes total)
Invention and innovation increases total factor productivity. A recent study by Raj Chetty and co-authors found that those people who become inventors are far more likely to have been raised in families at the top 1 percent of the income distribution than in median-income families. Further analysis showed that an important underlying cause was that children in high income families grew up meeting, knowing, and talking with people who were themselves inventors, but that children in median-income families had no such exposure to inventors. Having childhood knowledge of the invention process, the authors argued, makes someone far more likely to become an inventor as an adult.
A. (8 points) Why should the government be interested in a policy designed to encourage invention and innovation? Why doesn’t the Coase Theorem apply here?
B. (5 points) In light of this study, suggest one policy that might be implemented to encourage invention and innovation. Defend your suggestion.
(Inspiration: https://www.theatlantic.com/business/archive/2017/12/innovation-income-chetty/547202/
citing http://www.equality-of-opportunity.org/assets/documents/inventors_paper.pdf)
Question 10 (15 points; 13 minutes total)
Chain restaurants include places such as Olive Garden, Cheesecake Factory, Kentucky Fried Chicken, Popeyes, Del Taco, Subway, and many more.
A. (4 points) During the 2007-09 recession, sales at chain restaurants decreased. Would you therefore characterize “meals at chain restaurants” as a normal good or an inferior good? Defend your answer.
B. (1 point) Would you characterize the chain restaurant industry as perfect competition, monopolistic competition, or monopoly?
C. (5 points) Between the end of the recession in 2009 and 2015, sales at chain restaurants increased by 8 to 10 percent per year. That’s a huge annual increase. Starting in about 2010, there have been big increases each year in the number of chain restaurants. Explain why increased sales would lead to increases in the number of restaurants.
D. (5 points) Starting in 2016, “same store sales” have declined over time. “Same store sales” excludes sales at stores that have entered or exited the industry in the last year. “Same store sales” includes only sales at stores (here, restaurants) that were in business last year and this year. Would our usual analysis of adjustment to long-run equilibrium have predicted this result? Explain.
(Inspiration: https://www.nytimes.com/2017/10/31/business/too-many-restaurants-wall-street.html)
Part III. Comprehensive Essay Question (60 points)
You are finishing up a fabulous internship at an online news-and-opinion blog that focuses on economics issues. Your supervisor has given you one last assignment: Write a piece that provides some analysis of the Tax Cuts and Jobs Act (TCJA, also known as the GOP Tax Plan). Your readers are educated people who have an interest in and background knowledge of economics. Your supervisor has been impressed with the breadth and depth of your economic knowledge and with your ability to write a clear and compelling article. You don’t want to let your supervisor down!
Based on conversations with your supervisor, you decided you wanted to include the points below. You’re mostly happy with the outline but might re-order things for better flow. You can include visual representations of data as appropriate (a figure can be worth a thousand words), but no “textbook graphs” that illustrate economic concepts.
Preliminary Outline You Sketched Out for Yourself (which is why you referred to yourself as “I”)
Question 1 (20 points total; 17 minutes total)
This question is based on reader article #24, “Federal Funds and Interest on Reserves,” Federal Reserve Bank of New York, and “FAQs about Interest on Reserves and the Implementation of Monetary Policy,” Federal Reserve Bank of New York.
A. (5 points) Define IOER. Define FFR. When we talk about the FFR (also known as, FFER), what is the market we are discussing? (One phrase answers to each question are sufficient.)
B. (10 points) How does the New York Fed traditionally use Federal Open Market Operations (FOMO) to facilitate an increase the FFR? Be specific about what actions are taken. Include a graph of the FF market in your answer.
C. (5 points) After November 2008, who became the primary sellers of federal funds? How does this explain the fact that since 2008, the FFR has consistently been less than the IOER?
Question 2 (8 points; 7 minutes)
Suppose the federal government passes a bill that simultaneously does two things:
• taxes are decreased for high wealth households, saving them a total of $100 billion per year
• transfer payments (Medicaid, Social Security) are decreased for low income and elderly households, with a total cut of $100 billion per year
What is the effect of this bill on aggregate demand (possible answers: increase, decrease, stay the same)? What is the effect of this bill on employment? Defend your answers.
Question 3 (12 points total; 11 minutes total)
The Phillips curve remains, at least for now, a useful tool for monetary policy authorities.
A. (4 points) At the right, draw and label a Phillips curve. Indicate on the curve approximately where the U.S. economy is currently.
B. (8 points) The Fed (and other central banks around the globe) now practices “forward guidance.” What is forward guidance? How does the Fed’s use of forward guidance decrease the likelihood of the Phillips curve shifting?
Question 4 (15 points total; 13 minutes total)
Estimated values of the Taylor rule for the U.S. Fed are expressed by the following equation. Subscripts “t” refer to the time period. When all subscripts are “t” that means we are using the values for those variables in the same time period. For instance, if t = 2017:I, then any variable with a subscript “t” refers to the 2017:I value of that variable. A variable with a subscript “t+1” refers to the 2017:II value of that variable.
Target nominal FFRt = 4.63 + 1.28*(actual inflation ratet - 2.0) - 1.95*(actual unemployment ratet - 4.7)
A. (3 points) Using this estimated equation, what is the neutral value of the federal funds rate? What is the Fed’s target for the inflation rate? What is the Fed’s target for the unemployment rate?
B. (7 points) What is an “inflation hawk”? What is an “inflation dove”? Based on this estimated equation, would you characterize the Fed as hawkish or dovish? Why?
C. (5 points) When setting the target for the FFR, the Fed is actually forward-looking. That is, the Fed considers both current values of inflation and also what the inflation rate would be in the near future if the Fed were to do nothing. Does the equation above (in the prompt) capture this forward-looking behavior? Defend your answer.
Part II. Questions from the entire course (85 points total; 74 minutes total)
Question 5 (20 points total; 17 minutes total)
A. (8 points) Why does a decrease in interest rates typically lead to an increase in investment spending? In your answer, be sure to distinguish between the interest rate(s) that are relevant for firms using internal finance versus the interest rate(s) that are relevant for firms using external finance.
B. (12 points) Why does a decrease in interest rates typically lead to an increase in net export spending? (Assume this economy is the only economy that decreases interest rates.) Be complete.
Question 6 (7 points; 6 minutes)
The California economy, as measured by its real GDP, has been growing about 3.5 percent per year. Analysts expect that California’s economic growth will slow to about 2 percent per year as the economy reaches full employment and labor shortages appear.
Use one or more of these concepts to explain why analysts would expect growth to slow: PPF, AD, actual real GDP, potential real GDP.
(Inspiration: https://mynewsla.com/business/2017/12/06/economic-uh-oh-for-california-growth-slows-employment-booms-housing-tight/)
Question 7 (15 points total; 13 minutes total)
San Francisco announced a new parking meter policy. Under the old policy, the price for an hour of parking was fixed at $2.50 per hour. Under the new policy, the price for an hour of parking will vary, neighborhood by neighborhood, hour by hour, depending upon how many parking places are available. If there are lots of empty parking places when the price is $2.50 per hour, the price for an hour of parking will be decreased. If there are no empty parking places when the price is $2.50 per hour, the price for an hour of parking will be increased.
A. (6points) At the right, draw a supply and demand graph that captures the new policy. Show an instance in which the price would be low. Show an instance in which the price would be high.
B. (4 points) Analysts working for San Francisco believe the new policy will increase total revenue. Do we need to know the price-elasticity of demand for parking in order to determine if the new policy will increase revenue? Explain.
C. (5 points) Comparing the old policy (fixed price) and the new policy (variable price), what is the effect on consumer surplus at times when there are lots of empty parking places at a price of $2.50 per hour? At the right, sketch in the old and new CS. (Your graph at the right is your defense of your answer.)
