ECON 10020/20020

Principles of Macroeconomics

Problem Set 3

Solutions

Dennis C. Plott∗

University of Notre Dame

Department of Economics

February 23, 2015

∗Email: dennis.plott@gmail.com

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Name: Dennis C. Plott

General Instructions

1. Due: Thursday 19th February 2015 by 4:15 p.m.

2. Read and follow all instructions/directions carefully. An inability to follow instructions/directions willresult in points being deducted.

3. All problems sets submitted must be stapled, handwritten, and include the cover page.

4. Only problem sets submitted in person and/or in class will be accepted.

5. Answer all questions in blue or black ink only; i.e., no pencils or colored inks. The only exception: graphsmay be drawn in pencil. Note: use a guide of some sort (e.g., a ruler) for all graphs. Do not use white outor similar products, but neatly cross/scratch out any mistakes.

6. Write, mark, and draw your answers neatly and clearly. If your answer is illegible (i.e., difficult to read inthe least), then it will not be graded. It is your job to clearly communicate.

7. Label all graphs fully and completely; i.e., axes, intersections, curves, etc.

8. Support your answers as thoroughly as possible; i.e., graphically, conceptually, and mathematically. Note:this may not be feasible or necessary for all questions asked. State and define any concept utilized and listand name any equation used. In other words, show all of your work.

9. Do not copy from another student.

10. Note: only use materials from this class, listed textbooks, and suggested resources to answer questions.The Google can be quite useful and tempting, but very often a question has been constructed in a veryspecific manner; i.e., using a certain set of assumptions. Another source may have a very similar problem,but with slightly different underlying assumptions that change the answer completely. This is typicallynot obvious and will likely leave you very confused.

11. For the True/False/Uncertain questions clearly indicate your choice by writing either “True”, “False”, or“Uncertain” underneath the respective question. Unless explicitly instructed otherwise, a justification isrequired to receive credit.

12. For the multiple choice questions, choose the “best” answer and mark the letter in the spaces provided atthe bottom of the page. Only clearly written letters in the allocated space will be graded.

Original Score (%)

Adjustment (%) 0

Actual Score (%)

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1. The owners of a have a separate legal distinction from the business.

(A) corporation X A

(B) partnership

(C) sole proprietorship

(D) All of the above are correct.

2. Jeremy is thinking of starting up a small business selling NASCAR memorabilia. He is considering settingup his business as a sole proprietorship. What is one advantage to Jeremy of setting up his business as asole proprietorship?

(A) As a sole proprietor, Jeremy would face limited liability.

(B) As a sole proprietor, Jeremy would have the ability to share risk with shareholders.

(C) As a sole proprietor, Jeremy would have both ownership and control over the business. X C

(D) All of the above would be advantages of setting up his business as a sole proprietorship.

3. Some corporate governance experts believe that serving on a company’s board of directors for an extendedlength of time diminishes that member’s independence from the company’s CEO. If this is true, it wouldtend to

(A) reduce the principal-agent problem.

(B) increase the principal-agent problem. X B

(C) be in the best interest of shareholders.

(D) have no impact on the company’s performance, since the CEO is only one member of top management.

4. Generally with bond ratings, the higher the rating, the the interest rate an investor will receiveand the the risk that the issuer of the bond will default.

(A) higher; higher

(B) higher; lower

(C) lower; higher

(D) lower; lower X D

5. Abercrombie & Fitch wants to raise $8 million to finance the construction of a new store, and the companywishes to raise the funds through direct finance. Which of the following methods could it use?

(A) It could sell $8 million in bonds.

(B) It could borrow $8 million from a bank.

(C) It could issue $8 million in stocks.

(D) It could choose either A or C. X D

1. A 2. C 3. B 4. D 5. D

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6. If real GDP per capita doubles between 2005 and 2020, what is the average annual growth rate of realGDP per capita?

(A) 4.7% X A

(B) 10.5%

(C) 15%

(D) 21%

According to the Office for National Statistics in the United Kingdom, productivity in the UK in 2012 waswell below the average of the G7 countries, only faring better than Japan. The G7 is a group of the sevenmost industrialized countries, and includes Canada, France, Germany, Italy, Japan, the United Kingdom,and the United States. Compared to the G7 average, the UK was 16% less productive per hour worked,and output was 19% worse when measured on a per worker basis. The productivity gap was the largestfor the UK since 1994. Worker productivity has increased in all of the G7 nations except for the UKsince 2007, where it has fallen by two percentage points. The most productive workers were in the UnitedStates, where workers were 29 percentage points more productive per hour worked than in the UK.1

7. Refer to the Article Summary. Unlike in the UK, labor productivity in the other G7 nations has increasedsince 2007. An increase in labor productivity

(A) will increase the labor force participation rate.

