Part I. (68 points total; 1 hour total) Questions based on the last third of the course

Question 1. (10 points; 9 minutes)
What is “money”? Who creates money? Explain how money is created.

Question 2. (12 points; 10 minutes)
A.    (3 points) What is the “government’s budget deficit”? Does a tax cut increase or decrease the budget deficit (circle the answer)?
B.    (6 points) Explain why a tax cut leads to a smaller total increase in GDP than does an equal sized increase in government spending. (Simply writing down a formula is not an explanation.)
C.    (3 points) The December 2017 Trump Tax Cut primarily benefited corporations and high income or wealthy individuals. Why was the effect of the tax cut on the economy therefore smaller than it would have been if the tax cut had primarily affected low and middle income people?

Question 3. (22 points; 20 minutes)
Suppose aggregate demand, C + I + G + EX - IM, can be simplified to the following equation
    AD = 900 - 60*i + 0.4Y
The units are billions of dollars per month, and an interest rate of 1 percent is measured as 1 (not 0.01).
Suppose the Taylor Rule for this economy is
    i = 4 + 2*(actual - goal inflation rate) - 1*(actual - goal unemployment rate)
The goal inflation rate is 2 percent (use 2, not 0.02) and the goal unemployment rate is 4 percent (use 4, not 0.04).
A.    (4 points) Is the central bank in this economy relatively hawkish or dovish? Defend your answer.
B.    (7 points) Suppose the interest rate is initially 5 percent. What is the equilibrium level of income in this economy?
C.    (11 points) At the level of income you determined in part A, the unemployment rate is 3.5 percent and the inflation rate is 3 percent. What interest rate target will the central bank now set? Will this new interest rate target bring the economy closer to the central bank’s goals for unemployment and inflation? Explain.

Question 4. (12 points; 10 minutes) 
A.    (6 points) In today’s economy, it’s harder for workers to get promoted. In 2006, it took an average of 2 ½ years to get a promotion; today it takes 4 ½ years. As a result, fewer workers are willing to boost their productivity in an effort to impress the boss and get the promotion. In 2006, 25 percent of employees said they were willing to give “an extra oomph” at work (boost their productivity); today about 15 percent are willing to do so. Explain the connection to the Phillips curve.
B.    (6 points) When an employer lists a job opening, they receive hundreds of applications. Eightfold is a new product that uses artificial intelligence (AI) to scan resumes and quickly and accurately identify the applicants who are the best fit for the job. An economist who studied the use of AI in hiring said, “You get the more nontraditional, equally qualified, equally high-performing people, but the employer doesn’t seem to have to compete for them as much.” What effect might the use of AI have on the slope of the Phillips curve and why?

Question 5. (12 points; 10 minutes)
A.    (9 points) On Nov. 28, Fed Chairman Powell said the current FFR=2.25% is “just below” the neutral rate. That was a surprise; most people thought the neutral rate was about 4 percent. Why did Powell’s statement cause long-term interest rates to fall? How does that affect the slope of the yield curve? Illustrate at the right with two yield curves — one for before and one for after Powell’s statement.
B.    (3 points) One reason the stock market fell so much last week was that many (many!) analysts said “Oh no! This change in the slope of the yield curve means a recession [a drop in aggregate demand] is imminent!” Do you agree? Why or why not?

Part II. Questions from the entire course (72 points total; 1 hour total)

Question 6.    (12 points; 10 minutes)
Explain why an increase in interest rates in the U.S. decreases aggregate demand. Note which effect(s) occur if the increase in interest rates is experienced throughout the world, and which effect(s) occur only if the increase in interest rates is experienced only in the U.S. Be complete.

Question 7.    (12 points; 10 minutes)
The government climate change report issued November 23, 2018 predicts a 10 percent drop in U.S. GDP by 2100 due to climate change. There are multiple sources.
•    There will be increasingly common and severe natural disasters (hurricanes, tornadoes, floods, wildfires)
•    Clean-up and rebuilding after natural disasters will require reallocating resources from other economic activities
•     Infrastructure will be damaged or destroyed more frequently due to the increasingly common natural disasters
A.    (7 points) Explain why and under what circumstances the clean-up and rebuilding after a natural disaster requires a reduction in other economic activities. Use a production possibilities frontier to illustrate your explanation. Put clean-up & rebuilding “(C&R)” on one axis.
B.    (5 points) Explain the effect of damage and destruction of infrastructure on economic growth. Tell us how you would illustrate this in a PPF (but don’t actually draw it).