(Inspiration: http://www.sfgate.com/bayarea/article/SF-set-to-become-first-U-S-to-price-metered-12393425.php
http://www.sfexaminer.com/transit-agency-approves-surge-pricing-lower-raise-parking-meter-costs/)
Question 8 (15 points total; 13 minutes total)
A recent study of taxes assessed on goods sold showed that sellers will raise prices when taxes are increased, but do not lower prices when taxes are decreased.
A. (10 points) Below, show the effect of an increase in a tax on the price of output in the short run and the long run, assuming the market is perfectly competitive. Assume the tax is a constant dollar amount. Assume the tax revenue is remitted to the government by the seller. Use subscripts “1" to depict the initial condition, subscripts “2" to depict the new short-run equilibrium, and subscripts “3" to depict the new long-run equilibrium.
B. (5 points) The result of this recent study is surprising. One explanation the authors offered for why businesses would not lower their prices when taxes are lowered was that business owners are loss averse. How might loss aversion explain the tendency of businesses to increase prices when taxes are raised, but not decrease prices when taxes are lowered. (No graph is required for this part.)
(Inspiration: https://t.co/ZvmxgG5TdG which expands to
https://www.law.ucla.edu/~/media/Assets/Tax%20Policy%20Colloquium/Documents/Spring%202017/Benzarti%20Final%20Paper.ashx)
Question 9 (13 points total; 12 minutes total)
Invention and innovation increases total factor productivity. A recent study by Raj Chetty and co-authors found that those people who become inventors are far more likely to have been raised in families at the top 1 percent of the income distribution than in median-income families. Further analysis showed that an important underlying cause was that children in high income families grew up meeting, knowing, and talking with people who were themselves inventors, but that children in median-income families had no such exposure to inventors. Having childhood knowledge of the invention process, the authors argued, makes someone far more likely to become an inventor as an adult.
A. (8 points) Why should the government be interested in a policy designed to encourage invention and innovation? Why doesn’t the Coase Theorem apply here?
B. (5 points) In light of this study, suggest one policy that might be implemented to encourage invention and innovation. Defend your suggestion.
(Inspiration: https://www.theatlantic.com/business/archive/2017/12/innovation-income-chetty/547202/
citing http://www.equality-of-opportunity.org/assets/documents/inventors_paper.pdf)
Question 10 (15 points; 13 minutes total)
Chain restaurants include places such as Olive Garden, Cheesecake Factory, Kentucky Fried Chicken, Popeyes, Del Taco, Subway, and many more.
A. (4 points) During the 2007-09 recession, sales at chain restaurants decreased. Would you therefore characterize “meals at chain restaurants” as a normal good or an inferior good? Defend your answer.
B. (1 point) Would you characterize the chain restaurant industry as perfect competition, monopolistic competition, or monopoly?
C. (5 points) Between the end of the recession in 2009 and 2015, sales at chain restaurants increased by 8 to 10 percent per year. That’s a huge annual increase. Starting in about 2010, there have been big increases each year in the number of chain restaurants. Explain why increased sales would lead to increases in the number of restaurants.
D. (5 points) Starting in 2016, “same store sales” have declined over time. “Same store sales” excludes sales at stores that have entered or exited the industry in the last year. “Same store sales” includes only sales at stores (here, restaurants) that were in business last year and this year. Would our usual analysis of adjustment to long-run equilibrium have predicted this result? Explain.
(Inspiration: https://www.nytimes.com/2017/10/31/business/too-many-restaurants-wall-street.html)
Part III. Comprehensive Essay Question (60 points)
You are finishing up a fabulous internship at an online news-and-opinion blog that focuses on economics issues. Your supervisor has given you one last assignment: Write a piece that provides some analysis of the Tax Cuts and Jobs Act (TCJA, also known as the GOP Tax Plan). Your readers are educated people who have an interest in and background knowledge of economics. Your supervisor has been impressed with the breadth and depth of your economic knowledge and with your ability to write a clear and compelling article. You don’t want to let your supervisor down!
Based on conversations with your supervisor, you decided you wanted to include the points below. You’re mostly happy with the outline but might re-order things for better flow. You can include visual representations of data as appropriate (a figure can be worth a thousand words), but no “textbook graphs” that illustrate economic concepts.
Preliminary Outline You Sketched Out for Yourself (which is why you referred to yourself as “I”)
- Intro paragraph. Include a thesis statement here. Be sure reader knows that the specifics of TCJA vary between House and Senate versions (and are changing by the day), so I’ll mostly focus on the broad outlines.
- Broad outlines that I’ll focus on: [1] lower taxes on income (revenue - accounting costs) of corporations; [2] eliminating taxes on wealth transfers (bequests) for estates larger than $5 million; and [3] changes in taxes for middle and lower income families (“change” because it could be an income tax decrease, could be an increase, depends on family location and circumstances)
- Provide a clear brief analysis of the effects of the tax plan on long-run economic growth, unemployment, inflation, and inequality. It probably will be most clear if I separately analyze the effects of each of the three things in my broad outline. I’ll have to think about what flows better: grouping by what’s being affected (LR growth, unemployment, etc) or grouping by aspect of the tax bill (corporate taxes, wealth taxes, income taxes).
- Discuss what the Fed will likely do in response. Here I need to focus especially on the predicted net effects on unemployment and inflation. I should be sure to explain (briefly anyway) what the Fed’s mandate is, and why they consider unemployment and inflation in determining policy. Important here to distinguish between today’s inflation, anticipated inflation, and inflationary expectations.
- There are lots and lots of particular provisions in the bills. To make my article more compelling, I’ll choose one particular provision and analyze it.
- Best place to find information needed here: Joint Committee on Taxation (https://www.jct.gov/) and especially https://www.jct.gov/publications.html?func=startdown&id=5031 (House bill, “Description of H.R. 1") and https://www.jct.gov/publications.html?func=startdown&id=5032 (Senate bill, “Description of the Chairman’s Mark of TCJA”)
- I’ll choose just one particular provision out of all that is in those two documents. Almost everything in the bill is the elimination (or change) of the amount of tax credit or deductibility (a subsidy) that taxpayers currently receive for spending on some particular thing. After I choose what one provision I will focus on, I want to discuss what particular (micro) market that provision will affect, what the effect is likely to be, and whether or not there had been a justification for the existing (pre TCJA) provision based on the existence of externalities. (For instance, if the bill suggests eliminating the ability to deduct from taxes a taxpayer’s spending on X, what will that do to prices and quantities in the market for X? And, is there an externality associated with spending on X that had justified the existing ability to deduct spending for X from one’s taxable income?)
- Offer a conclusion: Is the TCJA good or bad for the US economy? That’s a normative question, so I better state what I think the goal ought to be.
This is the final from Prof. Olney's Fall 2016 offering of Economics 1.
The exam was written and administered in two parts (Parts I & II during the final exam period; Part III due during RRR week).
Part I.
Questions Covering the Last Third of the Course (58
points total; 45 minutes total)
Question 1 (10 points; 8 minutes)
Since the November 8 election, the dollar has strengthened by about 10 percent against the Mexican peso and by about 4 percent against the Euro. Explain how the following two events can account for these changes in the strength of the dollar.
• Event A: Long-term interest rate in the US – but not in other countries – have increased by about ½ percentage point since November 8
• Event B: President-Elect Trump's campaign comments about trade between Mexico and the US have led to the widely-held expectation that Mexican exports to the US will decrease markedly in 2017
Question 2 (15 points total; 11 minutes total)
In normal times, banks hold very low levels of excess reserves.
A. (6 points) In normal times, what do banks typically do with their excess reserves? In normal times, approximately what amount of excess reserves do banks typically hold?
B. (9 points) In normal times, what is the effect of an increase in the interest rate on excess reserves (IOER) on the federal funds rate (FFR)? Explain. Supplement your answer with a graph of the federal funds market.
Question 3 (10 points; 8 minutes)
Large increases in government spending for transportation infrastructure projects will have a smaller effect on U.S. GDP in 2017-18 than the same size projects would have had in 2008-09. Referring to article #25 (“How Powerful are Fiscal Multipliers in Recessions?” by Alan Auerbach and Yuriy Gorodnichenko), explain why.