(B) allows the average consumer to increase consumption. X B

(C) will create short-run, but not long-run, economic growth.

(D) will increase output and decrease wages in the long-run.

8. Refer to the Article Summary. depend on increases in labor productivity.

(A) Advances in technology

(B) Decreases in the inflation rate

(C) Decreases in the unemployment rate

(D) Increases in real GDP per capita X D

9. Which of the following is most liquid?

(A) a mutual fund share

(B) a government bond

(C) a corporate bond

(D) a dollar bill X D

10. When the government runs a budget deficit, we would expect to see that

(A) private saving will fall.

(B) investment will fall. X B

(C) G + TR < T .

(D) public saving is positive.

6. A 7. B 8. D 9. D 10. B

1“UK workers much less productive than others in the G7”, Guardian, September 18, 2013.

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11. The demand for loanable funds is downward sloping because the the interest rate, the thenumber of profitable investment projects a firm can undertake, and the the quantity demanded ofloanable funds.

(A) lower; greater; greater X A

(B) lower; smaller; greater

(C) greater; greater; greater

(D) greater; smaller; greater

12. A government budget surplus from reduced government spending (no change in net taxes) will thelevel of investment in the economy and the level of saving (private plus public) in the economy.

(A) increase; decrease

(B) increase; increase X B

(C) decrease; increase

(D) decrease; decrease

13. If net taxes fall by $80 billion, we would expect

(A) the government deficit to fall by $80 billion.

(B) household saving to rise by $80 billion.

(C) household saving to rise by less than $80 billion. X C

(D) household saving to fall by more than $80 billion.

14. Public saving in the economy can be increased by

(A) lowering taxes.

(B) raising government spending.

(C) raising taxes. X C

(D) raising transfer payments.

15. Economist Steve Landsburg2 has pointed out that Ebenezer Scrooge’s change in behavior from miser tospender might actually be detrimental to the economy because

(A) Scrooge’s miserly saving helped contribute to the production of investment goods rather thanconsumption goods. X A

(B) Scrooge was happiest when he was saving money, and happiness is the key to economic growth.

(C) saving has to be greater than consumption for the economy to grow.

(D) Scrooge’s consumption habits were more detrimental to the environment than were his earlier savinghabits.

11. A 12. B 13. C 14. C 15. A

2Slate “What I Like About Scrooge: In Praise of Misers” by Steven E. Landsburg 9 December 2004

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16. The demand for durable goods

(A) has decreased over time.

(B) declines by a greater percentage than does GDP during a recession. X B

(C) declines by a smaller percentage than does GDP during a recession.

(D) rises by a greater percentage than does GDP during a recession.

17. The Business Cycle Dating Committee, a part of the , officially decides when a recession beginsand ends.

(A) federal government

(B) Bureau of Labor Statistics

(C) National Bureau of Economic Research X C

(D) Federal Reserve

18. The Business Cycle Dating Committee defines a recession as

(A) two consecutive quarters of declining real GDP.

(B) two consecutive quarters of declining nominal GDP.

(C) a significant decline in activity visible in industrial production, employment, real income, andwholesale/retail trade lasting more than a few months. X C

(D) a significant decline in inflation and unemployment lasting more than a few months.

19. According to Douglass North, the Industrial Revolution occurred in England because

(A) the British Parliament took control of the government and could credibly commit to upholdingproperty rights. X A

(B) the British monarchy took control of the government and pledged not to raise taxes arbitrarily.

(C) the British courts became tied to the king and began to refuse to enforce property rights.

(D) the British Parliament instituted a command economy structure and implemented a planned economy.

20. If real GDP per capita in Ireland is estimated to be $7,400 in 2014, what will real GDP per capita be in2019 if real GDP per capita grows at an annual rate of 2.8%?

(A) $7,607

(B) $8,496 X B

(C) $9,472

(D) $20,720

16. B 17. C 18. C 19. A 20. B

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21. If GDP per capita rises by 2% between 2013 and 2014, which of the following is necessarily true?

(A) Real GDP has risen by more than 2%.

(B) The population has decreased.

(C) The population has increased, but by less than 2%.

