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Fall 2017 Final Exam

This is a standard, 3-hour final exam. The 10 multiple choice questions [not included here] are worth 1.5 points each, the 12 short-answer questions are worth 5 points each. The total exam will thus be 75 points.

Good practice is to read through the entire exam before you answer any question. Think! – I don’t ask the same question twice. All key in to one of our core concepts; look for jargon or examples that point you towards the appropriate framework. From your end, use our jargon – show you know how to play the game.

I provide brief indications of how you might answer below.

Part II: Short Answer Questions

  1. Y ≡ __ + __ + __ + __ – __ .
  2. Elaborate – what does each of the letters stand for?

  3. U is our metric for the health of labor markets. What does it measure, and what does it miss?
  4. Captures those actively looking for work, but misses those discouraged and underemployed so normal “headline” metric understates social costs. And so on.

  5. What is π? What does it measure, and what does it miss?
  6. The most common inflation measure uses the CPI to compare the cost of a standard basket of goods and services at two points in time. However the normal measure is slow to capture changes in consumer behavior – new goods, new shopping outlets – and quality changes and substitution among similar goods. It likely overstates the “true” change in the cost of living by about 1 percentage point. Similar measures capture economy-wide inflation (the GDP deflator) and price changes for other components of GDP.

  7. (S – I) + (T – G) ≡ (X – M). Use this framework to explain “crowding out.”
  8. This is an accounting identity, true by definition. If for example T taxes decrease, then the left hand side becomes more negative. So either the trade balance (X-M) must decrease or investment I must decrease (savings decisions and the government budget aren’t directly affected by changes in T).

  9. The “multiplier” – what is it, how does it work, when is it relevant?
  10. If there is an exogenous “injection” – an increase in X or I or G or Tr – or a decrease in taxes, then that will lead to an increase in AD and more people employed to meet that higher demand. They in turn consume that income, though some flows to imports, or taxes, or savings. That boosts AD a bit more. And the cycle repeats. In the pure case GDP thus rises about 1.5-2.0x the initial boost. However, that’s subject to the economy having commensurate slack. If there’s no unemployment, then a combination of inflation and offsetting reductions in AD due to the Fed’s response of boosting of interest rates will lead to a smaller multiplier.

  11. FP: τ, Tr and G. How would you use them to stimulate the economy? which are more (or less) effective?
  12. These are the tools of fiscal policy. Direct measures (G) are better than indirect (Tr – may be saved) and especially the very indirect (τ, businesses may not invest and especially if given to the wealthy, will be used for saving rather than consumption). All tend to “crowd out” I or (X-M).

  13. **“MP is flexible but unreliable as a tool for stimulating the economy.” Explain.
  14. You can lead a horse to water but you can’t make him drink. In addition, the magnitude of the response is uncertain and takes 18 m/s to have a full impact. But it does tend to “crowd in” I and (X-M), unlike FP. Flexibility … [you should know].

  15. Rounded off, today short-term interest rates are 1%, inflation is 2% and real growth is 3%. Is MP “accommodative” or “contractionary”? Why? What might a neutral policy look like?
  16. Real interest rates are thus 1%-2% = -1%. That’s much less than the growth rate, so this is highly stimulative. A neutral rate would be about the nominal growth rate of the economy, 3% real + 2% inflation = 5%.

  17. We face a tradeoff in that higher output can generate inflation. What are the strengths and limitations of this approach? Use appropriate jargon.
  18. The Phillips Curve suggests that deliberately slowing the economy – creating U – will lower π. Likewise boosting growth will lower U but raise π. However, that relationship isn’t empirically stable, as over time wages tend to rise with inflation so the curve shifts up / down. It likewise can be offset by changes in AS, as we saw with the 1970s stagflation when both U and π increased.

  19. The Box – the 40-foot shipping container – has raised incomes around the globe. Explain, tracing the economic logic and employing appropriate jargon.
  20. The reduction in shipping costs is functionally equivalent to a decrease in tariffs, allowing greater specialization via trade, in accord with the Law of Comparative Advantage. That boosts incomes by raising TFP (shifting AS to the right). US incomes rose, as clothing became cheaper. Chinese and Bengali incomes rose too, as jobs making clothing boosted incomes, while their countries could now afford to buy Boeing jets.

  21. Y = f (K, L, TFP). Answer ONE of (a) or (b).
    1. Insects evolve quickly, a problem for farmers. Bacteria and viruses evolve more quickly, a problem for everyone – and no new antibiotic has been found for 3 decades. So what?
    2. “Demography is Destiny.”
  22. A. As with the plague in 14th century Europe, this could lead to a very large, negative shift left in AS. Overall TFP will fall, as workers are absent more frequently, and children suffer in their schooling. Healthcare costs would likewise rise. The cumulative effect would likely be much greater than the rise in oil prices in the 1970s. If (as in the 14th century) this is sudden, then it can improve the land/man ratio in agriculture, particularly important in developing countries, and will more generally lead to higher K/L, improving the wages of those who survive. But the more likely impact is a general increase in illness.

    B. A decline in the TFR total fertility rate lowers the dependency rate and so boosts the share of population of working age, boosting GDP. That “demographic dividend” is amplified by greater participation of women in the labor force, as they spend fewer years in childcare. Eventually – as is happening in China, Japan, Europe and the US – this process runs out. The labor force stops increasing and old-age dependency rises. Of course when L grows slowly, so does GDP. And more of GDP must be devoted to retirees, slowing income growth for those who are working. The primary effect is through “L” though in the end game slower growth likely leads to lower investment and hence lower growth of K and TFP.

  23. Cyclical and structural, rules versus discretion: policymakers are not prescient, are subject to group-think and face pressure to prioritize short-run political considerations. Bad policy results, and bad macroeconomic policy is extraordinarily costly. One workaround is to eliminate discretion by imposing rules for setting policy.

    An example is to adopt a rule that the structural budget deficit be kept within a range of ±1% of GDP. Compare this with a “balanced budget amendment” that requires the deficit be kept at 0% of GDP. What happens in a recession under each rule, and how would FP need to respond?

If we mandate a balanced budget, then an economic boom, which would increase tax receipts, would lead to a budget surplus and thus would force either an expenditure increase or a tax cut. That would amplify any such change. Ditto on the bust side. So such a rule would be destabilizing, leading to a much more serious boom/bust cycle.
However, those changes would be to the “cyclical” component of the budget. A rule that focused on the “structural” component would accept that budgets tend to move towards surpluses in a boom and (greater) deficits in a slow economy. Such a rule might make sense. Of course under such a rule, Congress would not have been able to pass the recent tax cut. (Oddly, some of the most vocal supporters of a “simple” balanced budget amendment voted for the tax cut – our local Rep Bob Goodlatte is an example. But he’s a lawyer, and apparently doesn’t remember how to do arithmetic…)