Question 8.    (12 points; 10 minutes)
Lake Tahoe is a year-round vacation destination on the California/Nevada border. Houses near Lake Tahoe can be occupied by owners, by long-term renters who live year-round and work at Tahoe, or by short-term vacationers (Airbnb rentals). South Lake Tahoe is one town located on the lake. On November 6, voters in South Lake Tahoe banned vacation home rentals (Airbnb rentals) in their town. The ban takes effect on December 20. The ban was favored by people who live and work at Tahoe. The ban was opposed by people who own vacation home rentals. Assume the market for rental houses is monopolistically competitive and before Nov. 6 was in a long-run equilibrium.
•    What are the benefits of the vacation home rental ban for people who live year-round at Tahoe? Why would owners of vacation home rentals be opposed to the ban? In the long run, who will own houses in South Lake Tahoe? Be sure you’ve explained each of your answers.

Question 9.    (12 points; 10 minutes)
The market for oil can be modeled as one worldwide market. OPEC (Organization of Petroleum-Exporting Countries) is an organization of 15 oil-producing countries. OPEC met last week and decided to decrease oil production by 1.2 million barrels per day.
(Not relevant to the question but FYI: The two largest oil-exporters in OPEC are Russia and Saudi Arabia. The US is not a member of OPEC but due to technological change (fracking) and regulatory reform, the US has recently become the #1 producer of oil in the world.)
A.    (7 points) What effect should OPEC’s decision have on the price of oil? Why? Draw a supply and demand diagram that supports your answer.
B.    (5 points) OPEC made this decision in part because oil prices have been falling due to decreased worldwide demand for oil. What does this information suggest is the proper counterfactual to use when analyzing the effect on price of OPEC restricting production?

Question 10.    (24 points; 20 minutes)
Let’s think about gas taxes again. The global Paris Climate Agreement signed by 194 countries and the European Union calls on everyone to reduce global emissions to fight climate change. One strategy for doing so is by taxing purchases of gas (fuel taxes). But recently in France, there have been widespread protests against higher fuel taxes. The protests were led by commercial truck drivers (“truckers”) and poor and working class people.
A.    (10 points) Explain why a tax in the presence of a negative externality can bring the market equilibrium quantity closer to the socially optimal quantity.
B.    (6 points) What are the likely differences in the price elasticity of demand for gas (fuel) between truckers, poor-and-working-class people, and high income individuals? Defend your answer.
C.    (8 points) Traditionally, a gas tax has been assessed as a constant amount per gallon or liter. For instance, according to the OECD, in 2013, gas taxes were $3.29 per gallon in Germany, $1.25 per gallon in Canada, and $0.53 per gallon in the U.S. Charging a constant amount per gallon means gas taxes are a regressive tax: poor and working class people pay a much higher share of their income in gas taxes than do high income people. Suggest and defend a tax scheme that will accomplish two goals: lower consumption of gas, but not disproportionately affect poor and working class people.

Part III. Comprehensive Essay Question (60 points)

You are an intern for a newly-elected Senator who has been appointed to the Senate Banking Committee. This committee confirms appointees to the Federal Reserve Board of Governors. There are currently 3 Board vacancies. The Senator-Elect wants you to prepare a briefing paper on monetary policy that can be used to prepare for questioning Board Chairman Powell or an appointee nominated by President Trump for one of the three Board vacancies.

The Senator-Elect is an educated person with some background knowledge of economics, but has been out of college for a few decades. You were hired for this internship because of the breadth and depth of your economic knowledge and your ability to write. You don’t want to let the Senator-Elect down!

Here’s your drafted outline. Most definitely, include at least the points noted below. You can include visual representations of data as appropriate (a figure can be worth a thousand words; Fred is a good source).

• Intro paragraph. Set the stage. This paragraph should tell the Senator-Elect the focus of the rest of the briefing paper.
• Inflation hawk or dove. Explain the dual mandate of the Fed and what it means to be a hawk or a dove. Give the Senator-Elect a sample question or two that could be asked in a hearing to determine whether Chairman Powell or a Board nominee is an inflation hawk or dove.
• Role of interest rates. The Senator-Elect needs to understand how changes in interest rates affect unemployment and inflation. This will be an important part of the briefing paper.
• Start with the basics, explaining why higher interest rates slow economic growth, relative to the counterfactual.
• Need to explain the concept of the counterfactual in this context!
• Include some caveats – examples of circumstances under which the chain of events from Fed policy to economic growth might not unfold as expected.
• Connect economic growth to changes in unemployment and inflation. Why is there typically a tradeoff between unemployment and inflation?
• Address the puzzle of 2012-2016 when falling unemployment didn’t trigger rising inflation. What are the unanswered questions about the nature of the Phillips curve relationship? Offer the Senator-Elect a question to ask in a hearing to elicit the thoughts of the Chairman or a Board nominee.
• Labor markets are part of the puzzle, so walk the Senator-Elect through an analysis of labor markets.
• Concluding statement: What are the key points the Senator-Elect should keep in mind when questioning Chairman Powell or a Board nominee?

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”)

• 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.

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:

    •    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.
    •    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.

•    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.
•    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?
    •    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.

•    Conclusion paragraph: I need a concluding paragraph that wraps up the article and reiterates my recommendation.

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