(D) None of the above is necessarily true. X D

22. According to Joseph Schumpeter, the theory of creative destruction describes a process by which

(A) some new products unleash a gale of destruction that drive other new products out of the market.

(B) new products unleash a gale of destruction that drives old products out of the market. X B

(C) new products are created by the destruction of capital.

(D) the creation of new products never involves the destruction of old products.

23. An increase in the real interest rate will

(A) cause consumers to spend more and save less.

(B) most likely lower consumers’ purchases of durable goods. X B

(C) most likely lower the reward to savings.

(D) most likely lower the cost of borrowing.

24. Which of the following will raise consumer expenditures?

(A) an increase in interest rates

(B) a general decline in housing prices

(C) an increase in expected future income X C

(D) an increase in the price level

25. Decreases in the price level will

(A) lower consumption because goods and services are less affordable.

(B) raise consumption because goods and services are more affordable.

(C) raise consumption because real wealth increases. X C

(D) lower consumption because real wealth decreases.

21. D 22. B 23. B 24. C 25. C

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26. If national income increases by $20 million and consumption increases by $5 million, the marginal propensityto consume is

(A) 4.

(B) 0.75.

(C) 0.5.

(D) 0.25. X D

27. Which of the following best describes the “wealth effect”?

(A) When the price level falls, the real value of household wealth falls.

(B) When the price level falls, the nominal value of household wealth falls.

(C) When the price level falls, the nominal value of household wealth rises.

(D) When the price level falls, the real value of household wealth rises. X D

28. If firms are more pessimistic and believe that future profits will fall and remain weak for the next fewyears, then

(A) investment spending will fall. X A

(B) investment spending will rise.

(C) investment spending will remain unaffected.

(D) investment spending will rise and then fall.

29. Which of the following is a true statement about the multiplier?

(A) The multiplier rises as the MPC rises. X A

(B) The smaller the MPC, the larger the multiplier.

(C) The multiplier is a value between zero and one.

(D) The multiplier effect does not occur when autonomous expenditure decreases.

30. John Maynard Keynes argued that if many households decide at the same time to increase saving andreduce spending,

(A) this may benefit the economy in the short-run, but not in the long-run.

(B) the economy will benefit in the short-run and benefit by an even greater amount in the long-run.

(C) this will have a major negative impact on the economy in both the short-run and in the long-run.

(D) this may benefit the economy in the long-run, but could be counterproductive in the short-run. X D

26. D 27. D 28. A 29. A 30. D

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31. The “interest rate effect” can be described as an increase in the price level that raises the interest rateand chokes off

(A) government spending.

(B) government spending and unplanned investment.

(C) investment and consumption spending. X C

(D) net exports.

32. An increase in the price level will

(A) shift the aggregate demand curve to the left.

(B) shift the aggregate demand curve to the right.

(C) move the economy up along a stationary aggregate demand curve. X C

(D) move the economy down along a stationary aggregate demand curve.

33. If stricter immigration laws are imposed and many foreign workers in the United States are forced to goback to their home countries,

(A) the long-run aggregate supply curve will shift to the right.

(B) the long-run aggregate supply curve will shift to the left. X B

(C) we will move up along the long-run aggregate supply curve.

(D) we will move down along the long-run aggregate supply curve.

34. Workers expect inflation to rise from 3% to 5% next year. As a result, this should

(A) shift the short-run aggregate supply curve to the left. X A

(B) shift the short-run aggregate supply curve to the right.

(C) move the economy up along a stationary short-run aggregate supply curve.

(D) move the economy down along a stationary short-run aggregate supply curve.

35. The invention of the integrated circuit by Jack Kilby of Texas Instruments gave rise to the informationage. What did this technological change do the short-run supply curve?

(A) It shifted the short-run aggregate supply curve to the left.

(B) It shifted the short-run aggregate supply curve to the right. X B

(C) It moved the economy up along a stationary short-run aggregate supply curve.

(D) It moved the economy down along a stationary short-run aggregate supply curve.

31. C 32. C 33. B 34. A 35. B

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36. The Federal Aviation Administration’s (FAA) Next-Gen technology, NextGen Wake Turbulence Recater-gorization (Wake RECAT), is designed to save time and fuel while reducing CO2 emissions. Firms, suchas FedEx, are able to increase their flight operations thereby providing more reliable delivery of packages.Assume, for simplicity, this is a permanent change in technology for all air transport in the United States.3

Note: the two largest air delivery and freight service companies, UPS and FedEx, deliver approximately6.5 billion packages per year; i.e., this change in technology will affect the entire economy.