Question 4 (10 points total; 8 minutes total)
Suppose the Taylor rule is
interest rate target = 3 - 2*(actual unemployment - 4 ) + 1*(actual inflation rate - 2 )
A. (3 points) According to this Taylor rule, what are the values of the neutral interest rate, the central bank's goal for the unemployment rate, and the central bank's goal for the inflation rate? (No explanation needed.)
B. (7 points) Suppose the actual unemployment rate is 9 and the actual inflation rate is 0. What is the FFR target predicted by this Taylor Rule? Traditionally, would the central bank have a FFR target equal (or approximately equal) to the rate predicted by the Taylor Rule? Explain.
Question 5 (13 points total; 10 minutes total)
Ruby, a small business owner, is considering buying additional machinery for her company. She has been denied a loan by the bank and is considering financing the purchase with her credit card. The interest rate charged by the bank for a loan is 8 percent. The credit card interest rate is 22 percent.
A. (6 points) Should she buy the machinery? Explain your answer.
B. (7 points) The Presidential election results surprised Ruby. She now thinks inflation in 2017 - 2020 will be about 5 percent rather than the 2 percent she had been expecting. Does her change in expectations affect her decision to buy the machinery? Explain.
Part II. Questions Covering Any Part of the Course (82 points total; 62 minutes total)
Question 6 (10 points; 8 minutes)
There are two groups of companies that can sell a product. Companies in both groups face a typical upward sloping marginal cost curve. But for group A, their minimum average variable cost is $8 and for group B, their minimum average variable cost is $50. There are a large number of companies in each group. Draw the market supply curve for this product. Explain why you drew the Supply curve as you did. Why will $50 be the market price for this product over a wide range of demand curves?
Question 7 (15 points total; 11 minutes total)
Consider two economies. The sets of equations below describe Economy A and Economy B respectively.
Economy A
C = 100 + 0.6YD
I = 200 + 0.2Y
G = 300
EX = 400
IM = 150 + 0.1Y
TA = 500
TR = 300
Economy B
C = 100 + 0.6YD
I = 200 + 0.2Y
G = 300
EX = 400
IM = 150
TA = 500
TR = 300
A. (8 points) In which economy -- Economy A or Economy B -- is the spending multiplier larger? Explain your answer. In your answer, be sure you describe the multiplier process.
B. (7 points) Is the formula 1 / (1-mpc) the correct formula for the multiplier in either Economy A or Economy B? Explain your answer.
Question 8 (6 points; 5 minutes)
A state government offers a company $7 million if it will decrease the number of employees by 1,600 rather than by 2,400. In 2016 the company had 3,000 employees. In 2017, the company will have 1,400 employees and receive $7 million from the state government.
• From one perspective, the company is being paid $7 million for reducing its workforce by 1,600 employees.
• From another perspective, the company is being paid $7 million for increasing employment by 800 employees.
What is the proper counterfactual statement to use to evaluate the effectiveness of this policy of paying this company $7 million? Defend your answer.
Question 9 (15 points total; 11 minutes total)
Two policies are being considered to subsidize college educations at public universities such as Berkeley.
• Policy A: Use tax revenues to pay subsidies equal to the cost of tuition to all students.
• Policy B: Use tax revenues to pay subsidies equal to the cost of tuition to students whose families earn less than $125,000 per year.
A. (6 points) Use the concept of externalities to explain why subsidizing college education makes economic sense.
B. (9 points) Which policy -- Policy A or Policy B -- is more likely to generate the socially optimal quantity of public university graduates? Defend your answer. In your defense consider the price elasticity of demand for college education. Distinguish (if appropriate) between the price elasticities of the two groups of students -- those whose families earn more than $125,000 per year, and those whose families earn less than $125,000 per year.
Question 10 (36 points total; 27 minutes total)
Manufacturers of goods buy parts that are used in production. For example, car manufacturers buy engines that are produced by other companies, and then put those engines into the cars they are manufacturing and selling.
Suppose the parts that American manufacturers buy are produced in two places: in the US, or in other countries. You should think of those as two separate markets: the market for US produced parts, and the market for imported parts. Both markets for parts are perfectly competitive. The US-produced parts and imported parts are perfect substitutes. Currently, American goods manufacturers buy a mix of US-produced parts and imported parts.
President-Elect Trump has suggested implementing a 35 percent tariff (tax) on imported goods. A 35 percent tariff (tax on imports) means an imported part that had cost $1 to a US manufacturer would now cost $1.35, but the American-produced part would still cost just $1. The tariff is paid to the US federal government by the buyer. Assume there is currently no tariff, as is characteristic of a "free trade zone."
A. (10 points) Assume the parts-producing firms are initially in long-run competitive equilibrium. What is the short-run effect of the implementation of a 35 percent tariff on the price of parts imported from Mexico? On the profits of a typical Mexican company that produces parts? Explain and illustrate your answers.
B. (8 points) What is the short-run effect of the tariff on the price of parts produced in the US? Explain and illustrate your answer.
C. (10 points) What is the effect of the tariff on the inflation rate in the US? On the Phillips Curve? Explain your answers. Illustrate your Phillips Curve answer.
D. (8 points) Given the Fed's dual mandate, what is the Fed likely to do in response to the implementation of a steep tariff? What is the likely effect on the Fed's monetary policy action on employment? Why does the mix of doves and hawks on the FOMC affect your answer? Explain your answers.
Part III. The Comprehensive Essay Question (60 points)
You’ve decided to submit an op-ed to a reputable news-source read by millions of people around the world. You are going to offer your opinion of what the Fed should do at its December 13-14, 2016 FOMC meeting in light of the heightened uncertainty in the US economy post-November 8. Your readers are educated people who have only a rudimentary knowledge of economics. The editor who will decide whether to publish your op-ed needs to be impressed with the breadth and depth of your economic knowledge and with your ability to write a clear and compelling article.
You sketched out the outline below. You can include visual representations of data as appropriate (a figure can be worth a thousand words), but the news source you are writing for doesn’t allow graphs that illustrate economic concepts. Clarity matters most. Your goal is to have your article accepted for publication and to persuade readers to your point of view.
Outline
• Uncertainty is greater post-election. Things seem to change daily. I could capture two aspects of the uncertainty:
• Now, monetary policy. I should first discuss Federal Reserve monetary policy in general terms. What are the Fed’s goals? What data do they examine in deciding policy? Why have they been planning to raise rates in any case?
• Then comes my recommendation and its defense: Should the Fed raise rates at its December 13/14 meeting. Why?
Question 1 (10 points; 8 minutes)
Since the November 8 election, the dollar has strengthened by about 10 percent against the Mexican peso and by about 4 percent against the Euro. Explain how the following two events can account for these changes in the strength of the dollar.
• Event A: Long-term interest rate in the US – but not in other countries – have increased by about ½ percentage point since November 8
• Event B: President-Elect Trump's campaign comments about trade between Mexico and the US have led to the widely-held expectation that Mexican exports to the US will decrease markedly in 2017
Question 2 (15 points total; 11 minutes total)
In normal times, banks hold very low levels of excess reserves.
A. (6 points) In normal times, what do banks typically do with their excess reserves? In normal times, approximately what amount of excess reserves do banks typically hold?
B. (9 points) In normal times, what is the effect of an increase in the interest rate on excess reserves (IOER) on the federal funds rate (FFR)? Explain. Supplement your answer with a graph of the federal funds market.
Question 3 (10 points; 8 minutes)
Large increases in government spending for transportation infrastructure projects will have a smaller effect on U.S. GDP in 2017-18 than the same size projects would have had in 2008-09. Referring to article #25 (“How Powerful are Fiscal Multipliers in Recessions?” by Alan Auerbach and Yuriy Gorodnichenko), explain why.
Question 4 (10 points total; 8 minutes total)
Suppose the Taylor rule is
interest rate target = 3 - 2*(actual unemployment - 4 ) + 1*(actual inflation rate - 2 )
A. (3 points) According to this Taylor rule, what are the values of the neutral interest rate, the central bank's goal for the unemployment rate, and the central bank's goal for the inflation rate? (No explanation needed.)
B. (7 points) Suppose the actual unemployment rate is 9 and the actual inflation rate is 0. What is the FFR target predicted by this Taylor Rule? Traditionally, would the central bank have a FFR target equal (or approximately equal) to the rate predicted by the Taylor Rule? Explain.
Question 5 (13 points total; 10 minutes total)
Ruby, a small business owner, is considering buying additional machinery for her company. She has been denied a loan by the bank and is considering financing the purchase with her credit card. The interest rate charged by the bank for a loan is 8 percent. The credit card interest rate is 22 percent.
A. (6 points) Should she buy the machinery? Explain your answer.
B. (7 points) The Presidential election results surprised Ruby. She now thinks inflation in 2017 - 2020 will be about 5 percent rather than the 2 percent she had been expecting. Does her change in expectations affect her decision to buy the machinery? Explain.
Part II. Questions Covering Any Part of the Course (82 points total; 62 minutes total)
Question 6 (10 points; 8 minutes)
There are two groups of companies that can sell a product. Companies in both groups face a typical upward sloping marginal cost curve. But for group A, their minimum average variable cost is $8 and for group B, their minimum average variable cost is $50. There are a large number of companies in each group. Draw the market supply curve for this product. Explain why you drew the Supply curve as you did. Why will $50 be the market price for this product over a wide range of demand curves?
Question 7 (15 points total; 11 minutes total)
Consider two economies. The sets of equations below describe Economy A and Economy B respectively.
Economy A
C = 100 + 0.6YD
I = 200 + 0.2Y
G = 300
EX = 400
IM = 150 + 0.1Y
TA = 500
TR = 300
Economy B
C = 100 + 0.6YD
I = 200 + 0.2Y
G = 300
EX = 400
IM = 150
TA = 500
TR = 300
A. (8 points) In which economy -- Economy A or Economy B -- is the spending multiplier larger? Explain your answer. In your answer, be sure you describe the multiplier process.
B. (7 points) Is the formula 1 / (1-mpc) the correct formula for the multiplier in either Economy A or Economy B? Explain your answer.
Question 8 (6 points; 5 minutes)
A state government offers a company $7 million if it will decrease the number of employees by 1,600 rather than by 2,400. In 2016 the company had 3,000 employees. In 2017, the company will have 1,400 employees and receive $7 million from the state government.
• From one perspective, the company is being paid $7 million for reducing its workforce by 1,600 employees.
• From another perspective, the company is being paid $7 million for increasing employment by 800 employees.
What is the proper counterfactual statement to use to evaluate the effectiveness of this policy of paying this company $7 million? Defend your answer.
Question 9 (15 points total; 11 minutes total)
Two policies are being considered to subsidize college educations at public universities such as Berkeley.
• Policy A: Use tax revenues to pay subsidies equal to the cost of tuition to all students.
• Policy B: Use tax revenues to pay subsidies equal to the cost of tuition to students whose families earn less than $125,000 per year.
A. (6 points) Use the concept of externalities to explain why subsidizing college education makes economic sense.
B. (9 points) Which policy -- Policy A or Policy B -- is more likely to generate the socially optimal quantity of public university graduates? Defend your answer. In your defense consider the price elasticity of demand for college education. Distinguish (if appropriate) between the price elasticities of the two groups of students -- those whose families earn more than $125,000 per year, and those whose families earn less than $125,000 per year.
Question 10 (36 points total; 27 minutes total)
Manufacturers of goods buy parts that are used in production. For example, car manufacturers buy engines that are produced by other companies, and then put those engines into the cars they are manufacturing and selling.
Suppose the parts that American manufacturers buy are produced in two places: in the US, or in other countries. You should think of those as two separate markets: the market for US produced parts, and the market for imported parts. Both markets for parts are perfectly competitive. The US-produced parts and imported parts are perfect substitutes. Currently, American goods manufacturers buy a mix of US-produced parts and imported parts.
President-Elect Trump has suggested implementing a 35 percent tariff (tax) on imported goods. A 35 percent tariff (tax on imports) means an imported part that had cost $1 to a US manufacturer would now cost $1.35, but the American-produced part would still cost just $1. The tariff is paid to the US federal government by the buyer. Assume there is currently no tariff, as is characteristic of a "free trade zone."
A. (10 points) Assume the parts-producing firms are initially in long-run competitive equilibrium. What is the short-run effect of the implementation of a 35 percent tariff on the price of parts imported from Mexico? On the profits of a typical Mexican company that produces parts? Explain and illustrate your answers.
B. (8 points) What is the short-run effect of the tariff on the price of parts produced in the US? Explain and illustrate your answer.
C. (10 points) What is the effect of the tariff on the inflation rate in the US? On the Phillips Curve? Explain your answers. Illustrate your Phillips Curve answer.
D. (8 points) Given the Fed's dual mandate, what is the Fed likely to do in response to the implementation of a steep tariff? What is the likely effect on the Fed's monetary policy action on employment? Why does the mix of doves and hawks on the FOMC affect your answer? Explain your answers.
Part III. The Comprehensive Essay Question (60 points)
You’ve decided to submit an op-ed to a reputable news-source read by millions of people around the world. You are going to offer your opinion of what the Fed should do at its December 13-14, 2016 FOMC meeting in light of the heightened uncertainty in the US economy post-November 8. Your readers are educated people who have only a rudimentary knowledge of economics. The editor who will decide whether to publish your op-ed needs to be impressed with the breadth and depth of your economic knowledge and with your ability to write a clear and compelling article.
You sketched out the outline below. You can include visual representations of data as appropriate (a figure can be worth a thousand words), but the news source you are writing for doesn’t allow graphs that illustrate economic concepts. Clarity matters most. Your goal is to have your article accepted for publication and to persuade readers to your point of view.
Outline
• Uncertainty is greater post-election. Things seem to change daily. I could capture two aspects of the uncertainty:
• Fiscal policy, interest rates, inflation. Increased infrastructure spending , increased military spending, and tax cuts have been proposed. (Details may still be missing.) I should discuss the implications of such a package of fiscal policies for employment & inflation, while noting the uncertainty around what will actually happen.• Effects of uncertainty. There are several points I want to make here so this section will probably be long. Effect of heightened uncertainty on aggregate investment spending. Effects on banking and lending, perhaps through impact on asymmetric information. Effect on the strength of the dollar vis-à-vis foreign currencies. Effect on aggregate consumption and saving. And effect on inflationary expectations.
• Trade policy. Again, lots of uncertainty, but the talk has been about renegotiating trade policies and reducing US imports. Eliminating free trade zones would increase price of US exports to foreigners. I should outline the possibilities here.
• Now, monetary policy. I should first discuss Federal Reserve monetary policy in general terms. What are the Fed’s goals? What data do they examine in deciding policy? Why have they been planning to raise rates in any case?
• Then comes my recommendation and its defense: Should the Fed raise rates at its December 13/14 meeting. Why?
• As part of my defense, I should explain the expected effects of a rate increase on real GDP. Will the Fed’s actions slow growth, or trigger recession? I need to be sure to consider confounding factors: is anything raising expected rates of return on investment projects? What is happening to interest rates set by central banks in Europe and Asia? What other factors might affect real GDP?• Conclusion paragraph: I need a concluding paragraph that wraps up the article and reiterates my recommendation.
• The other part of my defense (or a caveat?) should be distribution. The US election certainly underscored the importance of class issues, which economists usually refer to as “distributional issues.” I need to explicitly address how my recommendation would affect workers in areas that used to be centers of manufacturing.
This is the final from Prof. Olney's Fall 2015 offering of Economics 1.
The exam was written and administered in two parts (Parts I & II during the final exam period; Part III due during RRR week).