For the following questions only analyze the pure change in technology (i.e., partial equilibrium analysis).Assume the nominal wage is fixed in the short-run and all markets begin in long-run equilibrium. Forchanges in the variables of interest, reference the initial level, unless instructed otherwise, in both theshort-run and long-run.

(a) Use the Solow growth model to show graphically, ceteris paribus, what effects, if any, the change intechnology would have on the: (i) capital to labor equilibrium and (ii) output per capita equilibriumin the very long-run. State explicitly what happens to each of the variables of interest; i.e., increase,decrease, unchanged, or ambiguous. No explanation is necessary for full credit.

k

y

A0f(k)

A1f(k)

sA0f(k)

sA1f(k)

(n + d)k

k∗0

y∗0

k∗1

y∗1

• ∆k∗ > 0

• ∆y∗ > 0

3“FedEx Increases Efficiency with Cutting-Edge Technology” 12 February 2015 by Jerica Phillips

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(b) Demonstrate the change in technology using the closed loanable funds (goods) market, ceteris paribus,in the long-run. Clearly explain the economic rationale for why the curve(s) shift, if at all. Stateexplicitly what occurs to the (i) real interest rate, (ii) quantity of savings, and (iii) quantity ofinvestment; i.e., increase, decrease, unchanged, or ambiguous.

r

S, I

I0(A0)

I1(A1)

S0

S0 = I0 S1 = I1

r1

r0

• ↑ A ceteris paribus−−−−−−−−−−→ higher expected future profitability for firms (a shifter of the desired investmentcurve −→ increase the quantity of investment (∆I > 0) at every level of the real interest rate;i.e., a shift rightward

=⇒ ∆r > 0

An increase in the real interest rate increases the opportunity cost of holding “money”.

Household will increase their quantity of saving; ↑ r c. p.−−−→↑ S =⇒ ∆S > 0

(i) ∆r > 0

(ii) ∆S > 0

(iii) ∆I > 0

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(c) Demonstrate the change in technology using the AD − SRAS − LRAS graph, ceteris paribus, inboth the short-run and long-run. Clearly explain the economic rationale for why the curve(s) shift, ifat all. State explicitly what occurs to the (i) price level, (ii) natural rate of output, and (iii) output,(iv) nominal wage; i.e., increase, decrease, unchanged, or ambiguous.

P

Y

AS1(A1,W0)

AS2(A1,W1)

AD0(I0)

AD1(I1)

AS0(A0,W0)

LRAS0(A1) LRAS1(A1)

Y 0 = Y0 Y 1 = Y2

P0

P1

P2

b

a

z

Y1

• increase in technology (given) −→ ↑ A ceteris paribus−−−−−−−−−−→ increases expected future profitability offirms −→ ↑ I −→ AD curve shifts rightward

• increase in technology (given) −→ ↑ A ceteris paribus−−−−−−−−−−→ increase in the full-employment capacityof the economy −→ shift LRAS curve rightward [production function: Y = AF (K,L)]

• increase in technology (given) −→ ↑ A ceteris paribus−−−−−−−−−−→ SRAS rightward.

• Note: As drawn, corresponds to the expansionary portion of the business cycle (Y > Y ). I thinkthis makes the most intuitive sense, but theoretically can be drawn with recessionary pressure(Y < Y ). On an exam I would specify. Consequently, the price level, P is ambiguous since itdepends on how much/far the AS and AD curves shift rightward.

– Short-Run (a− b)

∆P < ?

∆Y > 0 (Y > Y [As drawn])

∆Y > 0

∆W = 0

– Long-Run (b− z)Nominal wages become flexible in the long-run. In the short-run, due to the increase intechnology, Y > Y [As drawn]; i.e., expansion. When contracts are renegotiated or newworkers hired, workers will receive a higher nominal wage (↑W ). ↑W −→ higher input pricesfor firms allowing for lower production relative to the short-run equilibrium. The SRAS willsubsequently shift leftward until the economy returns to long-run equilibrium (Y = Y ). Justto reiterate, the opposite would occur if the graph was drawn with recessionary pressure.

∆P < ?

∆Y > 0 (Y = Y )

∆Y > 0

∆W > 0 [As drawn]

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Note: I do not know how authentic this is, but I thought you might enjoy it.

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