Part I. Questions Covering the Last
Third of the Course (50 points total; 35 minutes total)
Question 1 (14 points total; 10 minutes total) This question is based on article #21, "How Powerful are Fiscal Multipliers in Recessions?" by UC Berkeley Professors Alan Auerbach and Yuriy Gorodnichenko.
a. (4 points) According to the article by Auerbach and Gorodnichenko (A&G), during what part of the business cycle is the government spending multiplier relatively large? When is it relatively small?
b. (10 points) Auerbach and Gorodnichenko (A&G) estimate that the multiplier was about 0 in the early 1960s. If the economy is on the PPF, why would an increase in G have no effect on GDP? How is the rate of long-run GDP growth relevant to your answer? Draw a PPF that supports your explanation.
Question 2 (12 points total; 8 minutes total) The Phillips curve has a downward slope because, ceteris paribus, there is a tradeoff between unemployment and inflation.
a. (4 points) Why is a drop in unemployment associated with a rise in the inflation rate?
b. (8 points) Offer and defend one explanation for why the Phillips curve may be flatter today than it was twenty years ago.
Question 3 (10 points; 7 minutes) Japan's economy has been in or near recession for over 15 years. The interest rate controlled by Japan's central bank, the Bank of Japan, has been at or near the zero lower bound (ZLB) since 1998. Why is expansionary fiscal policy an important policy tool when interest rates are at the ZLB? Explain why and how expansionary fiscal policy will affect the government's budget deficit.
Question 4 (14 points total; 10 minutes total) The Taylor Rule is a simple equation that describes the connection between macroeconomic conditions and a central bank's interest rate target. In general the Taylor Rule is
interest rate target = neutral interest rate + A*(actual - target inflation) + B*(actual - target GDP growth rate)
a. (4 points) What does "neutral interest rate" mean?
b. (10 points) New Zealand (NZ) and Australia (AUS) each have their own central bank. Estimates of the Taylor Rule for each country, for 1992-2008, are (source: http://www.rbnz.govt.nz/research_and_publications/analytical_notes/2013/an2013_04.pdf)
• NZ: interest rate target = 6.7 + 0.5*(actual - target inflation) + 0.5*(actual - target GDP growth rate)
• AUS: interest rate target = 5.9 + 0.4*(actual - target inflation) + 0.8*(actual - target GDP growth rate)
Define "inflation hawk" and "inflation dove." Which country's central bank – New Zealand or Australia – was more relatively hawkish over the 1992-2008 period? Defend your answer.
Part II. Questions Covering Any Part of the Course (90 points total; 64 minutes total)
Question 5 (10 points; 7 minutes) The local electricity company, PG&E, wants to increase its total revenue earned from selling electricity to residents of the Bay Area. Should PG&E increase or decrease the price it charges for electricity? Explain. If you need to make an assumption in order to answer the question, do so explicitly and defend your assumption.
Question 6 (18 points total; 13 minutes total) Suppose interest rates decline.
a. (8 points) Explain why the decline in interest rates raises investment spending. Does your answer depend upon whether the business is using internal funds (accumulated savings) or external funds (a loan)? Explain why.
b. (10 points) Consider a business in a perfectly competitive industry that is initially at long-run competitive equilibrium. The business purchases additional machinery, which increases labor productivity. None of its competitors buy the machinery. Under what circumstances would you expect this business to now be earning abnormal profit? Show the effect in a graph of the firm that includes its short-run cost curves. Explain what you've drawn and how it relates to your answer to the question.
Question 7 (25 points total; 18 minutes total) All U.S. consumers have a FICO score, which is a measure of the likelihood the individual will make regular and timely payments on a loan or credit card. The FICO score allows lenders to screen potential borrowers, charging higher interest rates or denying credit to those who have bad FICO scores.
Suppose hackers break into the computer system that produces FICO scores. As a result of the hack, the FICO score assigned to any individual is probably wrong. Lenders know the system has been hacked.
a. (10 points) What is the likely effect of the hacking on consumer credit availability? Why? Your explanation should make reference to the concept of asymmetric information.
b. (5 points) In general, what is the likely effect of the hacking on consumption spending? Why?
c. (10 points) Families that can borrow or use credit cards don't have to cut their consumption spending as much following a lay-off or wage cut as do families that can't borrow or use credit cards. Consumer credit availability therefore probably matters more to consumption during a recession than it does during an expansion. Consider the effect of the FICO-system hack on real GDP. Will the effect of the hack on GDP be greater in a recession or in an expansion? Explain. Your explanation should make reference to the concepts of marginal propensity to consume and the multiplier.
Question 8 (20 points total; 14 minutes total) The North America Free Trade Agreement (NAFTA) was implemented in 1994. NAFTA eliminated all trade barriers between Canada, the U.S., and Mexico allowing for tariff-free trade between the three countries. NAFTA was and remains quite controversial.
a. (10 points) Arguments in favor of NAFTA point to the gains from trade. What does it mean for there to be "gains from trade"? What are the conditions under which there will be gains from trade? Your answer should make reference to the concept of comparative advantage.
b. (10 points) Arguments against NAFTA point to the costs of trade. For instance, the Economic Policy Institute in Washington DC argues
[NAFTA] caused the loss of some 700,000 jobs as production moved to Mexico. Most of these losses came in California, Texas, Michigan, and other states where manufacturing is concentrated. To be sure, there were some job gains along the border in service and retail sectors resulting from increased trucking activity, but these gains are small in relation to the losses, and are in lower paying occupations. (http://www.epi.org/blog/naftas-impact-workers/)
Explain how increased trade could cause a loss of U.S. manufacturing jobs. What is a negative effect of the loss of manufacturing jobs?
Question 9 (3 points, 2 minutes)
When you purchase 100 shares of stock in General Electric (a U.S. manufacturing company), is that investment? Explain.
Question 10 (14 points total; 10 minutes total) Just try finding a place to park a car in downtown Berkeley this time of year. The price of parking is $3 per hour. You can park for 2 hours. If you park more than 2 hours, the price jumps: you get a $55 parking ticket. Before the holiday season, most people park for about 90 minutes and then move their car.
a. (5 points) Compare high-income and low-income parkers. You can assume high-income people have income of more than $100 per hour, while low-income people earn minimum wage which is $11 per hour in Berkeley and $9 per hour in the rest of the Bay Area. Which group is receiving more consumer surplus from parking before the holiday season? Briefly (1-2 sentences), explain why.
b. (9 points) Explain why the increased demand for parking at this time of year will result in more parking tickets, but only for high-income people not for low-income people. Supplement your answer with a graph of a person’s demand for parking places. Show separately the demand by a high-income person and the demand by a low-income person. Assume the increase in demand for parking at the holidays is the same for both high-income and low-income people. Vertical axis: price per hour of parking. Quantity axis: # of hours a particular person wants to park.
Part III. The Comprehensive Essay Question (60 points)
Congratulations! You snagged a great job writing for one of the country’s best newspapers. Your first feature story is about the expected increase in interest rates that almost everyone expects the Fed to announce on December 16. Because you are new to the paper, you want to impress your bosses with the breadth and depth of your economic knowledge and with your ability to write a clear and compelling article. Your readers are educated people who have only a rudimentary knowledge of economics.
You’ve sketched out your outline (below), which you’ll use to guide your writing. You’ve decided you might include visual representations of data where appropriate (a figure can be worth a thousand words), but the newspaper you write for doesn’t allow graphs that illustrate economic concepts. Clarity is what matters most to your readers (and thus to your bosses).
Outline
• Intro paragraph. It’s not a mystery novel; I need an intro paragraph that does a good job of letting readers know what I’ll discuss in the article
• Set the stage by discussing Federal Reserve monetary policy in general terms. What are the Fed’s goals as they set monetary policy? What economic data does the Fed consider when setting interest rates? Why does the Fed want to return the federal funds rate to its neutral rate before the next recession begins?
• Now add some context. Why and when did the Fed lower rates as far as they did, and why have they kept them low for so long? Put the Great Recession in historical context: In what ways was the 2007-2009 downturn different from most other downturns since the 1970s? How has the recovery been different from recoveries following previous recessions?
• The Fed will probably raise rates after its December 15/16 meeting. Why now? Why not earlier this year? Why not wait another year?
• The Fed’s inflation target is 2 percent. Why aren’t they waiting until inflation approaches 2% before raising rates? Start by noting what’s actually been happening to inflation rates (best to distinguish here between the all-items CPI inflation and inflation for some of the expenditure sub-categories). Then I can draw on micro principles to explain why increased global competition limits the ability of firms to increase prices in response to changes in demand or in costs of production.
• Now comes the really important part of the article: Explain the expected effects of a rate increase on aggregate demand and real GDP. Will the Fed’s actions slow growth, or trigger recession? I need to be sure to consider confounding factors: is anything raising expected rates of return on investment projects? What is happening to interest rates set by central banks in Europe and Asia?
• Since the Occupy Movement of 2011, distributional issues have been of interest to a lot of people. I better take time to consider whether increased interest rates have differential impacts on different groups in the economy.
• Conclusion paragraph: I need a concluding paragraph that wraps up the article and lets readers know what to expect in coming months
Question 1 (14 points total; 10 minutes total) This question is based on article #21, "How Powerful are Fiscal Multipliers in Recessions?" by UC Berkeley Professors Alan Auerbach and Yuriy Gorodnichenko.
a. (4 points) According to the article by Auerbach and Gorodnichenko (A&G), during what part of the business cycle is the government spending multiplier relatively large? When is it relatively small?
b. (10 points) Auerbach and Gorodnichenko (A&G) estimate that the multiplier was about 0 in the early 1960s. If the economy is on the PPF, why would an increase in G have no effect on GDP? How is the rate of long-run GDP growth relevant to your answer? Draw a PPF that supports your explanation.
Question 2 (12 points total; 8 minutes total) The Phillips curve has a downward slope because, ceteris paribus, there is a tradeoff between unemployment and inflation.
a. (4 points) Why is a drop in unemployment associated with a rise in the inflation rate?
b. (8 points) Offer and defend one explanation for why the Phillips curve may be flatter today than it was twenty years ago.
Question 3 (10 points; 7 minutes) Japan's economy has been in or near recession for over 15 years. The interest rate controlled by Japan's central bank, the Bank of Japan, has been at or near the zero lower bound (ZLB) since 1998. Why is expansionary fiscal policy an important policy tool when interest rates are at the ZLB? Explain why and how expansionary fiscal policy will affect the government's budget deficit.
Question 4 (14 points total; 10 minutes total) The Taylor Rule is a simple equation that describes the connection between macroeconomic conditions and a central bank's interest rate target. In general the Taylor Rule is
interest rate target = neutral interest rate + A*(actual - target inflation) + B*(actual - target GDP growth rate)
a. (4 points) What does "neutral interest rate" mean?
b. (10 points) New Zealand (NZ) and Australia (AUS) each have their own central bank. Estimates of the Taylor Rule for each country, for 1992-2008, are (source: http://www.rbnz.govt.nz/research_and_publications/analytical_notes/2013/an2013_04.pdf)
• NZ: interest rate target = 6.7 + 0.5*(actual - target inflation) + 0.5*(actual - target GDP growth rate)
• AUS: interest rate target = 5.9 + 0.4*(actual - target inflation) + 0.8*(actual - target GDP growth rate)
Define "inflation hawk" and "inflation dove." Which country's central bank – New Zealand or Australia – was more relatively hawkish over the 1992-2008 period? Defend your answer.
Part II. Questions Covering Any Part of the Course (90 points total; 64 minutes total)
Question 5 (10 points; 7 minutes) The local electricity company, PG&E, wants to increase its total revenue earned from selling electricity to residents of the Bay Area. Should PG&E increase or decrease the price it charges for electricity? Explain. If you need to make an assumption in order to answer the question, do so explicitly and defend your assumption.
Question 6 (18 points total; 13 minutes total) Suppose interest rates decline.
a. (8 points) Explain why the decline in interest rates raises investment spending. Does your answer depend upon whether the business is using internal funds (accumulated savings) or external funds (a loan)? Explain why.
b. (10 points) Consider a business in a perfectly competitive industry that is initially at long-run competitive equilibrium. The business purchases additional machinery, which increases labor productivity. None of its competitors buy the machinery. Under what circumstances would you expect this business to now be earning abnormal profit? Show the effect in a graph of the firm that includes its short-run cost curves. Explain what you've drawn and how it relates to your answer to the question.
Question 7 (25 points total; 18 minutes total) All U.S. consumers have a FICO score, which is a measure of the likelihood the individual will make regular and timely payments on a loan or credit card. The FICO score allows lenders to screen potential borrowers, charging higher interest rates or denying credit to those who have bad FICO scores.
Suppose hackers break into the computer system that produces FICO scores. As a result of the hack, the FICO score assigned to any individual is probably wrong. Lenders know the system has been hacked.
a. (10 points) What is the likely effect of the hacking on consumer credit availability? Why? Your explanation should make reference to the concept of asymmetric information.
b. (5 points) In general, what is the likely effect of the hacking on consumption spending? Why?
c. (10 points) Families that can borrow or use credit cards don't have to cut their consumption spending as much following a lay-off or wage cut as do families that can't borrow or use credit cards. Consumer credit availability therefore probably matters more to consumption during a recession than it does during an expansion. Consider the effect of the FICO-system hack on real GDP. Will the effect of the hack on GDP be greater in a recession or in an expansion? Explain. Your explanation should make reference to the concepts of marginal propensity to consume and the multiplier.
Question 8 (20 points total; 14 minutes total) The North America Free Trade Agreement (NAFTA) was implemented in 1994. NAFTA eliminated all trade barriers between Canada, the U.S., and Mexico allowing for tariff-free trade between the three countries. NAFTA was and remains quite controversial.
a. (10 points) Arguments in favor of NAFTA point to the gains from trade. What does it mean for there to be "gains from trade"? What are the conditions under which there will be gains from trade? Your answer should make reference to the concept of comparative advantage.
b. (10 points) Arguments against NAFTA point to the costs of trade. For instance, the Economic Policy Institute in Washington DC argues
[NAFTA] caused the loss of some 700,000 jobs as production moved to Mexico. Most of these losses came in California, Texas, Michigan, and other states where manufacturing is concentrated. To be sure, there were some job gains along the border in service and retail sectors resulting from increased trucking activity, but these gains are small in relation to the losses, and are in lower paying occupations. (http://www.epi.org/blog/naftas-impact-workers/)
Explain how increased trade could cause a loss of U.S. manufacturing jobs. What is a negative effect of the loss of manufacturing jobs?
Question 9 (3 points, 2 minutes)
When you purchase 100 shares of stock in General Electric (a U.S. manufacturing company), is that investment? Explain.
Question 10 (14 points total; 10 minutes total) Just try finding a place to park a car in downtown Berkeley this time of year. The price of parking is $3 per hour. You can park for 2 hours. If you park more than 2 hours, the price jumps: you get a $55 parking ticket. Before the holiday season, most people park for about 90 minutes and then move their car.
a. (5 points) Compare high-income and low-income parkers. You can assume high-income people have income of more than $100 per hour, while low-income people earn minimum wage which is $11 per hour in Berkeley and $9 per hour in the rest of the Bay Area. Which group is receiving more consumer surplus from parking before the holiday season? Briefly (1-2 sentences), explain why.
b. (9 points) Explain why the increased demand for parking at this time of year will result in more parking tickets, but only for high-income people not for low-income people. Supplement your answer with a graph of a person’s demand for parking places. Show separately the demand by a high-income person and the demand by a low-income person. Assume the increase in demand for parking at the holidays is the same for both high-income and low-income people. Vertical axis: price per hour of parking. Quantity axis: # of hours a particular person wants to park.
Part III. The Comprehensive Essay Question (60 points)
Congratulations! You snagged a great job writing for one of the country’s best newspapers. Your first feature story is about the expected increase in interest rates that almost everyone expects the Fed to announce on December 16. Because you are new to the paper, you want to impress your bosses with the breadth and depth of your economic knowledge and with your ability to write a clear and compelling article. Your readers are educated people who have only a rudimentary knowledge of economics.
You’ve sketched out your outline (below), which you’ll use to guide your writing. You’ve decided you might include visual representations of data where appropriate (a figure can be worth a thousand words), but the newspaper you write for doesn’t allow graphs that illustrate economic concepts. Clarity is what matters most to your readers (and thus to your bosses).
Outline
• Intro paragraph. It’s not a mystery novel; I need an intro paragraph that does a good job of letting readers know what I’ll discuss in the article
• Set the stage by discussing Federal Reserve monetary policy in general terms. What are the Fed’s goals as they set monetary policy? What economic data does the Fed consider when setting interest rates? Why does the Fed want to return the federal funds rate to its neutral rate before the next recession begins?
• Now add some context. Why and when did the Fed lower rates as far as they did, and why have they kept them low for so long? Put the Great Recession in historical context: In what ways was the 2007-2009 downturn different from most other downturns since the 1970s? How has the recovery been different from recoveries following previous recessions?
• The Fed will probably raise rates after its December 15/16 meeting. Why now? Why not earlier this year? Why not wait another year?
• The Fed’s inflation target is 2 percent. Why aren’t they waiting until inflation approaches 2% before raising rates? Start by noting what’s actually been happening to inflation rates (best to distinguish here between the all-items CPI inflation and inflation for some of the expenditure sub-categories). Then I can draw on micro principles to explain why increased global competition limits the ability of firms to increase prices in response to changes in demand or in costs of production.
• Now comes the really important part of the article: Explain the expected effects of a rate increase on aggregate demand and real GDP. Will the Fed’s actions slow growth, or trigger recession? I need to be sure to consider confounding factors: is anything raising expected rates of return on investment projects? What is happening to interest rates set by central banks in Europe and Asia?
• Since the Occupy Movement of 2011, distributional issues have been of interest to a lot of people. I better take time to consider whether increased interest rates have differential impacts on different groups in the economy.
• Conclusion paragraph: I need a concluding paragraph that wraps up the article and lets readers know what to expect in coming months
This is the final from Prof. Olney's Fall 2014 offering of Economics 1.
The exam was written and administered in three parts.
Part I Covering not quite the entire last
third of the course (macro but not monetary theory),
administered two weeks before the last day of instruction in
Fall 2014 (60 points)
1. (12 points total; 9 minutes total)
Suppose the economy can be described by the following
equations. All amounts are billions of dollars per year.
C = 1,000 + 0.6YD
TR = 2,000
TA = 3,000
I = 5,000
G = 2,000
EX = 600
IM = 2,000 + 0.2Y
What is the equilibrium level of output and income? Show all your work or you will receive zero (0) points on this question. If you cannot solve this problem without a calculator, set it up and go as far as you can to receive as much partial credit as possible. No calculators allowed during the exam. Please put a box around your answer.
2. (24 points total; 18 minutes total) As the economy improves – lower unemployment, more aggregate demand, faster GDP growth – the Fed will begin increasing interest rates.
A. (6 points; 4 minutes) All else constant, what effect will higher interest rates have on businesses purchases of machinery? Explain.
B. (6 points; 4 minutes) Explain why your answer to part (a) changes if an improving economy leads to two events: an increase in interest rates by the Fed, and an increase in business optimism.
C. (12 points; 9 minutes) Suppose only the U.S. raises interest rates. What effect will higher interest rates have on the value of the dollar vis-a-vis other currencies? On U.S. imports? On U.S. exports? Step-by-step, explain your answers.
3. (14 points total; 11 minutes total)
A. (8 points; 6 minutes) Explain why the initial changes in investment and net export spending result in an even larger total change in real GDP.
B. (6 points; 4 minutes) Consumer spending responds more to changes in income in a downturn than in an expansion. All else constant, when will a one percentage point change in interest rates have a greater effect on GDP: in a downturn, or in an expansion? Explain.
4. (10 points total; 7 minutes total)
(6 points; 4 minutes) According to the article “Stimulating the Economy in an Era of Debt and Deficit,” by Joseph E. Stiglitz, in The Economists' Voice (March 2012), what is one of the usual two objections to using expansionary fiscal policy? Why can this objection be dismissed in the current economic environment? (If you didn’t read the article, say so and we’ll give you 2 points for honesty. If you didn’t read the article and you fill up this space with garbage, you’ll get 0 points for wasting your and our time.)
b. (4 points; 3 minutes) Using the production possibilities frontier model at the right, show the effect of increasing the production of government goods and services. Does it matter whether you begin on, versus inside, the production possibilities frontier? Relate this analysis to the current economic environment.
Part II. Questions covering the entire course (80 points)
Question 5 (16 points, 14 minutes) Consider two different economies: F and A.
Economy F: people in economy F have family and friends with substantial wealth who will help them out financially if they are unemployed
Economy A: people in economy A have family and friends with little or no wealth who therefore can’t help them out financially if they are unemployed
Remember: the marginal propensity to consume out of disposable income (ΔC/ΔYD) is much greater than the marginal propensity to consume out of wealth (ΔC/ΔW).
A. (10 points) In a recession, which economy suffers more? Explain.
B. (6 points) Suppose the government is considering enacting this policy:
If you don’t have family and friends who will help you out when you are unemployed, you can receive extra government unemployment benefits.
What is the moral hazard problem with this policy? (If you don’t know, at least define ‘moral hazard’ for partial credit.)
Question 6 (31 points; 25 minutes)
Oil is a key input to
production of many items. Crude oil prices are falling,
as depicted in the graph (Source: FRB-St Louis).
In the United States, hydraulic fracturing (“fracking”) is a technology developed in the 1940s and widely used to extract oil from the earth. Technological change in 1997 made it much cheaper for oil extraction companies to use fracking in shale, which is a type of rock found in large parts of North America.
A. (10 points) The oil market is a world wide market. Suppose that individual oil extraction companies can be depicted as perfectly competitive firms. Explain why the 1997 technological change led to a big boom in U.S. oil production and a decrease in the world price of oil. Supplement your answer with graph(s).
B. (6 points) If the price of oil fell below $80 a barrel, oil extraction companies using fracking said they would shut down. Explain their decision using relevant economic concepts.
C. (6 points) Draw a production possibilities frontier for the U.S. at the right. Production of oil goes on the vertical axis; production of all other goods and services goes on the horizontal axis. What is the effect of the 1997 technological change? Briefly explain your graph.
D. (9 points) The Fed appears likely to increase interest rates in mid-2015. Does the pattern of oil prices depicted on page 2 make it more likely or less likely that increasing interest rates will harm the economy? Why are inflationary expectations an important part of your answer? If drawing a graph makes your answer more clear, go ahead and include a graph.
Question 7 (14 points; 11 minutes) In January 2014, Mexico implemented a soda tax of one peso per liter, about 10 % of the purchase price. The tax revenue will be used to fund health education programs to further discourage consumption of obesity-enhancing goods.
A. (8 points) Sales of soda fell 10 percent. What can you say about the price elasticity of demand for soda in Mexico?
B. (6 points) Under what condition(s) is the soda tax in Mexico the optimal size?
Question 8 (19 points; 15 minutes)
In Europe, the unemployment rate is above 11 percent, the inflation rate is near 0, and inflationary expectations are falling. The central bank of Europe (ECB, European Central Bank) lowered its target interest rate to 0.05% earlier this year.
A. (6 points) Illustrate the information above in a Phillips Curve. Briefly explain your graph.
B. (3 points) Some observers refer to the German members of the ECB as “hawks.” What does it mean for a central bank board member to be a hawk?
C. (10 points) The ECB is considering implementing quantitative easing because it is at the zero lower bound. What is the “zero lower bound”? What is “quantitative easing”? Does quantitative easing necessarily lead to an increase in economic activity? Reference recent U.S. economic history in your answer.
C = 1,000 + 0.6YD
TR = 2,000
TA = 3,000
I = 5,000
G = 2,000
EX = 600
IM = 2,000 + 0.2Y
What is the equilibrium level of output and income? Show all your work or you will receive zero (0) points on this question. If you cannot solve this problem without a calculator, set it up and go as far as you can to receive as much partial credit as possible. No calculators allowed during the exam. Please put a box around your answer.
2. (24 points total; 18 minutes total) As the economy improves – lower unemployment, more aggregate demand, faster GDP growth – the Fed will begin increasing interest rates.
A. (6 points; 4 minutes) All else constant, what effect will higher interest rates have on businesses purchases of machinery? Explain.
B. (6 points; 4 minutes) Explain why your answer to part (a) changes if an improving economy leads to two events: an increase in interest rates by the Fed, and an increase in business optimism.
C. (12 points; 9 minutes) Suppose only the U.S. raises interest rates. What effect will higher interest rates have on the value of the dollar vis-a-vis other currencies? On U.S. imports? On U.S. exports? Step-by-step, explain your answers.
3. (14 points total; 11 minutes total)
A. (8 points; 6 minutes) Explain why the initial changes in investment and net export spending result in an even larger total change in real GDP.
B. (6 points; 4 minutes) Consumer spending responds more to changes in income in a downturn than in an expansion. All else constant, when will a one percentage point change in interest rates have a greater effect on GDP: in a downturn, or in an expansion? Explain.
4. (10 points total; 7 minutes total)
(6 points; 4 minutes) According to the article “Stimulating the Economy in an Era of Debt and Deficit,” by Joseph E. Stiglitz, in The Economists' Voice (March 2012), what is one of the usual two objections to using expansionary fiscal policy? Why can this objection be dismissed in the current economic environment? (If you didn’t read the article, say so and we’ll give you 2 points for honesty. If you didn’t read the article and you fill up this space with garbage, you’ll get 0 points for wasting your and our time.)
b. (4 points; 3 minutes) Using the production possibilities frontier model at the right, show the effect of increasing the production of government goods and services. Does it matter whether you begin on, versus inside, the production possibilities frontier? Relate this analysis to the current economic environment.
Part II. Questions covering the entire course (80 points)
Question 5 (16 points, 14 minutes) Consider two different economies: F and A.
Economy F: people in economy F have family and friends with substantial wealth who will help them out financially if they are unemployed
Economy A: people in economy A have family and friends with little or no wealth who therefore can’t help them out financially if they are unemployed
Remember: the marginal propensity to consume out of disposable income (ΔC/ΔYD) is much greater than the marginal propensity to consume out of wealth (ΔC/ΔW).
A. (10 points) In a recession, which economy suffers more? Explain.
B. (6 points) Suppose the government is considering enacting this policy:
If you don’t have family and friends who will help you out when you are unemployed, you can receive extra government unemployment benefits.
What is the moral hazard problem with this policy? (If you don’t know, at least define ‘moral hazard’ for partial credit.)
Question 6 (31 points; 25 minutes)
Oil is a key input to
production of many items. Crude oil prices are falling,
as depicted in the graph (Source: FRB-St Louis). In the United States, hydraulic fracturing (“fracking”) is a technology developed in the 1940s and widely used to extract oil from the earth. Technological change in 1997 made it much cheaper for oil extraction companies to use fracking in shale, which is a type of rock found in large parts of North America.
A. (10 points) The oil market is a world wide market. Suppose that individual oil extraction companies can be depicted as perfectly competitive firms. Explain why the 1997 technological change led to a big boom in U.S. oil production and a decrease in the world price of oil. Supplement your answer with graph(s).
B. (6 points) If the price of oil fell below $80 a barrel, oil extraction companies using fracking said they would shut down. Explain their decision using relevant economic concepts.
C. (6 points) Draw a production possibilities frontier for the U.S. at the right. Production of oil goes on the vertical axis; production of all other goods and services goes on the horizontal axis. What is the effect of the 1997 technological change? Briefly explain your graph.
D. (9 points) The Fed appears likely to increase interest rates in mid-2015. Does the pattern of oil prices depicted on page 2 make it more likely or less likely that increasing interest rates will harm the economy? Why are inflationary expectations an important part of your answer? If drawing a graph makes your answer more clear, go ahead and include a graph.
Question 7 (14 points; 11 minutes) In January 2014, Mexico implemented a soda tax of one peso per liter, about 10 % of the purchase price. The tax revenue will be used to fund health education programs to further discourage consumption of obesity-enhancing goods.
A. (8 points) Sales of soda fell 10 percent. What can you say about the price elasticity of demand for soda in Mexico?
B. (6 points) Under what condition(s) is the soda tax in Mexico the optimal size?
Question 8 (19 points; 15 minutes)
In Europe, the unemployment rate is above 11 percent, the inflation rate is near 0, and inflationary expectations are falling. The central bank of Europe (ECB, European Central Bank) lowered its target interest rate to 0.05% earlier this year.
A. (6 points) Illustrate the information above in a Phillips Curve. Briefly explain your graph.
B. (3 points) Some observers refer to the German members of the ECB as “hawks.” What does it mean for a central bank board member to be a hawk?
C. (10 points) The ECB is considering implementing quantitative easing because it is at the zero lower bound. What is the “zero lower bound”? What is “quantitative easing”? Does quantitative easing necessarily lead to an increase in economic activity? Reference recent U.S. economic history in your answer.
Part III. Comprehensive Essay Question (60 points)
Congratulations! Based on your excellent Cal education and your expertise in economics, you have been hired as an economic analyst by JA Homes (JAH), a large nationwide construction company that specializes in residential housing. Your first task is to write a briefing paper that discusses economic factors that will affect JAH’s business environment over the next few years. Your bosses will use your paper in their deliberations about how much to expand (or contract) the firm between now and 2017. Because you are new to the firm, you want to impress your bosses with the breadth and depth of your economic knowledge and with your ability to apply your knowledge in this particular situation. Your paper will be read by your bosses: educated men and women who have only a rudimentary knowledge of economics.
You’ve sketched out the following outline, which you’ll use to guide your writing. You’ve decided you might include visual representations of data where appropriate (a figure can be worth a thousand words), but it doesn’t make much sense to include graphs that illustrate economic concepts. Clear explanations are more valuable to your bosses than textbook/lecture style graphs.
Outline
• Intro paragraph with a recommendation: Should JAH expand or contract in the next three years? Give a brief defense of recommendation. (The rest of the essay will build the detailed defense of the recommendation.)
• Set the stage by discussing the current state of the U.S. economy (unemployment, inflation, growth). Put today in historical context: In what ways is the recovery to date different from recoveries following previous recessions?
• Discuss Federal Reserve policy. Interest rates are key in the housing industry, so it’s important to try to predict what the Fed will do with interest rates in the next year or so. Take time to explain how the macroeconomy affects Fed policy, and how Fed policy affects the macroeconomy.
• JAH builds houses for the middle classes – second, third, and fourth quintiles of the income distribution. Distribution matters. Be sure to distinguish between trends in aggregate income and trends for the middle classes.
• The market for houses can be captured reasonably well with a simple supply & demand model. Put predictions for 2014-2017 in perspective by discussing the various forces that affected the market for houses starting in the early 2000s.
• JAH hires thousands of workers, mostly skilled tradespeople, and there are rumors that the company is considering cutting wages. Include a side note addressing asymmetric information, and how wage cuts may affect labor markets.
• Conclude with a re-statement of the recommendation and its defense: Should JAH expand or contract in the next three years? Why or why not?